Blount/LE on STX Investment Conclusion
Recent checks indicate that overall HDD demand
is tracking generally in line w/ seasonal norms
(desktop weaker, notebook stronger, enterprise in
line). Further, the issues impacting various HDD
component suppliers appear to be more company
specific rather than indicative of overall HDD
demand. We believe that stock appreciation will
be driven by expected margin expansion starting
in the Dec and Mar qtrs with the transition of
Maxtor products to STX platforms within the next
few weeks. Downside support is likely to be
provided by the $2.5B (~20 of market cap)
accelerated share buyback now that the $1.5B
debt deal has been completed. We would
continue to be buyers of STX and reiterate our
1-OW rating and $31 PT. We maintain our EPS
est. for FY05 and FY06 at $1.90 and $2.95,
respectively.
Summary Unit shipments generally in line with desktop
weak, notebook strong, enterprise in line
Pricing remains competitive - particularly in
notebooks and desktop OEMs. Rate of decline
appears to have slowed in recent weeks.
Inventory levels (channel and balance sheet) are
gradually improving.
Fine-tuning our Seagate model for recent debt deal and share buyback.
Units. Our checks suggest that hard drive sell-through this quarter is tracking approximately to seasonal norms but with
variation within the segments. Desktop unit demand appears to be at the weaker end of seasonality, while notebook unit
demand remains strong. Enterprise and consumer unit shipments appear to be about as expected.
Pricing. Pricing in the September quarter has remained competitive particularly in desktops and notebooks. Further, while
OEM desktop pricing for the December quarter remains very competitive, data points suggest that the rate of pricing erosion in the channel may be slowing, and in some regions even firming. Western Digital sent out a letter last week to the channel
raising prices. Notebook pricing continues to be competitive as there are more competitors for fewer units in the notebook
segment then in the desktop space. A recent OEM auction was unusually competitive with 6 different bidders participating.
Inventory Levels. Data points suggest that inventory levels in the channel, and on company balance sheets, are starting to
trend downward though still modestly higher than we would like.
Recent Data Points.
Xyratex. (XRTX, not covered) Last week Xyratex announced results for its HDD division that significantly exceeded
expectations, but gave guidance for a significant sequential decline. XRTX reported storage infrastructure revenue of
$114.6M, approximately $24 million higher than the midpoint of original guidance of $86.5-$94 million. XRTX’s storage
infrastructure revenue is primary related to HDD testing equipment sold to largely to Seagate and Western Digital. The better
than expected performance resulted from pull forward of orders from Q4 to Q3 as Seagate replaces Maxtor’s test processes
and equipment with Xyratex products and our belief that Western Digital accelerated a planned capacity addition because of
unexpected upside in demand from a customer. The XRTX data points are consistent with other data points we have
gathered, suggesting that Seagate will have completely transitioned the Maxtor desktop products to the Seagate platform
within the next 1-2 weeks and Maxtor’s enterprise class products by early December. We do not believe that XRTX’s
comments are a reflection of a reduction in current demand; rather it appears that both STX and WDC are putting in place the
capacity necessary to support the normal seasonal upswing in unit demand.
Innovex. (INVX, not covered) Earlier this week, Innovex, a major supplier of HDD flex suspension assemblies (FSA) and
actuator flex circuits (AFC), held a conference call disclosing disappointing results. Innovex lowered guidance for the
September quarter to $32 million (-33% y/y) down from the previous guidance of $39-$42 million (-12% to -18% y/y) citing
lower demand for hard disk drives. These data points run contrary to our current checks which suggest demand for enterprise
class HDDs (where the FSA is primarily used) are generally experiencing normal seasonality. Rather, we believe the Innovex
data points reflect a continuation of a trend of Seagate moving away from the FSA technology TSA/CIS product manufactured
by Hutchinson (HTCH) and MagneComp (Not Covered). We believe INVX’s decision to close its Eastlake, Ohio, and
Litchfield, MN plants is further evidence of the permanence of the technology shift rather than a reflection of quarterly
demand.
Komag. (KOMG, not covered) Several weeks ago, Komag reduced its guidance for the September quarter to 3% q/q
revenue growth vs. prior guidance of 5% q/q revenue growth. At the time, we felt that the KOMG reduction was a reflection of
double ordering by some of the HDD vendors based on prior quarter’s media constraints. Further investigation suggests that
double ordering was just one of the factors. Rather, we believe that KOMG’s shortfall was due to a combination of slightly
softer than expected desktop demand, double ordering by drive vendors, a work down in channel and finished goods
inventories by major customers (which reduces component supply sell-in volume by approximately 2%-3% versus HDD
system unit sell-out) and the loss of some media share within the WDC account to Fuji Electric. Komag does not currently
have a revenue generating product within the 2.5” notebook market.
Best Buy. Best Buy (BBY, 1-OW/1-Positive covered by Alan Rifkin) reported rev for F2Q06 (Aug) above our firm and street
expectations and reiterated its prior guidance for full year as we move into the seasonally strong holiday qtr. BBY mgmt
indicated consumer demand in advanced TVs and next-gen gaming consoles remain solid, while PC demand was somewhat
more mixed with desktops weak and notebooks showing continued strength. XBOX 360, PS3 and Nintendo Wii are expected
to be high demand gift items for the holidays, with external HDD storage for these game consoles expected to have high
attach rates. We note that Seagate’s 1.8” drives are designed into the XBOX 360, Nintendo Wii, and the Playstation 3. PS3 is
being released selectively on November 11 with either a 20GB or 60GB 1.8” HDDs. Sony (1-OW/1-Positive covered by
Steven Myers) mgmt indicated that it plans to ship 6 million PS3 units by March 2007, and will debut 400K units in the US
and 100K units in Japan for the November launch. Nintendo (3-Underweight/2-Neutral covered Nicholas Spratt) mgmt also
stated that it plans to sell 6 million Wii units by March 2007, but did not indicate how many units will be available on the
November 19 launch in the US and December 2 launch in Japan.
Circuit City. Circuit City (CC, 2-Equal / 1-Positive, covered by Alan M. Rifkin) reported revs above our firm and street
expectations. During the call, management updated full year guidance of up 9-11% with domestic comps up 7-9%. CC
mgmt’s outlook was optimistic for full year domestic sales, and expects its international sales to return to profitability this year.
Within their IT sales category, which account for 33% of their sales, desktops were down double digits, offset by notebooks up
double digits. Printer and monitor sales were down single digits. Implying MP3 players, portable digital audio products, as
well as its accessories, were up double digits. Overall, we believe consumer electronic retail channels continue to be healthy
with mgmt outlook optimistic as we enter the holiday season.
$1.5B Debt Offering.
STX recently raised $1.5B in debt to retire $400M of 8% notes, and also accelerate its $2.5 billion share buyback program.
Though debt service should weigh in on earnings, we believe it will more than offset with lower weighted average coupon
payments and reduced share count. It will be 3 tranches with $300M or 20% of the proceeds bearing an interest rate of 84
bps above LIBOR, ~$600M or 40% of the proceeds with a fixed interest rate of 6.375%, and the remaining $600M bearing an
interest rate of 6.8%. This currently has a weighted average interest rate of 6.52%, which is below the 8% on the $400M bond,
and may slightly vary due to the change in daily LIBOR rates.
Valuation
Our $31 price target is based on a 0.8x relative P/E multiple using our CY 2007 EPS estimate of $2.70 with the 2007 S&P 500
multiple of 14.0x. |
