Saturday, June 7, 2014

Should I Buy STX? 3 Pros, 3 Cons

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For the fiscal first quarter, Seagate Technology (STX) could not keep up with analysts’ expecations. Seagate earnings came to $1.29 per share and revenues were $3.49 billion while the Street was looking for EPS of $1.31 and revenues of $3.56 billion. Seagate stock fell by about 5% after hours.

It looks like the weakness was mostly due to a soft global economy. But again, Seagate stock has already had a big run, up about 64% for the year, so it’s not surprising that the stock is pulling back now.

Is this a buying opportunity, or could the stumble be a sign of things to come? To see, here's a look at the pros and cons:

STX Pros

Massive Operator: STX has a diverse set of storage products, including hard drives, solid state hybrid and solid state drives. STX also has a thriving service business that provides online backup, data protection and recovery. A key advantage for the company is actually its vertical integration — STX controls the design, assembly and manufacturing of its storage products. Because of this, the company has better control over quality and can also be quicker in getting to market. But that comes at heavy R&D costs, amounting to roughly 8% or $1.1 billion per year. Still, the company has 5,570 U.S. patents and 1,965 patents issued in various foreign jurisdictions.

Secular Trends: The amount of existing data continues to grow at an incredible pace, driven by the proliferation of mobile devices, cloud computing, social networking and Big Data. These things all require high-performance storage solutions like the ones STX offers. And going forward, there are likely to be even more megatrends that will boost growth. Wearable technology — like watches or Google (GOOG) glasses — and driverless cars will both be heavy users of data.

Shareholder Friendly: STX has a policy of returning 70% of operating cash flow and 90% of free cash flow in the form of dividends and stock buybacks. The current yield is an attractive 3.1%. And the company should have no problems keeping up the payments — after all, STX remains a cash machine. In the latest quarter, operating cash flows came to $682 million.

STX Cons

Cyclical: The performance of STX is highly sensitive to the global economy. Even a small deceleration of growth can turn into a material impact. Unfortunately, there are already signs of some headwinds. Consumer confidence in the U.S. dropped to the lowest levels in about a year, with the culprit likely being the 16-day shutdown of the federal government. This is even more troubling as companies gear up for the Christmas season.

PC Industry: The prospects do not look good for PCs. According to Gartner, shipments are forecasted to plunge by 11.2% in 2013 as growth in tablets is soars by an expected 53.4%. That’s bad news for STX. After all, the company gets about 13% of its revenues from Dell alone, and another 10% from Hewlett-Packard (HPQ). And tablets rely more and more on cloud-based memory, which hurts STX even more.

Competition: STX must compete against larger operators like Western Digital (WDC), Hitachi Global and Toshiba. They all have tremendous scale and top-notch products. As a result, the competition is often based on prices, which can pressure margins. But the storage industry also includes a spate of well-funded startups using next-generation technologies like Flash memory. Those startups could ultimately be key players for markets like tablets and smartphones.

Verdict

For the long haul, the prospects for STX look promising. The company has the scale and technology to benefit from megatrends like mobile, Big Data and cloud computing. What's more, it has the resources to pull off acquisitions of emerging startups that offer cutting-edge technologies.

In the meantime, STX continues to generate substantial operating cash flows. Of course, this means the company can pay strong dividends, which should help alleviate downside pressure on the stock. In fact, the valuation remains attractive, with a forward price-to-earnings ratio of a mere 8X.

So should you buy STX? Yes, in light of the factors above, the pros outweigh the cons on the stock for now.

Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.

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