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Morningstar | Seagate Preps to Weather Nearline HDD Headwinds; Lowering FVE to $40 from $42

Seagate Technology started fiscal 2019 off with a strong quarter, as results beat consensus on both top and bottom lines. Seagate benefited from solid demand for its mass storage offerings with total exabytes growing by more than 40% year over year. However, as Western Digital intimated on the call last week, a pause in demand from enterprise and cloud customers for the firm’s high-ASP nearline products is going to be leave total sales significantly diminished going for the next three to four quarters. In evidence of this, average ASPs in the quarter fell sequentially by 4% to $70 and we expect further declines throughout the year as cloud customers work through existing inventory. As a result, we are lowering our fair value estimate to $40 from $42 but we expect the decline in nearline demand is temporary as ongoing data proliferation will require increased high capacity products. Shares for the no-moat storage company are slightly overvalued, in our view.

Revenue in the first quarter of fiscal 2019 grew by 14% year over year to $2.9 billion, with strong demand from edge non-compute products like gaming storage as well as mission-critical enterprise units. Sales of units for the latter products increased by 15% sequentially and management announced that average capacity for the mission-critical market increased to 1 terabyte. Sales from HDDs in total increased by 6% year over year while enterprise systems and flash declined by 22% over the same period. Guidance for the second quarter assumes SSD sales will grow in the low double digits but will be offset by declines in systems sales. HDDs are expected to decline significantly because of the aforementioned weakening demand from cloud players as well as some softening in China sales amid the ongoing geopolitical situation. Total revenue is expected to decline sequentially by 9% at the midpoint of guidance to $2.7 billion while the firm expects to remain at the low-end for gross margins near 29%-30%.

While we are pleased that Seagate was able to drive growth from mission-critical products as a result of the relative strength they have in the market (in comparison with competitors Toshiba and Western Digital), longer term we believe SSDs will dominate these use cases and we project units declining by roughly 30% on average over our explicit forecast. Growth in nearline and high-capacity drives for business-critical processes are the critical market for the firm, which makes the near-term headwinds a slight concern. That said, we are pleased to hear that average capacity for business-critical products increased to 7 TB, with management detailing how the 10 TB nearline product is the dominant SKU driving enterprise revenue. Management intends to ship samples of the 16 TB heat-assisted memory recording devices in early calendar 2019 with the expectation of 20 TB drives based on the same technology shipping in 2020.

The broader NAND flash declines are a concern for the storage business in general but Seagate (unlike close competitor Western Digital) has a relatively small exposure to the technology. This will of course insulate the top and bottom lines from the extreme shifts in the supply and demand environment while still making the firm more at risk of missing out in the secular transition from HDDs to SSDs.