If I were to start this article by writing “I don’t mean to brag, but…,” that’d be a lie. I do plan to brag. The act of stating that you don’t want to do something, and then going ahead and doing that thing strongly suggests that the first part of the sentence is just a way to make you look less personally odious. People who know me well understand on a deep level that I have no problem embracing my inner odiousness, so here goes. I’ve done well with my investments in Seagate Technology (STX). In late November of 2018, I wrote the first of two articles on Seagate. It was bullish, hence the very imaginative title “Buy Seagate Technologies” and investors earned a return of ~21% subsequent to that, as compared to a 14% return for the S&P 500 over the same time period. I then shifted to neutral and wrote in November of 2019 that I’d be selling my shares. Subsequent to that, the shares lost 15.6% against a gain of 2% for the S&P 500.
Today, I’ll endanger my record here and offer another commentary about whether it makes sense to buy back in again. I’ll try to make that determination by looking at both the financial history here and the stock itself. I’ll also recommend another options trade, as the last one I recommended worked out rather well in my estimation. For those who can’t stand my writing, and who somehow missed the title of this article, I’ll come right to the point. I think shares of Seagate represent great value at current levels. I think investors would be wise to buy.
The financial history here is impressive in my view. Although it’s been cyclical, obviously, over the past six years, profits have increased at a CAGR of about 4%, in spite of the fact that revenue has declined at a CAGR of about 4.5% over the same time period. Additionally, management has treated shareholders fairly well, as evidenced by the fact that they’ve grown dividends per share at a CAGR of about 7% since 2014. I think the dividend is obviously important to investors, so I want to concentrate here on whether the dividend is safe or not. In my view, if the dividend is secure, the shares will likely do well, and the reverse if the dividend is in doubt.
Dividend sustainability is all about cash in my view. For that reason, I want to review the size and timing of future outflows of cash, and compare them to likely current and future sources of cash. The greater the spread between these, the better, obviously. In keeping with my obsession about making your lives easier, dear readers, I’ve compiled a list of upcoming cash outflows. Please note that the 2020 CAPEX figure comes right from the latest 10-K, and the $467 figure is an average of the last three years of PP&E investments. Obviously, this is an imprecise measure and my goal is to try to understand what future year will be the most onerous on a cash flow basis. Based on the table, I think 2022 and 2023 will be particularly expensive for the company.
Source: Latest 10-K
Against those future obligations, the company has just over $1.6 billion of cash on hand. In addition, the company has generated an annual average of just over $1.93 billion in cash from operations since 2017. This suggests to me that the dividend is quite safe, and that I’d be very comfortable buying these shares if, to borrow the tagline of a timeless game-show, the price is right.
Source: Company filings
The Stock: Is the Price Right?
For better or worse, most investors can’t simply buy the future cash flows of a given business. We invest in companies via stocks that trade in a public market, and stocks are often a poor proxy for the fortunes of a given company, and they move up and down in price based on factors unrelated to the underlying company. For instance, stock markets are affected by the actions of central bankers. Additionally, institutional investors might affect stock prices generally when they determine that “stocks” are more or less appealing than some other asset class. This suggests to me that I need to write about the stock itself as a thing distinct from the underlying business.
When I look at a stock, I want to try to determine the risk vs. reward of the investment, and I think cheaper stocks have both lower risk and higher return potentials than more expensive stocks. In my view, cheaper stocks have lower risk because negative news is, to some extent, already “priced in;” so negative news won’t drive share prices much lower. They have potentially higher return because when cheap stocks post surprisingly good results, shares tend to spike upwards in price.
I judge whether a stock is cheap or not in a few ways, ranging from the more simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value, like earnings, free cash flow, and the like. The less an investor needs to pay for $1 of future value, the better in my estimation. In particular, I want to see a stock trading at a discount relative to both the overall market and to its own history. When I first wrote about Seagate, I made much of the fact that it was trading at a price to free cash flow of ~9 times. I became far less sanguine later when the shares were trading at a price to free cash flow of about 15.5 times. At the moment, the shares are closer to the lower band, per the following:
While I will be buying these shares at current prices, I can understand that an investor might be nervous about joining me because this is a particularly strange time in market history. Valuations generally remain lofty in the teeth of a global recession. In my view, an investor could be forgiven for wanting to wait for a more attractive entry price. There are two problems with waiting, though. First, there’s no reason to suppose that shares will continue to fall in price, as the dividends act as a sort of support for shares. Second, if the shares do drop in price, there’s no reason to suppose that the investor will take advantage of the drop and buy. Typically, shares will drop in price for reasons that seem immediately plausible. The platitude “buy low” is barely helpful in the context of a large drop in price that seems to make a great deal of sense. This is why so many investors, myself among them, look back longingly at massive price drops, wishing they bought and not sat on the sidelines. The fact is that humans are social animals who are very much influenced by each other, and it’s hard to buy when others are panicked.
I think short put options represent a great compromise for an investor who likes this business, but is nervous about buying at the current price. The short put generates an immediate premium, which satisfies the human need to “do something.” Additionally, the short put acts as a sort of Ulysses Pact (Ulysses pact), in that it can in some sense “force” the investor to buy at an advantageous price at a time when they may not want to. In an emotionally “cold” state, the investor decides that buying a given asset at a given price will lead to great long-term returns. The short put facilitates this by offering a compulsion to buy that asset at that price, no matter what the then current mood is. This is why I am such a fan of short puts, and I think my own experiences with Seagate validates this view somewhat.
In my previous missive on Seagate, I suggested that investors sell the June 2020 puts with a strike of $45. At the time, the bid-asked spread on those was $1.60-1.63. Although I didn’t happen to be exercised on these, there was a chance that I would be as Seagate dropped well below the strike price this past March, obviously. Had I been exercised, I would be sitting on a 9% capital gain in the space of a few months, which would have been good. As it stands, I’ll have to console myself in collecting the premium on seven of these puts, which is a fairly decent consolation prize in my estimation.
I like to repeat success when I can, so I’m recommending selling another batch of Seagate puts. At the moment, my preferred options to sell are the January 2021 Seagate puts with a strike of $40. These are currently bid-asked at $2.29-3.15, and they represent a “win-win” trade in my estimation. If the shares remain above the strike price, the investor will simply pocket the premium and drive on, which is obviously a win. If the shares drop in price, and the shares are “put” to the investor, they will be obliged to buy, but they’ll do so at a price that represents a great entry price. If the investor simply takes the bid on these, and is subsequently exercised, they’ll buy this great company at a net price of about $37.70. This corresponds to a dividend yield of just under 7%, and a price to free cash flow of just over 9. Please remember that that ratio is what got me excited about this company in the first place, so I think $37.70 would be a great entry price for this business.
I hope you’re excited about the prospects of a “win-win” trade, dear reader, because it’s time for me to significantly damage your optimism by writing about risk. The nature of the world is such that we humans must choose between a host of imperfect trade-offs. There is no “risk-free” option, and short puts are no different in this regard. We do our best to navigate the world by exchanging one pair of risk-reward trade-offs for another. For example, holding cash presents the risk of erosion of purchasing power via inflation and the reward of preserving capital at times of extreme volatility. Unless you’re just joining us, the risk-reward trade-off of buying shares is self-evident, especially in 2020.
I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money, and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.
Puts are distinct from stocks in that some put writers don’t want to actually buy the stock – they simply want to collect premia. Such investors care more about maximizing their income and will, therefore, be less discriminating about which stock they sell puts on. These people don’t want to own the underlying security. I like my sleep far too much to play short puts in this way. I’m only willing to sell puts on companies I’m willing to buy at prices I’m willing to pay. For that reason, being exercised isn’t the hardship for me that it might be for many other put writers. My advice is that if you are considering this strategy yourself, you would be wise to only ever write puts on companies you’d be happy to own.
In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day.
I’ll conclude this rather long discussion of risks by indulging my tendency toward tedious repetition, and I’ll use the trade I’m currently recommending as an example. An investor can choose to buy Seagate today at a price of ~$47.40. Alternatively, they can generate a credit for their accounts immediately by selling put options that oblige them – under the worst possible circumstance – to buy the shares at a net price 20% below today’s level. Buying the same asset at a one-fifth discount is the definition of lower risk, in my view.
I think this is a very well-run, shareholder-friendly firm, and I think the stock is trading very near a reasonable price at the moment. Most importantly, in my view, the dividend is sustainable, and I think there’s room for further increases down the road. That said, I can understand why some investors are either still shellshocked from the recent market tumult or they’re nervous about sudden recovery of stock prices in the face of a recession. For such people, I think short put options offer a lower risk way to “play” this business. For my part, I’m both buying back in and selling the puts described above over the next day or two.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in STX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In addition to buying shares back, I’ll be selling 10 of the puts described in this article.