Looking For Big Gains in Technology? Remember Memory

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

While our dependency on technology and instant access to information continues to grow, our methods for accessing and storing that information are constantly evolving and advancing. While many will seek added storage capacity in the cloud, there will continue to be large demand for data storage inside our ever smaller devices. Investors today have the opportunity to take advantage of this trend and profit for years to come by selecting the right investments and avoiding the wrong ones now.

Great for the past year but bad for the future?

Famous short-seller Jim Chanos was speaking at the Ira Sohn Conference last month, and presented his case for short-selling shares of hard-drive maker Seagate Technology (NASDAQ: STX) based upon his belief in the death of the PC and heavy insider selling of shares. While Mr. Chanos has achieved an enormous amount of success short-selling stocks, this particular technique is not one to which I subscribe; however, when someone of his stature offers an opinion, it is always wise to take note.

Over the past year, shares of Seagate have delivered quite an exciting ride to shareholders as they rocketed up 105% from a low of $21.62 to a high of $44.44 in May. It takes some conviction to consider shorting shares of a stock with this kind of upward momentum driving it; so I was interested to see the numbers that could have led to such a conclusion. I personally believe that the obituaries proclaiming the “death of the PC” are premature and overblown; after all, I can remember the pronouncements of the decline American manufacturing from my childhood and the predictions of our future demise as the world's largest manufacturer, yet I continue to be employed in an American manufacturing  and we still lead the world today.

Seagate currently offers shareholders an attractive dividend yield of 3.53% that only requires a payout ratio of 19%. With price to earnings ratios of only 8.17 times and 7.87 times respective 2013 & 2014 earnings, the shares appear to be cheap. A bit more investigation also reveals that, over the past 5 years, the business has produced average returns on equity and capital of 20.1% and 10.9%. This just isn’t looking like a business to sell short; but they are also past results.

With a debt to equity ratio of 0.75 and annual sales growth of only 5.63% over the past 5 years, the business model begins to show some weaknesses. The 5.2% net margins are also weak for a technology business. One key point in the presentation Mr. Chanos delivered highlighted the high percentage of the total cost, “approaching 10%”, of a PC that is represented by the hard drive. The drive makers can expect enormous pricing pressure going forward and, as demand for their product slows, excess capacity will drive prices lower. Given the forward projected earnings growth rate of 1% annually for the next 5 years, Seagate no longer appears to be so inexpensive.

Is this the same story with a different name?

Western Digital (NASDAQ: WDC) is another major manufacturer of hard drives for PC’s and laptops. While its production of solid state drives and networking products provide it with a bit more diversification than I see in Seagate, hard drives are the primary revenue producer for the company.

On the surface, the numbers for Western Digital look very similar to those of Seagate with the exception of the debt to equity where Western Digital carries a ratio of only 0.24 compared to the 0.75 of Seagate. As with Seagate, the 2013 and 2014 price to earnings ratios are very reasonable at 7.6 times and 8.11 times earnings respectively. The 5-year average returns on equity and capital at 24.3% and 20.8% are truly impressive but once again, these numbers indicate past results and we invest for the future.

The 5-year forward consensus earnings growth projection for Western is only 2.5%/year which also serves to confirm the dismal forward prospects for Seagate. Considering the dividend yield and growth rate, I would not expect to pay more than 4 times to 5 times 2014 earnings for Western Digital at this time and it is currently much higher than that.

Another name but this time the opposite story

While the stories of Seagate and Western Digital tell the tale of two businesses where the growth and prosperity of the past seem to have quickly faded into a slow and difficult future, the story of SanDisk (NASDAQ: SNDK) appears to weave a diametrically opposed version of a business coming out of a slow period and about to surge forward in the next generation of technology advancements. SanDisk is a major manufacturer of flash drives that can be embedded or portable, and due to the lack of moving parts are more conducive to use in mobile devices requiring data storage.

At first glance, SanDisk might appear to be far more expensive than our other two prospects based upon the P/E ratios of 15.41 and 13.54 against 2013 & 2014 projected earnings, but the 5-year projected growth rate for its earnings of 17.6% per year reveal it to be the least expensive of the three. Also, given the superiority of its products for use in portable devices that can be jostled around during use, the products would seem to be better suited for the overall future direction of the market. If the share price simply rises to keep pace with the projected earnings growth rate, investors will attain phenomenal returns in this stock over the next several years.

Final thoughts and actions

While I do believe the predictions of the “death of the PC” are overly dramatic and at least premature, I do agree that Western Digital and Seagate are at best facing slow forward growth prospects and difficult market conditions for their products. Given the fundamentals and current valuations, I do not believe these two businesses present and acceptable risk/reward ratio to justify my capital. SanDisk, however, offers almost everything I look for in a long-term investment and looks poised to deliver exceptional annual returns for the next 5 years.

While Seagate Technology pays a significant and growing dividend and seems able to generate the cash flow to support it, a global slowdown in demand for digital memory storage has begun to put pressure on margins. Is Seagate worthy of your investment consideration (and dollars)? The Motley Fool answers this question and more in our most in-depth Seagate research available for smart investors like you. Thousands have already claimed their own premium ticker coverage, and you can gain instant access to your own by clicking here now.

Ken McGaha 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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