Seagate Warning Spills Over, Even With Low Expectations Already Considered

Seagate Technology PLC (NASDAQ: STX) has gone from bad to worse. After losing 3% during a day when the broad market was higher, its initial loss was last seen at almost 4%, in the after-hours stock trading after the company issued a financial warning. This now gets the pullback down to almost 50% of its 2015 highs, and even worse than that from the 2014 highs.

Seagate’s preliminary quarterly financial data are a disappointment for the company and likely for rival Western Digital Corp. (NASDAQ: WDC). It might also reflect poorly on SanDisk Corp. (NASDAQ: SNDK) if the weakness spills over into Western Digital too much — at least that would be the case if M&A arbitrage investors worry about unlikely merger risks arising. As a reminder, these two companies are in a pending merger, but they have approved their merger and are awaiting closure in the second quarter of 2016.

Seagate announced that it now expects to report revenue of approximately $2.6 billion and non-GAAP gross margin of approximately 23% for its fiscal third quarter 2016. The company further said that it now expects to report HDD unit shipments were roughly 39 million, representing approximately 40% market share.

Non-GAAP operating expenses for the fiscal third quarter are expected to be approximately $438 million, slightly lower than forecasted non-GAAP operating expenses.

Most investors have been treading very cautiously on the portable storage market. After all, you can almost get a 1 terabyte (TB) drive for close to free now. Seagate’s previous third-quarter forecast was for revenues of closer to $2.7 billion and non-GAAP gross margin of approximately 25.6%.

The company noted that the difference in its revenue and non-GAAP gross margin from its prior forecast was mostly attributed to lower demand for traditional mission-critical HDD enterprise products, lower demand for its systems and silicon products, lower demand for desktop client products primarily in China, and its own decision to not aggressively participate in the low-capacity notebook market. The company further added that reduced demand was combined with focused inventory reductions decreasing its own factory utilization.

When the company said “primarily,” it seems like nothing was left out here. It seems systemic. Still, Seagate did go on to say that an offset to some of the weak demand was stronger than expected demand for its 8 TB nearline products. As such, Seagate believes that an increasing level of enterprise applications are shifting to cloud environments. This admission might seem a bit more than obvious to cloud and storage watchers.

Steve Luczo, Seagate’s chairman and chief executive officer, said:

We are disappointed that we did not anticipate the weaker demand in the March quarter. There are many complex issues impacting the traditional go to market channels in our market, which are reducing our forecast visibility. Despite the disruption of the shifts in our traditional mission critical HDD business in the near term, we believe the long term benefit of cloud architectures for end users, and the related need for very high capacity drives, is a net positive for Seagate and the HDD industry.

The Company is in the process of prioritizing our strategic positioning, manufacturing footprint and operating expense investments to achieve the appropriate level of normalized earnings. We anticipate that these actions will be implemented over the next several quarters.

Seagate’s 4% loss in the after-hours had its shares down at $32.50. It has a consensus analyst price target of $36.21, or did before this, and a 52-week trading range of $26.25 to $60.09. Its market cap at the close of trading on Wednesday was just over $10 billion.

Western Digital shares closed up almost 2% at $44.80 on Wednesday, but the stock was last seen down 3.8% at $43.08 in sympathy. The stock has a consensus analyst target of $69.96 and a 52-week range of $38.64 to $102.07. Western Digital was downgraded to Neutral from Buy at Longbow Research just the same morning, ahead of Seagate’s warning.

SanDisk closed up seven cents to $76.75 on Wednesday. Its shares were not seen trading in the after-hours, implying that there are little or no tertiary merger risks.

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