Seagate (STX) is a rarity in the technology sector. Based on its recent share price, the stock offers a 5.5% dividend yield. Such a high dividend yield is usually reserved for utility stocks. Seagate has a volatile dividend history. It is not on the list of Dividend Achievers, a group of 271 stocks with 10+ years of consecutive dividend increases.

You can see the full Dividend Achievers List here.

But, its high yield has attracted the attention of Joel Greenblatt, Managing Principal and Co-Chief Investment Officer of Gotham Asset Management. Seagate is one of the top 20 dividend stocks in Joel Greenblatt’s portfolio. Gotham owns approximately 546,000 shares of Seagate, an investment worth roughly $21 million.

Seagate has a very high dividend yield, which is normally a ‘red flag’ that the company is in trouble. While Seagate is in a turnaround phase, it continues to generate enough cash flow to maintain its hefty dividend payout. This article will analyze Seagate and its dividend.

Business Overview

Seagate provides data storage products, mainly hard disk drives, which account for 90% of the company’s revenue by product line. Seagate had a difficult year in 2016.  Revenue declined 19% for the year. The decline in revenue was due to three factors, which were the strong U.S. dollar, weaker economic conditions in China, and the troubles facing the personal computer segment. Seagate has a large international footprint, with the majority of its revenue coming from outside the U.S. Its revenue breakdown by geography is below:

• Americas (29% of annual revenue)
• Europe, Middle East, and Africa (17% of annual revenue)
• Asia-Pacific (54% of annual revenue)

More than half Seagate’s annual revenue comes from Asia, meaning the slowdown in the Chinese economy last year hit the company particularly hard. And, the steady decline in global PC shipments has caused related storage devices to decline in tandem. The smartphone boom has shown no signs of slowing down. As more computing functions are performed on smartphones, there is less demand for laptop and desktop computers. Technology industry research firm Gartner found that 2016 marked the 5th consecutive year that global PC shipments fell. For the year, 2016 PC shipments declined 6.2% from 2015. PC client shipments continue to represent 24% of Seagate’s HDD revenue. That said, the company still generated more than $11 billion of revenue last year.

Source: 2016 Earnings Presentation, page 4

In response to the industry slowdown, Seagate announced a significant restructuring. This also weighed on the company’s profits last year. Diluted earnings-per-share fell 84%, due in part to a $175 million restructuring charge. Still, the company remained profitable, even in a difficult climate. And, on an adjusted basis, Seagate had earnings-per-share of $2.26. One reason for this is because, despite increased adoption of solid-state and flash, hard disk drives have retained a high level of demand. Hard disk drives continue to be the primary choice for mass storage, particularly among enterprise customers, because of their high performance and cost effectiveness.

Growth Prospects

The first strategic priority for Seagate is to stabilize its core HDD business. Since HDD products represent most of its business, this is critical to Seagate’s turnaround. Fortunately, there are clear signs that Seagate’s recovery is gaining momentum. High-capacity HDDs continue to see strong demand. Future growth opportunities in this segment include consumer, surveillance, and DVR. Last quarter, revenue from these areas increased 19% year-over-year. Also, Seagate’s exabyte shipment growth has accelerated in recent quarters, due to demand for higher-capacity drives.

Source: Q2 FY 2017 Earnings Presentation, page 8

Conditions have significantly improved to start fiscal 2017. Adjusted earnings-per-share rose to $1.38 last quarter, up 68% year over year. Cost cuts are also having an effect: Seagate’s gross margin reached 30.8% last quarter, the highest level over the past year. Operating expenses, as a percentage of revenue, fell to 18% last quarter, down from 21% in the previous quarter.

Source: Q2 FY 2017 Earnings Presentation, page 4

This drove a very strong performance in the most recent quarter, and management is hopeful the turnaround can continue moving forward. Longer-term, Seagate is making investments in new storage technologies, in particular the cloud. The broader gravitation from the PC to the cloud continues unabated. Seagate is investing heavily in cloud storage, to capitalize on the trend. For example, in 2015 Seagate acquired Dot Hill Systems for $695 million. This acquisition helps the company expand its reach in storage systems and software. Seagate’s strong free cash flow allows it to invest both internally and through acquisition, to more pursue its growth in new areas.

Dividend Analysis

It wasn’t too long ago that hardly any tech stocks paid dividends at all. But the tech boom-and-bust of the 1990s changed that. In the aftermath of the tech bubble bursting, investors began to put pressure on tech companies to share the wealth. Since strong tech companies generate high levels of cash flow, they are well-equipped to pay hefty dividends. Macro-economic conditions worsened in 2016, but Seagate still managed to generate $1.1 billion of free cash flow for the year. This more than covered its dividend, which required $727 million of cash last year. 

On a percentage basis, Seagate’s dividend accounted for 67% of its 2016 free cash flow. A payout ratio of two-thirds of free cash flow should allow Seagate to maintain its dividend, provided business conditions do not deteriorate much further.

Another promising sign for the dividend is that Seagate does not have a dangerous level of debt on the company’s balance sheet. At the end of last quarter, Seagate held $1.7 billion of cash and cash equivalents on its balance sheet, compared with $4.1 billion of long-term debt. Seagate has a current ratio of 1.5, which means its current assets exceed its current liabilities by 50%.

Final Thoughts

Joel Greenblatt owns many cheap, high-yield dividend stocks in Gotham’s portfolios. This includes stocks from the technology sector, that pay solid dividends to shareholders. In that same vein, it is not surprising to see that Seagate is also included. Seagate trades for a price-to-earnings ratio of 20, which is slightly below the average stock in the S&P 500 Index. And, assuming its turnaround materializes, the company’s earnings stand to grow in 2017 and beyond. With a 5.5% dividend yield that appears covered by free cash flow, Seagate is an attractive dividend stock pick, and is a rarity for the technology sector.