Seagate Shares Shoot Higher

A postearnings rally continues.
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Seagate Tech

(STX) - Get Report

extended its post-earnings rally despite continued pressure on profit margins and a broad selloff in stocks.

Shares of the hard-disk drive maker were up 83 cents, or 3.4%, to $24.95 on Friday, following the company's report that fourth-quarter revenue grew 8.5% to $2.74 billion, beating most analysts' forecast.

The share price gains underscore investors' confidence that Seagate's operating efficiency can offset relentless price competition in the fast-growing market for consumer devices.

The company is relying on its manufacturing and research and development units to cut costs while bringing new products to market with minimal defects. That's a delicate balance that Seagate must reach as it sees the greatest growth opportunity coming from the consumer devices such as digital video recorders, video-game consoles and data storage equipment for home computer networks.

During the conference call late Thursday following the earnings release, Seagate executives refused to provide forecasts on how hard-drive prices would react to continued competition from Japanese conglomerates

Hitachi

(HIT)

and

Samsung

. Competition with these companies is clouding Seagate's insight into pricing trends for its hard-disk drives, executives said.

What is clear is that a growing portion of Seagate's sales is coming from consumer goods that use lower-priced hard drives. Price competition has exacerbated this trend. The end result is that the average selling price of Seagate's hard-disk drives is likely to continue sliding -- putting a ceiling on Seagate's profit margins.

Following the conference call, Chief Financial Officer Charles Pope said investors have recently asked whether they should expect operating margins to fall permanently below the company's target range of 24% to 26%. Some have suggested that operating margins might fall to 22% on a long-term basis.

"It's too early to tell if that's the case, but given the very aggressive pricing that we see and trend toward lower average selling prices, you could build a case that that's the likelihood," said Pope.

Seagate is working with the factors within its control, said Pope. The company has improved its factory utilization rates and cut operating costs. These efforts have lowered Seagate's break-even point from 17% of revenue to 13%.

The company has also steadily improved the amount of cash it generates from operations by keeping inventory lean and collecting receivables at a faster pace. In the fourth quarter, cash flow from operations rose to $373 million from $259 million in the March quarter and negative cash flow in the September quarter.

This will help the company to maintain is 40-cent dividend and to invest in developing new products.

What's more, the outlook for margins isn't entirely dim. Seagate and its chief rival

Western Digital

(WDC) - Get Report

stand to benefit from an expected rise in personal computer sales during the second half of the year, says Citigroup analyst Paul Mansky. He also expects industrywide capacity to fall in line with demand later this year, which could soften pressure on profit margins.

Citigroup provides investment banking services to Seagate and owns its shares.

"It's going to be a tough road for them, and its still early in the game, but I think margins are going to begin to creep up a little," says Chris Brown, manager of the Pax World Balanced Fund, which holds about 425,000 Seagate shares.

Brown also thinks that Seagate's stock price already reflects the price competition as well as the threat of competing technologies such as solid-state memory chips. He's expecting strong second-half sales led by continued strength in personal computers, and he says the "bloodletting" from the price war seems to be moderating.

"If they can pick up some momentum and gain some pricing power in the second half, I definitely think we'll see some price appreciation in the stock," says Brown.