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Morning Update

Yesterday Seagate Technology closed up 1.4% on the day, easily outpacing the broad markets gains. However option trading on the stock was only mildly bullish. Option volume was concentrated in calls but most of these were sold, not bought. The biggest trade of the day was the sale of 1700 March 36 calls for $1.53 against the purchase of 170,000 shares at 34.43. This is a modestly bullish trade that expects the stock to rise to 36 by March expiration.

Seagate is a high beta stock that is up about 10% year to date and 36% since its late November lows. The call sold in the buy-write trade yesterday coincides with Seagate’s 2012 high at 35.71, which is the next major point of resistance for the stock. Despite the rally Seagate looks cheap by many metrics: it trades at a 4.6 times earnings, 3.9 times free cash flow, and 0.8 times sales. In addition Seagate has a 4.4% dividend yield and has reduced outstanding shares by an average of 5% per year over the last 5 years through buy backs. However, compared to its historical metrics instead of other large cap stocks, Seagate looks more fairly priced. Over the past five years Seagate has traded with an average price to sales ratio of 0.76 and a typical gross margin range of 14-31% versus its current gross margin of 33%. By historical benchmarks Seagate looks fully valued at its current level, especially considering growth prospects going forward are meager.

Seagate is one of the largest hard drive producers in the world. But right now solid state drives, which are smaller, faster, and more durable than hard drives are catching on in the market place. Tablet computers use solid state drives exclusively, and solid state drives are being seen increasingly in notebook and ultrabook computers. Tablets are expected to outsell notebooks in 2013 which will drive a lot of demand for solid state drive and reduce the need for hard drives. To counter this trend Seagate has made some acquisitions in the solid state drive space such as LaCie and DensBits, but the company is still behind the game. Its solid state drive market share is less than 10%.

The key to Seagate’s growth going forward will be to use its sales clout and large production facilities to quickly gain market share in the SSD business. Share appreciation will be driven by this, as well as continued share buy backs and dividends.

At current levels the stock looks to be fully valued, which means it neither has much downside or upside risk. Therefore, for investors who want to stick with the stock for its 4.4% dividend yield and future growth prospects if it can gain SSD market share, I like the idea of selling the March 36 call. This allows you to participate in the stock’s appreciation from 34.43 to 36 where you would be called away from your shares. This is a good level because it is a major level of resistance. By selling the March 36 call you get paid $1.53 which will create an additional 4.4% of yield over the next 58 days.

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