Seagate's Stock Is a Steal at Current Valuations

Making sure that our computers, iPods, mobile phones and digital video recorders can handle the load of our data-heavy addictions has put Seagate in a digital sweet spot. Independent research firm International Data Corp. forecasts that unit volume of hard disk drives will grow by roughly 61% to 700 million in 2010 from 436 million last year. Seagate is also solidifying its position in the external hard drive business with the launch of a new product line for consumers, and it's making a foray into storage services, both of which are markets with a lot of room for growth.

For investors, a recent selloff (see chart below) in Seagate's shares has made for a prime investing opportunity. Amid what I think are overblown concerns regarding the competitive threat of flash storage (more on that in a moment), the stock has fallen 14% since it hit a 52-week high of $28.51 on Jan. 25. Now, the shares are trading around $24.40.

"Clearly the market, blinded by overall market uncertainties, seasonality, tradition, or flash noise, is missing a true growth story in Seagate at current levels," wrote Needham & Co. analyst Richard Kugele on March 12.

Seagate is the leading hard-disk-drive maker in the world, shipping more than a third of all drives in 2006. During its latest quarter, which ended Dec. 29, the company grew its revenue by 30% to $3 billion and shipped a record seven million disk drives for consumer electronics devices such as iPods, digital video recorders, notebook computers and desktop PCs.

It's impressive growth, but the company isn't stopping there. Seagate Chief Executive William Watkins has reportedly said he plans to grow the company's revenue to $20 billion over the next three or four years. Just to put that goal into perspective, the company recently reiterated its expectation that it would rake in $11.5 billion to $11.7 billion in revenue during fiscal 2007, which ends June 30. During fiscal 2006, it recorded $9.2 billion in revenue.

The $1.9 billion acquisition of former competitor Maxtor, completed last May, should help Seagate reach that goal. With Maxtor, the company is solidifying its position in the external storage industry against such players as Iomega (IOM) and France's La Cie. It's also bringing its brand name, which is largely known by enterprise customers, directly to consumers.

Seagate's FreeAgent line of portable storage devices recently made their debut on store shelves. Referred to by the company as "data movers" these sleekly designed storage devices, the smallest of which is about the size of your typical cellphone, allow you to store and access your desktop on other computers. So when you hook in a FreeAgent device (usually through a USB or FireWire port), your passwords, web browser, contacts, email, etc., pop up on the screen as if you're looking at your computer at home. To get the Seagate name out to consumers, the company is planning to launch a marketing campaign and to use hip packaging that rivals Apple Computer's (AAPL).

With its recent $185 million all-cash acquisition of EVault, Seagate is also venturing into the online storage services arena. For a monthly fee, small-business owners and individuals can use EVault's software to back up their data, and Seagate will store it for them.

All of these moves will help Seagate expand its business and improve gross margins. In its latest quarter, the company's gross margins were just 20%. During a conference call in January, Seagate's chief marketing officer, Brian Dexheimer, reiterated the company's long-term goal of 24% to 26% gross margins. He said the company expects to increase gross margins to 24% in its current third quarter and to hit 25% in the June quarter.

All of the pieces seem to be falling into place at Seagate. However, one issue that has been weighing on investors — and Seagate's shares recently — is a concern that as flash memory prices continue to fall, flash storage will start replacing hard disk drives in the notebook computer and others markets. Appropriately named, flash memory is faster than the dynamic random access memory, or DRAM, found in hard disk drives. Flash holds on to data even after the power source is turned off, so there's no need to wait for a computer to boot up when it's turned on or comes out of sleep mode.

Flash fears were heightened by a recent research report written by American Technology Research analyst Shaw Wu, who predicted that Apple would unveil a small notebook computer that relies solely on flash memory. Other concerns have arisen that Apple will also convert its video iPod line to NAND, a type of flash memory commonly used in digital-music players, USB memory sticks and digital cameras.

Those worries, however, appear to be exaggerated. IDC's hard disk drive research manager John Rydning explains flash is still way too pricey to be the threat to hard disk drives. Hard disk memory costs less than a dollar a gigabyte while flash memory can cost anywhere between $5 and $10 per gigabyte, he says. So unless the capacity requirements are extremely low, the cost to have an all-flash memory device is pretty high. Even if flash prices plunge, Rydning still thinks computer makers will opt for a hybrid strategy. "Wherever flash storage is used, we expect a hard disk drive to be there in order to back up the data," he says.

Putting those fears aside makes Seagate, at its recently depressed stock price, an attractive opportunity. Needham's Kugele, who has a Strong Buy rating on Seagate's shares, says the stock is trading around nine times his calendar 2007 per-share earnings estimates of $2.60, when it should be trading closer to 13 times that amount at around $34 a share. (Needham has conducted investment-banking business with Seagate in the past 12 months.)

Citigroup analyst Paul Mansky recently upgraded his rating on the shares to Buy from Hold based on the company's valuation and its improving fundamentals. He has a $32 price target. (Citigroup has conducted non-investment-banking business with Seagate in the past 12 months and makes a market in the company's shares.)

Seagate's low stock price, improving profits and growing market opportunities are almost as attractive as all of those digital photos, music and video that its products let you store, except the former could give smart investors a lot more than just happy memories.