No. of Recommendations: 4
Hi everyone,


STX / WDC analysis: and

It may surprise some of you, but this morning is the first I had heard of the terrible monsoon flooding in Thailand and all the damage, death, and injuries that have been happening there. I don't have TV and don't listen to much news beyond what I can listen to on NPR during my (short) drive portion of my daily morning and evening commute. I just hadn't heard about it. (Now that I have, my wife and I will be donating some money to the Red Cross to help them help over there.)

I also don't keep daily track of the companies in this port except for checking for large price movements and WDC, while it's down for the week, hasn't been significantly down on any given day.

Having caught up a bit on what's been happening, going through the earnings release and the conference call, and comparing Seagate (STX) and Western Digital (WDC) fundamentally with the most recent numbers, and thinking about some things, here's where I'm standing at the moment.

I like the comments and focus of John Coyne, WDC's CEO. He said several times in the call (at least twice, once in the prepared remarks and once in answering a question) that "It's a very serious situation, but it's short-term in nature and we will recover from it." This, given that it will probably take a year for WDC and the industry to recover. I like the kind of long-term thinking comments like that one imply and I'll gladly hitch my wagon to a company with a management team that thinks like that.

Flooding impact
The impact of the flooding for WDC is that manufacturing capability will be constrained until they reopen the closed factories, and then clean and test (or replace) the equipment that was damaged in the flooding. That part's going to hurt WDC more than STX in the short term because WDC's factories happened to have gotten flooded while STX's hadn't. However, there are broader issues.

First, flooding has also affected the makers of the components of the hard drives. Those suppliers are hurt and they sell to more than just WDC. If those guys are down for a long time, the whole Thailand HDD industry -- including both WDC and STX -- will be hurt.

Second, the flooding has also damaged or destroyed a fair amount of infrastructure in the country, such as roads. If the manufacturers cannot move product from the factories (regardless if they're damaged by the floods or not) to shipping points and on to customers, then the industry as a whole is hurt.

Seagate market share gain
Several analysts see the situation as a bonus to STX and some have predicted that it could expand its HDD market share from roughly 31% to 50%, at the expense of WDC. However, the situation is very fluid with more variables than just who had to close factories (WDC) and who didn't (STX). See my points above. STX is likely to gain market share in the short-term, but over the long-term the picture is much murkier. WDC has a pretty good reputation for its HDDs and once it gets back on its feet, it will be aggressively going after any market share it managed to lose. Let's call this a mid-term (2-3 year, possibly) issue.

Will I be buying STX?
In a word, no. There are several reasons for this, all of them fundamental in nature:
      1) WDC has a stronger balance sheet, with $3.4 billion in net cash vs. STX's net debt of $584 million (I know, not terrible).
      2) WDC has no problems covering its interest payments, with a trailing interest coverage ratio of over 80x. STX's ratio is 3.5x.
      3) WDC manages its operations better than STX, with a (0.1) day CCC vs. 10.9 days for STX.
      4) Expected growth rates off of trailing FCF at tonight's closing prices: 0.1% / 0% / 0% for WDC and 11.3% / 5.7% / 0% for STX (usual 15% discount rate).
      5) D/E at WDC is 4.6% compared to 144% at STX.
      6) At current prices, the G&D P/E is 11.3 (well into value territory of < 16), while STX's is 19.7. Plus, it qualifies for two other Graham value points with earnings yield > 2x AAA-bond yields and total debt < 2/3 of TBV. If it paid a dividend (which it doesn't unfortunately), it would have a shot of meeting that criteria, as well (DY > 2/3 AAA-bond yield).

Now, I could buy STX, hoping it will fare better than WDC through this crisis and benefit in any share price rise, but after today's jump (27.9%), a lot of that's already priced in and there's still the very real risk that STX will end up being hurt just as badly as WDC if component supplier constraints and/or infrastructure issues in Thailand come to pass. Even the analysts upgrading STX today (e.g. Jayson Noland of Baird) say that STX is speculative given the uncertainties remaining in Thailand. Plus, with higher expectations come higher losses if and when those expectations are not met. There's less room for error in STX's stock at its current price.

Will I sell WDC?
Probably not. The comments by Coyne really impressed me. He gets that businesses are long-term things. Plus, the expected merger with Hitachi GST will help the company in the long term. Its factories in Thailand have not been flooded yet (just like STX's), so if the merger goes through this quarter (which is the goal, assuming the EU and other polities approve by the end of November), the short-term effect to WDC would be lessened to some extent.

Final thoughts
Well, one thing that this disaster has caused to happen is the total removal of the HDD inventory glut that had analysts so worried a mere 6 to 9 months ago. Prices are likely to go up, too, at least in the short term as supply tightens up.

I'm comfortable with the portfolio's position in WDC, sitting at a 4% level of investable capital. I might consider upping it, depending on how management handles the situation in Thailand, how they communicate that to shareholders, and the price.

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