seagate q4 call notes

I have about three clips of this on, so my read is going to be biased whether I want it to be or not. clip one from when its deal was announced, clip 2 was a slow add on pull backs, and clip 3 was added yesterday as a punt on earnings. stock is down 11% amc, I was wrong and got my fingers burnt, mentally its very tempting to try to go through the call and find reasons that the market was wrong and to look for excuses, going to try to NOT be biased.

seeking alpha have the transcipt of the call, which I find very handy; seekingAlphaLink

$2.9bn revenue for quarter
$0.28 eps non-gaap
tam 166mm
32% market share
- believe june TAM is not inventory build but true demand
margin improved, not as much as they would have historically in this environment
*THAT* is the disappointment. they say because of four factors;
1) agreed pricing with OEM before demand surge
2) 'didn't achieve out time to maturity targets'
3) commodity price rises
4) able to service demand, but in lower margin segments

sold $600mm of senior unsec notes
sep tam think 165-170mm, $2.9bn revenue, see 200bp impact of commodity prices on margins, looking to offset them (but sound skeptical), also say that they'll look to pass them on.
r&d and sga @ $350mm
0.29-0.33 forecast eps

cerium oxide

q&a shows they aren't executing transitions well, and are wasting resources and tech -> not what I or the market expected.

Yes its disappointing, especially as its really execution failure when the market is presenting good opportunities, and if you're and investor like me, that bought the stock because of improving sector dynamics you're probably even more frustrated. It certainly marks down management in my books. What will enrage me is if management still take fat comp.

I messed up adding to the position yesterday. Am glad that I have sensible risk limits and will review whether to add based on price action today.

"Seagate Technology Terminates Private Equity Discussions And Announces Share Repurchase Authorization"

http://www.seagate.com/ww/v/index.jsp?locale=en-US&name=private-equity-termination-repurchase-seagate-pr&vgnextoid=6692a92cf699c210VgnVCM1000001a48090aRCRD

Interesting the company instantly announced a share buyback, however the Raven is skeptical as to much many share will actually get bought back and when given that they intend to do it out of future cashflow. $2bn would be ~154mm shares, approx a third of the company!

Leverage?
Just for giggles where would that take the leverage of the firm? The Raven thinks its quite possible for their margins to fall to 15% then using 4yr average revenue and SGA, we're talking EBITDA of $1.3bn. Current assets cover long term debt and current liabilities currently, so leverage would be 1.5x still investment grade. but 10% margin and its 2.7 and we're getting to the covenant zone. Its not clear that its a lock either, there are strategic hurdles and a cash rich competitor, maybe levering up isn't the smartest trade.

So what are historical returns for announced huge buybacks?
Ok there aren't many companies that announce they're going to buy back a third of the company. Interpolating the stats isn't too easy, as two factors tend to drive returns, size of announcement and completion rates, which in this case are contradictory, top decile announcement size and probably lower quartile completion rate. Looks like about a 3% pop on the announcement, and another 5% over the year.

How much fat was on this puppy?
Punters are going to compare it to where WDC has traded, however its very clear that WDC priced in its own possible LBO on the back of the STX news, because taking a historical ratio of where they traded would indicate that STX was already at fair value to WDC before last nights announcement. Perhaps the trade on th open for the Raven will be to cover his very small STX short and sell some WDC, we shall as always check the price action at the time.

$STX call

Company said they couldn't give future guidance or comment on PE approach given legality, which made for a short (if late and bland) call.

Interestingly they didn't participate in the "13th week", which $WDC had said was at twice the average rate of the prceding 12weeks. They think that the 13th week was busier because of pulled forward demand because of China's golden week, and quarter end dates.

$0.31 EPS and missed revenue.
49.2mm units (backs out ASP of $55) they said approx 8% q/q price decline. gross margin of 20.4%
'competitors more tenacious than years past'

long discussion on SSD's and hybrids in relation to notebooks, netbooks and MacBook Air.



general thoughts;
STX had popped up on the Raven's LBO candidates screen just based on historical numbers, however he'd excluded it because of the margin pressure and "third competitor" issue. To him it doesn't make sense for a PE firm to take such a big punt on storage when there are so many issues which management of the firm really don't have so much control over. Its also not apparent that higher financial leverage is either appropriate or adds value to equity holders. As the stories appeared in the WSJ its not to be written off lightly, there's a pretty good chance that a bid does materialize, and the rumoured price range is anything from $15 to $25. Anything above the 52w should be heavily mentally discounted.

FT article on Hitatchi Global Storage

Hitatchi is looking to sell its storage business, interestinly its lower margins and agressive attempts to take market share aren't helping the supply-demand imbalance. Strategically wouldn't it make more sense to buy the lowest margin competitor, accept market share and work on the cost base? the $1bn price tag for ~ $2.5bn of sales would value $STX and $WDC at $4.32bn and $3.84bn, or $9.15 and $16.76+$8.7=$25.5

$WDC earnings call

As the Raven has noted on the blog a few times, the sector will face margin pressure going forward. That's clear that this is happening from their current results. Yes sales hit estimates, net income was there, however that doesn't disguise what's happening with the MARGIN.

• average selling price $46, -$3 lower than last year, -$1 q/q.
• historical seasonality suggests this should be the best quarter for demand
• gross margin adjusted for SGA was 15.8% last year 20.8%, unajusted 18.2% v 23.2%
• margin decline driven by lower average selling prices, which is being driven by an excess of ~10mm units (Raven estimate), "6-8mm units need to get burnt off" ~ 5% capacity
• management correctly say that Seagate's ownership structure won't matter to industry pricing
• margin errosion is WITH them giving up market share to our ominous 3rd party

next quarter's guidance appeared to be 50-60c although the line was terrible and the accent heavy, so when the replays up it needs to be checked. Seasonally the coming quarters will be weak historically and there doesn't look like too much to get excited about buying this stock. Two interesting side points from the call; 1) company see increased demand for sea shipped product rather than by air, which can pull demand from back to school next year into the preceding quarter and 2) China's demand may change seasonality going forward, although hard to tell given economic volatility.

very roughly its got about $12 of cash, so its run rate p/e on next quarter is ~ 7.5, however;

The Raven wasn't so clear as to what effect the ipad is having for solid state devices, or just how much the company held back from shifting product to protect prices. The company is going to look at strategy and investment decisions and implied that some products didn't make sense at these prices...

Anyway its interesting and is definitely a better looking from the perch than Seagate, but if anything it and $STX are a short tomorrow and perhaps for the next few months depending on price action. Longer term though, enterprise does look a good bet, and of course it could be LBO'd. So its definitely a high risk position either way.

An interesting point from Zecco on $WDC and $STX

The Raven read this and thought it was interesting;

http://pulse.zecco.com/2010/07/data-storage-valuation-versus-earnings-stx-wdc/

Basically it points out that data storage is cheap ie. $100 for a terabyte now. It doesn't explicitly say it, but the argument is then that 1Terabyte is enough space for you to store everything you could want and therefore that you'd just buy the cheaper version of the 1TB. Now it would be easy to dismiss this argument by regurgitating a quote about a desktop PC being everything you could need in the 90s. The Raven thinks it more interesting to wonder where the actual limit might be using a bit of imagination. As we're only really looking at personal data storage what items do people like to store? (and a point he's going to dig some more into offline)
photos, music, films, books? software? personal documents


photos, music and films all have the potential to upgrade again to higher resolution formats requiring more storage space, books less so, but software and the personal documents they produce if anything produce larger and larger files. Without even looking at the massive increase in commercial data that will be stored in the future its easy to make an argument that the size of files will expand to fill the space available to store them.

The other point that really should be thought about is what percentage of the population actually store this kind of data on their pc's, and if there is a potential generational effect, as stupid as this sounds the Raven would have a rather good punt that penetration of these sorts of products is much lower with consumers the older they are. ie. Your average 50yr old isn't going to have as many digital photos as your 30 something, or as many photos as that 30 something will have in 20yrs. Just to make the maths easier, lets say people only buy storage when they get to 20, and that penetration really only goes up to 40, thats 20yrs of the population that could be 40yrs in 20yrs time. Not a huge growth rate, but certainley not a stagnating industry at 3.5% p.a. growth for 20yrs.

It still looks like a situation to sit on one's hands. Especially given his other previous thoughts on WDC and STX...

http://blackraven999.blogspot.com/2010/08/wdc.html

http://blackraven999.blogspot.com/2010/08/stx-translation-of-wdc-comments.html

STX translation of WDC comments

Given the view the Raven has as to where $WDC should trade (in yesterdays post), then its relatively simple to make the same sort of read across in valuation terms to $STX given the belief that the "third party" drives margins down to 15% for these two players.

(the Raven is thinking that would be a great name for an activist hedge fund, you wouldn't need to be writing caustic letters with such an ominous name)

Reducing STX margins to 15%, then applying the same prop. adjusted EV/ebitda multiple then a stock price of $7.50 compares to $23. ($28.73 -> $10.67) a lot lower than its current price. Keeping its 3% margin premium that it had to $WDC then you have $9 and $13, so that tells you that the market is expecting them to be able to keep that premium, whether that's wise or not is a much more difficult call to make.

If the Raven is going to be buying anything in the near term future its going to be $WDC rather than $STX.

WDC

This is a stock that the Raven has been keeping quite a close eye on the last couple of weeks (he's traded around a small punter sized position). The company makes hard drives, the Raven actually uses one of their external hard drives to back up all his data.


VALUATION
This stock is cheap, by whatever metric you'd look at it classically, if you're using historic data it looks cheap. EV/ebitda(ttm) its 1.84x, p/e(ttm) 4.5, p/s 0.6, p/b 1.32, forward p/e 5.7.


CHART
This looks like a three legged dog with fleas. a blind three legged dog. Its fallen 41% since its high towards the end of April. Its done 40% more volume than one would have expected in that period as well. The 200dsma is 44% higher, basically its ugly, and looks oversold, but thats not a reason for it turn tomorrow.

WHO OWNS IT?
Index funds, mutual funds and relatively passive money, so who's been selling??
4.3% of the float is short, 1.8 as a SR. (as of the middle of the month - so not very informative), not particularly high.


WHAT's THE GOSSIP/FEAR?
Going through some of the fears;
1) SSD tech becomes cheap enough to shut out HDD
2) inventory build up and volatile ASP (normal hardware producer risk really)
3) the "cloud"
4) areal growth rates too high or too slow (too high drives down the margin, too slow and SSD becomes cheaper relatively)

There is a lot of uniformed speculation as to what the fear is in the stock, the Raven doesn't claim to be any wiser than the street on this one, so its best to go through the obvious angles and see if it makes a bit more sense. SSD technically just isn't cheap enough to be competition just yet, the Raven also knows enough about the street to realize that this isn't a risk that has suddenly been priced in since April!! Neither is the cloud, or projected areal growth rates. So clearly by process of ellimination, investors are worried about inventory build up, pricing, etc. A "normal" fear in this sort of stock.

Listening to $STX and $WDC's earnings calls, its pretty clear that they both saw the same thing, the rather ominous sounding "third player" in their space producing an excess of 5mm units. They both speculate whether this is because the TP doesn't have as much control as they do, ie. aren't able to dial down their production as quickly, OR whether this is a deliberate shot at trying to gain market share with a limited number of OEM (original equipment manufacturers) that the TP is particularly close with. To the Raven the latter makes sense. In which case one should go and give the margins and balance sheet a good kicking to check how cheap the stock really is?

Ok, so looking at the suspected TP's driving down prices, the Raven thinks 'they' are running on a gross margin of ~15%, but also with higher r&d costs, and probably lower net margins than either STX or WDC. It does mean however that pricing could be quite weak, with bloody noses all round (although quite STX and WDC management seem quite aware of the danger of chasing market share thankfully). The Raven does think that the most conservative level is a 15% drop in ASP (average selling price). In which case WDC becomes break even, and worth ~ $11 of the cash its got on the balance sheet.

Realistically its easy to see WDC's margins get compressed down to 15% in the short term to match our TP's lower margins. That would mean EPS ttm of $1.95 ish. Putting that on a "value" p/e of 10x and you've got $19.50+$11cash = $30.50. So its only 16% higher than Friday's close. Certainley not bargain basement valuation in this scenario, putting a margin of saftey of 25% on that and you're at $23. (if you're a real punter though you could argue that you should use a market multiple of 14x and a 25% discount then you're looking at $28.73)

The other general trading point the Raven would make is that there seems little point being a hero, or draw a line in the sand, its much easier to trade the right hand side of a U than the left hand side, or "don't catch a falling knife", or "monkey's don't pick bottoms", etc, etc. Basically IF the Raven thought this was a screaming buy from a valuation standpoint, he's nimble and small enough to wait until the stock starts to move up before starting to buy. He's had a quick run of some quantitative screens and he'd only buy this stock when it broke throught its five day moving average on the shortest time frame.

So to sum up;
Looking in the rear view mirror, WDC is cheap. However the stock is telling traders and investors that there are worries about the future, by process of elimination it is 'clear' that market level inventory build up and weak margins going forward are a big risk given other market participants increasing supply and being less responsive to demand. The Raven believes that as a worst case scenario the stock trades at $11, at a realistic downside the stock is worth $30.50, so the Raven would look to buy a meaningful portfolio sized position if the stock went below $23 with the condition that the stock broke above its 5dma after that.