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Why Seagate Stock Could Be a Yield Trap

Vince Martin

The fundamental case for hard drive manufacturer Seagate Technology plc (NASDAQ:STX) seems pretty easy to make. STX stock is cheap, trading at 1en times analysts’ average fiscal 2019 earnings-per-share estimates. And Seagate stock also offers one of the best dividends of any S&P 500 stock, yielding 5.45% at the moment.

Seagate (STX) Stock Is Cheap, But STX Stock Is Facing Risks

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The problem is that a cheap valuation, and particularly, a high dividend aren’t enough on their own to guarantee that a stock will perform well. Investors in stocks like General Electric (NYSE:GE), Owens & Minor (NYSE:OMI), Anheuser-Busch InBev (NYSE:BUD) and Kraft Heinz (NASDAQ:KHC) have learned that lesson lately. And there are reasons why STX stock looks so cheap and why its dividend yield is so high.

The Case Against STX Stock

From a broad standpoint, the main concern about STX stock at this point is reasonably clear: Seagate’s  business is declining. Analysts’ consensus fiscal 2019 revenue estimate suggests that, on average, by the end of this year, its sales will have declined over 5% per year for seven years. Earnings – again, assuming the Street is correct – will follow a similar (and slightly worse) trajectory. The-top-and-bottom-line declines factor in the impact of acquisitions (including Seagate’s purchases of Xyratex and a flash business from Broadcom (NASDAQ:AVGO)).

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Hard disk drive (HDD) sales have been pressured by continuous changes, such as lower PC unit sales and a shift away from DVRs (digital video recorders). In general, selling HDDs is tough: as Seagate itself points out in its filings, HDD prices generally decline over time.

Ten times earnings seems “cheap.” A 5.4% dividend yield looks attractive. But dividends don’t drive valuations, and STX will have to cut that distribution at some point because its business is declining. Seagate admittedly doesn’t look to be in danger on that front just yet, since its  payout ratio still sits at a reasonable 55%.


That said, Seagate hasn’t raised its dividend since 2016. And it only takes one downcycle – or a few more years of declining profits – for that payout ratio to rise, potentially putting the dividend at risk.

The Case for Seagate Stock

To be fair, Seagate’s current outlook isn’t quite that simple. Of late, STX has shown some signs of life. HDDs provide memory to outsourced cloud providers, at a cheaper cost than flash/NAND products from rivals like Micron Technology (NASDAQ:MU). And STX’s revenue rose 4% in fiscal 2018, while its prices have rebounded, with its ASPs (average selling prices) jumping to $69 in FY18 from $61 two years prior.

As a result, Seagate was able to drive adjusted EPS of $5.51 last year. And while the company is unlikely to repeat that performance this year, some external factors are weighing on its profits. Specifically, there’s been a clear slowdown among cloud providers, who have overbuilt their inventories, as fellow memory provider Western Digital (NASDAQ:WDC) has pointed out. Both Western and Seagate expect that headwind to abate in the second half of calendar 2019, when cloud providers should begin growing again.

And while the shares of MU and WDC have been hammered – down 38% and 52% from their 52-week highs, respectively – STX has performed a bit better. It’s down just 26% from its highs, thanks to a nice rally from its December lows.

That relative strength makes some sense. STX’s HDD business might be growing more slowly than NAND and DRAM memory businesses. But in terms of demand and particularly pricing, the HDD business is more stable. That’s a key reason why Seagate stock hasn’t been pressured to the same extent as other memory stocks.

And given the low valuation of STX stock, stable is good enough. If strengthening cloud demand offsets pressure in PCs and elsewhere, cost-cutting and new business initiatives (including the company’s small flash business) can drive modest growth. Something like 12-13 times $5 of EPS by FY21 gets STX stock over $60. Including dividends, that suggests annual returns of 20%.

What to Watch For

There are a couple of near-term problems with the bull case on Seagate stock, however. The first is – perhaps oddly – NAND pricing. Plunges in NAND have pressured other stocks,  but they also create a risk for Seagate’s business. NAND performs better than HDDs, but HDDs have kept some  market share due to their markedly lower upfront cost.

As a result, multiple analysts have worried that HDDs could be “cannibalized” by cheaper NAND. Seagate CEO Dave Mosley was asked directly about that potential trend at a recent conference  and admitted that a number of STX’s products could be negatively impacted.

The second problem is that even the “cheap” multiple of STX stock leaves little room for error. Seagate already is taking cost out of its business this year, giving it less room to do so going forward. Declining prices will consistently pressure STX stock and make its execution paramount.

And so ten times earnings might seem cheap , but for STX stock, it’s really not. The forward price/earnings multiples of STX stock have stayed mostly in the single-digits for the past few years. Analysts don;t expect STX to grow much in fiscal 2020, and they don’t expect STX stock to rise much, either. Analysts’average  price target on STX stock  (a bit over $43) actually is below the current STX stock price of $45.60.

I do see value in the memory space,  but I’m not sure that Seagate provides value. Micron stock still seems attractive, as I wrote in January, for reasons that go beyond the fact that it is “cheaper” on an earnings basis. WDC’s case is weaker, but it could attract value-seekers as well.

For Seagate, however, the problem is relatively simple. It’s in a really tough business. It’s not a business that is going to be valued at 20 times or even 15 times earnings at any point other than the bottom of the cycle. If STX is being too optimistic about the second half of the year, Seagate actually could be closer to a cyclical top. And that would spell disaster for STX stock.

As of this writing, Vince Martin has no positions in any securities mentioned.

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