Many of the most popular high yield stocks are real estate investment trusts (REITs), master limited partnership (MLPs), and business development companies (BDCs).
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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.
|Company||Operating Margin||Net Margin||FCF Margin||Return On Assets||Return On Equity||Return On Invested Capital|
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 enough to power 6.7 million American homes), improving the energy efficiency, and thus cost effectiveness, of data centers is a secular trend that will only continue.
Can’t Seagate simply transition to SSD based technology? The answer is complicated, but over time Seagate will be forced to evolve toward an entirely solid state business model if it wants to survive.
However, the problem is that its expertise is in hard drives, and it doesn’t seem to have a competitive advantage in SSD.
In fact the company outsources its NAND flash solid state memory from Micron Technologies (MU), specifically because it wants to minimize the high fixed costs that come with manufacturing this superior but more expensive form of memory storage.
That’s in contrast to major rival Western Digital (WDC), which acquired SanDisk in 2016 for $16 billion specifically because it was one of the world’s leading producers of solid state memory.
In other words, Seagate is at a distinct disadvantage when it comes to the long-term future, precisely for the kind of short-term cost cutting efforts it is currently pursuing (outsourcing SSD production) in order to stem the decline in its bottom line.
Seagate is also a vertically-integrated HDD manufacturer, making it more challenging and costly for the company to change directions.
As a result, Seagate’s dividend is likely to come under increasing pressure and even face risk of being cut or even suspended entirely over the coming years.
Seagate’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Seagate’s Dividend Safety Score of 19 means that it is one of the riskiest dividends on Wall Street.
That should come as no shock to investors, since Seagate doesn’t have that great record sustaining its payout during times of economic distress.
While Seagate has nicely increased its dividend in recent years, that’s been driven by its decision to raise its payout ratios, which are now approaching more dangerous levels.
Then there’s the issue of the company’s weakening balance sheet. While not yet dangerously overleveraged, with a current ratio still well above one and sufficient cash reserves to fund the dividend for the next nine quarters, Seagate’s torrid pace of buybacks has largely been funded by rising debt levels.
You can see that Seagate’s debt to capital ratio has increased meaningfully over the last decade. I prefer to invest in companies with a debt to capital ratio no higher than 50% in most cases.
While that may have worked when interest rates were at all-time lows and cheap debt capital was easily accessible, a rising interest rate environment could create a somewhat more challenging environment for the company.
When we compare Seagate’s balance sheet to its industry peers, we similarly see cause for concern.
While the leverage ratio is relatively low, at the same time the company’s high debt/capital ratio, and lower-than-average current ratio gives it a credit rating that is dangerously close to junk status.
|Company||Debt / EBITDA||EBITDA / Interest||Debt / Capital||Current Ratio||S&P Credit Rating|
Sources: Morningstar, Fast Graphs
Combined with the decline of its core HDD business, which could eventually become obsolete, Seagate will need to devote a larger share of its free cash flow going forward to deleveraging. You can see that Seagate’s sales have declined year-over-year each of the last eight quarters.
In fact, rating firm Moody’s (MCO) recently warned that it has a negative outlook on the company’s debt, which could soon result in a credit downgrade.
A downgrade to junk bond status could be troublesome for the company because it would mean much higher refinancing costs in the future, as well as less flexibility when it comes to acquiring SSD manufacturing ability going forward.
Given that Seagate will eventually have to invest heavily in SSD to remain relevant in the coming years, the company might not be able to afford the $727 million annual dividend cost.
Seagate’s Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Seagate’s Dividend Growth Score is 32, which at first may surprise you given the company’s strong payout growth in recent years.
However, we need to remember that Seagate is a company that appears to be secular decline.
Seagate will likely struggle with negative top and bottom line growth in the coming years, potentially causing its already high payout ratios to climb to unsustainable levels.
That could explain why the dividend has been frozen for the last six quarters.
Worse still, given the company’s worrisome business outlook, as well as its past history of completely eliminating its payout during the last recession, a best case scenario for Seagate is likely one in which it can simply maintain the current dividend, with little to no long-term growth potential.
Even if management continues the dividend, Seagate seems likely to underperform the market in the long-term, especially from today’s high valuations.
In the past year, Seagate has soared nearly 90% compared to the S&P 500’s total return of about 12%.
As you can see, not only is Seagate’s current P/E far higher than its industry median, but it’s also nearly triple its historic norm.
While the dividend yield is certainly attractive, and in fact is higher than 88% of its peers, given the dangers of a future dividend cut, owning Seagate shares at these levels doesn’t seem like a prudent idea to me.
|Company||Trailing P/E||Historical P/E||Dividend Yield||Historical Yield|
Seagate’s valuation almost seems to be completely ignoring the risk of SSDs to its core business. In fact, in its last earnings release Seagate didn’t even mention solid state storage, and during the conference call management only mentioned the term once.
I would prefer if Seagate more directly addressed this potentially existential threat, one that is likely to only further erode the company’s sales, profits, and cash flow in the years to come.
Concluding Thoughts On Seagate Technologies
Given the secular headwinds to growth that Seagate is facing, even the current high yield doesn’t compensate investors sufficiently for the risks that owning this company represents.
With many better quality high yield stocks available, investors really have no reason to put their hard-earned money at risk with what could very likely prove to be a long-term value trap.