Seagate warns that its margins are being hit by a “bubble” in rare earth prices

Hard disk manufacturer Seagate Technology reported earnings last night (July 20) and indicated that margins are getting hit by the rising prices of rare earths. Rare earth prices have risen particularly fast in the last 60 days. From the Seeking Alpha transcript of the earnings conference call:

“We do, however, expect a positive margin impact of a more stable pricing environment to be offset by the following factors: the costs of many upstream materials, especially rare earth elements, which have increased significantly. These costs are expected to adversely impact gross margins by at least 200 basis points…”

Seagate has been unable to offset these costs, but over the long-term believes there are no supply problems:

“In regards to the increasing cost of upstream materials, Seagate has historically been able to absorb these cost increases and insulate our customers. However, the recent dramatic increase in the cost of rare earth elements, combined with a pre-existing upward trend for a broad base of other commodities, far exceeds our ability to find offsetting cost reductions. While we are exploring opportunities to reduce the content of certain rare earth elements that are used in the manufacture of hard disk drive components, we will be discussing with our customers, passing through what we hope are temporary surcharges related to upstream earth-based commodities. It’s important to note that for the relevant rare earth materials, there does not appear to be a significant supply constraint. And while we have a short-term concern over margin impact, we do not currently have a long-term concern.”

During the Q&A session, Seagate management explained that rare earths are about 2% of the cost of a hard drive due to usage of rare earths in the the VCM magnet and the motor. Management also indicated there remains high uncertainty as to whether the company can pass on the higher costs of rare earths to customers although Seagate does not need to wait for demand of its drives to surpass supply in order to raise these prices.

Seagate appears very optimistic that no real supply issue exists with rare earths. Management is particularly optimistic that U.S. mines alone (presumable Molycorp?) will solve the problem and bring prices down. They even went so far as to call current prices a “bubble”:

“…it doesn’t appear that there’s a true supply constraint here. There’s a lot of dynamics around owners of rare earth materials and processors of rare earth materials and who is controlling inventories at what level, as opposed to there’s fundamentally some shortage. If there was fundamentally a shortage, then I would think that the fact that price is supposedly representing supply and demand. If you effectively reduce supply or enormously increase demand, that would mean that there’s a sustained increase in price. I think this feels a little bit like a bubble…So I think our point is that right now, since it doesn’t feel like there’s a fundamental supply issue, that it probably works itself out. And by the way, if these prices stay high, guess what, there’s a bunch of U.S.-based mines that are going to come online again, and it will solve itself. It’s not like the stuff doesn’t exist. It’s just that a lot of mines were closed down when the prices fell below $75, whatever the magic price is, and we’re well above that right now. So I don’t think it’s a long-term issue.”

Management compared the price run in rare earths to a run they experienced with ruthenium in 2006 that lasted for 2006. I do not know about the dynamics of that market. I will need to research more closely what happened in 2006 to understand the specific similarities to today’s rare earth market. Stay tuned…

Disclosure: Author is net long Molycorp (MCP)