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Technology Stocks : Seagate Technology

STX 278.47

+1.0%

Nov 6 4:00 PM EST

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From: duedilly	8/9/2006 9:33:34 AM
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MS/Runkle - Seagate Technology Range Bound Near-Term; Look to Own into CY2007 Conclusion: Pricing and product transitions mute seasonal period and create stock volatility near-term. Downward earnings revision is a step in the right direction in terms of setting up for attractive risk:reward into next year. We look for attractive entry points to own this name into new segment exposure (1.8- inch/MP3 player), technology transition (perpendicular and low-cost platforms) and integration leverage over the next 12-months. What's New ? Near-term: STX acknowledged some slowing in demand during the June Q but generally expects normal seasonal unit trends plagued by a more aggressive pricing environment in September. Faster MXO integration creates negative operating leverage near-term but sets the model up for potentially stronger and more consistent results next calendar year. What's New ? Next 12 months: Several catalysts exist next year including: 1) Vista and Woodcrest product cycles; 2) new 1.8-inch product with the potential to ship into new AAPL/MSFT media players; 3) market share gains with higher capacity perpendicular and lower-cost/low capacity drives; and 4) positive operating leverage from full MXO integration (scheduled to be completed by December 2006). Model Implication: New model reflects more aggressive pricing environment, faster MXO integration (negative operating leverage in Sept/Dec) and higher initial tax rate. See Exhibit 2 for full details on our model changes. Stock Implication: A competitive pricing environment is likely to keep STX at the low-end of historical P/E ranges (8-12x) — or $19-22 based on our new CY07 EPS of $2.44. With the stock likely to trade near trough valuation (both P/E and EV/Sales) — downside is limited assuming execution or competitive pressures don’t intensify. Assumptions Value DriverKey Assumptions Revenue Drivers Potential negative: 1) MXO revenue share losses - especially in low-end desktop. 2) More aggressive pricing environment. 3) Stable, not growing Enterprise market. Potential positive: 1) Continued growth in DVR and gaming with Incremental CE opportunities - 1.8-inch. 2) Vista and Woodcrest present market growth opportunities in 2007. 3) New perpendicular technology and low-cost/low-capacity product could drive STX market share gains in C2007. Margin Drivers Potential Negative: 1) Negative operating leverage as STX transitions MXO lines. 2) More aggressive pricing environment. 3) Excess finished goods inventory needs to be worked down. Potential positive: 1) New technology/product transitions in C2H07. 2) Full MXO integration by December 2006. 3) Potential for healthier pricing and demand fundamentals with industry product cycles - including Vista and Woodcrest. Investment Case Exhibit 2 on the next page compares our new vs. old STX- MXO combined forecast for the next four quarters. In addition any stabilization in pricing or acceleration in demand, a lower tax rate and higher share repurchase run- rate present potential upside drivers to our forecast. Valuation From a valuation standpoint, the disk drive industry typically trades at a P/E range of 8-12x with Seagate’s leadership position typically commanding a slight premium. STX currently trades at 9x our CY07 EPS — towards the low-end of historical averages. If we look at Sales metrics, STX currently trades just below 1.0x EV/Sales – towards the low- end of its historical EV/Sales range of 1.0-1.2x. Risks: The most significant risk from our viewpoint is simultaneous execution of a major technology transition (to perpendicular) and integration of a sizeable and overlapping business. We do believe Seagate is best positioned to manage through these changes — given its lead in perpendicular technology, market leadership position and recent execution. Successful integration of manufacturing, R&D and supply chain resources is key to obtaining FY07 and FY08 pro forma targets laid out by management and any push-out on timing or degree of synergies would be viewed as a negative. Beyond execution and integration, revenue leakage and demand fundamentals are key to monitor. Management believes the deal is accretive even in the context of 50%+ revenue loss but clearly risk (and investment requirements) increases with leakage. Industry risks (with or without the Maxtor acquisitions) include slowing demand and growing inventories in the PC supply chain, mis-execution of the perpendicular technology transition and flash becoming more competitive with hard disk drive solutions over time.

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