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Morningstar | Seagate Posts Solid 2Q, Although Performance Will Be Further Tested in 3Q; Maintaining $40 FVE

Seagate Technology reported second-quarter results that were in line with the firm’s prior revenue guidance and which slightly exceeded our expectations for profitability. The firm experienced solid demand for its mission-critical hard-disk drives, or HDDs, while also maintaining gross margins in the long-term target range. That said, guidance for the upcoming quarter indicates this solidity will be sorely tested amid global economic uncertainty which is expected to curb sales of PC products and slowdown nearline storage investments by cloud and enterprise customers. Both Seagate and Western Digital previously disclosed that nearline investment activity would be soft going into the back half of fiscal 2019, causing sales declines and depressing margins, but Seagate’s guidance (like its competitor last week) suggested the drawdown had not reached its nadir. We reiterate our view that despite near-term headwinds from cloud investment delays and macro impediments, data proliferation will require clients to invest in Seagate and Western’s high capacity products. As before, we expect the storage environment to improve in fiscal 2020 and we will maintain our fair value estimate of $40 and no-moat rating for Seagate.

Sales in the second quarter declined by 7% year over year to $2.7 billion, which represented a 9% sequential decline. Enterprise systems and flash-related sales increased by nearly 6% versus the prior year’s quarter to $225 million but it was not enough to offset the 8% decline from the much larger HDD segment. Mission critical enterprise products performed well, with exabytes shipped increasing by 13% sequentially. By contrast, nearline exabytes shipped declined by 22% versus the previous quarter causing enterprise HDD ASPs to slip by 9% due to the aforementioned pause in high-capacity demand. Despite the headwinds, gross margins remained solid at 29.2% during the quarter, within management’s target range between 29% and 33%.

Management expects revenue in the third quarter to total $2.3 billion at the midpoint of guidance, which would represent a sequential revenue decline of 15% and a nearly 18% loss on a year-over-year basis. The decline will be due primarily to the cloud storage investment “pause.” Management commentary also suggested that the burgeoning surveillance market, an area of higher margin products in the edge non-compute segment, was also being impacted by the macroeconomic environment delaying government investment in smart infrastructure. Adjusted gross margins in the upcoming quarter are expected to decline by more than 250 basis points sequentially to 26% due to mix shift and low factory utilization. As a result, adjusted earnings per share are expected to decline by more than 50% to $0.70 at the midpoint of management’s guidance.