Market and Porfolio

Stocks fell on Wednesday to finish with sizeable losses, but they managed to close off their session lows.

The Nasdaq lost 1.5%, while the S&P 500 shed 1% and ended under the 1400 level. The Dow Jones industrial average dropped 0.9%.  This will end NASDAQ’s 7 week winning streak.

The day’s news largely was on the negative side. The Institute for Supply Management’s service sector index fell 1.3 points in March to 56, indicating the sector continues to expand, but it was below forecasts. Payroll services provider ADP said private companies added 209,000 jobs last month, below expectations. And there were lingering worries over the latest Fed minutes, which came out Tuesday and indicated policymakers are not planning for additional economic stimulus measures.  Finally Spanish bond sale reminded that the PIIGS are still lurking around.

Now the question is – Whether SPX will break the 3 month trend line? This breach of support will be indicative of changing sentiment. And finally our good old 50 DMA will come into prominence. But these things do happen after such a run up. In fact we might see some more profit taking tomorrow based on the long weekend ahead, specially to ward off surprises by Euro and Friday’s  job data.

Now if you look around most of the leaders hung in today with minor correction on low volume to average volume. The leaders of this bull market seem healthy and in control. Some such as PCLN bucked the trend today. On equity side SNDK lost 7% after company cut its revenue forecast and trimmed it’s margin.

Portfolio Time –

The only company to be beaten up today was ALLT. It has been up more than 55% YTD, but 8 out of 11 analyst, who follow this name, maintain buy recommendation on it with average price target of $25. SXCI and  URI almost gave back their yesterday’s gains.

Declining crude is taking its toll on WLL, CLR and APA, though continental is clinging to the 50 DMA.

The earning’s change in latest quarter mentioned above is not correct. It seems that Telechart lags the fundamental data update by a month or so. I recently trimmed FFIV, sold all ALXN. I might close CLR and URI of the 50 DMA is broken comprehensively. I plan on taking some profit off ALLT and LNKD. The idea behind taking profit is to have enough cash in hand to a scoop new buys or make additional buys when stocks bounce of the 50 DMA, such as CRUS below.

Lastly during such times, when market is going sideways, keep an eye on Leaders. They will break before market craters. Thus acting as precursor to the impending correction. The leaders of this market are ULTA, SCSS, AAPL, PCLN, CMG, ISRG, TPX, STX, FFIV, EMC, VMW, RAX, etc.

Some good reads –

  • Employment up 209K (ADP)
  • ECB holds steady (MW)
  • Fed signals no need for more easing (BL)
  • Gold continues post-FOMC minutes fall (BL)
  • Copper falls as dollar rises (REU)
  • Brent slips toward $124 on Saudi supply (REU)
  • Sagging orders suggest eurozone in recession (FP)
  • Eurozone retail sales disappoint (REU)
  • German factory orders disappoint (BL)
  • Spanish yields reach 12-week high (BL)
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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.

FaceOff – China data vs US data

And the winner is China PMI. The Dow ended lower for a third consecutive session dropping 78 points as concerns mount over China’s manufacturing index being down for the 5th month in a row.  The S&P 500 lost 10 points today and the NASDAQ lost 12 points. This was despite the fact that new jobless claims fell more than expected last week, while an index of leading economic indicators for February rose more than forecast.

China’s manufacturing activity shrank in March for the fifth straight month, while manufacturing in the 17-member euro zone contracted more than expected, led by declines in France and Germany. This took toll on sectors such as energy, materials and industrial.

But despite all this we are still in bull as long as we hang onto 1370 in S&P 500. This current mild weakness in the averages is not unexpected given the magnitude of the market move from October of last year.  It would not surprise me to see continued short term sideways action over the near term or even a drop of 2% points.

So if you look at charts above 1370 will act as pivot point. The reasons are – you have previous high support, 50 DMA and the trend line support. Moreover the breakouts did not disappoint today – look at LNKD, WDC, ALLT and GNC. Surprisingly LULU reversed even after not so weak guidance. LULU might have lost it’s momo status.

Good Reads. Tons of them today –

China & Eurozone factories shrink (REU)

Another day of Copper beating (BL)

Keystone XL – Again! (BL)

US Economy and Sentiment (BL)

Hunger Games (MW)

Oil lower amid talk of tapping reserves (FIN)

Gold in tandem with China as well! (REU)