Even in the best of times, the disk drive business has been fiercely competitive and prone to brutal cyclicality. While Seagate (NYSE:STX) has survived long enough to be a leading player in disk drives, the company's future is still under assault. In the short-term, there are ample worries about whether the PC market will have a decent 2011 and survive the inroads made by alternatives like tablets and phones from Apple (Nasdaq:AAPL), Dell (Nasdaq:DELL), Samsung and Research In Motion (Nasdaq:RIMM). Longer term, there is the question of whether conversion to solid state drives will supplant the core of Seagate's business entirely.

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The Quarter That Was
For the here and now, Seagate is posting mediocre performance. The company's fiscal second quarter met consensus and was in line with a prior preannouncement. What's more, this cyclical malaise really did not surprise anybody all that much.

Consequently, there is not so much concern that revenue rose 1% sequentially, but fell 10% from last year's level. Gross margin was a bit more of a concern, though, as the performance was relatively feeble (gross margin declined 1,100 basis points from last year's level). Likewise, operating income was weak, falling by 64% on a year-over-year basis.

All in all, Seagate's performance was hurt not only by a general slowdown in PCs, but a decision not to compete on price in certain markets. As a result, unit volume declined and the company had less operating efficiency. One small bright spot was the company's non-computer business, where there was some volume strength in drives for applications like DVRs and gaming consoles.

The Road Ahead
More of a concern to the Street than past performance was Seagate's relatively conservative near-term outlook for the hard drive market. It was not really out of step with what Western Digital (NYSE:WDC) said a bit earlier, but also not what investors really want to hear. It also sets up an interesting contrast with other industry players. Intel (Nasdaq:INTC) sounded pretty optimistic about PC shipments for 2011, and Nvidia (Nasdaq:NVDA) likewise seems relatively positive on the PC market.

Outside of these processor and graphics players, PC-sensitive chip players like Marvel (Nasdaq:MRVL) and ON Semiconductor (Nasdaq:ONNN) do not sound all that dour either. So the question may be whether there is channel inventory issues in the drive space and if not, why there is such divergent outlook. Of course, timing can always be a factor as well - perhaps the optimism from Intel is more loaded towards the back end of the year and Seagate is more focused on the very near-term.

Taking a longer view of Seagate, though, there are both reasons for hope and concern. Solid state drives remain a very real threat to the core of Seagate's business. While Seagate does have its Pulsar SSD line and a joint venture with Samsung in enterprise SSD, the fact remains that companies like Intel, Micron (NYSE:MU), Samsung, and Sandisk (Nasdaq:SNDK) have been at the memory chip game longer and there is not much evidence yet to argue that Seagate and Western Digital can elbow their way into this market. As SSD prices keep declining, performance keeps improving, and devices like tablets take more share from PCs, it will become an increasingly significant issue.

On the positive side, at least Seagate has some alternatives and opportunities. The company can build from the Pulsar and has the financial resources to acquire more technology. Moreover, the story is really just beginning for the company's i365 business. There will be plenty of competition in cloud-based data backup and recovery, including Seagate customers like EMC (NYSE:EMC), Dell, and Hewlett Packard (NYSE:HPQ), but i365 could be an underappreciated ace in the hole for Seagate.

The Bottom Line
Like so many of yesteryear's once-hot tech companies, Seagate trades at a rather undemanding valuation. If Seagate can limit its 10-year free cash declines to a CAGR of 2% and produce low single-digit growth thereafter, the shares could be undervalued by 20% or more. In other words, the market is pricing Seagate as though it will do little more than hold the fort in the future. Bears will certainly point to the expansion of solid state memory as the death knell of Seagate, but bulls who believe that Seagate can find a way to stay in the game could be rewarded for their patience. (The CAGR is a good and valuable tool to evaluate investment options, but it does not tell the whole story. Check out CAGR: The Good, The Bad And The Ugly.)

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Tickers in this Article: STX, DELL, EMC, WDC, RIMM, HPQ, AAPL

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