Investing in Seagate (Nasdaq:STX) is at least a little like playing chicken with a freight train. While I don't want to entirely dismiss Seagate's potential to transition into new products, technologies and end markets, the fact remains that its core hard disk drive (HDD) market is facing a one-two punch from increasing solid state drive (SSD) substitutions and a switch from PCs to mobile devices, like smartphones and tablets. Although the HDD business is not going to vanish, investors face the difficult prospect of trying to get both the timing and the magnitude of the decline right, as well as Seagate's ability to generate (and/or reinvest) cash during that decline.

SEE: A Primer On Investing In The Tech Industry

As Previously Announced, Second Quarter Results Weren't Bad
Seagate gave updated guidance earlier in January and that took a lot of the surprise and uncertainty out of this report. Revenue rose 15% from the year-ago level, while falling 2% sequentially. HDD units increased 24 and 1% respectively, as year-on-year growth reached double-digits for enterprise, client and non-computer segments. Prices continue to decline, however, as ASPs fell 7% from last year and 3% from the last quarter.

While Seagate's margins were largely in line with expectations, that doesn't mean that they were strong. Gross margin fell four points from last year and about one-and-a-half points sequentially, as the company absorbed both the lower ASPs and adverse mix shifts. Operating income likewise declined - 8% from last year and 13% from the last quarter.

SEE: Technology Sector Funds

The PC Refresh Cavalry Seems to Have Been Lost
Investors in stocks ranging from Seagate and hard drive rival Western Digital (Nasdaq:WDC) to Intel (Nasdaq:INTC) to Microsoft (Nasdaq:MSFT) and Dell (Nasdaq:DELL) put a lot of faith in the idea that new chips and Windows 8 would drive a rebound in PC demand. So far that hasn't happened. Whether it's because Windows 8 isn't as good as hoped, manufacturers have been slow to bring models to market that exploit its advantages or that many expected PC users are now former PC users doesn't really matter - the bottom line is that volume has disappointed and that's a direct threat to Seagate's model.

To that end, management did lower its guidance for the next quarter by about 4% relative to the prior average Street estimate. It should be noted that most analysts are still expecting the PC refresh cycle to happen, but time will tell if they're right.

SEE: 4 Industry-Changing Tech Trends

Seagate's Solid State Strategy Getting More Solid
It's still not entirely clear how Seagate is going to play in a world where the company's markets will increasingly embrace and adopt solid state alternatives to its HDD products. At a minimum, the company is not ignoring the transition.

Hybrid drives could prove to be an important intermediate step. SSDs are still about 10 times more expensive than HDDs on a per-GB basis, but Seagate (and its rivals) have developed hybrid drives that basically use a solid state component for frequently-accessed storage, speeding up the overall experience at a fraction of the cost of full SSD drives.

Seagate also has its own SSD business - Pulsar. While Pulsar is more oriented towards enterprise customers today and it's unclear if the company wants to go head-to-head with Intel, Samsung (OTC:SSNLF), OCZ (Nasdaq:OCZ) and others in SSD drives, that option is there.

Most recently, though, the company has also announced a strategic investment in Virident - a company that provides flash-based PCIe products and technology for data centers and enterprise customers. This looks like a direct threat to Fusion-io (NYSE:FIO) and LSI (Nasdaq:LSI), and it will be interesting to see how the relationship with Virident develops over time, particularly as a big part of the bull thesis on LSI is its ability to become a strong No.2 to Fusion-io in enterprise flash storage.

SEE: 5 Reasons Old Tech Is Soaring

The Bottom Line
The general consensus on Seagate at this point is that the company is not going to be particularly successful in handling the market transition from HDD to SSD, and that it is condemned to steady revenue erosion. I'm not completely convinced that that has to be the case, though I agree that the threat is there. At a minimum, though, I do believe that the company is going to be hard-pressed to grow margins or expand its free cash flow (FCF) generation to a significant degree.

That being the case, the company's low EV/EBTIDA, EV/sales and P/E ratios don't impress me all that much, nor does it give me confidence that these shares are a major bargain at today's prices. Although the expectation of ongoing and inexorable FCF contraction in the high single digits per year doesn't suggest much downside from here, it also doesn't suggest a compelling bargain worthy of the risk.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  2. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  3. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  6. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  7. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  8. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
  9. Mutual Funds & ETFs

    ETF Analysis: Schwab US Broad Market

    Take an in-depth look at the Schwab U.S. Broad Market ETF, an incredibly low-cost fund based on a wide selection of the U.S. equity market.
  10. Professionals

    Tips for Helping Clients Though Market Corrections

    When the stock market sees a steep drop, clients are bound to get anxious. Here are some tips for talking them off the ledge.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  5. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  6. BHD (Berhad)

    The suffix Bhd. is an abbreviation of a Malay word "berhad," ...
RELATED FAQS
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  4. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  5. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
  6. What happens to the shares of stock purchased in a tender offer?

    The shares of stock purchased in a tender offer become the property of the purchaser. From that point forward, the purchaser, ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!