Look To The West
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Something unfortunate is going to happen in a minute. As soon as I mention the industry, I'm probably going to lose some readers. There are some who believe this industry is in a slow decline, and reading about these companies is a waste of time. The industry is hard drive manufacturing. For those who are willing to read the industry reports with an open mind, there appears to be significant opportunity for investors. There are two large companies that dominate the industry, Seagate Technology (NASDAQ: STX) and Western Digital (NASDAQ: WDC). I've written about Seagate's promise in the past, but I'm increasingly impressed with what's happening at Western Digital as well.
Where Does It All Go?
Now I know I won't convince anyone that Western Digital is a good investment unless we first establish whether the hard drive industry is dying or not. There are several factors at work that I believe will benefit the hard drive industry over the next few years. While many people believe that smartphones and tablets are replacing traditional laptop and desktop computers, there is one challenge that everyone seems to be ignoring.
Smartphones and tablets create content like pictures and videos that have to be stored somewhere. Since smartphones and tablets use flash memory, it is not reasonable to store these pictures and videos on the devices. Flash memory is much more expensive than traditional storage. Some would suggest that cloud storage is the solution, but that is simply not the case. Most free cloud storage is limited to somewhere between 2 GB and 10 GB. Customers are unlikely to pay $9.99 or more per month for more storage when they can purchase a traditional hard drive at a relatively inexpensive price.
Another factor driving storage needs is the increase in enterprise storage requirements. The movement of the healthcare industry toward digital documentation puts an untold amount of data into digital form. Everyone from large multinationals to the flower shop down the street is moving their paper information to digital formats. Digital storage is more secure, easier to organize, and easier to access than paper files. In many cases, this data finds its way onto a traditional hard drive.
The Old Guard Is Changing The Game Again
Another factor that should drive traditional hard drive sales is the rise of the Ultrabook concept that was “inspired” by Intel (NASDAQ: INTC). Intel needs this category to grow to continue its dominance of the semiconductor industry. The company is looking to make the Ultrabook the replacement for both laptops and tablets. With more convertible Ultrabooks being introduced, Intel hopes to further blur the line between tablet and laptop. What is interesting about many Ultrabooks is, the hard drive they utilize is a traditional mobile hard drive. PC manufacturers know that this new form factor will only find support with appropriate pricing. In order to keep costs down, a traditional hard drive makes more sense than flash memory.
Now it wouldn't be fair to mention the rise of the Ultrabook category without also bringing up the company that obviously benefits from improved PC sales. Microsoft's (NASDAQ: MSFT) Windows 8 is an operating system designed for touch input. Touch screens have been the norm in the smartphone and tablet space. However, laptops and desktops are still primarily the domain of mice or touch-pads. With an increase in touchscreen desktop models, and laptops with touchscreens, Windows 8 is poised to capture more market share. Given the sheer size of the Windows 8 operating system, a traditional hard drive is almost required.
The Proof Is In The Numbers
If investors need proof that Western Digital could be a good investment, just look at their current quarterly results. In the last three months, Western Digital saw revenue increase 90%, non-GAAP EPS was up 242%, and hard drive shipments increased over 100%. Considering during the same quarter, Seagate also shipped 24% more hard drives on a year-over-year basis, it seems the hard drive industry is doing better than some would like to admit.
If you go beyond the headline earnings, Western Digital looks even more impressive. The company retired 4.2 million shares in the current quarter, and the company's net cash position increased 57.70% year-over-year. More important for investors is, their free cash flow increased over 103%, and their dividend payout ratio is just 23%.
On the surface, Western Digital's 2.14% yield and 1.5% estimated growth in earnings aren't going to catch most investors attention. However, with a 23% payout ratio and huge free cash flow growth, the company can afford to reward investors with a better yield and further share repurchases. Seagate offers a better yield at 4.5%, and both companies will likely surprise analysts with their growth over the next few years. The old guard of Microsoft and Intel both offer compelling values with 3.3% and 4.2% yields respectively. Each company is expected to grow earnings by around 8% to 12% over the next few years, and both have payout ratios of 50% or less.
While Microsoft and Intel look like good values for risk averse investors, those who are willing to ride a turnaround should consider Seagate and Western Digital. Both companies have low payout ratios, huge free cash flow, and are repurchasing shares. If customers continue to choose traditional hard drives because of their cost effective storage, the dual forces of the rise of Ultrabooks, and digitization, should be a boon for both companies.
MHenage owns shares of Intel and Seagate Technology. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel, Microsoft, and 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!