Many of the most popular high yield stocks are real estate investment trusts (REITs), master limited partnership (MLPs), and business development companies (BDCs).
When it comes to regular corporations, however, a very high dividend yield can be a warning sign that something is fundamentally flawed with the company’s business model.
Many of these companies tend to have relatively low Dividend Safety Scores, indicating that their dividends could be at risk of being cut in the future.
Let’s take a closer look at Seagate Technology (STX), which offers a high dividend yield above 5% and has paid higher dividends for six straight years, to see if the stock could be appropriate for our Conservative Retirees dividend portfolio.
Founded in 1978 in Dublin, Ireland, Seagate Technology is one of the world’s largest suppliers of data storage hardware, including hard drives, solid state hybrid drives, solid state flash based drives, and memory cards.
The company’s products are found in everything from PCs, mobile phones, tablets, and digital video recorders (DVRs) to cloud computing servers.
However, Seagate’s fortunes continued to be tied to its specialty, hard disk drives (HDDs), which is the industry it helped pioneer.
HDDs are devices that store digital information on rotating disks with magnetic surfaces. They have been used in a number electronic devices such as PCs for decades.
Up until recently, Seagate was flying high on the boom in demand for data storage devices.
While that demand continues to grow rampantly, the company is facing major challenges in growing its top and bottom line on two fronts.
First, the introduction of solid state, NAND flash memory, or SSD technology, has really cut into Seagate’s growth runway.
Unlike hard drive memory storage, which involves a physically spinning magnetic medium, solid state NAND memory has no moving parts.
This makes it more reliable (less likely to break), far more energy efficient, and also much faster to operate (instant on vs. boot up).
As a result, technology research firm Gartner forecast in early 2016 that enterprise SSD industry revenue could surpass HDD revenue this year.
The second major challenge Seagate has faced is that it’s operating in a fiercely competitive and highly commoditized market, one that is increasingly pressured by weakening demand for desktop computers as well.
That results in weak pricing power because increasing HDD production from low-cost rivals in Asia means Seagate is in a constant battle for market share, pressuring its margins and returns on shareholder capital.
You can see that the overall disk drive market’s revenue has shrunk over the past two years, while Seagate’s market share (green bars) has also declined. Toshiba’s share gain was driven at least in part by its broad presence in both HDDs and SSDs, which makes it easier for customers to consolidate their business with one supplier.
However, the news isn’t all bad for Seagate. For example, while the data storage business may have razor thin margins, Seagate has been able to generate better-than-average returns thanks to its economies of scale and aggressive cost cutting efforts.
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In fact, management’s dedication to disciplined capital spending is why Seagate still generates substantial free cash flow, which allows it to return cash to shareholders via aggressive buybacks (share count declining by 7.1% CAGR over the past nine years) and one of the market’s most generous dividends.
In addition, the overall market for data storage devices continues to grow at a torrid pace and is expected to rise to 1.181 million Terabytes per year of shipments by 2020 (more than double 2015’s shipments).
The strong growth in data storage devices is due to a multitude of factors, including the rise of big data, artificial intelligence and machine learning, the growth of the internet of things (including driverless cars), and cloud computing.
In fact, the amount of data being generated per year is expected to rise almost 10 fold from 16 zetabytes last year to 163 zetabytes, or 163 billion terabytes, by 2025.
Increasingly more and more of this data is being stored in the cloud, requiring massive growth in giant data farms.
On a cost per GB basis hard drives still have the upper hand, thanks to ongoing innovations by Seagate such as heat assisted magnetic recording.
This technology uses a laser to heat the part of the disk that data is being written to, which increases the data density of the material.
In other words, it allows Seagate to increase the capacity of its hard drives and thus prolongs the length of time that HDDs will have a cost advantage over solid state devices.
However, it’s important to remember that at some point SSDs will likely come down in price enough to convince many of the world’s data centers switch to this competing technology.
This is really the largest risk to long-term Seagate investors.
The only reason that Seagate’s business hasn’t declined more in recent years is because the volume of data being generated by the world (and the need to store and analyze it) has grown so much faster than the improvements in SSD costs.
However, remember that SSDs are generally superior to hard drive storage because their lack of moving parts makes them much faster, more reliable (longer lasting), and energy efficient.
At some point in the future, when SSDs become more cost competitive with HDDs (which can only be improved so much based on physical limitations), the world’s data centers are more likely to make the switch to run entirely on SSD-based server farms.
That’s especially true because SSD servers would be able to last far longer and consume vastly less power.
Considering that U.S. data centers are expected to consume 73 billion Kilowatt hours of power by 2020 (about 2% of all the electricity used in the U.S., which is