Investors who bought Seagate for the massive dividend have had a nice surprise over the last year. But can Seagate’s 40% one-year run continue?
Investors in Seagate Technology PLC (NASDAQ:STX) have reason to celebrate. Shares of the hard disk drive (HDD) manufacturer have advanced by 40% in the last year.
The company’s strong return even caught its most ardent investors by surprise, as the most-rational bullish argument for the company was for it to match the greater market’s growth while continuing its outsized dividend yield, which topped 7.5% as late as October.
Even with the strong rally, Seagate continues to trail the market on both a three-year and five-year basis.
The question for new investors is whether both the stock’s rally and its dividend are sustainable. Is Seagate back from the dead?
IMAGE SOURCE: GETTY IMAGES
A tale of two consumers: personal versus enterprise
The Seagate story differs by end user. The prevailing bearish argument against Seagate is the rapid technology shift from HDD storage on laptops and personal computing systems to solid-state drivers (SSDs).
Although HDDs are cheaper with more capacity, SSDs are faster, more reliable, and with a smaller form factor for ultra-portable products like tablets and premium laptops. A combination of lower device sales, along with a shift to SSD-powered premium devices have hurt the company’s top line.
On the other hand, enterprise consumers have boosted Seagate’s performance as the company has greatly benefited from the rapid growth of data centers. HDDs continue to be used in these applications, and the growth of data centers and cloud computing continues to proliferate.
In the recently reported third fiscal quarter, revenue attributable to enterprise comprised 44% of total revenue, versus 22% for client compute; in the third quarter of 2016, those figures were 37% and 30%, respectively.
Seagate’s dividend is safe, even under considerable pressure
A cursory look at Seagate’s financials shows how the SSD shift has pressured the company. For comparison purposes, Seagate reported $10.8 billion in revenue in fiscal 2017, versus $14.9 billion five years prior, a total decrease of 27.5%, or 6.2% annualized. Further down the income statement, it was worse, as operating income fell 60.4% during this time frame due to margin erosion.
However, Seagate’s dividend appears to be safe. At the high point — fiscal 2016 — Seagate’s payout ratio was 66.5% due to a precipitous drop in free cash flow. The next year, a combination of $1 billion in cost cuts and lower dividend payouts due to share-count reductions dropped this figure to below 40%.
AUTHOR’S CHART. DATA FROM SEAGATE’S 10K
Notwithstanding significant deterioration in its end markets, Seagate will be able to service its dividend for the foreseeable future.
Seagate remains cheap, but caution is warranted
Even with the recent rally, Seagate is still a cheap stock, trading at 12 times estimated forward earnings. But in my opinion, Seagate is the true definition of a hold.
For investors shrewd enough to jump in when shares were yielding more than 7%, shares have put up solid gains and the company will be able to service the dividend for the foreseeable future as strength from data center application will offset the bigger personal market. Plus, it’s unlikely the valuation will further compress from this level.
But for investors looking to initiate a new position, its current 4% yield is not worth the risk of investing in a company that is rapidly being displaced in its primary market. There are lower-risk ways to earn a similar yield, and it’s likely the company’s strategy of cutting costs will eventually be exhausted, leaving investors with a stock tied to a declining market.
This article originally appeared on The Motley Fool.
