Ole Hansen
As the Chinese stock market bubble bursts, Saxo's Ole Hansen looks at the dramatic effect this is having on world commodities and growth.
Article / 25 October 2012 at 9:21 GMT

Why the hard disc industry is too expensive at a P/E of 4

Equity Analyst

Executive summary

  • Thai floods have inflated the earnings of Seagate and Western Digital - the two main hard disc producers
  • Revenues, margins and earnings will all quickly come down due to ample inventory supplies
  • Current valuations will be possibly double or triple due to a rapid decrease in earnings and margins
  • Go short Seagate or Western Digital or stay out!

The hard disc industry was deeply affected by the Thai floods in the middle of 2011. Up to 60 percent of the manufacturing facilities for Western Digital, the biggest hard disc maker with a market share of around 45 percent, were severely damaged and could not be used for several months. This was a major setback for the industry as around 25-30 percent of global hard disc manufacturing was impacted in the second half of 2011.

The flood hurt the industry in two ways. It depleted the inventory of hard discs for consumers (PC manufacturers) and secondly the inventory depletion led to hard disc prices skyrocketing by 100-150 percent. For most industries inventory cycles are not important, but for notoriously cyclical industries such as the semiconductor or hard disc industries, inventory cycles can make the difference between a 50 percent gain or a 50 percent loss for a stockholder. 

Revenue and margins

Why prices skyrocketed?
After the flood, PC manufacturers began to quickly load up on hard discs due to the fear of shortage, sending hard disc prices sky high which in turn increased gross margins for the two main producers, Seagate and Western Digital (which combined have 90 percent of the market). Both companies went from gross margins of 18-20 percent to 30 percent from September 2011 to December 2011 (as shown in Chart 1 above), quite a massive, but yet temporary jump in prices and margins.

In these three months, Western Digital (Nasdaq:WDC) only benefited when its gross margins increased, but did not benefit from an increase in sales due to the fact that it could not produce the required ouput given that 60 percent of its manufacturing facilities lay idle. Margins for the comapny jumped from 19.7 percent to 32.2 percent, while sales fell from USD 2.7 billion to 2 bn. Seagate (Nasdaq:STX) meanwhile also benefited from an increase in selling prices with a jump in gross margins from 19.5 percent to 31.7 percent for the same three month period, but unlike WDC it also benefited by being able to sell more units since its factories were left intact by the floods. STX sales went from USD 2.8 bn to USD 3.2 bn, stealing market share away from WDC, which would continue until March of 2012, where revenues went up from USD 3.2 to USD 4.5 and margins increased a further 5 percent (all shown in Chart 1 above).

Sales are up, margins are up, and earnings are up, so why isn't the market buying?
Currently Western Digital and Seagate are trading at trailing P/Es of around 4-5x, which sounds like an amazing bargain given their strong growth in the last two to three years. But again we come back to the cylicality of the business which has and will have a huge effect on the companies' top and bottom lines. The cyclicality and the inventory factor is a huge worry for analysts who pestered Western Digital's management about it during the September 2012 quarterly earnings call. The company said that it was 'managing its inventory cautiously' and that it expecting to maintain its margins at around 30 percent with full year 2013 EPS at around USD 10. Sounds pretty good, doesn't it?

Not so fast... we can see that both Western Digital and Seagate's margins are starting to fall, albeit not by much, along with revenues, which tells me one thing, the companies' hard disc sales are declining but the companies have not yet thrown in the towel by reducing their selling prices, but this will come...

WDC and STX historical gross margins

We can easily see from Chart 2, that gross margins are extremely cyclical for both companies, with a 12 year 'normal' margin between 15 percent and 25 percent. We can also easily see that the large rebound from mid 2009 to mid 2010 was primarily driven by PC manufacturers rebuilding their hard disc inventory after the financial crash, when companies had stopped ordering hard discs due to the fear of a lack of demand. And now we see a similar upswing where PC manufacturers have been building back up their inventory levels after the Thailand flood fears. So what is next? Well since the industry hasn't changed much, apart from some consolidation, the industry will probably go back to the more normal margins in the low 20s. And this is the main reason why investors are not willing to pow into these stocks.

And we can see why in Chart 3. Because of their earnings cyclicality, when earnings peak, the stock price peaks and valuation bottoms, and when earnings crash, valuation increases and the stock price bottoms. Given that we are at peak earnings, investors are shying away from the stock and for good reason.

Cyclicality of earnings, valuation and stock price

We are starting to see a slowdown already as Western Digital just recently reported it Q1-2013 on October 22. The company’s sales dropped 15 percent from from its peak in June. The peak in June was undoubtedly due to inventory rebuilding and market share gains that it had lost to Seagate during the Thai floods. But inventory rebuilding which appears to have slown down significantly can not continue forever and this is where we are now, right after the earnings peak.

So if earnings are peaking, what are the 'normal' earnings?
We can see from Chart 2 that high selling prices and fat margins will most likely not persist, which begs the question 'what are the companies' normal earnings?' We can estimate Seagate's current normal sales to be around USD 11 bn to USD 12 bn at a reasonable gross margin of 25 percent, and a net income margin at around 10 percent. So over a normal inventory cycle, the company would be earning around USD 1 bn- USD 1.2 bn in earnings (a far cry from its FY 2012 earnings of USD 2.9 bn) growing at the expected industry growth rate of 8 percent. With Seagate's current market value of around USD 11 bn, the company can be seen trading a 'normal' or cyclically adjusted P/E of around 10, not too expensive.

The problem with this is obviously that the market is not so great at judging cyclicality, at least not in the long term. This is why in Chart 3 we see that stock prices of both WDC and STX are extremely volatile. Therefore it is still possible to make large profits from this.

Earnings should drop off a cliff faster than the market will sell off the stock, which will push valuations up, and this is when astute investors should be buying, at least that is the historical pattern. I normally do not advise to look for short term gains, but in this case, it does seem pretty obvious that sales and earnings will be coming down given the lack of positive earnings catalysts in the near future. And if you think the market is already aware of this, it is quite possible, but I believe that the market is greatly undervaluing the massive short term earnings risks that these companies are about to face.

Earnings volatility

How to trade this?
For aggressive traders, an aggressively priced put option in the stock or a short CFD on Seagate would be good trades to take advantage of the companies' earnings volatility. Although I believe that both companies are good short candidates, I believe that Seagate has more to lose since their earnings were more temporarily inflated by the flood and are therefore more likely to come down faster than Western Digital's.

For longer term investors who do not want to short, I would most likely wait until summer next year to put a long position, to wait out the inventory cycle and the bottoming of earnings. From a longer term perspective, the hard disc industry is expected to grow at around 8 percent until 2016, and given that the industry is a de facto duopoly, it would bode well for a long term investor.

Moral of the hard disc industry, buy when the P/E is high and sell when the P/E is low.

benlouro benlouro
very good article, thanks.
Cyprustrader Cyprustrader
very insightful!


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