The Data Effect – STX and WDC

The amount of information requiring storage is growing rapidly, which should continue to fuel demand for storage for years to come. Secular trends toward increasing storage requirements–the creation, sharing, and aggregation of digital content, data backup requirements, and the increasing use of storage in consumer electronic devices–have been a boon for hard disk drive makers in recent years. Industry shipments have grown by double-digit rates in each of the past eight years except 2009.

Seagate Technology –

In general Seagate’s revenue, 65%-75% comes from original-equipment manufacturers like Hewlett-Packard, Dell, and EMC; the balance is from distributors that resell to smaller firms, as well as retail stores. The company is the largest producer of mission-critical enterprise drives. It enjoys a market share of 50-60% in the enterprise segment.

But STX fails to match the margins of its competitor-in-chief Western digital. Off late Seagate has placed increasing emphasis on becoming a leaner company in hopes of emulating the low operating expenses of Western Digital. Significant upside to current operating margin levels exists if Seagate can successfully lower its selling, general, and administrative and research and development costs.

Valuations of STX

Following are the historical earnings and stock price for Seagate –

Year

EPS

High ($)

Low ($)

2007

1.39

28

20

2008

2.7

26

3

2009

-5.13

18

2

2010

3.34

21

9

2011

1.24

18

9

2012

6.24

 

 

2013

8.74

You can see from the above table that earnings are estimated to explode in next couple of years if the company sustains a margin of 22-26%. Even after flooding inThailand that disrupted the data storage devices industry, Seagate was able to generate excellent margins and sell units at premium of 68$ instead of historical average of 60$.

Let’s look at relative valuations.

P/E 13
P/E 5 Year Range 3-17
Forward P/E 3
ROE 22%
Cash Flow/Share 3
R&D Expense of sales 8%
Beta 1.30

Even after rallying 70% year to date this stock has a forward P/E of 3.2. On the basis of historical P/E and based on industry trend I am looking at stock price of 40$ in next 12 months, consensus is 35$. This means that STX has 50% upside from current level. The 2012 earnings of at least 6$ is substantiated by the numbers that we saw in latest quarter. Seagate’s second-quarter revenue of $3.2 billion was at the high end of management’s recently revised outlook, and the 31.6% gross margin was well ahead of its historical margins thanks to favorable hard drive pricing. Impressively, Seagate generated $576 million in free cash flow during the quarter, which is roughly triple its average quarterly free cash flow generation and substantially higher than the $421 million generated in all of fiscal 2011.

Finally the icing on the cake is the 3% dividend yield. The management has excellent return on equity track record and has repurchased shares from time to time.

Chart Time –

When to buy – You can add STX around 26.9-27.1$ and double it up if it goes down to 50 DMA i.e. 25.5$. The stock has good support at 24.5$ as well. So unless we see Mayan calendar effect or Ben Bernanke stops printing $, I suggest that you stay put.

Enter Western Digital –

This is another behemoth in the HDD industry. Western Digital has operationally outperformed its peers in recent years, having the lowest operating expense levels while being the industry’s most successful company in the M&A field during the past decade. With the acquisition of Hitachi’s hard drive unit, the company will become the world’s largest hard drive manufacturer by both unit volume and revenue. The Hitachi acquisition gives WD a major presence in the mission-critical enterprise market. Successful share growth here is likely to increase the firm’s gross margin profile.

Valuations of WDC

Following are the historical earnings and stock prices for WDC –

Year

EPS

High ($)

Low ($)

2007

1.94

31

16

2008

4.38

40

9

2009

2.54

44

11

2010

6.05

47

23

2011

3.28

41

22

2012

6.56

 

 

2013

8.71

This paints almost a similar picture as STX.

P/E 10
P/E 5 Year Range 3-13
Forward P/E 5
ROE 15%
Cash Flow/Share 5.89
R&D Expense of sales 7%
Beta 1.22

The earnings upside gives this stock a forward P/E of 5.7. Hence the consensus target price of this stock is around 60$. This is based on the assumption that the supply chain disruptions will be relatively short-term in nature, and there will be a significant snap-back in revenue and operating profits in 2013 as the firm benefits from the effects of recent industry consolidation.

On the contrary, the imbalance between supply and demand should allow Western Digital to maintain average selling prices at or near $65 per unit, down moderately from $69 per unit obtained in the current quarter. Western Digital has not seen average selling prices above $60 since 2007, and the current favorable pricing environment allowed the firm to generate record gross margins of 32.5% in the current quarter versus an average gross margin of 20% earned between 2006 and 2011. But again this is a short lived phenomenon and the prices will decline to historical levels as the supply settles.

Chart Time –

The Stock recently broke out from a 7 week base on above average volume but it will face tough time going above 48-50$.

When to buy – You can buy some around 41.5-42$ and add to the position if the stock goes to 39-40 which will also be the 50 DMA and hence providing good support to the stock.

Devil’s Advocate

Although these secular trends remain intact, emerging substitute technologies pose an increasing threat.

Solid-state drives, which use NAND flash memory, are the primary threat to hard drive manufacturers. NAND has distinct performance advantages over disk drive technology, including faster read/write times and lower power consumption.

The second major technology risk is the cannibalization of HDD by Cloud technology. The latest optical drives used in cloud technology by companies such as EMC is faster and smarter. I have personally worked on TIER1 and TIER2 VMAX storage of EMC. These devices have lower I/O wait times and faster reads/writes than standard HDDs. The device is adaptive in nature and optimizes its performance on the basis of the data it reads and writes – it evolves.

The bottom line is HDD industry will see a decline but maybe towards the other half of this decade. SSD technology currently costs between 5 and 20 times more than a disk drive on a cost/gigabyte basis.

Don’t write of HDD companies as yet

Though SSD costs are falling quickly, HDD costs are falling as well. Disk drive reductions are predominantly driven by increasing areal density, or the number of gigabytes that can be stored on a disk platter. During 2011-12, annual areal density gains of 20%-30% are expected, which alone will drive almost similar annual cost reductions on a cost/GB basis. These will occur because of refinements to perpendicular media recording, the current (and aging) generation of disk (media) technology that has led to large areal density gains during the past few years. Heat-assisted magnetic recording is expected to take the reins from PMR by 2013, and as a result, it is expected that 30%-40% annual increases in areal density are likely to continue in future years. The resulting cost reductions should be sufficient to keep SSDs on the fringes of the mainstream computing market for at least a few more years, given that annual NAND cost reductions are expected to be in the 35%-40% range during the next few years.

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4 comments on “The Data Effect – STX and WDC

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