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.
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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.
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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.
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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.
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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.
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