WDC - Seagate Technology: Downgrading To Hold - Mixed Demand Signal

2023-10-28 09:00:00 ET

Summary

• We’re downgrading Seagate Technology to a hold as we see a very mixed demand signal in 2024.
• We do not believe its legacy storage business will rebound in 2024 as flash (SSD) storage pricing is now extremely competitive in $/GB against small to mid-capacity HDD.
• We think the HDD industry's adoption of HAMR technology could depress cloud HDD unit volumes in 2024 as storage capacity growth could exceed industry storage demand growth.
• Furthermore, we believe the Video and Surveillance market will likely remain depressed as the China property market remains in turmoil.
• We now expect STX to underperform the technology peer group in the near-to-medium term.

We're downgrading Seagate Technology ( STX ) to a hold post-1Q24. We think 1Q24 and the outlook for the next quarter confirm a very mixed demand signal in 2024. This September quarter, sales declined 9% QoQ and 28.9% Y/Y to $1.45B, missing consensus by $40M and guided for sales growth of 7% QoQ to $1.55, trailing consensus of $1.61B. We're less optimistic about STX now as we don't think the legacy storage business will rebound in 2024 and believe the HAMR technology transition will harm unit volume growth.

Management was a bit guarded on the demand outlook; management guided for revenue of ~$1.4-$1.7B in the September quarter and missed the midpoint by $1B and then guided for ~$1.55B for the December quarter versus the expectation of $1.61, missing by $60M. We think the HAMR technology could act as a headwind in 2024 as we expect HAMR technology to depress cloud HDD unit volumes as it ramps in 2024. HAMR stands for Heat Assisted Magnetic Recording, which is the next-gen of enterprise hard drive capacity; essentially, HAMR is a magnetic storage tech for increasing the amount of data that can be stored on a magnetic device, so it increases storage capacity. We think with the industry transition to HAMR technology, there will be fewer cloud HDD unit volumes as customers won't need more volumes to keep up with capacity with the expanded HAMR storage capacity. Our main concern is that storage capacity growth could exceed industry storage demand growth; in other words, the capacity growth will outpace the growth in demand for storage capacity. Basically, there will be more capacity available than demand for it. We think customers won't need as many units to store data after the HAMR transition and see this weighing on unit volume growth for STX, which achieves the bulk of its revenue from HDD sales.

Additionally, we see a higher risk profile from exposure to weakness in China. We believe the Video and Surveillance market will likely remain depressed as the Chinese property market remains in turmoil; STX is exposed to China's slower-than-expected recovery, specifically to China's struggling property market and the weight this has on end demand to set up video and surveillance. We don't expect the company to outperform financially in the near-term.

The stock is up 27% YTD, outperforming the S&P 500 by 19%. The stock is up 17% over the past six months, versus Western Digital Corp ( WDC ), up by 17%, and S&P 500, up 2%. We now expect STX to underperform the technology peer group in the near-to-medium term. We recommend investors stay on the sidelines toward 1H24.

The following graph outlines STX stock performance against the S&P 500.

Near-term headwinds hindering outperformance

We're seeing a gradual recovery in cloud storage spending in 2024; mass storage sales increased 3% QoQ to $1.01B, and legacy HDD sales dropped 31% QoQ to $278M. We're constructive on recovering cloud storage spending into 2024 as we think it'll boost HDD revenue, accounting for 89.3% of total sales. Still, we see near-term headwinds weighing on STX's financial outperformance. Additionally, we don't see the legacy storage business rebounding in 2024 because flash/SSD Storage pricing now is highly competitive in $/GB against small to mid-capacity HDD.

The following chart outlines quarterly financial trends

We also think the HAMR technology transition will also harm storage spending, resulting in lower cloud HDD unit volume. While we previously expected this investment thesis to play out on a longer time frame, we now think this will be a headwind in 2024. The HAMR technology allows for more HDD capacity growth that could outpace storage demand in an already rebounding storage demand environment. We recommend investors wait for this headwind to play out.

Valuation

The stock is trading below the peer group. On EV/Sales, the stock is trading at 2.6x C2023 versus the peer group average of 5.1x. We think the macro weakness has been priced into the stock for the most part, but we don't see the stock outperforming into 2024. The following chart outlines STX's valuation against the peer group.

Word on Wall Street

Wall Street remains more bearish on the stock this quarter. Of the 25 analysts covering the stock, eight are buy-rated, 15 are hold-rated, and the remaining are sell-rated. The stock is currently priced at $67 per share. The median sell-side price target is $65, while the mean is $64 with 3-4% possible downside.

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

What to do with the stock

We now expect STX to underperform the technology peer group in the near-to-medium term. Hence, we're downgrading the stock to a hold. We see a less favorable risk-reward profile for the stock into 2024. We think STX is at a higher risk of underperforming due to the HAMR-based transition and China's end demand weakness. We recommend investors stay on the sidelines for 2H23.

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