Friday, July 26, 2013


Well, Hutchinson has taken quite a hit today.  I suppose this is my worst case scenario from the other day - that the market reacts poorly to Western Digital and Seagate on Wednesday, and also to Hutchinson on Thursday.  I'm not sure why the reactions have been so bearish.  The companies' results and forward guidance seem more or less in line with expectations.  The only thing I can figure is that investors were hoping to see stronger forecasts for hard drive sales into 2014.

Looking at Hutchinson specifically, this is what I said in the pre-earnings post:
The main news will be Hutchinson's guidance on sales in the coming quarter and any color they add about further gains in the DSA (dual stage actuator) segment.  I don't expect it, but any more delays in additional sales from new DSA projects or larger than expected drops in TSA+ sales would require some soul searching about future expectations.  What I would like to see is a firm path to 125 million units per quarter over the next few quarters, with a good jump in sales in the 4Q 2013 guidance to something over 110 million units.
On this front, they forecast 100 to 110 million units for this quarter, which is slightly less than I had hoped, and in the conference call they pointed to a level of 130 million units by the summer of 2014, which is basically in line with what I had hoped.

It is odd to be disappointed with a stock that is still up 150% in 9 months, even with this drop.  In September 2011, they had quarterly production of 127 million units.  76 million of those were TSA+ and basically none were DSA.  Then the floods hit Thailand.  TSA+ sales had doubled over the previous year at that point, and I would have hoped to see a continuation of some aggressive trend of TSA+ sales once the flood effects subsided.  This is where my forecasts were wrong.  Net of DSA sales (DSA suspensions include TSA+ or TSA flexures), TSA+ sales last quarter were about 70 million units - basically flat from September of 2011.

Now, one thing that happened was that hard drive TAM (total available market), has declined unexpectedly over that time, due to declines in PC and laptop sales, but even given that, I was surprised by the abrupt change in the trajectory of TSA+ sales.

In the meantime, company guidance has been pretty accurate.  DSA sales are about where the company has always guided.  And, cost cutting measures have generally been near the company's guidance.  So, I can't really fault the company for my optimistic forecasts, and for all of my disappointment, the basic long-term story here is intact.

An optimistic speculator has to be careful not to give in to confirmation bias and friendly revisions in the narrative which causes him to go down with the ship.  But, I'm still pretty confident that this story remains basically on its long term path.  My earlier forecasts for Hutchinson factored in a probability of bankruptcy of 1/3 or more.  At this point in the story, that danger is basically off the table.  The very bad and the very good possible outcomes have been trimmed down, and we are basically gliding along to a valuation somewhere above $10.

One of my early valuation models was one that back-tested surprisingly well, based only on the level of the NASDAQ and gross margins.  Here is the model:

E(HTCH) = E(HTCH/trend) * HTCH(trend)

HTCH(trend) = 3.58*et*-.008 * (NASDAQ / 435.5)1.48492

E(HTCH/trend) = .066538 + 12.44242*(GM) + 2.572864*(CGM)
                                (.42)               (14.5)                    (3.9)
E(HTCH) = forecast share price of HTCH
t= number of months since March 1990
NASDAQ = level of the NASDAQ Composite Index
GM= trailing 15 month gross margin
CGM = 6 month change in quarterly gross margin
This is a backward looking pricing model, although the gross margin trend would bring in a sort of forward looking effect.   I developed this model in late 2011, so the period since then is out of sample.  It continues to work well.  In fact, it predicts a price today, based on last night's news, of $3.84!  Normally, I would naysay a backward looking model, but it could be the case that Hutchinson's extended period of bad performance has eroded management credibility enough that the market is discounting their projections.  But, in the several years that I have been following them, their guidance regarding margins has been very credible.  The dip in margins this quarter was from a mixture of issues that they had warned about and a reasonable one-time issue.  They are not a management team that comes up with one-time problems to explain every quarter.  And, in fact, last quarter had very good margins, which management warned were due to timing issues that would reduce margins this quarter.
In any case, here is the model, with a forecast price based on a gradual increase into late 2014 of quarterly production of 130 million units with gross margins rising to about 19% by then.  It's worth noting, though, that even if the current running, normalized sales and margins are used, with no sales growth at all and no savings from Thai production, this model still produces a target price of $9 to $10.

The fruition of this position is still dependent on margins coming through.  Here is a graph of recent gross margins:

After several years in the low single digits, gross margins are now near 10% again.  Even with no sales increases, margins will gain another 3% as production continues to be transferred back to Thailand.  Margins are only at 19% at the top end of the forecasted price level above, which is still conservative.  If the company's plans for DSA units continue to play out, gross margins would get into the 20% to 30% range again, at least until the next disruption in their market.
As a reality check, here is how my forecast looked at the beginning of 2012:
At the time, I had 3 scenarios for sales levels.  Except for Scenario 1, they were all too optimistic for this time frame, although the differences aren't as great as they seem.  The market doesn't seem to be smoothing out the noise of the last couple of quarters in it's valuation.  The forecasted margins that fed this forecast were near the margins that the company is experiencing.  The top end of guidance for this quarter would basically match scenario 2, with a one quarter delay in the timeline, which is acceptable considering the decline the hard drive market has seen compared to expectations from early 2012.
I am confident also because they have a tremendous asset base, which due to accelerated depreciation and write downs during the previous years where sales have lagged, is largely off-balance-sheet.  This means that GAAP profit will understate cash flows by around 70 cents per share for some time.  In this case, that difference warrants the same valuation multiple of GAAP earnings.  So, even on a no-growth trajectory, with a very low PE multiple, we are looking at conservative valuations above $5.  Those valuations increase substantially as DSA sales continue to grow.
In summary, this looks like a position that a strong investor needs to hold onto through volatile noise.  Operationally and financially, this is actually a much safer position than it has been any time in the last several years.  I'm not always right about these things.  I've ridden my share of positions to zero.  So, while I can't promise that this position will avoid future losses, I can promise that the speculator who tends to sell this kind of position when markets move like they did today will always in the end lose everything.
The one change in position that might be warranted going forward could be to replace some long shares with February (or May, when they come out) call options, which, at the appropriate leverage, could provide some downside protection in a worse case scenario where DSA sales don't come through, and higher gains in the scenarios which I expect to see.  The high volatility makes the options look expensive, but I think they have been worth the high price more often than not, and will continue to be as the company goes through this paradigm shift.

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