Tuesday, June 12, 2012

STX: Evolving market, accelerating profits

Seagate Technology PLC (STX) makes data storage devices -- hard drives for computers and other tech products, such as DVRs. The company, incorporated in Ireland but headquartered in Cupertino, California, shipped its 1 billionth hard drive in 2008.

I'm writing about Seagate for two reasons. One is that David Einhorn's Greenlight Capital hedge fund has raised its stake in STX, a very public vote of confidence. The second is that I own and sell options on STX as part of my diagonal spread hedging strategy.

STX, like almost all stocks, was hammered in May. The price hit an all-time high of $32.55 on May 1, only to falter and then, beginning May 15, to tumble down to a low of $21.62 on June 1.

The price has since recovered a little, and for four days straight approached the $24 level, only to pull back to around $23 today.

I have no way of knowing what Einhorn is thinking when he doubles down on STX. I presume that Seagate's fall came because of worries about the Euro-zone crisis, and that smart traders who go long now are convinced that the crisis will be resolved in an orderly manner that will minimize collateral damage.

The analyst consensus on STX tilts toward the bullish side, although not strongly so.

Being one of the top hard drive makers these days has the air of being an top buggy-whip maker in 1888, the year that Karl Benz began auto production in Germany.

Storage technology is changing. My new Lenovo ThinkPad doesn't have a hard drive. It uses flash memory, with no moving parts above the molecular level. My music is stored somewhere out in The Cloud.

Hard drives will surely exist for decades to come, and but I would argue that the days of mass retail hard drives are drawing to a close. The primary markets going forward will be institutional data storage, with big, expensive drives but fewer of them. At the retail level, the main product will be solid state drives, an area where Seagate is also a player. The 2 billionth hard drive may not ship for a very long time.

That's not to say that Seagate's business will become unprofitable, only that the technology, the market and business model are evolving.

"Unprofitable" is not a word that applies to Seagate this year. It has a stunningly high return on equity, 64%, with a moderately high level of debt, amounting to 78% of equity.

Institutions own 74% of shares and the price is cheap: It takes only 72 cents in shares to control a dollar in sales.

Earnings have accelerated sharply the last two quarters, with very high upside earnings surprises in each.

The company trades 14.1 million shares a day, on average, support a very wide selection of options with extremely high open interest and very narrow bid/ask spreads. For an options trader, STX is liquidity heaven.

Implied volatility stands at 68%, near the top of the 6-month range. The trend has been zig-zagging down since June 5.

Options are pricing in an assumption that in the next month the stock will trade between $27.61 and $18.59 two-thirds of the time, a range that brackets a 20% gain or loss.

Bearish options -- puts -- are trading with volume 9% above the five-day average. Bullish options -- calls -- are trading at 51% of the average.

Seagate next publishes earnings on July 20. The stocks goes ex-dividend in July on a quarterly payout yielding 4.33% annualized.

Decision for my account: As noted above, I already own STX as part of a hedging strategy: I own  in-the-money August call options, and I sell front-month out-of-the-money call options for income, using the long August calls to hedge the short options in case I need to deliver actual shares to a buyer. The beauty of diagonal spreads the way I structure them is that I get to sell options repeatedly against the long calls, reducing my basis and, in this case, ensuring that my position is profitable even in a period of declining prices.

So the question here is whether or not STX is a reasonable directional play to the bull side. The market hasn't reacted with wild exuberance to Einhorn's announcement, so it's not a case of trying to catch the train after it has pulled out of the station.

The key chart point for me is the four failed attempts to challenge the $24 level, followed by today's pullback. I'd like to see a break above $24 and the establishment of a clear uptrend before entering. On the other hand, if I were contemplating shares, I would want to get in now in order to capture the dividend, possibly selling covered calls against the position.

At this point, for myself, I'm uncertain what I'll do. I already have substantial exposure to STX and must weigh the benefits of adding exposure against opportunities elsewhere that increase my diversification. If I had no exposure in my account, I would most likely open a bull position, either shares now or directional options, once a break above $24 had occurred.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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