Seagate Technology plc: Net Debt Nonsense; Demand a Significant Margin of Safety ($STX, $WDC, $DELL)

I like the hard drive manufacturing industry for a few reasons. First, the  industry is becoming more concentrated. Two years ago, it was dominated by five firms that were locked in heated competition. Today? Thanks to consolidation, just three. Higher concentration is terrible for consumers, but great for investors. In an industry like this which sells commoditized products, intense competition leads to the erosion of margins (and thus returns) far more quickly than in other industries. So industry consolidation should be beneficial for investors in the long run as competitive pressure abates.

Second, analysts in this industry are excessively focused on the next quarter. Though it is generally the case that analysts are performance myopic, in this industry they are exceptionally so. This leads to analyst overreaction which translates nicely to Mr. Market overreaction.

Here’s a good example: In July 2010, Western Digital Corp. (NYSE: WDC) reported its Q4 and full year earnings. In response four firms reduced their targets, and did so by an average of 18.2%. The company’s shares fell 13% over the next three days. Today, the same firms have targets that are above their original targets from last year. This is common – targets fluctuate all over the place. This happens because excessively complex models give the illusion of accuracy, yet slight changes in inputs each quarter result in highly volatile outputs. This might make sense for extremely short-term investors (though I doubt it), but it frequently creates opportunities for long-term value investors that don’t suffer from performance myopia. A single bad quarter can send shares spiraling downward (like in WDC’s case), only to recover (and then some!) a quarter or two later. Investors in July 2010 who held until the company released its earnings in April (and Analysts raised their targets again) were rewarded with a gain greater than 50%. 

Let’s turn to Seagate Technology plc (NASDAQ: STX). In July, the company issued its 3Q 2011 earnings. Mr. Market was unimpressed, and sent STX shares down 16.83% the next day. STX was on my watchlist so I decided to take a closer look.

First, the company’s returns:

Seagate Technology plc - Returns, 2002 - 3Q 2011

Seagate Technology plc - Returns, 2002 - 3Q 2011

Historically, the company has earned strong returns, hovering around 20% and above. The massive drop in 2009 was largely the result of a $2.3 billion write-down in Goodwill, a non-cash charge that was a common occurrence at the time as companies took “big baths” in the depths of the recession (when bearish sentiment was at its max, the rationale is that it won’t get much worse, so it is the best time to do a mea culpa). 

Let’s look at the company’s free cash flows:

Seagate Technology plc - Free Cash Flows, 2002 - 3Q 2011

Seagate Technology plc - Free Cash Flows, 2002 - 3Q 2011

Capital expenditures are the difference between cash flows from operations (the green bars) and free cash flows (the blue bars), and the rather large and persistent difference shown in this chart, suggests the company operates in a fairly capital intensive industry. The ratio of free cash flows to net income is also persistently below 1.0, which is likely the result of the company’s continued growth (sales more than doubled from 2002 to 2008) rather than a financial shenanigan (I would be worried if this ratio was persistently below 1.0 for a mature company in a mature industry). 

One thing I like about the company is that, like Dell Inc (NASDAQ: DELL), the company has an impressive cash conversion cycle which can be a source of competitive advantage.

Seagate Technology plc - Cash Conversion Cycle, 2002 - 3Q 2011

Seagate Technology plc - Cash Conversion Cycle, 2002 - 3Q 2011

One area of concern is that the company has a hefty debt load.

Seagate Technology plc - Capital Structure, 2002 - 3Q 2011

Seagate Technology plc - Capital Structure, 2002 - 3Q 2011

As you can see, the company also carries a large amount of cash. While most focus on the net of the two (“net debt”), I would rather the company use the cash to pay down the debt. From my perspective, the cash can quickly disappear via a variety of transactions, leaving the investor with a suddenly over-leveraged company. 

This concern might be particularly relevant for STX because it has been actively spending cash to repurchase its own shares. The company has spent $710 million in the last two quarters and $1,294 million over the last five quarters doing this. At the same time, the company issued $1,323 million in long-term debt. I know a lot of investors are pushing for this right now (“issue debt at historically low rates and repurchase shares that are generating returns in excess of the cost of debt”), but I am not a fan. Increased debt leads to increased risk, and I don’t care much for returns that improve due solely to balance sheet management. I am a fan of share repurchases, but not when debt levels are high and certainly not when the repurchases are financed with increased debt!

Given the increased risk that I see in the company, I demand a larger margin of safety than I normally would. In valuing STX, I used a variety of revenue scenarios and historical margins to create a range of estimated intrinsic value. Though I found STX to be undervalued, I do not believe there is a large enough margin of safety (especially in relation to my bearish scenarios which show a sizable downside) to justify a purchase. However, if the company once again trades in the low $12′s (on a per share basis, which it did as recently as March), I would be very interested (especially if they reduce their debt levels).

What do you think about Seagate?

Author Disclosure: No position.

Talk to Frank about Seagate Technology plc

 

  • Wacht Woord

    They trade at  $11.40 today (the day of this post). May I ask what scenarios you used to come to this price?

    I usually use a quick DCF model to come to an initial valuation and decide whether to evaluate further however their CF is really irregular (like you posted already):

    2001       2002       2003       2004       2005       2006       2007       2008       2009       2010       TTM

    Free Cash Flow USD Mil—365     366         30           737         449         37           1608       190         1293       319

    Using 1293 with 0% growth, discount rate and 30% margin of safety leads to $20.36

    Using 319 with 0% growth, discount rate and 30% margin of safety leads to $4.39

    Using the 5-year average of 715 with the same metrics leads to $10.88 indicating a slight over-valuation.

    So I’m curious to find what metrics you used.