Ole Hansen
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Article / 01 November 2012 at 9:15 GMT

Seagate's large miss highlights deceleration in hard disk margins

Equity Analyst

Executive summary

  • Hard disk industry goes through regular industry decycling
  • STX's Q1 revenues and earnings fell 17% and 43% respectively
  • STX margins gross margins declined from 33% to 28.4%
  • Expect sales, earnings and margins to fall until summer 2013


Hard disk industry

I highlighted in a previous theme how the hard disk industry was going through its regular inventory decycling which pushes down revenues, margins and profits, along with stock prices. This cycle usually happens every 2 - 2.5 years and is eerily steady in timing and pattern (see Chart 1). This time around the management of both market leaders, Seagate Technology (NASDAQ:STX) and Western Digital (NASDAQ:WDC) which account for 90% of hard disk sales, believe that this time things will be different. The first quarter of 2013 says otherwise...

Revenues, margins and income are falling

Both companies are already seeing pressure on sales and margins. Although Western Digital beat its EPS and revenue forecast when it released its Q1 on October 22nd, the market was not reassured due to the 15% revenue and 31% net income decline from the previous quarter. Seagate Technology, which released its earnings on the 31st, reported an even bigger drop in revenues and earnings. STX's revenues and earnings fell 17% and 43% respectively as gross margins declined from 33% to 28.4% which I believe is just the beginning (see Chart 1).

As I argued in my post last week, Seagate has farther to fall than Western Digital. 60% of Western Digital's manufacturing facilities were damaged due to the Thai flood, while Seagate's own FABs were left intact benefiting the company as Seagate was able to temporarily increase its margins and market share as PC manufacturers were left scrambling for hard disks. But what we have seen in the past few quarters is Western Digital gaining back its market share.

Chart 1 says it all...

Chart 1 STX and WDC gross margin %

Due to the cyclical nature of the industry, both companies should see sales pressure coming the typical inventory cycle. As the effects of the Thai floods have receded, the boomerang effect of the cycle comes back as a bang. Segate's Q1 earnings reinforced my thesis that the technology hardware sector is going through an overall slowdown, specifically the hard disk industry.

Too obvious?

But if the inventory cycle seems like an obvious occurance, why aren't analysts more bearish? Well for one, analysts are tied to the forecasts of the management and management for both Seagate and Western Digital have been 'cautious' but optimistic, therefore analysts also have to be cautious yet optimistic.

Both companies have rationalized their 2012 margins as sustainable in the 30% region due to consolidation in the industry. Both companies believe that they will be able to sustain margin due to the pricing power that the company will have in this de facto duopoly but as we have see in both companies' Q1 results, the companies still do not control their selling prices which is still dominated by the cycle

In the long term the duopoly will certainly benefit both companies and both are in great shape, but in the next 6-8 months the inventory cycle will cast a heavy shadow on the companies, as inventory supplied to the industry is ample one year after the floods. Expect sales, earnings and margins to fall until the summer... along with the stock prices.

So to reiterate on my previous post, stay out of Seagate Technology and Western Digital or go short. Either way, you don't want to be long these stocks over the next 6 months. 






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