Fox/ML on HDD (couple days ago)
A near term turn in the tide
The tide turns
We continue with our Buy rating on Seagate following our visit to Diskcon(a major
hard disk drive trade show) last week. We think the HDD industry is likely to see
a more rational competitive environment during the most important part of the
calendar year for the industry. When combined with more confidence in STX’s
ability to realize efficiencies from integrating the acquisition of Maxtor, we think
the stock is likely to rebound further in coming months.
What’s lost could always be won back
We would not be surprised if STX is able to recapture some of the market share
lost following the Maxtor acquisition, which was more than many investors
expected (~50% of MXO sales). We expect new low cost PC HDDs (for the low
end of the PC market) to be introduced to volume by STX in coming weeks.
What STX can control best: Its own operations
We think STX lowered the bar more than enough in August (with FQ4 results)
given a slower than expected start to its acquisition of MXO in the form of high
initial dilution to EPS. Following the trade show, we remain extremely comfortable
with our expectations that cost savings from the acquisition of MXO will drive a
meaningful improvement in EPS over the next 2-3 quarters.
Hitachi: When is bad news actually good news?
On Friday, Hitachi significantly reduced its F2007 (March) outlook. Our colleague,
Yoshihara-san believes Hitachi is struggling with lower HDD prices as well as low
production yields on server HDD heads. We estimate Hitachi’s market share at
~15-20% of total industry revenues. We think further pressure on Hitachi’s profits
and stock could actually be positive for the HDD industry since the company will
focus more on profitability; thereby, creating one more major competitor with little
appetite for unattractive business.
A near term turn
We continue with our Buy rating on Seagate following our visit to Diskcon
(a major hard disk drive trade show) last week. We think the HDD industry is
likely to see a more rational competitive environment during the most important
part of the calendar year for the industry. When combined with more confidence
in STX’s ability to realize efficiencies from integrating the acquisition of Maxtor,
we think the stock is likely to rebound further in coming months. Based on field
checks at the trade show, we believe HDD vendors have recently been walking
away from unattractive business in sync with the traditional seasonal ramp
(September to November), which we think is occurring. Although, above average
inventories entering this period have taken away from some of the leverage one
would normally expect, we think our HDD expectations for the remainder of the
calendar year incorporate these inventories into our thinking.
What’s lost could always be won back. In fact, we would not be surprised if
STX is able to recapture some of the market share lost following the Maxtor
acquisition, which was more than many investors expected (~50% of MXO sales).
We expect new low cost PC HDDs (for the low end of the PC market) to be
introduced in volume by STX in coming weeks. These new products could
potentially allow STX to re-capture some market share lost in the initial months
following the Maxtor acquisition. Although we are not currently modeling for STX
to re-gain lost MXO share, we would expect such gains to be at average PC HDD
margins if they were to occur.
What STX can control best: Its own operations. We think STX lowered the
bar more than enough in August (with FQ4 results) given a slower than expected
start to its acquisition of MXO in the form of high initial dilution to EPS. We
remain extremely comfortable with our expectations that cost savings from the
acquisition of MXO will drive a meaningful improvement in EPS over the next 2-3
quarters. We think MXO products are ramping down as planned and that
operations in China are being utilized more efficiently. STX also appears to be
experiencing no major manufacturing issues ramping new perpendicular
technology (PMR) and we think the transition will provide margin benefits over
time, especially given that PMR yields are already at very acceptable levels.
Industry expectations are that ~15% of industry production will move to
perpendicular recording during 2006 before rising to 30-50% in 2007 and ~80% in
2008. We think PMR can be a positive catalyst for the stock longer term given
STX’s technological lead in PMR and the cost advantages that arise, especially
on higher end products, due to rising data density per square inch and the
component reductions it promotes.
Longer term there is more Q’s than A’s. However, our visit to Diskcon yielded
more questions than answers for investors attempting to gage the long term
dynamics in the HDD supply chain. These questions will continue to weigh on
valuation in our opinion. There are numerous opportunities for unit growth, a
richer mix of products driven by the constant innovation in the industry and a
more diverse set of applications. However, there are also technological
challenges that need to be addressed, and more importantly, the industry needs
to prove that the competitive environment will prove rational. Recent competitive
and capacity trends following STX’s acquisition of MXO reduced investor
confidence about industry sensibility. Long term positives include the potential for
the HDD industry to add more value in its designs over time. Besides hybrid
drives, the need for data security (disk encryption) and power efficiency needs
provide opportunity.
Hitachi: When is bad news actually good news? On Friday, Hitachi significantly
reduced its F2007 (March) operating profit outlook by ¥110B (to ¥180B), which
includes an additional ¥32B in losses at Hitachi’s HDD operations (to ¥40B) in
C2006. Our colleague Yoshihara-san believes Hitachi is struggling with lower HDD
prices as well as low production yields on server HDD heads. We estimate
Hitachi’s market share at ~15-20% of total industry revenues. We think further
pressure on Hitachi’s profits and stock could actually be positive for the HDD
industry since the company will focus more on profitability; thereby, creating one
more major competitor with little appetite for unattractive business. Although,
Hitachi has likely not been the most aggressive Asian supplier on price, we think
pressures at Hitachi can add some more sanity to industry pricing in coming
quarters. Yoshihara-san has not ruled out a major restructuring at Hitachi.
More consolidation sooner rather than later? Some sources at the trade show
look for more HDD industry consolidation as soon as the next 3-12 months. We
think near term consolidation is more likely to occur among HDD component
makers (e.g., heads, media) than among the remaining six major HDD OEMs.
We believe the STX-MXO transaction has left certain MXO dependant suppliers
re-evaluating their strategic positioning and that as market share shifts stabilize
there could be a level of uncertainty that drives acquisitions.
A near term risk could be 2.5” pricing surprises. Yoshihara-san is concerned
about the rapidly growing 2.5” HDD market, where July production reached
almost half the level of the 3.5” market. All six major HDD OEMs participate in
the 2.5” market with rising visions on their position in this attractive segment of
the industry. However, tight supply of glass media could be a gating factor in the
near term that limits price competition on 2.5” HDDs.
We expect some form factor news. The 0.85” and 1” HDD may be further de-
emphasized by the industry in coming months (Hitachi and Toshiba have leading
share in these products) given competition from flash memory. Based on
discussions at the trade show, we would also not be surprised to see the re-
introduction of the 1.3” form factor as a way to reduce footprint by ~50% relative
to 1.8” drives while providing at least ~50% more capacity than 1” HDDs for
handheld applications. In addition, there was a lot of discussion about the
potential introduction of hybrid disk drives, which combine flash memory in a hard
disk drive in order to significantly improve boot-up time with the introduction of
Windows Vista while reducing HDD spin time meaningfully, which can improve
reliability. If accepted in the marketplace, hybrid drives will be focused on the
notebook PC market following the introduction of Vista by Microsoft, who appears
to be very much in favor of hybrid drives.
Price Objective Basis & Risk
Our $25 price target for Seagate (STX, $22.09, C-1-7) assumes the shares trade
to around 10X the annual EPS run rate achievable by year end. Also, the stock is
at ~5X on an F2007E EV/EBITDA basis with EBITDA growth of more than 25% in
our model for the current fiscal year. Since going public again in 2002, investors
have on average paid a low double digit P/E multiple and 6.5-7.5X EBITDA. We
think opportunities from Maxtor, excellent free cash flows, respectable ROIC and
improved industry dynamics help support valuation. Risks to an investment in
Seagate are the successful completion and integration of Maxtor, a high
dependency on the PC desktop market (~50% of sales), a vertical manufacturing
integration strategy that brings higher fixed costs, customer concentration, the
ability to smoothly advance new technologies in its products, the industry’s
historical inability to avoid harsh downturns, and of course the supply/demand
environment in HDDs. |
