Four Factors to Consider Before Buying Data Storage Stocks

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

There are several variables you should consider before investing in companies engaged in the data storage business: (1) competitive pressures, (2) free cash flow generation, (3) strategic actions, (4) and new product focus. I consider these four main variables in the three companies below. While some have swung into low multiples, it is important to distinguish the value traps from the firms with favorable risk/reward. If there are any catalysts other than an assumption that the market has the multiples wrong, it may very well not be a value trap…

EMC Corporation (NYSE: EMC) vs. Western Digital (NASDAQ: WDC)

EMC trades at 13x past earnings and generates substantial free cash flow. FCF has been consistently on the rise--growing from $1.4 billion in 3Q06 (ttm) to $5.8 billion in 3Q12 (ttm). This represents a compound annual growth rate of 26.7%, and now yields a stellar 11.1%. No analyst has a "sell" rating, and 34 of 39 reporting analysts rate it a "buy" or better, 12 of which even say "strong buy." And for good reason: The company has a 11.4% return on invested capital, a clean balance sheet (debt to capital is 0.6x versus 3.9x for the industry average), and a compelling price-too-book multiple of 2.5x (versus 3.7x for the industry average).

The data storage company is updating its products portfolio to focus on cloud computing and rising data demand. New innovations include a high-end VMAX storage system that will improve performance by as much as 300% and a mid-range VNX system that cuts flash memory costs. I further like the companies strategic actions, such as buying out More IT Resources and spinning off its Pivotal labs mobile software business and its Greenplum database and analytics business to VMware. The acquisition of More IT Resources, which was also spun off with Greenplum, is meaningful, since it enables the company to better allocate resources in real-time.

I also believe the company has more favorable risk/reward than peer Western Digital, which is a value trap. Western Digital may trade at 5x past earnings, but EPS is on the decline. Cleveland Research has argued that the company's already big drop in hard drive shipment guidance may not be pessimistic enough. An absence of catalysts and strong pricing pressures will also help shareholders experience nothing but lost returns over at least the near-term.

Why You Should Take on Risk, buy Xyratex (NASDAQ: XRTX)

If you want the greatest potential reward, I recommend buying data storage producers that are in the small cap space and are potential buyout targets. Xyratex, which is 33% below book value and has no debt on the balance sheet, fits the bill. Despite expectations for $0.19 per share losses next year, dividends are still high at 3.2%. In the long-term, analysts expect EPS to grow by a rate of 5%. When combined with reasonable multiple expansion and the capital allocation policy, this is enough to drive outperformance for shareholders.

There are several ways to look at Xyratex. In the third quarter, the company generated EPS of $0.37, which was 7 cents below expectations, and revenue of $276 million, which was $43 million below expectations. Moreover, management has guided for 4Q12 midpoint revenue of ~$260 million, well below the $328 million original forecast. The bears would argue that this reflects a weakening company. However, in my view, now that shares have fallen 46% from the 52-week low, the worst has been priced in and shareholders can get in at bargain prices. Management was very candid in the third quarter earnings call about a challenging environment ahead between 4Q12 and 1H12. It is taking the appropriate strategy now to be conservative on spending until conditions improve. I encourage buying now that the worst has been communicated and management is focused on investing in only areas that will catalyze growth, such as high-performance computing and big data. The existing ClusterStor solution can be leveraged to address this market and illustrate the company as more of a solution provider than a pure OEM component supplier.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of EMC 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!

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