Are These 2 HDD Stocks a Buy?

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Are These Analysts Right With These Industry Calls?

A bullish industry call

Seagate Technology (NASDAQ: STX) and Western Digital (NASDAQ: WDC) both traded considerably higher on Thursday, after a Longbow analyst said he believes hard disk drive (HDD) shipments bottomed in the first half of 2013.

He said that channel checks indicate “relatively stable” pricing and that cloud-driven enterprise is offsetting PC weakness. Moreover, he believes that shares are undervalued based on $2 billion of free cash flow for each company.

If the HDD market is seeing these improvements and pricing is becoming stable, then there’s no doubt that it is an undervalued space. Seagate Technology trades at just 8 times next year’s earnings with a price/sales of 1.04. Western Digital trades at 7.8 times future earnings and just 0.90 times sales. Both metrics are far below the S&P 500 and technology sector; by about 50%.

Despite being so cheap, both stocks have doubled in value over the last year, as both have grown through acquisitions in the HDD space. Clearly, Longbow believes that both could trade significantly higher. Yet, if I had to choose one, it’s Western Digital.

An indications of a clear winner in the space

These two companies, Western Digital and Seagate Technologies, operate in the same space, are valued similarly, and have seen nearly identical performance. For the most part, investors have gravitated towards Seagate because it pays a much higher dividend and is one of the most shareholder friendly companies in the market; returning almost 100% of its free cash flow back to shareholders in dividends and buybacks.

But what worries me about Seagate is that the company seems to be standing still, maybe even falling behind, while Western Digital strives forward. Six months ago, both Western Digital and Seagate Technology had a 43% stake in the HDD market. This means that combined, these two companies controlled more than 85% of the market.

Yet, during the most recent quarter, Seagate pegged its market share at 41% (down from 43%) and Western Digital’s share grew one percentage point to 44.4%. Considering the fact that Seagate actually has a greater market capitalization ($1.3 billion greater), I think that this growth could bode well for Western Digital’s stock moving forward.

Not to mention, Seagate carries a premium compared to Western Digital because it is the more effective of the two companies; and also because it attracts more dividend investors. Western Digital and Seagate Technology have operating margins of 15.67% and 17.67%, respectively. But because Seagate’s margins are higher, there is also less room for improvements.

This was seen during Seagate’s most recent quarterly report, as Seagate’s gross margin was flat while Western Digital’s rose 50 basis points year-over-year. So while I do agree with Longbow that these stocks are cheap, and that the PC market may have bottomed, I do think that Western Digital is the most promising stock for the future.

Final thoughts

In 2012, Seagate Technology was one of my largest holdings, and was a great investment. In my book, Taking Charge With Value Investing (McGraw-Hill, 2013), I explain how the most effective investors are able to detach themselves from stocks that have returned them wealth, and are able to constantly re-evaluate the market to find the best value.

While this may sound like common sense, this is a chief problem among retail investors, as they often have trouble knowing when to sell and then “letting go” of stocks that they have purchased in the past. With Western Digital, I have had to reassess my outlook on the space, and my opinion of which company is the best. But after realizing that Western Digital is stealing market share, has more room to improve, and is making high-profile acquisitions (sTec) to enter new markets, I think it is the greatest investment opportunity in a cheap HDD market.

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Brian Nichols is long WDC. 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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