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One of the beaten down technology names that captures our interest during this market rout is Seagate Technologies (STX). This is primarily driven by its low peer comp multiples, hardware cycle refresh tied to next-generation consoles, and diminished supply chain exposure tied to the COVID-19 outbreak.
Given the scope of recent market volatility, and the degree to which it has affected equities over the past several weeks, investors need to be more selective. We think a recovery tantamount to the 1987 stock market crash could create alpha or returns that are abnormal. But, when assuming a recovery, we don’t anticipate returns to be evenly distributed among equities, as investors are likely to pile back into equities that have an identifiable catalyst that adds growth/momentum to the underlying narrative that’s not priced in.
Why Seagate Technologies?
We’re looking to invest into companies with a clearly identified catalyst that’s not priced into the stock. Of course, that’s a bit of a broad descriptor, but as we outline the impact from next-gen console hardware, which ties into the launch of Xbox Series X and (perhaps) PlayStation 5 in October, (which sits outside the timeframe by which COVID-19 disruption will likely impact the computing hardware supply chain in 1H’20). As such, we view the momentum tied to the launch of new console hardware to be a positive catalyst that could mitigate some of the supply chain disturbance in the storage/NAND segment. Not to mention, semiconductors tend to generate more revenue toward Q3’ or Q4’ of any given calendar year due to seasonality, so the near-term quarterly numbers are likely ugly, but also priced in.
However, the back-half contribution from console builds definitely isn’t priced in, and when taking into consideration Seagate’s already generous P/E multiple of 6.9x versus average semiconductor computer hardware P/E multiples of 17.61x, the stock is already trading at a substantial discount. Currently, Seagate trades at $46 per share, but we think there’s significant upside tied to its valuation. For example, Intel trades at 10.61x earnings, Western Digital trades at 29.57x earnings. The average storage device industry’s P/E multiple is 11.11x earnings. Therefore if Seagate reports in-line earnings of $5.05 for the current fiscal year, and the stock trades at 11.11x earnings the stock should eventually trade at $56.10 implying +22% upside. Keep in mind, this is a realistic scenario, and when valuations reflate across the computer hardware sector, the companies that are likely to outperform post market crash are the equities with implied revenue/earnings upside that’s not priced in. Therefore, we’re looking to buy some more Seagate shares in the near-term.
Trademarks Property of Microsoft & Sony Entertainment
It’s anticipated that both the Xbox Series X and the PlayStation 5 will come with an 1TB SSD and 825GB SSD, but what’s not commonly known is the hardware supplier (Seagate) for its exclusive external drive. Microsoft (MSFT) went with a custom Seagate SSD for its expandable storage. This is unlike AMD (AMD) where everyone already anticipates the impact from console hardware refresh to be inclusive of AMD parts and would be more comparative to prior console cycle impact. However, there’s very little news/financial coverage when pertaining to the SSD storage, or the supplier behind the next-gen Xbox and PlayStation, which is what makes us more excited.
Given the outsized dependency on HDDs (hard disk drives) in the prior console cycle, the transition to flash storage creates an outsized impact on performance, which can be witnessed here via a Microsoft tech demo involving a YouTube influencer.
Based on the teardown/preview the justification for flash storage is driven by:
- Heat dissipation and the need to conserve space in the Xbox Series X given the enlarged chassis.
- Faster load times and transition times (based on early developer kits with Xbox One game titles), which means the loading screens will be very minimal, and transition times will be blistering fast.
- Offloading of memory onto NVME flash enlarges the capacity of memory allowing game developers to load more items into games creating more immersive experiences, which is important for RPGs (role playing games) and also online multiplayer (where load times and server latency could be partially mitigated).
In terms of PlayStation 5 preview, there’s not as much information, so we’re anticipating Sony (SNE) to make a major announcement at E3 2020 (assuming the event isn’t cancelled due to COVID-19). This will provide gamers & investors more details on Sony’s proprietary storage. However, the news tied to Sony’s upcoming storage indicates that Samsung (OTC:SSNLF) will be the next major supplier, which makes sense as there were patent filings indicating that Sony had developed cartridge storage, thus requiring a custom design.
When there’s a custom design involved it implies the need for a fab to manufacture the custom SSD, which by necessity requires access to Samsung’s fabs, as it remains the world’s largest supplier of memory/flash storage thus having ample capacity. Therefore, we think the rumors tied to Sony and Samsung check out, because Sony still needs to take its custom design to a fab, and secondly Samsung’s announcement of custom storage for next-gen gaming hardware kind of just gave it away.
Sony revealed that its upcoming storage would operate on a PCIE 4.0 interface with data transfer speeds of 5.5 GB/s. Similarly, Samsung unveiled an PCIE 4.0 interface for storage via its CES 2020 introduction making it the first-gen counterpart from its prior PCIE 3.0 interface. Samsung also unveiled data read/write speeds that average 5.75 GB/s which is comparable to the data transfer rates Sony unveiled at a recent tech briefing.
Given all of this, why not invest in Samsung?
The inclusion into console hardware is less impactful financially, as Samsung’s revenue base is far more significant and broadly diversified with smartphone’s and displays creating more moving assumptions. Not to mention, Samsung already has disproportionate share in the NAND and Memory segment with Samsung dominating 35% of the NAND flash market as of Q4’19, according to Statista. So, it doesn’t move the needle as much when compared to Seagate Technologies (where Seagate generated 92% of its revenue from HDDs last quarter).
However, Western Digital (WDC) was the supplier for the PlayStation 4, and the absence of Western Digital in PlayStation 5 could prove to be a headwind. Of course, we could be wrong, but there’s little reasoning to suggest Sony went with a Western Digital SSD in its upcoming console.
Therefore, we’re primarily focusing on the opportunity from the frame of Xbox Series X revenue contribution to Seagate Technologies.
Quantifying the opportunity for Seagate Technologies
The implied upside for Seagate from the Xbox Series X is anticipated to be significant. Mainly because of the custom expandable storage CF Express cards that Seagate has developed for expandable storage for Xbox Series X. This custom storage expansion is impactful, as it’s anticipated that it will be the only expandable storage option for Xbox gamers for Microsoft’s upcoming console.
Trademarks Property of Microsoft and Seagate Technologies
Wedbush Analyst Matthew Bryson estimates that the CF Express Cards will be built in volume to the tune of 1 to 2 million units with an average price point of $100. Whereas custom storage won’t be necessary for the PS5, hence the peripheral opportunity is more distributed among other NAND makers.
This implies $100M to $200M revenue impact from the launch of Xbox Series X where Seagate’s Enterprise Data Solutions and SSD business generated revenue of $771M revenue in FY’19. Therefore, the inclusion at the mid-point of $150M revenue for its much smaller SSD/Enterprise data business is actually significant because it could drive revenue growth of +19.4% for the segment assuming organic growth remains constant for its other product lines.
Furthermore, it signals that Seagate can still compete for market share despite its overwhelming dependency on mass storage via its HDD business where it generated $9.6B revenue in FY’19. The HDD business mainly survives because of the need for cheap storage in data centers whereas the consumer business has mostly shifted away from HDDs in favor of either flash or NAND based storage.
Hence, the outlook for its core business remained mostly stable, as they announced the release of 16TB HDDs for enterprise applications such as network attached storage (NAS), mass capacity storage, and etc. While, expectations tied to COVID-19 impact was mostly contained to a widened revenue guidance range it doesn’t seem as significant of a headwind, but the markets have priced-in much more financial impact tied to the recent supply chain distributions tied to Coronavirus.
According to Gianluca Romano (CFO of Seagate):
As the Coronavirus outbreak continues, we have made our first priority the health and well-being of our employees and partners. We are also working with our suppliers to meet customer demand and mitigate risk to production, while we currently do not expect any material financial impact in the March quarter, there is still a lot of uncertainty, and therefore we are widening our revenue and EPS guidance ranges. With this in mind, we expect revenue to be in the range of $2.7 billion +7% to -7%.
Therefore in an absolute worst-case scenario assuming the guidance still applies, Seagate may report revenue of $2.51 billion in Q3’19, which still suggests y/y revenue growth from prior year comps. The company reported revenue of $2.3 billion in Q3’19, which suggests that if Seagate has managed to keep the impact to its supply chain more limited, and is able to report at even the low-end of the revenue guidance range – revenue is anticipated to grow by +9.1% in the upcoming quarter.
What about the risk factors?
Well, the downside to our thesis ties into the length of the COVID-19 outbreak and how disruptive it could be for the computer hardware supply chain. Expectations could shift to the downside if management’s revenue guidance proves to be too optimistic, or the scope of the virus impact becomes more disruptive than what analyst consensus expects. There’s a lot of uncertainty tied to the length of impact in the United States, and so as a consequence our thesis would be negatively impacted if business activity is affected for 6-9 months.
While, we remain optimistic on the transitional narrative. There’s also the fact that Seagate’s SSD business is nascent, and could fall further behind peers in terms of technical roadmap. Developing cutting edge flash memory is capital intensive so maintaining attractive margins while developing technical continuity in its storage business could prove difficult.
Conclusion
The company is making inroads to shift more revenue contribution to its nascent SSD business, which investors have mostly ignored, but there’s actually signs of life tied to their efforts given the impact of upcoming game consoles. In fact, we think Seagate trades at a discount when compared to peers due to its technology roadmap, and its dependency on HDDs versus SSDs. But, given the on-going transition into SSDs, and the need for cheap HDDs in datacenters we think investors have overly discounted the growth prospects of the company.
What’s more important isn’t the absolute dollar contribution of Xbox Series X, but the fact that Seagate is doing something to generate more expectations tied to its SSD business. Meaning that even if HDDs are considered a legacy business and could struggle to sustain revenues/margins due to tech obsolescence given enough years… the management team still seems to be doing a good enough of a job harvesting its core IP in HDDs while gradually ramping-up expectations tied to SSDs. When Seagate generates more notable revenue contribution from SSDs the doomsday scenario will likely abate thus shifting shareholders expectations to a less dire scenario, as the company returns to a more normalized valuation comparable to hardware peers in the technology space.
Therefore, we’re excited by the recent market rout, as we’re in a unique position to pick-up an already cheap stock at an even cheaper price without hardly any expectations tied to a transition into the SSD business where there are signs of enough progress to keep us excited. In other words, it’s not a value trap, but rather a re-emerging growth narrative that investors have mostly ignored thus creating an attractive investment opportunity.
Disclosure: I am/we are long STX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.