Global Technology| July 22, 2015 DDoowwnnggrraaddiinngg SSeeaaggaattee Downgrading Seagate (STX) to UW, from OW, with $34 PT Downgrading to Underweight from Overweight: Our prior Overweight view was that the combination of upside from cloud orders and price stability from a consolidated industry could drive gross margins higher over time. While the industry continues to behave rationally, with inventory at three-year lows and pricing stable, we now see less uplift from cloud. As a result of our lowered view on cloud capex (accounts for as much as 12% of revenue, higher percent of profits), we lower our FY16 (fiscal year-end June 2016) revenue and EPS to $12.4B and $3.38, from $12.8B and $4.08 previously. Our estimates are now well below consensus (by 6% for Revenue and 20% for EPS). We now believe Seagate will lose much of the cushion from large hyperscale/cloud storage purchases it enjoyed over the past year and was a key. We believe near-line or capacity optimized storage, which includes these cloud data center purchases, accounts for 14% of revenue (FY14) and a higher portion of profits. Additionally, slower unit growth in this category, combined with lower client and enterprise units, will pressure fixed cost absorption. Our lowered estimates still assume Seagate can deliver the low-end of its 27-32% gross margin target but weaker volume and enterprise/cloud mix could push it lower without significant restructuring over the next few quarters – making the bear case more likely than the bull case in the near-term. Lower PT to $34 from $49: Our prior $49 PT credited STX with multiple expansion from historical levels as cloud became a larger growth driver and inventory/pricing behavior reflected a more consolidated industry. We now believe that with weaker demand across PC, enterprise, and cloud that P/E is likely to return to the high-end of the three year average range of 8-10x. Our $34 PT is based on 10x our lowered FY16 EPS of $3.38 as compared to a 12x P/E implied by our prior target of $49. The new 10x P/E is now at the low-end of IT Hardware ranges, reflecting our view that top-line will decline by 10% in FY16 and EPS by 24% (more than revenue due to margin weakness from lower fixed cost absorption and fewer mix benefits). Where we could be wrong – bull/bear case view: Our bull case of $62 stock price assumes the weakness in cloud data center growth is short-lived and a recovery in unit growth pushes gross margin to the upper end of Seagate’s 27-32% target range. Cloud strength offsets PC/enterprise weakness and allows the company to deliver slight EPS expansion in FY16 despite meaningful investments in upgrading the product portfolio this year. Our bear case of $25 assumes gross margin breaks the 27-32% target range as weaker volumes and mix shift away from higher margin categories, enterprise and cloud, offset the benefits of a consolidated industry. 9x bear case EPS of $2.76 assumes P/E multiple returns to the mid-point of Seagate’s three year average range of 8-10x and in-line with the lower end of ranges for IT Hardware peers including HPQ. 25