Tortora / Pru initiation on STX & WDC 2 days ago - HIGHLIGHTS
• Initiating coverage of Seagate with an Underweight rating and a $17 price target.
• We recognize Seagate as the hard disk drive (HDD) industry technology leader and believe that the
company’s product portfolio is the broadest and most technologically advanced.
• We think the company will benefit from entry into the fast growing 1.8” market - we project 25%
share by late CY’07 or early CY’08.
• However, we are concerned about industry conditions. PC and HDD demand growth is slowing,
HDD inventory has begun building throughout the supply chain, and recent trends in industry capital
spending foreshadow an acceleration of capacity additions. We see a challenging pricing
environment and margin compression in the coming quarters.
• We also see overall share gains as harder to come by as more industry capacity comes online. We
expect tougher competition in notebooks and risk to the company’s inherited Maxtor share in desktop
and enterprise.
• Net, we see limited FY’07 organic revenue growth and expect pricing pressure to drive gross margin
well below the 24% level of FY’06. Our FY07 EPS estimate of $1.39 is $0.40-$0.50 below company
guidance and Street estimates.
DISCUSSION
We are initiating coverage of Seagate with an Underweight rating and a $17 price target. We see Seagate
as the clear technology leader in the hard disk drive (HDD) industry and expect the company to benefit
from entry into the fast growing 1.8” HDD market. However, we believe the stock will react to industry
conditions beyond the company’s control including slowing HDD demand, elevated inventories, and
overcapacity. We expect these factors to bring revenue and margin challenges over the next several
quarters. Additionally, we remain cautious on share loss in Seagate’s core enterprise and desktop markets
resulting from the Maxtor acquisition, and think incremental share gains in the notebook segment will be
tougher to come by.
Technology Leadership Appears Sustainable Long-term
Seagate leverages high levels of technology investment into product leadership. The company’s R&D
spending is well above that of its competitors. This spending is spread across Seagate’s vertically
integrated business model – from recording heads to media (platters) to drive assemblies. Being
vertically integrated, Seagate is at the forefront of evolving industry trends, influencing the direction and
timing for new technologies. As a result, the company maintains a richer product mix and profit margin
than its competitors, as it is usually among the first to introduce new higher priced form factors and high
capacity (GB) drives.
For example, Seagate is leading the HDD industry charge on perpendicular magnetic recording (PMR),
approximately two quarters ahead of competitors in most market segments. The adoption of PMR (bits
oriented vertically) is required to enable higher capacity drives, as the current technology of longitudinal
recording (bits oriented horizontally) is nearing its areal density (bits per unit area) limit. PMR
implementation requires technological advancements in media (platters) and read/write mechanisms
(heads), as well as management of their interactions. As the first major HDD technology change in over
a decade, this transition has been the source of much concern. However, Seagate has been investing in
PMR R&D for seven years, developing the component technologies required and testing their
interactions.
Seagate is launching all its new products on PMR and plans to have these drives reach 50% of shipments
by the end of FY’07. With PMR, the company has introduced new capacity points for the enterprise,
desktop, DVR, notebook, and media player segments. This represents the industry’s first widespread
proliferation of this technology.
We believe Seagate’s high levels of R&D investment and vertical integration will enable the company to
continue to drive areal density improvements and lead the market to new form factors and capacity points.
As a result, we see Seagate continuing to maintain the broadest and most technologically advanced
product portfolio in the industry.
Expect Strong 1.8” Ramp in 1HCY’07
The only major HDD market that Seagate has not participated in is the 1.8” segment, where the success of
Apple’s iPod product has driven 100+% annual unit growth in recent years. We expect flash memory to
provide competition in this space by 2009, but in the meantime we believe it remains an attractive market,
second only to the enterprise segment in terms of gross margin. Microsoft’s planned entry into the media
player market with Zune should ensure 1.8” demand growth for the next several quarters.
Currently only Toshiba (with approximately 75% unit share) and Hitachi have 1.8” HDD offerings, so
there is certainly room for additional entrants. Seagate has announced its ST18 product utilizing PMR for
this market segment. Customer qualifications had not started as of early August, but Seagate expects to
be shipping meaningful volumes by FYQ3’07 (CYQ1’07). We believe that Seagate should be able to
gain share fairly rapidly in this segment, as we expect the company to ship into both Apple’s iPod and
Microsoft’s Zune. We are modeling a strong ramp in 1HCY’07 and project that Seagate could capture
25% of 1.8” unit share by late CY’07 or early CY‘08 (Figure 1).
Facing Multiple Industry Headwinds
Despite Seagate’s leadership position in the HDD industry, we believe that the stock will be subject to
industry conditions beyond the company’s control including slowing HDD demand, elevated inventories,
and overcapacity. We review each of these items in more detail below.
Slowing Demand
Over the past few years the hard disk drive market has seen explosive unit growth, in part due to the
strong PC demand environment and in part due to the penetration of HDDs into new consumer electronics
applications such as media players and personal video recorders. PC growth rates have slowed in the
first half of 2006 and we believe that this trend will continue. As PCs represent approximately 75% of
total HDD demand, we expect the annual HDD unit growth rate to fall to 11% in 2007 (from 25% in
2005). (Figure 2).
Elevated Inventories
The industry has also benefited from tight supply over the last several quarters, which has helped to
stabilize prices. Whereas declines in blended ASP averaged greater than 10% per year over 2002-2004,
price declines moderated to low single digits during 2005 and early 2006 (Figure 3).
However, this Figure also shows that price declines have begun to pick up in the most recent quarters,
most notably in the desktop and notebook HDD segments. This pricing pressure is consistent with our
supply chain models, which suggest that the supply tightness is diminishing. Inventory has recently
begun building at PC OEMs, PC contract manufacturers, hard disk drive distributors, and hard disk drive
OEMs (Figure 4).
The last time HDD OEM inventory levels were at similar levels to today was in early 2004, when the
HDD stocks declined in value by over 50% until inventories were cleared.
Capacity Additions Expected
More concerning, the recent industry CapEx trend foreshadows a potential acceleration of capacity
additions, at a time when we expect demand to be slowing. The relationship between capacity expansion
and CapEx is presented in Figure 5. Over the past few years, there has been a consistent relationship
between capacity and CapEx four quarters prior - which is reasonable, as four quarters is an approximate
average between short lead time equipment for drive assembly and longer lead time facilities or head and
media equipment. We expect the growth in CapEx spending since mid-2005 to translate into higher
industry capacity in the coming quarters. Our capacity forecast considers that a portion of the CapEx
spending will be used for the industry’s transition to perpendicular recording and that Seagate will
decommission a portion of Maxtor capacity (we assume Seagate will reuse two-thirds of Maxtor’s
capacity) (Figure 5).
We believe the industry’s capacity expansion plans are due in part to the optimistic consensus HDD
growth forecasts. Other contributing factors include the struggle over the 15-18% share that Maxtor held
in the desktop and enterprise segments prior to its acquisition by Seagate, and intensified competition
between the six vendors in the notebook segment. The HDD OEMs fighting for share in each of these
segments must believe they have the ability to supply the volume, and as share settles out some of this
capacity will be left unconsumed.
Figure 6 shows our HDD capacity forecast alongside our unit demand forecast. HDD demand growth has
been slowing since its peak in Q2’05, driven by moderating PC demand. The rate of capacity expansion
has exceeded demand growth thus far in 2006, contributing to the HDD inventory build and aggressive
pricing in the notebook and desktop markets. We expect slower demand growth to continue to be
outstripped by capacity additions in the coming quarters.
In sum, we think the combination of slowing demand, elevated inventory levels, and capacity additions
signals risk for industry leader Seagate. We expect pricing pressure and lower unit sales to impact the
company’s margin and revenue in the coming quarters.
Market Share Upside Harder to Come By
As previously discussed, we expect Seagate to quickly gain share beginning early 2007 in the 1.8” market
segment. We also expect the company to net a total of 6-7% unit share as the Maxtor business becomes
fully accounted for in Seagate’s financials in FYQ1’07 (Figure 7). Outside of this, we see share gains as
being harder to come by for the company. In the 2.5” segment, we anticipate a moderation of share gains.
We are modeling Seagate to grow its 2.5” share by 2% per year, down from 11% for the past year, as
improved availability of glass media enables competitors to aggressively bid for share. Moreover, we
believe some share loss in Seagate’s core enterprise and desktop markets is likely to result from the
Maxtor transition over the next few quarters. We are modeling Seagate to lose ~2% share from FYQ1’07
(CYQ3’06) in each of these segments, consistent with our checks that PC OEMs plan to continue
redistributing business to other HDD vendors in order to maintain a more level playing field. All told, we
believe Seagate will be limited to total HDD share gains of about 1% per year from here (Figure 7).
Forecasting Limited Revenue and Profit Growth
Netting it out, we expect Seagate’s financial performance to be adversely impacted by industry
conditions. For FY’07, we see limited revenue growth outside of the Maxtor volume and expect gross
margin to fall to well below the 24% level of FY’06, driven more by pricing pressure than by Maxtor
dilution (Figure 8).
Earnings Forecast
Seagate’s FY’07 guidance is revenue of $11.8-12.3B and EPS of $1.90-2.00. The company expects
FYQ1’07 (CYQ3’06) earnings dilution from the Maxtor acquisition due to elevated inventory levels and
low capacity utilization, but a strong acceleration of both demand and profitability after fiscal Q1. Our
FY’07 forecasts of $11.0B revenue and $1.39 EPS are well below both the company’s guidance and
consensus estimates ($11.9B revenue and $1.80 EPS). We expect slowing industry demand growth and a
tough pricing environment to limit the acceleration out of fiscal Q1.
Of note is that Seagate’s board has approved a $2.5B stock buy-back over the next 2 years. To help fund
the stock repurchase and repay $400M of long-term debt, in September 2006 the company announced a
$1.25B unsecured note offering and entry into a new $500M revolving credit facility. There are also
secondary lock-up expirations to occur on October 21, 2006 and January 3, 2007, a total of 25M shares
for each date.
Valuation
Our $17 price target is based on a 12.5x multiple to our FY’07 EPS forecast of $1.39. A 12.5x multiple is
consistent with the company’s historical median forward P/E.
Risks to our Investment Case
Continued Strong HDD Demand - We are forecasting slowing HDD demand over the next several quarters.
Should the growth rate be above our forecasts, there could be risk to our Underweight rating, as this
would likely result in upside to our earnings estimates.
Moderate HDD Industry Capacity Growth - Capacity growth is the other side of the supply/demand equation.
Based on the apparent market share aspirations of the various HDD OEMs and the recent levels of
industry CapEx, we expect an oversupply situation to result. However, if the CapEx does not translate
into higher capacity or if one or more OEMs decide to cede market share, supply and demand could come
into balance, benefiting pricing and margins. This development would likely result in higher earnings
estimates vs. what we are modeling.
Additional Seagate Market Share Gains - We believe that intensified HDD competition in the face of slowing
demand will limit Seagate market share gains. We also think that PC OEMs will be reluctant to let
Seagate maintain the majority of Maxtor’s desktop and enterprise share. However, should one or more
competitors stumble in PMR implementation, that volume could come to technology leader Seagate.
~~~~~~~~~~~~~
HIGHLIGHTS
• Initiating coverage of Western Digital with an Underweight rating and a $15 price target.
• As the clear cost leader in the hard disk drive (HDD) industry, we believe Western Digital is
positioned to gain share. We forecast share to grow by 3% in FY’07 and 1% in FY’08.
• However, we are concerned about industry conditions. PC and HDD demand growth is slowing,
HDD inventory has begun building throughout the supply chain, and recent trends in industry capital
spending foreshadow an acceleration of capacity additions. We see a challenging pricing
environment and margin compression in the coming quarters.
• The company’s pending transition to perpendicular magnetic recording (PMR) adds an element of
risk. We expect this to be a challenging technology transition for the industry and would like to see
additional evidence of high volume ramps by WD using this technology.
• Our FY’07 $4.9B revenue forecast is roughly in line with the consensus estimate of $4.8B. However,
our $1.61 EPS forecast for FY'07 is $0.19 below consensus estimates on lower gross margin
expectations.
DISCUSSION
We are initiating coverage of Western Digital with an Underweight rating and a $15 price target. We see
Western Digital as the clear cost leader in the hard disk drive (HDD) industry and believe that the
company is positioned for additional share gains in the desktop and notebook market segments.
However, we believe the stock will react to industry conditions beyond the company’s control including
slowing HDD demand, elevated inventories, and overcapacity. Additionally, we think the company’s
pending transition to perpendicular magnetic recording (PMR) adds an element of risk.
Expect Further Share Gains
Western Digital has become the industry cost leader by using a “fast follower” approach in terms of
technology adoption and leveraging strategic partnerships with its suppliers. These strategies have
resulted in lower levels of capital investment and R&D spending relative to its industry peers. This cost
leadership has enabled the company to gain 7% share in the desktop segment since 2002, and positions
the company well for continued share gains, in both the desktop class and notebook segments.
Thus far in 2006, we estimate that Western Digital has captured 2-3% of Maxtor’s 3.5” desktop class
share. Our checks indicate that Maxtor volume re-distribution is likely to continue through the next
couple quarters, as PC OEMs are uncomfortable with Seagate retaining the majority of Maxtor’s share.
We expect the heated price competition seen in Q2’06 to continue as desktop HDD competitors fight for
share. This plays to Western Digital’s forte as the low cost supplier and should enable the company to
win additional business. We also believe that Western Digital is poised to capitalize on its strengths and
increase its volume in the OEM-dominated, commodity 3.5” DVR/PVR market segment. All told, we are
forecasting 3.5” desktop class share gains of 3% in FY’07.
With the 2.5” notebook HDD segment beginning to more closely resemble the 3.5” desktop segment –
high unit volume, increasing price-sensitivity, and difficulty in differentiation on product features – we
believe that Western Digital will grow its share here as well. Moreover, we believe that industry glass
media supply constraints have limited notebook share for the company thus far. As availability of glass
media improves, we expect Western Digital to aggressively bid for share. We are forecasting 3-5% share
gains per year in the 2.5” segment.
Facing Multiple Industry Headwinds
Despite Western Digital’s cost leadership, we believe that the stock will be subject to industry conditions
beyond the company’s control including slowing HDD demand, elevated inventories, and overcapacity.
We review each of these items in more detail below.
Slowing Demand
Over the past few years the hard disk drive market has seen explosive unit growth, in part due to the
strong PC demand environment and in part due to the penetration of HDDs into new consumer electronics
applications such as media players and personal video recorders. PC growth rates have slowed in the
first half of 2006 and we believe that this trend will continue. As PCs represent approximately 75% of
total HDD demand, we expect the annual HDD unit growth rate to fall to 11% in 2007 (from 25% in
2005). (Figure 2).
Elevated Inventories
The industry has also benefited from tight supply over the last several quarters, which has helped to
stabilize prices. Whereas declines in blended ASP averaged greater than 10% per year over 2002-2004,
price declines moderated to low single digits during 2005 and early 2006 (see below).
However, the above graph also shows that price declines have begun to pick up in the most recent
quarters, most notably in the desktop and notebook HDD segments. This pricing pressure is consistent
with our supply chain models, which suggest that the supply tightness is diminishing. Inventory has
recently begun building at PC OEMs, PC contract manufacturers, hard disk drive distributors, and hard
disk drive OEMs (demonstrated below).
The last time HDD OEM inventory was at similar levels as today’s was in early 2004, when the HDD
stocks declined in value by over 50% until inventories were cleared.
Capacity Additions Expected
More concerning, the recent industry Capital Expenditures trend foreshadows a potential acceleration of
capacity additions, at a time when we expect demand to be slowing. The relationship between capacity
expansion and Capital Expenditures is presented in Figure 5. Over the past few years, there has been a
consistent relationship between capacity and Capital Expenditures four quarters prior - which is
reasonable, as four quarters is an approximate average between short lead time equipment for drive
assembly and longer lead time facilities or head and media equipment. We expect the growth in Capital
Spending since mid-2005 to translate into higher industry capacity in the coming quarters. Our capacity
forecast considers that a portion of the Capital Expenditures spending will be used for the industry’s
transition to perpendicular recording and that Seagate will decommission a portion of Maxtor capacity
(we assume Seagate will reuse two-thirds of Maxtor’s capacity) (Figure 5).
The industry’s capacity expansion plans are due in part to the optimistic consensus HDD demand growth
forecasts. Other contributing factors include the struggle over the 15-18% share that Maxtor held in the
desktop and enterprise segments prior to its acquisition by Seagate, and intensified competition between
the six vendors in the notebook segment. The HDD OEMs fighting for share in each of these segments
must believe they have the ability to supply the volume, and as share settles out some of this capacity will
be left unconsumed.
Figure 6 shows our HDD capacity forecast alongside our unit demand forecast. HDD demand growth has
been slowing since its peak in Q2’05, driven by moderating PC demand. The rate of capacity expansion
has exceeded demand growth thus far in 2006, contributing to the HDD inventory build and aggressive
pricing in the notebook and desktop markets. We expect slower demand growth to continue to be
outstripped by capacity additions in the coming quarters.
In sum, we think the combination of slowing PC demand, elevated inventory levels, and industry capacity
additions signals risk for Western Digital. We foresee a challenging pricing environment leading to
margin compression in the coming quarters (Figure 7).
Perpendicular Transition Adds Risk
The HDD industry is reaching the limits of areal density (bits per unit area) improvement using
longitudinal recording technology. In order to continue to increase GB drive capacity and maintain HDD
attractiveness vs. flash memory, the industry is transitioning to perpendicular magnetic recording (PMR).
As the first major HDD technology change in over a decade, this transition has been the source of much
concern. Seagate has been leading the charge and has introduced PMR-based products across its product
line. Other HDD OEMs, such as Toshiba in the 1.8” HDD space, have also adopted PMR. However, the
technology transition is not simple and looms as a potential disruptive force in the HDD industry. There
is the risk that one or more HDD OEMs will stumble in PMR development and proliferation.
One factor that makes PMR different than past industry technology transitions is that multiple HDD
components are affected. PMR implementation requires technological advancements for both media
(platters) and read/write mechanisms (heads), as well as management of their interactions. Vertically
integrated OEMs such as Seagate are advantaged in their ability to control the development and test the
compatibility of the affected HDD components.
Whereas Western Digital has been working closely with component suppliers in PMR development, we
feel that a few factors imply some level of risk to the company’s transition to PMR. First of all, Western
Digital is dependant upon component suppliers to successfully develop the required technology and then
execute to their product plans. Secondly, by heads and media being one level removed from each other
(not all in-house), the risk increases that their interactions cannot be fully explored, at least not to the
same extent as with a vertically integrated vendor. And with PMR shipments having just begun for
Western Digital, it is too early to say with confidence that issues will not arise. Finally, Western Digital
has been very successful at differentiating on cost, not on technology. It is possible that the complexity of
the technology transition could be an issue for the company.
We recognize that the company has a successful track record in managing technology transitions and that
it has begun shipping its Scorpio notebook drive with PMR technology. However, we believe that it still
could be a challenge to ramp PMR to high volume and proliferate the technology across the entire product
portfolio. While we are not betting against Western Digital being able to make this technology transition,
we feel that it is important to recognize the incremental risk.
Earnings Forecast
Our FY’07 forecasts of $4.9B revenue is roughly in line with the consensus estimate of $4.8B, as we
expect the company to continue to gain share. However, our $1.61 EPS forecast for FY’07 is $0.19
below the consensus estimates due to the margin pressure we expect in coming quarters.
Of note is that Western Digital has announced an internal investigation into its historical stock option
grants. As of mid-September, this review had not been completed and the company delayed the filing of
its 10-K Form for FY’06.
Valuation
Our $15 price target is based on a 9.5x multiple to our FY’07 EPS forecast of $1.61. Given the risk
inherent in Western Digital’s transition to PMR, our 9.5x multiple is below the company’s historical
median forward P/E (excluding the bubble period) of 11.7.
Risks to our Investment Case
Continued Strong HDD Demand - We are forecasting slowing HDD demand growth over the next several
quarters. Should the growth rate be above our forecasts, there could be risk to our Underweight rating, as
this would likely result in upside to our earnings estimates.
Moderate HDD Industry Capacity Growth - Capacity growth is the other side of the supply/demand equation.
Based on the apparent market share aspirations of the various HDD OEMs and the recent levels of
industry Capital Expenditures, we expect an oversupply situation to result. However, if the Capital
Expenditures does not translate into higher capacity or if one or more OEMs decide to cede market share,
supply and demand could come into balance, benefiting pricing and margins. This development would
likely result in higher earnings estimates vs. what we are modeling.
Successful PMR Ramp and Proliferation - We think the company’s pending transition to perpendicular
magnetic recording adds an element of risk. If Western Digital successfully proliferates PMR technology
throughout its product portfolio, there will be greater certainty regarding the company’s future financial
performance, and thus the stock would deserve a higher multiple.
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