Seagate: different this time

Here’s a frightening combination: a company in a cyclical industry with gross margins and a share price sitting near historical highs, and analyst targets that assume those margins will stay high. This pair is a standard symptom of Wall Street’s commonest mental illness, the belief that when the cycle turns next time, it will be gentler than last time.

Seagate, which makes disc drives, has a 10-year average gross margin of 23 per cent. In its fiscal 2012 year (ended last June) the margin hit a peak above 30 per cent. So far this year it is in the high 20s – exactly where analysts are expecting it to stay through fiscal 2015. If one assumes that 10-year average margins are maintained for 2015, and that everything else stays fixed, forecast earnings per share for that year come out at something under $4, as opposed to the $6 or so expected now. Suddenly, Seagate’s price-to-2015 earnings multiple of under 8 times does not look cheap. Use the “normalised” $4 per share, as above, and the stock is worth $30 rather than $46. Eek. And to make matters worse, Seagate sells two-thirds of its unit volume to struggling personal computer makers. Tablets and phones use solid-state memory, not disc drives.

Yet the stock was one of the 20 best performers in the S&P 500 in the second quarter. So why isn’t the market anticipating normalised margins? First, the disc drive industry, having undergone a final round of consolidation two years ago, is now a three-player industry, with Western Digital and Toshiba rounding out the oligopoly. Second, the word “cloud” can be used with moderate coherence in the context of Seagate’s business: the centralised data centres that make distributed computing possible need lots of storage, supporting disc drive demand in the long term. Both points have some logic, but investors should be scared all the same.

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