Seagate: Markets Frets On Peaking Margins

This should be a big day for Seagate (STX). The company late yesterday posted strong results for the September quarter, provided Street-beating December guidance and told investors that for the June 2010 year, it should earn at least $2.20 a share on a pro forma basis, 30 cents above the consensus.

So, uh, why is the stock trading off?

Well, I’ll tell you why: the concern on the Street is that from a profitability stand-point, things aren’t going to be getting any better than this.

Seagate told investors yesterday that its long-range model is now for gross margin of 22%-26%; that is above the old model of 19%-24%. And the company said that margins in Q4 should be near the high end of the new range. The worry on the Street is that the company’s margin expansion has maxed out.

That theme came up repeatedly in today’s batch of Street research on the quarter:

• Keith Bachman, BMO Capital Markets: “Gross margins are peaking, which is usually a negative for a drive company stock.”


• Amit Daryanani, RBC Capital: “Seagate is likely operating at peak profitability metrics due to constrained supply.”


• Robert Cihra, Caris & Co.: “STX’s dramatic rebound now puts it within earshot of re-testing ‘peak’ margins, and thereby testing the stock.”

This is not to say that profits have peaked. Far from it. In fact, as CEO Steve Luczo told me yesterday, the June 2010 guidance makes no assumption about either a pick-up in IT spending or a surge in PC sales as a result of the arrival of Windows 7. Cihra notes that while investors may not want to pay up for historically volatile hard-drive industry profits, they might ante up for cash and cash flow. He thinks the company can be net cash positive by the March quarter, “something most probably wouldn’t even imagine just a couple quarters ago.” While the “directional” money has been made off the turnaround bottom in the stock, Cihra adds, there is still upside, with the stock trading for under 9x calendar 2010 EPS estimates.

I’d add that a subsidiary concern to the peak margin discussion is fear that Seagate at some point will ramp up capacity; if there is one thing drive investors have been trained to do, it is to shudder at the thought of capacity expansion. So while EPS estimates today are ratcheting higher to match the new guidance, the stock is floundering.

STX is down 33 cents, or 2%, to $15.22.