Seagate: Cheap Stock, Great Chart

Every once in a while one my deep value style comes across a name that is compellingly cheap despite a big move and a good chart. Seagate is that stock, right here right now.

At $18, the stock trades for only 10x’s earnings…….for this QUARTER. Because of the Thai flooding and the Samsung deal, Seagate will have blowout profits this March quarter, and in calendar 2012 as well. I am estimating around $6-7 in eps this year. I also expect the company to generate $3 billion in free cash flow which will be returned to shareholders via CEO Steve Luczo’s excellent capital allocation program.

So with such massive earnings/cash flow why is Seagate so cheap? Much of the investment community is uncertain on how to value Seagate’s windfall. The likes of Goldman, JP Morgan, and Deutsche Bank relentlessly poo-poo the company and the industry. Well let me help them.

I won’t pay for Seagate’s short term flood related windfall profits, but I will pay for normalized profits and dividends. And both get me to $40 per share. Here is how. Assuming the WDC-Hitachi Storage deal closes this quarter, Seagate/Samsung will have around 40% market share of a 700 million unit industry on normal demand. That gives Seagate 280 million units priced at $60 per for around $17 billion in revenues. With gross margins at 25% and operating expenses at 10% that gives us 15% operating margins and 13% net profit margins. This $2.2 billion net is around $4.60 of normalized profits on 480 million shares outstanding.

But I don’t expect that share count to stay flat. With such massive free cash flow, and a large award from Western Digital, Seagate should repurchase at least 50-80 million shares in the next 2 years. So the normalized eps should rise to at least $5 per share. And, I expect a doubling of Seagate’s dividend in the next 2 years to around $1.50, or at least a 30% dividend payout ratio.

So where can the stock trade on these profits? Well, at 8x’s normalized profits, Seagate would be $40. At a 4% dividend yield, still rich in this environment, the stock would be $37.50. Do you want to avoid this $18 stock because Wall Street is worried that Seagate’s current annualized $8 eps run rate is unsustainable? I don’t think so.

Now Seagate has had a big run of the bottom. In fact, it’s one of the few tech stocks essentially at its 52 week high, despite the talking heads relentless disparaging of the HDD industry. And, I rarely support buying the 52 week high list. But in this instance, a powerful chart combined with a ridiculously cheap stock and excellent fundamentals should make for a much higher near term price move.

I have shared with you my price objectives if things play out as expected. However, they do depend on the industry’s final merger closing as well as the global economy holding up. The WDC Hitachi merger should get done. Why anyone would object to consolidation in an industry generating only 25% gross margins I will never get. It’s time for the HDD company managements to capture some value for stockholders in the form of consistent, acceptable returns on capital employed. It’s time they stop acting like technology’s airline industry.

And, success in this idea also depends on the global economy muddling through. A severe recession would crimp demand and hurt operating rates for the industry. Despite a better secular story from consolidation and pricing and accelerating demand growth for storage, the HDD business is still an economically sensitive one.

Seagate is a cheap stock with a good chart. The HDD shortage is real and the company is essentially on allocation for all of 2012. Astute management will use massive free cash flow to maximize shareholder value. I expect much higher profits, cash flow, and dividends to support a stock price that makes the current share level seem like a steal.

If you have room for an aggressive equity position in the risk-on side of your portfolio, take a hard look at Seagate. It’s not often one gets a chance to buy a stock breaking out at 4 x’s normalized earnings.