Sell These Storage Makers, Buy This One

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

Storage makers hit a wall of worry in the last few days, driven by weak quarterly results, a tepid outlook, and weaker profits. It is no secret that hard drive manufacturing is a mature market, but investors need to ask just one question: are storage devices just commodities set on a path of a permanent decline?

Profit margins slip

Seagate (NASDAQ: STX) reported a 5.6% decline in gross margin, at a 28% level, from a year-ago period. In its supplemental financial information presentation, Seagate reported most of its shipment growth came from enterprise storage. Client Computer shipments declined substantially from last year: Seagate shipped 34.7 million units in the fourth quarter (fiscal 2013), compared to a peak of 46.3 million in fiscal 2012. Conversely, Enterprise Storage dropped by just 0.3 million units in the same period. Shipments actually grew from 6.9 million units in the first quarter of 2012 to 8.2 million in the fourth quarter of 2013.

On the bright side, the average gigabyte per drive increased steadily over the last eight quarters, while inventory turns were also steady. This suggests that Seagate will need to ship more storage capacity per unit to at least sustain sales.

The drop in Seagate also hurt Western Digital (NASDAQ: WDC). Even though the magnitude of the decline was similar for both companies, Seagate is down 10% on the month, while investors in Western Digital are breakeven:

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STX data by YCharts

Both hard drive makers have similar characteristics. The P/E, price to sales, and EBITDA are roughly the same. Seagate offers a higher yield, but this was not sufficient to prevent the stock sell-off.

<table> <thead> <tr><th> <p><strong>NAME </strong></p> </th><th> <p><strong>PRICE </strong></p> </th><th> <p><strong>MKT CAP </strong></p> </th><th> <p><strong>P/E </strong></p> </th><th> <p><strong>YIELD </strong></p> </th><th> <p><strong>PRICE/SALES </strong></p> </th><th> <p><strong>EBITDA </strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>Seagate</p> </td> <td> <p><strong>40.3</strong></p> </td> <td> <p>14.47B</p> </td> <td> <p>8.38</p> </td> <td> <p>3.7</p> </td> <td> <p>1.03</p> </td> <td> <p>2.97B</p> <div> </div> </td> </tr> <tr> <td> <p>Western Digital</p> </td> <td> <p><strong>62.6</strong></p> </td> <td> <p>14.77B</p> </td> <td> <p>9.27</p> </td> <td> <p>1.6</p> </td> <td> <p>0.96</p> </td> <td> <p>3.32B</p> </td> </tr> </tbody> </table>

Data Source: Yahoo! Finance

Competitor faces challenges too

Investors were disappointed when Western Digital issued a weak guidance for the current quarter. The disk makers expect revenue to meet analyst consensus at best. The company could earn between $1.95 and $2.05 per share. This compares unfavorably to a consensus of $2.05 per share, because Western Digital could come in with results below this figure. In the last quarter, shipments dropped to 59.9 million units, a 16% decline from last year. Sales were hurt by weak notebook (negative 27%) and desktop (negative 24%) shipments. Enterprise shipments did not grow, while shipments for consumer electronics offset the decline.

Flash storage: more promise

Unlike the hard drive makers, SanDisk (NASDAQ: SNDK) issued solid guidance for the current quarter. Instead of guiding on the consensus of $1.49 billion in revenue, SanDisk thinks it can generate revenue as high as $1.575 billion. In the last quarter, prices for NAND flash continued to be strong. This helped the flash drive maker report a gross margin of 46.7%. This represents an 18.4% improvement compared to last year.

The company earned $1.21 per share, beating estimates by a full $0.28 per share. Sales grew 43% year-over-year to $1.48 billion.

Foolish bottom line

Every time investors speculated that hard drives were just commodities, the underlying companies sold off. Western Digital and Seagate then traded to new heights. It might be time to consider that these companies reached a peak. By selling these shares, investors could focus on the NAND flash market, which has better growth characteristics. Demand for flash storage is still growing, thanks to a sustainable growth in demand for mobile devices like smartphones. This implies that the pullback in shares of SanDisk should be viewed as a buying opportunity.

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Chris Lau has no position in any stocks mentioned. 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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