Hard to pass on the hard drive industry?

Seagate and Western Digital are bigger companies than I like to talk about, but there's just a lot of neat things to think about.  The stocks have been talked about before on other sites and Whitney Tilson recently disclosed a position in Seagate.  Both investors spoke about it before the recently announced acquisition of Samsung's hard drive business, which means the prices have come up a bit.  Assuming the Seagate/Samsung deal and the deal for Western Digital/Hitachi close without problems, the market will become an effective duopoly with 2 players controlling 85%+ of the market for hard drives.  Companies that operate in duopolies or have an effective monopoly on certain products or services always interest me since they tend to have more pricing power than businesses in more competitive environments.

Tilson on Seagate (emphasis mine):

Tilson explains this is a tricky trade and one that requires investors to remain nimble.”It’s a declining business and could turn into a value trap,” he says. “But we think the demise of Seagate is overblown in the market. That’s why we own it.”Tilson explains that in these kinds of circumstance he believes, “If you buy it cheaply enough and there’s enough capital allocation you can make money. Seagate is very cheap, producing a lot of cash, paying north of a 4% dividend and buying back a ton of stock.”However, he reiterates “This is a bet that the business doesn’t decline as quickly as the Street thinks.”

I think there is a lot of risk in this business.  While pre-merger there is an effective net-cash position, the existence of debt puts unnecessary fixed costs into the operations, and post merger, Seagate will have a net debt position.  Debt takes away a lot of flexibility in a declining business.  Carlos Slim got a great deal (14%+ interest) tossing a lifeline to the NYT in the depths of the recession when advertising budgets were cut across the board.  Debt can force you to do things that aren't in the interest of shareholders simply because you have no choice.

The real question though, is my cherry picked example indicative of what could happen to Seagate?  Is that the kind of thinking Mr. Market is currently applying to Seagate's stock price?  The market has responded well to the announcement of continued consolidation because they anticipate higher margins due to less competition.  Tilson hints at this when he mentions "capital allocation" which I interpret as not throwing more money into this business and returning it to shareholders.  While the shares are admittedly cheap (both Seagate and Western Digital), I find it difficult to get a handle on what the next few years could look like.  The market seems to have already rewarded the companies with higher valuations from foregone margin improvement, further reducing the margin of safety one can receive.

My gut assumption was the companies like Hewlett Packard and Dell would account for like 20-30% of revenue each, but they are only 10-15% (only?).  As hard drives are a commodity product and Dell and HP aren't exactly morons, they likely sprinkle their business around to several suppliers.  It will be interesting to see who gains the upper hand in pricing power as the hard drive makers will have a higher concentration of customers, but will control most of the supply in the market.  The wildcard in this scenario is that with declining volumes due to technological shifts, the Seagate and Western Digital might chose to forgo margins in exchange for volume.

I think this situation has a lot of similarities to UVV and AOI, which I discussed previously.  They are both in declining commodity businesses, but operate as duopolies (tentatively for the hard drive makers). While I profess no knowledge of the future of digital storage technologies, as a casual observer it appears that hard drives will play a role for at least the next few years.  Tobacco leaf merchants will play a role for a while and face no risk of obsolescence, although the market seems to believe they will become redundant.  I find it curious that people state the proliferation of smart phones and tablets, which don't use hard drives, as a reason to be bearish on the hard drive manufacturers.  While some other form of storage may emerge for PCs, I don't think the majority of people will be forgoing purchasing PCs in exchange for their phones and tablets any time soon.

I think trying to sort the forest from the trees when it comes to a business in a declining industries with debt becomes a task beyond my capacity.  I would be a lot more interested if these businesses had little to no debt, because all the cash they generate would be for shareholders and it would take out a lot of the risk.  I know that the industry isn't going to disappear, there appears to be some likelihood of increased profit margins, and Mr. Market seems to have punished these stocks up until recently.  This will make for an interesting case study, but I would struggle to put an accurate value on the possibilities.