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Hard Disk Drive Makers and Secular Decline

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Hard disk drive makers, Seagate Technology (NASDAQ: STX) and Western Digital (NASDAQ: WDC), seem to look bargain priced. Both are trading at very low PE ratios, Seagate at around 4x earnings and Western Digital at 5x. Both also offer relatively high dividend yields with Seagate at around 4.80% and Western Digital at 2.30%. They have also put up some excellent results recently.

In their latest quarter, Seagate reported sales of $3.7 billion rising 33% from the previous year. Earnings came in at $582 million or $1.42 per diluted share with net profit quadrupling. Western Digital posted revenues of $4.0 billion, up 50% from the previous year. Net income more than doubled to $519 million or $2.06 per diluted share.

As impressive as these indicators are, they may be misleading. Future earnings are a key variable in assessing a bargain stock and anticipating future earnings in an industry that's in secular decline can be very difficult. The evidence seems to suggest that the hard disk drive (HDD) makers may be facing secular decline and earnings performance could be at serious risk.

The newspaper industry is a good example of the deterioration that can take place. Industry leaders Gannett (NYSE: GCI) and The New York Times (NYSE: NYT) have both seen significant pain from a secular shift from print news to online distribution.

Gannett saw revenues decline 35% from around $8.0 billion in 2006 to $5.2 billion in 2011. Profits dropped from $1.2 billion to $440 million and profit margins fell from 14.5% to 8.4% during the same period. Shareholders saw their stock price drop from around $58 per share to $14.

The New York Times saw a similar scenario. Their sales went from $4.0 billion to $2.3 billion between 2006 and 2011, a 43% fall. Earnings plunged from $168 million to $91 million and margins went from 4.2% to 3.9%. The company's market price collapsed from $25 per share to around $9.

Though the HDD decline may not rival that of the newspaper business, leaders Seagate and Western Digital still face significant uncertainty over future revenues and profits. Investors need to consider the major factors that might determine the scope of the industry's potential downside.

1. Major factors influencing projected revenues:

The major negative factor for future revenues is the deteriorating nature of the HDD core market. The shift to smartphones and tablets for online access has put personal computer sales, a key revenue source, under pressure. For the three months ended September 2012, Western Digital believes that overall hard drive industry shipments totaled approximately 139 million units, down 21% from the prior- year period and down 11% sequentially from the June quarter as a result of the softer demand environment.

Another negative influence is increased competition from the solid state drive. A selling point of the solid state drive is that it saves on power usage when compared to the mechanical disk drive Seagate and Western Digital specialize in. Lower power usage is attractive, especially with tablets and smartphones, because it reduces the draw on battery power.

There are some positive factors that will help the HDD makers maintain revenues. The industry has undergone a major consolidation. Seagate acquired Samsung Hard Disk Drive and Western Digital combined with Hitachi Global Storage. This consolidated four of the top HDD makers into two industry giants, allowing Seagate and Western Digital to wield market share power versus their smaller rivals.

Another positive factor is new technology being delivered within the industry. For example, Western Digital has recently put forth helium-filled drives to help fight off the competition from solid state. These newly introduced drives are aimed to reduce power consumption and enable increased capacity.

2. Major factors influencing projected profits:

Recent results have shown an incredible rise in the profit margins of both Seagate and Western Digital. In the last quarter, net profit margins were about 16% at Seagate, compared to 9% in 2006. Net profit margins were 13% at Western Digital, compared to 8% in 2006. These increases can be attributed to a significant rise in their product’s Average Selling Price (ASP), but it is doubtful that these ASP's can be maintained.

There are some issues that may put significant pressure on ASP’s and profits. The receding effects of disruptive flooding in Thailand should result in increased production and supply, lowering ASP's.

A greater danger to profit margins could be the increased chance for a price war between these two hard disk drive giants. If the entire drive market contracts as expected, each industry player will eventually be tempted to increase their share of the shrinking market. Since the HDD product is somewhat commoditized, battling on price would be a likely strategy.

The Bottom Line

Investing successfully in an industry in secular decline is not easy. It takes an accurate assessment of the situation, some excellent timing and even a little luck to obtain a satisfactory result. Bargains can be found and profits can be made with the HDD makers, but critical analysis will be necessary to get the odds in one’s favor.

grahamsway (Bob Chandler) has no position in any stocks mentioned. The Motley Fool owns shares of Western Digital Corp.. 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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