Outback Steakhouse and Seagate Technologies

I was just sitting in the shop while it stormed outside, three quarters done with this post, when I noticed the lights flicker in the bar. I quickly hit the save as draft button just as the power went out across the entire building, saving this post for posterity. You'd think that the power would all go out simultaneously, but since I replaced the copper wires with praseodymium ones the electrical impulse was delayed long enough for me to save this post. And no, that really doesn't make any sense even if you read the article it's linked to, which is totally sweet since it deals with a breakthrough for quantum computing...

My blog is in some ways a reflection of myself, in the sense that what I blog about is a reflection of my interests. As of the past week, one thing I find myself becoming increasingly interested in is the stock market and investing in general, so don't be surprised if more and more of my posts relate to the current moves I'm making in the market- as opposed to things like why Ted Kennedy deserves a good dousing at the public urinal.

Case in point: After my initial killing on InFocus (infs), my next move was to acquire Seagate Technologies and Outback Steakhouse. For reasons as to why I bought Seagate, read Barron’s article. You can't access it without a password, so I'll paraphrase from the interview.

Seagate, the largest disc drive maker, is down to $15 from $21.
Marcin: The run rate of earnings is $2.20 a share (me: that is one of the main things we look for, apparently we'll buy just about anything if earnings are $2 a share.).

So this is a classic defiance stock? (me: A defiance stock is one that you buy when current opinion is against it, i.e. in defiance of prevailing market strategy)
Marcin: It is a classic stock where the P/E ratio is too good to be true. One of two things has to happen. The stock price has to go up meaningfully, or the earnings have to degrade materially. We believe that the investment community has it wrong this time on Seagate.

What's the knock against SeaGate?
Marcin: The knock is that the disc drive cycle is as good as it gets. And SeaGate is doing so well from a profitability and competitive perspective that it can't get any better. We think that is silly. Seagate is the market leader with a 30% share. Unit growth is accelerating because of consumer electronic applications and pricing degradation is slowing. For the first time in five years, the industry is experiencing double digit revenue growth, yet there are only two companies making money, Seagate and Western Digital. The other [4] are breaking even. There is no incentive for the industry to embark upon a price war when the industry on a whole is breaking even.

What's going right for the industry?
Marcin: The consume electronics market, which was only two million units two years ago, could be 75 million units this year. Disc drives are in mp3 players, set top cable tv boxes. The home run application would be cellphones. We don't know yet whether small disc drives or flash memory takes over the storage function of a cell phone handset. Nokia makes a fun that has a hard drive in it, if the industry gets 10% of the cell phone market in three years, that will be 100 million hard drives in cell phones. If that story plays out, Seagate, with it's 30% share would be a major beneficiary.

Could Seagate hit $25 in a year?
Marcin: It could be $30 a stock. The stock was at $30 two years ago when it had a run rate of $1.50 a share. It wouldn't be unreasonable to put a 13 or 14 P/E ratio on $2.20 of earnings for a globally dominant technology company with double-digit growth ahead of it.

Hmmm... interesting!

For Outback, I'm going to attempt to offer a simplified explanation from how it was explained to me. Outback sales have increased steadily by about 260 million dollars a year for the last five years to over 3 billion dollars last year. Basically, the Outback operating model is to generate ridiculous amounts of cash, use that cash to build more restaurants, and then create even more ridiculous amounts of cash. This cash is then kicked back to the investors in the form of ever increasing earnings per share (also total outstanding shares have actually been decreasing- which is basically reducing outstanding debt, further increasing EPS), which increases the overall price of the stock. The chart below illustrates the steady upward trend of the stock price.

From the chart, you will also see that Outback continually fluctuates around the average positive slope of the price based on momentum trading. You'll also see that right now it appears to be at a trough (draw a line through all the lows and you'll see they match up surprisingly well). While in no way is this a guaranteed indication that the price will soon rise, I like it. Also, the price/sales ratio is .82. Here is what Yahoo has to say about the P/S ratio-

As the name implies, the price/sales ratio is the company's price divided by its sales (or revenue). But because the sales number is rarely expressed as a per-share figure, it's easier to divide a company's total market value by its total sales for the last 12 months. (Market value =stock price x shares outstanding.) Generally speaking, a company trading at a PSR of less than 1 should attract your attention.

Think about it: If a company has sales of $1 billion but a market value of $900 million, it has a PSR of 0.9. That means you can buy $1 of its sales for only 90 cents. There may be plenty else wrong with the company to justify such a low price (like maybe it's losing money), but that's not always the case. It might just be an overlooked bargain.

O'Shaughnessy found that PSRs work best for large-cap companies, perhaps because their market values tend to be much closer to their massive sales to begin with. The ratio is less appropriate for service companies like banks or insurers that don't really have sales. Most value investors set their PSR hurdle at 2 and below when looking for undervalued situations. But, as always, we'd counsel that you compare a company's PSR value to its competitors and its own history.

Outback Steakhouses are most definitely are not losing money. Over the last five years, the P/S ratio has averaged around 1.13. Undervalued? I think so. However, today I lost money on both companies. My solution? I'm doubling down as soon as the new deposit clears.