2 Concerns for this Hard Disk Drive Leader

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Seagate Technology (NASDAQ: STX) has been one of my favorite stocks for many years -- in my book, Taking Charge With Value Investing (McGraw-Hill, 2013), I described it as the quintessential example of a value investment. While I am still holding today, and don’t yet have plans to sell, there were two things that bothered me from the company’s market-moving quarter.

Earnings at a Glance

During the final two days of last week Seagate Technology had gains over 11% as the stock reached new all-time highs and crossed over $40. These gains came after the company crushed FQ3 earnings expectations. For the quarter, Seagate posted revenue of $3.53 billion ($150 million better than the consensus) and an EPS of $1.26 ($0.11 better than expectations).

Seagate also bought back $102 million worth of shares and paid off $379 million in debt. By most accounts, it was a great quarter, one in which revenue declined 21% but was expected due to the weakness in PCs. When you consider the stock’s 4% yield and its price/sales of 0.90 and its forward P/E ratio of 7.50 then you realize that Seagate was priced accordingly to see fundamental declines, hence making it a good stock.

Two Minor Concerns to Monitor

Market Share

Seagate saw a lot of its quarterly growth within segments of the cloud, however Seagate has been the number one company in the hard disk drive market for the last few years. Therefore, I did find its revised market share a bit worrisome. The company estimates that the hard-disk drive market saw 136 million shipments in FQ3 and that its market share was 41%. Not a bad piece of market share, although when compared with Western Digital (NASDAQ: WDC) it does create some concern.

Western Digital reported earnings on April 24 and also saw a solid quarterly beat. Western Digital operates in the same business as Seagate, in fact the two are virtually the same. With there being no industry numbers on actual shipments, the market size and demand is typically taken from the estimates of these two companies. For the last quarter, Western Digital estimates 135.4 million shipments, which is consistent with Seagate’s 136 million estimate.

According to Seagate, its share was 41% and this was down from 43% in the previous quarter. On the other hand, Western Digital pegged its share at 44.4%, up from 43.6% in the previous quarter. Hence Seagate lost market share and Western Digital gained share. Back on April 23, I tweeted (@bnichols9883) to pay attention to Seagate’s market share, and possibly use it as a method to determine the company with the most upside. I found it worrisome that Western Digital saw such a large boost and was watching closely to see how Seagate performed. And while both companies still command almost 90% of the market (collectively) and are cheap relative to fundamentals, I would watch in future quarters to see if this trend continues.

Gross Margin

Unlike the SDD market used in tablets and smartphones, the HDD market commands high margins and is the reason that Seagate is able to return large amounts of capital to its shareholders. In 2012 margins saw great improvements, and in 2013 one of the major concerns has been the performance of margins with the decline in PCs.

For the quarter, Seagate’s gross margin was flat quarter-over-quarter at 27.6%. Thus margins most likely have reached a peak or at minimum are close. While this is fine, Western Digital did see a 50 basis point rise to 28.2% while also seeing its market share increase. Hence this is another fundamental area of concern to monitor. Seagate investors should watch and see if margins and market share continue to rise while Seagate’s margins remain flat and its market share diminishes. This could very well be a one-time event, but with the stock trading at new highs, you must not minimize the small things, as pullbacks are much quicker to develop.

Final Thoughts

If there’s anything that we learned from Seagate’s quarter it is that the company is not as dependent upon PCs as some would like to think. The company’s presence in both personal and cloud environments is carrying it into the next wave of performance.

While its presence in PCs remains large, and we are starting to see some concerns, the company still looks to be executing with perfection and remains one of the most shareholder-friendly companies in the market. At this point, investors should monitor the two areas of concern, and possibly take some gains off the table, but overall, I say Seagate remains a great company, at least right now. 

Brian Nichols is long STX. The Motley Fool owns shares of Western Digital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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