INVESTMENT THESIS
BUY-rated Seagate Technology plc (NGS: STX). Drive controllers for both HDDs and SSDs use a CPU, typically ARM-based. RISC-V is a free, open and standards-based architecture, and Seagate may be looking to move beyond ARM for its drive controllers particularly with NVidia having agreed to acquire ARM Holdings.
Although Seagate missed consensus revenue expectations for fiscal 1Q21 (calendar 3Q20), the company guided for strong sequential revenue momentum and may move to positive annual top-line comps in the second half of fiscal 2021.
Seagate is seeing stronger data center demand, which helps its mix and margins. Some key end markets, including mission-critical and enterprise server, continue to be disrupted by pandemic-related shutdowns. Others, including video surveillance and imaging (VSI), are showing signs of recovery. Seagate achieved sequential improvement in non-GAAP earnings in fiscal 1Q21. Profitshave begun to improve as demand has strengthened, and as supply-chain, production and go-to-market costs have normalized. Seagate is also benefiting from a higher mix of mass capacity drives for cloud customers. Going forward, the enterprise market is expected to gradually improve, while data center is expected to remain strong. Seagate recently announced a 3% hike in its quarterly dividend, and also added $3 billion to its share repurchase authorization. In a challenging time, this focus on shareholder returns sends a reassuring message to investors.
As industry demand recovers and normalizes, Seagate will for the first time meet an accelerating demand and pricing environment with a portfolio aligned with growing market opportunities, rather than with an overreliance on the client end market that formerly dominated. With the company’s shift toward growing, high-value-added markets, STX shares appear undervalued at current levels.
RECENT DEVELOPMENTS
STX rose 54% in 2019, ahead of the 39% gain for the information processing, data center and storage peer group. STX declined 7% in 2018; the peer group declined 14%. STX shares advanced 10% in 2017, compared to an 18% gain for the peer group. STX rose 4% in 2016, versus a 12% peer group gain.
Seagate announced its processors at the RISC-V 2020 Summit after several years of development. Seagate rival Western Digital also participated in the RISC-V Summit and is also developing RISC-V processors.
The two cores, based on RISC (‘reduced instruction set computing’)-V technology, are designed to power data mobility and trustworthiness, according to the company. They come in a system-on-a-chip (SoC) design.
Both HDDs and SSDs rely on controllers. Given a similar bus, controllers can be interchangeable between SSDs and HDDs. Controllers require a CPU, and the CPU is typically ARM-based. Unlike ARM, which is licensed, RISC-V is royalty-free; it is also an open and standards-based architecture.
In addition to what the company has identified as performance advantages, by adopting RISC-V Seagate may be looking to move beyond ARM for its drive controllers. That could be particularly important now that NVidia has agreed to acquire ARM Holdings.
The move is also consistent with what compute companies are doing in the modern era, which is designing their own semiconductors. For years, the balance of power shifted away from ‘box makers,’ meaning server and compute companies, as data center operators replaced expensive servers with white-box or customized solutions. In this environment, power shifted to semiconductor and software companies. Given that most semiconductor companies are fabless and rely on merchant partners such as Taiwan Semiconductor, that has opened the door for compute companies to regain the initiative by designing their own chips.
Apple is the most visible actor in this space, designing its own ARM-based ‘Bionic’ processors for iPhone and iPad. Apple has now also moved Intel CPUs out of its Mac family and is using its own CPUs. And Apple has signaled that it will be displacing Qualcomm mobile modems in its phones with its own design. Alphabet uses its own tensor chips in its AI data centers. We also expect Western Digital to announce RISC-V processors to displace ARM cores in its drive controllers.
For Seagate, this architecture is unlikely to figure meaningfully in the company’s products in the current fiscal year or even in fiscal 2022. Over time, the use of the company’s own cores will have a multitude of benefits, including increased performance, greater security, and lower power consumption. Additionally, use of these cores will increase the dollar content per device for Seagate’s HDDs and SSDs.
Although Seagate missed consensus revenue expectations for fiscal 1Q21 (calendar 3Q20), the company guided for strong sequential revenue momentum and may move to positive annual top-line comps in the second half of fiscal 2021. Seagate is seeing stronger data center demand, which helps its mix and margins. Some key end markets, including mission-critical and enterprise server, continue to be disrupted by pandemic-related shutdowns. Others, including video surveillance and imaging (VSI), are showing signs of recovery.
The major driver of Seagate’s sales and profits remains multi-terabit near-line drives for CSP, cloud data center, and enterprise customers. In October, CEO Dave Mosley stated that Seagate is building on the strong momentum of its 16-Tb drives, and is now qualifying its 18-Tb drives with multiple customers. The company’s 20-Tb drive, based on HAMR technology, is scheduled to begin shipping in December. The CEO further pointed out that environmental impact is lower in the larger drives on a per-bit power-consumption basis.
Data center investments vary among cloud service providers (CSPs) and internet content customers, and also reflect mass capacity transition timing and installed base replacement timing. Despite these complicating factors, Seagate is modeling sequential improvement in demand from CSPs and cloud data center customers overall in the December quarter and throughout fiscal 2021.
In other markets, the CEO stated that recovery was ‘well underway.’ Seagate experienced solid-double-digit revenue growth for consumer drives, which was partly seasonal but also reflected Seagate’s strong demand among prosumers, gamers and other high-end consumer HDD categories. In the video image applications (VIA) market, revenue doubled sequentially; this reflected a resurgence in on-premises security and smart video projects.
Weakness in enterprise demand for servers offset some of the strength in prosumer and VIA, impacting both nearline, mission-critical, and systems sales. Seagate recently announced a 3% hike in its quarterly dividend, and also added $3 billion to its share repurchase authorization. In a challenging time, this focus on shareholder returns sends a reassuring message to investors.
EARNINGS & GROWTH ANALYSIS
Revenue was just above the $2.30 billion midpoint of the $2.10-$2.50 billion guidance range, though below the $2.34 billion consensus call.
The non-GAAP gross margin was 26.5% in 1Q21, versus 27.3% in 4Q20 and 26.7%. The non-GAAP operating margin was 12.7% in 1Q21, versus 14.8% in 4Q20 and 12.8% a year earlier.
Non-GAAP earnings for fiscal 1Q21 totaled $0.93 per diluted share, down 9% year-over-year and $0.27 sequentially from fiscal 4Q20. For all of FY20, revenue of $10.51 billion was up 1% from $10.39 billion in FY19. Non-GAAP earnings totaled $4.96 per diluted share, up 3% from $4.80 in FY19.
For 2Q21, Seagate forecast revenue of $2.55 billion, +/- $200 million, for a range of $2.35-$2.75 billion. It also projected non-GAAP EPS of $1.10, +/- $0.15, for a range of $0.95-$1.25. At the respective midpoints, revenue would be down 4% year-over-year but up 10% sequentially; and non-GAAP EPS would be down 19% year-over-year, but up sharply on a sequential basis.
Our FY21 non-GAAP earnings forecast is $4.87 per diluted share. We are reiterating our FY22 forecast of $5.44 per diluted share.
FINANCIAL STRENGTH & DIVIDEND
In FY18, Seagate invested $1.3 billion in the Bain consortium that purchased TSM in order to assure access to NVM memory. In 4Q19, Seagate received a $1.35 billion payment representing the redemption of its ownership in the asset; Seagate retains access to NVM memory.
Debt was $4.16 billion at the end of fiscal 2020, $4.25 billion at the end of fiscal 2019, $4.92 billion at the end of fiscal 2018, $5.0 billion at the end of fiscal 2017, and $4.13 billion at the end of fiscal 2016.
Cash was $1.66 billion at the end of 1Q21. Cash was $1.72 billion at the end of fiscal 2020, $2.20 billion at the end of fiscal 2019, $1.85 billion at the close of fiscal 2018, $2.54 billion at the end of fiscal 2017, and $1.20 billion at the end of fiscal 2016. In mid-2015, cash surged to $3.3 billion following the WDC award. Seagate used much of that cash to repurchase shares.
Cash flow from operations was $1.76 billion in FY19, $2.11 billion in FY18, $1.91 billion in FY17, and $1.68 billion in FY16. Seagate has become an aggressive repurchaser of its stock, spending $29 billion to buy stock between FY16 and FY19. In October 2020, Seagate added $3 billion to its share repurchase authorization. Including that amount, as of October 2020, $4.2 billion remained on its existing authorization.
In September 2019, Seagate announced a 3% increase in its quarterly dividend, to $0.65 per share. That followed a multiyear hiatus. Previously, Seagate announced quarterly dividend hikes to $0.54 in October 2014, to $0.43 in October 2013, and to $0.38 in November 2012. Seagate, which suspended its dividend in fiscal 2009, initiated a quarterly dividend of $0.18 per common share in April 2011.
Our annual dividend estimates are $2.66 for FY21 and $2.74 for FY22. Cash flow coverage of the dividend remains about 2- to 3-times the dividend payment.
MANAGEMENT & RISKS
Dave Mosley became the company’s CEO in October 2017 after previously serving as president and COO. Former CEO Stephen Luczo is executive chairman of the board. CFO Dave Morton left Seagate at the end of August 2018 to become CFO at Tesla (where he lasted a month after clashing with Elon Musk). Gianluca Romano is now CFO. Seagate’s EVP of Worldwide Marketing is Jim Murphy, and its CIO is Ravi Naik.
A main risk for Seagate, as for other memory companies, is the possibility of a general economic downturn and a corresponding dip in demand for networking gear related to the pandemic. We believe Seagate has the financial strength, market leadership, and growth characteristics to weather this storm and emerge a stronger player. Further, it is serving multiple markets, including data center and compute, that are seeing accelerating demand based on data traffic growth driven by the shelter-at-home movement.
In 2018, Seagate invested $1 billion in the Bain consortium to assure adequate NVM supply. Toshiba Memory has since bought out that investment, while retaining its supply agreements with Seagate.
We are concerned that Seagate faces structural challenges in addition to the cyclical pressures impacting markets such as China. Seagate intends to ‘prioritize strategic positioning,’ which may entail an adjustment period as it reassesses its end markets.
The traditional HDD business has decreased its exposure to the PC industry, but still has some client sensitivity. HDDs are facing pressure from substitution (tablets and smartphones), technology (SSDs replacing HDDs in PCs), and economic factors. The newest risk is that industry margins are deflating faster than anticipated. We note that Seagate’s strong enterprise presence is a positive for margins.
COMPANY DESCRIPTION
Seagate Technology provides hard disk drives (HDDs) to the personal computer, enterprise server, storage, retail, and consumer device markets. In December 2011, Seagate completed the acquisition of Samsung’s HDD business for $1.4 billion in cash and stock. In calendar 2014, Seagate acquired Xyratex and LSI’s SSD assets. In 2018 Seagate invested $1 billion in the Bain consortium to assure adequate NVM supply. Toshiba Memory has since bought out that investment, while retaining NVM supply agreements with Seagate.
VALUATION
STX trades at 13.6-times our FY21 EPS estimate and at 12.1-times our FY22 projection. Given the long-term lag in STX performance, however, the two-year forward relative P/E of 0.57.
With industry rivals moving up sharply, peer indicated value has moved to the low $80s in a rapidly rising trend, and remains well above current prices. Discounted free cash flow valuation points to a terminal value in the low $100s, in a stable trend. Our calculated fair value of $95 per share is in a clear rising trend and well above current prices.
Overall, we believe that Seagate is closer to the end of demand and pricing weakness in memory than to the beginning. As industry demand recovers, Seagate will for the first time meet an accelerating demand and pricing environment with a portfolio aligned with growing market opportunities, rather than with the client end market that formerly dominated. We are reiterating our BUY rating with a 12-month target price of $75 (raised from $57).
On December 17 at midday, BUY-rated STX traded at $66.26, down $0.05.
Source: Argus
