Do Hard Drives Belong in Your Portfolio?

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

Modern hard drives have been around since the 1980's. The hard drive industry as it exists today has three dominant players: Seagate (NASDAQ: STX), Western Digital (NASDAQ: WDC) and Toshiba (NASDAQOTH: TOSBF)

If you live in America, for the past few years you've probably noticed the rise of smartphones and tablets. This rise has coincided with a decline in sales of personal computers. Those who are bearish on hard drive makers often cite this trend as a primary reason to stay away from shares of those companies. Hard drive technology is going the way of the dodo bird, so they say. Accordingly, companies whose profits depend on selling hard drives will perform poorly in the stock market.

It isn't that simple

First of all, there is strong evidence to suggest that the demand for hard drives, while declining, is still nowhere near disappearing completely. While solid state drives have many advantages that hard drives simply can't replicate, the relative low cost of hard drives ensures that they will still be profitable for years to come. This will at least continue until solid state drives aren't so darned expensive.

Just look at Seagate's hard drives sales. It took the company 28 years to sell one billion hard drives, a feat which it accomplished in 2008. Reaching 2 billion hard drives only took the company an additional five years. A sales increase of that magnitude leads me to believe that hard drives are not close to becoming extinct.

Hard drive makers are priced at extinction rates

With the exception of Toshiba, all of the hard drive makers sport incredibly low price-to-earnings ratios right now. One possible reason that Toshiba's shares aren't as cheap is that the company is nowhere near as dependent on revenues from hard drives as Western Digital and Seagate are.

Western Digital sports a price-to-earnings ratio of 8.72 and its dividend yield currently stands at 1.4%. The company is a relative newcomer when it comes to distributing dividends to shareholders.

Seagate's price-to-earnings ratio of 7.58 is also very low. Seagate has a strong record of paying dividends to shareholders; right now, the company's shares yield 3.2%. In May the company was named the top dividend stock of the Nasdaq 100.

Two out of these three companies, Western Digital and Seagate, are priced as if demand for hard drives is going to dry up in the near future. That is incredibly unlikely, but even if hard drives eventually do become obsolete that is no reason for investors to panic.

It's not like these companies are sclerotic 

Great companies usually notice when changes are occurring in the area in which they operate. Sometimes a company's management will accurately surmise that a failure to adapt will lead to their doom. Accordingly, all three of these companies are innovating to stave off becoming obsolete.

Last month, Seagate unveiled its thinnest hard drive ever. While still too large for many ultra-thin laptops, the company demoed its ultra-thin hard drive on an Android tablet. Trefis predicts that Seagate disk drives will be used in 20% of all tablet devices by 2019, up from just 4% today.

Western Digital recently acquired a company named sTec for $340 million dollars. STec claims to be the first company to have deployed solid state drives into large-scale enterprise environments. To date, it has shipped 14 million solid state drives to enterprise environments. Western Digital is not about to be blindsided by a shift towards solid state drives.

Not wanting to be left behind, Toshiba is also innovating. The company recently released a new hybrid drive. This new family of hybrid drives is only 7 millimeters thick, the company's thinnest ever.

Foolish final thoughts

The stocks of hard drive makers are priced as though hard drive technology will become extinct soon, an event that will inevitably be followed by the demise of companies than manufacture the technology.

There are two problems with this. First hard drive technology isn't becoming extinct anytime soon. At this point in time, the massive differences in price between solid state drives and hard drives mandates that hard drives will be used for at least the next couple of years.

Second, by the time hard drives do finally become obsolete, the companies that create them will have moved on to making solid state drives. Seagate and Toshiba are working hard on hybrid drives, which combine the performance of a solid state drive with the cost efficiency of a hard drive. Western Digital made an acquisition this year to increase its presence in the solid state drive arena.

In conclusion, it appears to me that Western Digital and Seagate are both cheap right now. Pessimism has pushed those two stocks down, and nothing like pessimism to create a contrarian opportunity. Said pessimism does not appear to have cheapened the stock of Toshiba, a company that is not as dependent on its disk drive operations.

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Ryan Palmer 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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