WDC - Seagate: Capacity For Growth In 2023 - Upgrading To Buy

Summary

• We are moving Seagate to a buy as we believe the stock has hit its inflection point.
• We expect HDD industry demand-supply dynamics to improve this year; hence, we expect STX will outperform expectations in 2023.
• We believe STX provides a favorable risk-reward scenario even if the semi-space doesn’t rebound in 1H23. We expect STX to enjoy improved ASP and cloud customer demand for higher-capacity HDDs.
• We believe STX is not immune to macro headwinds, but still expect the company to gradually see HDD demand recover toward 2H23.
• We believe the downside has been factored into the stock for the most part. Hence, we recommend investors buy the stock at its current levels.

We are moving Seagate ( STX ) to a Buy rating. STX's 2Q23 earning results reported a 39.4% Y/Y drop in revenues but still beat expectations. While the 2Q23 earnings report showed sequentially and Y/Y declines, we believe the STX's major headwinds of a weaker spending environment and high inventory levels have been factored into the stock. We expect STX has hit its inflection point and believe the company is well-positioned to outperform expectations in 2023.

STX remains our favorite stock in the storage space, a preferred investment over competitor Western Digital Company ( WDC ). While both operate in the storage space, STX's revenue is more Hard Disk Drive (HDD) dependent, while WDC is more exposed to Solid Slate Drives (SSDs) and flash markets. We expect STX is better positioned to rebound this year as we see HDD industry demand-supply dynamics improving toward 2H23. Our bullish sentiment on the stock is further driven by our belief that STX is well-positioned to grow meaningfully, even if the broader semi-space doesn't rebound in terms of unit volume growth in 1H23. We expect STX to grow in 2023 due to cloud customers' adoption of higher capacity HDD and improved ASP driven by new products. We recommend investors buy the stock at current levels.

HDD industry demand-supply recover

STX's 2Q23 earnings results reported total HDD shipments of 113 exabytes, down 5% sequentially. Our bullish sentiment on STX is driven by our belief that HDD industry demand-supply dynamics will improve this year on two fronts:

1. Cloud Customer adoption of higher capacity HDDs:

We expect STX to benefit from the transition of cloud customers to higher-capacity HDDs. STX announced it would launch its 25TB-plus drives this quarter; we expect this to boost demand as the 20TB-plus family of nearline products made up 60% of nearline exabyte shipments this quarter. The company will also launch its 30-plus TB HAMR (Heat-Assisted Magnetic Recording)-based product family in its 4Q23 quarter; we expect this to drive growth in 2024. We believe STX's HDD offerings will drive mass capacity demand as cloud customers continue to adopt higher-capacity HDDs. We believe the company's depressed HDD sales over the past few quarters resulted from more cautious near-term buying decisions by cloud and enterprise customers. We believe higher inventory levels built up during the pandemic and the weaker spending environment have caused the stock sell-off over the past year, with STX stock dropping 35%. Going into 2023, we believe the major macro headwinds are behind STX. The company's 2Q23 quarter beat estimates for revenue and EPS, and we expect the company to continue outperforming expectations toward 2H23.

2. Improved ASP driving revenue

We're focusing on upgrading semi-stocks that we believe will be resilient even if the semi-space does not rebound meaningfully in 1H23. Part of our bullish sentiment on STX is our belief that the company's growth will also be driven by improved ASP in 2023. STX will be shipping new larger capacity HDDs, which we expect will move ASP higher- namely, the 20TB-plus family product line and 26TB SMR (Shingled magnetic recording)-based HDDs. We expect these products' improved ASP will offset any weaker unit volume growth in 2023. We expect the improved ASP to also help boost the company's gross margin in coming quarters even if units bottom in 1H23.

The better storage stock

STX and WDC are the two storage names constantly pegged against one another- and we believe STX is the better pick between the two. WDC stock outperforms STX over the past year- the following graph outlines both stocks' performance over the past year.

Despite STX's underperformance, we expect the company to be better positioned to see demand recovery than WDC. STX is more exposed to HDD markets, with HDD revenue accounting for 88% of total revenue in 2Q23. We expect HDD demand to recover faster than flash market demand to which WDC is more exposed. While we believe it's fair to say SSDs have largely replaced HDDs in Client/PC markets, we believe the larger capacity and lower cost-per-capacity unit of HDDs still make them a necessity to keep up with global storage demand.

We believe STX's HDD-centric business will experience demand tailwinds from cloud and enterprise companies in the long run and experience a quicker uptick in demand in the near-term compared to flash markets. WDC's recent quarter, 2Q23 , reported sales declining 17% sequentially and reported weaker HDD sales and flash revenues. We don't see the Client/PC market demand recovering in the near term, and hence are more constructive on STX as it shrinks its PC Client mix, effectively making any downsides in this market have a less significant impact on the company. On the other hand, we expect WDC to continue to be pressured by the oversupply in the flash market and the normalizing PC TAM. We expect STX to outperform WDC toward 2024 and recommend investors buy STX at current levels as an entry point into the storage space.

Valuation

We believe STX is relatively cheap, trading at 20.8x C2023 EPS $3.28 on a P/E basis compared to the peer group average at 25.7x. The stock is trading at 2.2x EV/C2023 Sales versus the peer group average of 5.0x. We believe STX is a value stock at current levels and recommend investors buy into the company's 2023 rebound.

The following table outlines STX's valuation compared to the peer group.

Word on Wall Street

Wall Street doesn't share our bullish sentiment on STX. Of the 26 analysts covering the stock, 11 are buy-rated, 14 are hold-rated, and the remaining are sell-rated. We attribute Wall Street's bearish sentiment to the weaker spending environment negatively impacting the storage space over the past year. Still, we expect demand-supply dynamics for HDDs to recover toward 2024. The stock is currently priced at $68 per share. The median sell-side price target is $70, while the mean is $66.

The following tables outline STX's sell-side ratings and price targets.

What to do with the stock

We're bullish on STX as we expect the worst of the macro headwinds to be in the rearview mirror for the company. We expect the company to outperform expectations this year, driven by a demand recovery for HDDs as cloud customers adopt higher-capacity HDDs. We also believe the company will benefit from improved ASP on its new larger capacity HDDs. We believe STX provides a more favorable risk-reward profile than its competitor, WDC. To top it off, we believe STX stock is relatively cheap compared to the peer group and for the growth prospects it holds in 2023. Hence, we recommend investors buy the stock at current levels.

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