Seagate: When is a profit warning not a profit warning?

23rd July 2012 by The Harried House Hunter

By Nick Kirrage.

When is a profit warning not a profit warning? When it is accompanied by the news the company giving the warning has also bought back 10% of its entire market capitalisation in the space of just three months.

US technology company Seagate is a one of the world’s largest manufacturers of hard disk drives – a sector dominated by a handful of companies, most of whom operate out of Thailand. When the country was hit by severe floods last year, what has been described as “a fortuitous accident of geography” – its manufacturing plant is situated on higher ground than those of its competitors – saw Seagate as the only one with production unaffected.

This left the company with a choice – it could either ramp up its prices aggressively for the next few months or it could raise them by a more measured amount but, in return, lock its customers into 18-month contracts. This would prevent Seagate having to respond to orders on an almost weekly basis, which clearly makes running a business very difficult, and so it used its newfound position of dominance to improve its long term situation.

All of which has proved very positive for the company – with the exception of one small wrinkle. Seagate has had to warn the market its profits will come in marginally under the numbers included in its most recent quarterly guidance. No matter that the latest guidance had profits some 400% higher than where the company expected them to be before the floods – in the US, if you miss your numbers in any way at all, most investors tend to react very badly first and ask questions later.

We are not most investors, however, so let’s look at what is going on at Seagate in a little more depth. Over the next 12 months, analysts are talking about the business making $9 of earnings per share, which on a share price of $24 means the price/earnings ratio is not even 3x. Meanwhile the key consideration is not Seagate missing its three-month numbers by a fraction but what the structural improvement it says will come from the new contracts will mean for its long-term profits.

On this, nobody can be 100% certain but what Seagate’s management are sure – the company’s shares are currently undervalued. Nobody is giving the company any credit – either for sustaining today’s profits or for future profits being any higher than had been expected – and management are buying back stock like it is going out of fashion.

The last three months has seen Seagate spend in the region of $1bn (£647m) buying back roughly 10% of the company’s market capitalisation. When, in the wake of the Thai floods, Seagate’s fortunes and cash levels both improved dramatically, management targeted a reduction in the company’s outstanding share capital from 450 million to 350 million shares but the successful realisation of that plan depends on factors, such as the profits being made and the price at which the stock is bought back.

With Seagate’s shares having been quite weak of late and then disappointing in the short term, it has suddenly become a lot cheaper for management to buy back that stock. As a result, the company has been able to enjoy a reasonably virtuous circle where being able to buy back shares on the cheap leads to earnings per share rising further.

It is a powerful illustration of what can happen when a fortuitous turn of events coincides with a management team who seemingly understand not only how to take advantage of the cards they have been dealt to push through structural changes to improve the business but also who understand shareholder value.

In stark contrast to other managements who would prefer to seek out large – though not necessarily value-enhancing – acquisitions, the Seagate team to do not appear afraid to shrink their business in order to grow shareholder value.

To sign up for Mindful Money’s daily newsletter click here.

Leave a Reply

Your email address will not be published. Required fields are marked *