Stock Review: $STX–Seagate Technology is Fully Valued today

Seagate Technology PLC (Stock: STX) is a US based company specializing in hard disk drives and storage solutions. They compete in markets such as ‘client compute’ which includes desktop and mobile computing, ‘client non compute’ that includes storage systems for other electronic devices such as gaming console system and digital home theaters etc. and ‘enterprise storage solutions’ such as large networks and cloud computing.

STX have high Research and Development costs as they try to stay in tune with the needs of their customers and keep at the forefront of technology. They design and manufacture storage solutions which involves the production of individual components that ends with a fully assembled disk drive. STX believe by designing and manufacturing their own parts it gives them an advantage with lower costs and to improve the functionality of components so that they work together efficiently.

STX like their competitor Western Digital (WDC) have recently acquired smaller firms to grow their businesses. STX purchased LaCie S.A (“LAC”) in 2012 to help them expand their markets in Europe and Japan and Samsung Hard Disk Drive Operations in 2011 to gain access to Samsung’s distribution channels, research and development and their manufacturing assets.

STX sales have declined 6% compared to 2013 Q1 (year on year comparison) mainly due to declining PC demand. STX believe the market is heading to ‘mobile’, ‘cloud storage’ and ‘open source computing’. They have been shifting their focus towards those markets and have allocated resources accordingly.

The stock currently values the company in the market at $17.17 B and yields 2.77% in dividends.

Recent movements – Not in Quarter 1, 2014 report

Oct 8, 2013 STX purchased 32.7M ordinary shares back from Samsung for an approximate value of $1.5B. This reduced the overall outstanding shares of STX by approximately 9%. Samsung still holds 12.5M shares and a seat on the board which indicates their interest in staying long term strategic partners.

Oct 22, 2013 Seagate reveals that they have made a break through with their Kinetic Open Storage Platform for cloud infrastructure. More on this in the ‘looking forward’ section.

Nov 5, 2013 STX issued $800M of senior notes that net them $791M after underwriting costs. The debt bears an interest rate of 3.75% and is due 2018. STX plans to use this cash for general corporate purposes which may include the retirement of other debt or growth strategies.

Nov 6, 2013 STX announces they are shipping the world’s thinnest 2TB storage solution.

Risks involved with Seagate Stock

STX is correlated with the technology industry and therefore risks such as obsolete parts, machinery and products become a serious problem. They need to manage inventory levels, production runs and keep on top of customer trends.

STX spends large amounts on product development to stay in the forefront of technology. These costs will only get larger with time as STX need to constantly stay in front of the curve with enticing new products. Over the last quarter the company spent approximately 294M or 8.4% of their revenue, on R&D.

Moore’s Law is a factor that comes into play with a company like STX. Basically Moore’s law states that the number of transistors in computer hardware will double every two years. As the following graph shows the costs for a GB of data just in the last 13 years and fallen over 99.6% and since the average software needed for home computing has not increased at the same rate there is a discrepancy to what is available and what is needed. This suggests lower revenue in the future.

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2000

$11.00

2005

$1.24

2010

$0.09

2013

$0.05

 

Solid State Drives (SDD) have no moving mechanical components which is different from hard disk drives (HDD) or floppy disks which contain spinning disks and movable read/write heads. These disks (SDD) are more resistant to physical shocks, run silently, have lower access time and less latency. Due to the move to more portable computing such as tablets one would expect over time for SDD’s to overtake HDD and although STX have their own SDD’s in production a significant part of their factories are still dedicated to HDD production. This therefore indicates sometime in the future possible restructuring costs and asset impairment.


Looking forward

Big Data

There is a lot of hype based on “big data”. Big Data is the name given for large collection of data that can be used to create inferences that before could not have been deduced. Earlier due to limitations on size of storage and computing power these large sets were not able to be formed and thus subsets were used. Due to Moore’s Law as stated in the ‘risks’ section time will allow more data to be used and more accurate patterns formed. For example, Google uses your past searching data to formulate the best advertising targeted at your needs. If through ‘big data’ Google is now able to connect you and your family’s data together the computer would be able to infer patterns and trends that would have been impossible with your data alone. In statistics a larger sample size enables better results and thus is the idea behind ‘Big Data’.

STX sees the future of the industry between ‘mobile’, ‘cloud storage’ and ‘open source computing’. As per the last quarter’s conference call Steve Luczo, CEO, stated that they believe that by 2020 the demand for data growth and demand for storage will outpace current infrastructure capabilities. Their R&D teams are focused on advancing their products to align with where they believe storage is heading.

Kinetic Cloud Solution

Kinetic Open Storage Platform is supposed to revolutionize ‘scale-out storage architectures’ as announced on STX’s website. They claim it could cut total costs ownership (TCO) of average cloud infrastructure by up to 50%, while improves performance and scalability.

A report by industry research analyst company IDC projects that worldwide spending on public cloud services by 2017 will reach $107B the current 2013 estimate of $47.7B.

Debt

STX just issued $800M of debt at a low interest rate of 3.75% suggesting that the market does not need a high risk premium. Companies that are profitable have the ability to use debt to leverage their returns and thus maximize shareholder return. Debt can sometimes be seen as a signal to the market that the Company is doing strong enough and therefore can increase their debt capacity and still be financially secure.

Competitive Landscape

STX compete in the data storage device sector and their main competitors are SanDisk Corp. (“SNDK”) and Western Digital Corp. (“WDC”).

Table 1 (ttm, as of Dec 15, 2013)

STX

WDC

SNDK

Revenue

14.11B

15.12B

5.98B

Gross Margins

27%

28%

44%

Earnings per share

4.53

3.93

3.78

Market Cap

16.31B

18.68B

14.97B

P/E

11.04

20.13

17.53

P/B

4.82

2.26

2.24

P/TBV

6.34

3.34

2.49

 

Sandisk (SNDK) has positioned themselves differently with flash drives and SSD technology and do not compete directly with STX and WDC. For the following analysis I will only compare STX and WDC as their operations are very similar and they compete for the same customers.


STX vs. WDC

Looking at table 1 we notice STX and WDC seem very similar in operation figures. STX earnings were higher but their P/E is nearly half of WDC suggesting that the market believe WDC will grow at a faster rate than STX.

For both companies there is a difference between price-to-book value (P/B) and price-to-tangible book value (P/TBV) which is due to all the acquisitions that occurred during the last couple of years and therefore both companies hold significant goodwill and intangible assets on their books.

Breaking down the revenue of we see that STX derived more of their sales through their OEM channels while WDC in comparison had proportional larger positions through distributors and retail.

Table 2

STX

 

WDC

Fiscal Years Ended 2013

Jun-28

 

Jun-28

       

Revenues by Channel (%)

     

OEM

68%

 

63%

Distributors

21%

 

24%

Retail

11%

 

13%

Revenues by Geography (%)

     

Americas

27%

 

26%

EMEA

19%

 

20%

Asia Pacific

54%

 

54%

OEM stands for original equipment manufacturer and includes all revenues that are purchased by other companies whether it be components or finished products and sell the products through retail branded as their own. OEM revenues normally mean large constant orders which allow purchasing companies to obtain needed components or products without the need for large capital expenditures like factories.

Due to WDC having larger revenues the actual dollar value received from OEM channels are very similar between STX and WDC thus suggesting they both have similar market share in that sector.

Table 3

 

STX

       

WDC

 
 

Revenue

R&D

EBIT Margin

   

Revenue

R&D

EBIT Margin

2010

11,395

877

15.35%

 

2010

9,850

611

15.56%

2011

10,971

875

7.29%

 

2011

9,526

703

8.39%

2012

14,939

1,006

20.96%

 

2012

12,478

1,055

14.39%

2013

14,351

1,133

14.31%

 

2013

15,351

1,572

8.39%

TTM

14,107

1,159

13.38%

 

TTM

15,120

1,577

8.20%

                 

Total R&D

 

5,050

   

Total R&D

 

5,518

 

EBIT Average

 

14.26%

   

EBIT Average

 

10.99%

 
                     

Table 3 figures are in millions except for percentages. In 2011 the floods hit Thailand where their manufacturing factors are based thus showing the abnormal results for both companies. Averages include 2011.

Looking through the numbers in Table 3 we can see even though WDC has invested more in R&D (nominally) their margins are substantially less than STX suggesting STX holds a stronger franchise.

Valuation of the Stock

A company like Seagate derives much leverage from its intellectual capital. This can be either in-house developed R&D or purchased IC (which may often be buried under goodwill/intangibles columns of the balance sheet). Other sources of value include their existing customer relationships, franchise value or the brand, and more. A conservative way to value is to look at the current balance sheet and augment it by estimating the value of these intangibles that a new entrant will need to reproduce to be able to compete at the same level as Seagate.

Adjusted Balance Sheet

Balance Sheet

   

As at 27 Sept, 2013

Adjustments

vs. Book Value

Current assets:

   

Cash and cash equivalents

1,924,000,000

100.00%

Short-term investments

489,000,000

100.00%

Restricted cash and investments

108,000,000

100.00%

Accounts receivable, net

1,456,200,000

90.00%

Inventories

685,950,000

78.75%

Deferred income taxes

114,000,000

100.00%

Other current assets

450,900,000

90.00%

Total current assets

5,228,050,000

92.94%

     

PP&E

1,640,250,000

75.00%

Goodwill

95,400,000

20.00%

Other intangible assets, net

295,200,000

80.00%

Deferred income taxes

457,000,000

100.00%

Other assets, net

207,000,000

90.00%

Total Assets

7,922,900,000

84.78%

     

Total Liabilities

$ 5,656,000,000

100.00%


Adjusted Equity

2,266,900,000

Outstanding shares

356,810,000

Per Share

6.35

Adjustments Detail

Inventories – This was split between:

- 15% discount with their finished goods

- 25% discount with their work-in-progress

- 30% discount in raw materials.

Goodwill – due to the recent nature of the purchases I believe there is still some value and to be conservative I have discounted their book value figure by 80%

Intangible assets – I believe there is still significant value gained through the distribution channels, customer relations and research purchased from Samsung and thus have only discount this figure by 20%.

The remaining assets I have discounted by 10% except PP&E which is discounted by 25% to be conservative and take into consideration obsolete technology.

This statement does not include all the recent movements made by STX as mentioned in ‘recent movement’ section e.g. issued debt and repurchased shares for cash.


Reproduction value – Assets

This valuation technic looks at what it would cost if another firm were to try replicate the earnings of STX. When trying to assess a value to a firm there are tangible costs such as property, plant and equipment and there are intangible costs such as staff training, patents and branding etc.

A firm like STX has spent billions on Research and Development and advertising to position themselves at the forefront of storage solutions and therefore this represents value.

Research & Development

To calculate this value I have chosen to take a depreciated total of R&D over the last 3 years. To be conservative I am taking the approach that any research done more than 3 years ago has now become public knowledge.

I am treating R&D as a capital investment and have depreciated the costs using a straight line method over 12 quarters. This would add approximately $1.8B to the value of STX.

Advertising

This falls under the selling, general and administrating (SG&A) expense and therefore we do not know the exact costs spent on building their brand. I am basing my value on the follow conservative assumptions:

- Taking an average of SG&A expense over the last 10 years against revenue to weed out any annual variations and use the latest quarter’s revenue as a base

- 30% of all SG&A was spent on advertising

- It would take 4 years of advertising expense to build a brand like STX

This would add approximately $190M to the value.

To reproduce the intangibles of STX it would cost approximately $2B over and above their book value.

 

Quarter 1, 2014

Reproduction Adjustment

Total Value

Per Share

Book value

3,689,000,000

1,966,416,667

5,655,416,667

15.85

Adjusted Book Value

2,266,900,000

1,966,416,667

4,233,316,667

11.86

A reproduction analysis is not very telling in isolation since given that amount of cash does not guarantee one is able to reproduce the earnings of STX. Even with this caveat, we are looking at a wide gap between the reproduction value  and the value of the company in the market. There has to be more value in other intangible assets of the company that allows it to generate the earnings it does.

Next we will look at the earnings power and the suggested valuation.

Earnings Power Value (EPV)

Adjustments were made to Q1 2014 earnings to normalize them against the last 8 quarters or 2 fiscal years. At the current revenue against average costs (including capital expenditure, a 35% tax rate and no interest tax shield) the cash earnings for last quarter would have been approximately $433M or $1.73B per year ($4.86 per share). The trailing twelve months actual Operating Free Cash Flows (OFCF) was $1.9B suggesting our adjustments are conservative.

Using a discount rate of 12% to reflect the risk involved with STX, the Earnings Power Value (EPV) would be approximately $14.4B or $40.49 a share. This is taking into consideration only maintenance capital expenditure and no growth prospects. In reality, the future growth is likely to be non-zero so we veer to the conservative side.


Bottom-line

STX has strong earnings, attractive margins, a board looking to disburse cash to investors and a solid plan for the future. Their changing focus from personal computers to mobile and cloud services is in line with the shift currently taking place in the industry. There is much good to say about the company, but we are more interested in whether the stock represents a good value or not.

At the current price of $52.65/share, Seagate stock appears to be fully valued and offers no margin of safety. While the company continues to stay at the front of the technology curve and keep its products relevant. I am not too convinced in the width of the moat it enjoys and paying the current market price is tantamount to betting on a flawless execution in the future. This is a risky bet to make, and I cannot justify making it at a price over $35/share.

Note: Research and analysis by Erwin, reviewed by me.

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