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Challenges Ahead For This Tech Stock

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Data storage device makers have seen terrific gains and continue to trade at low multiple. Even more impressively, a large number still have impressive free cash flow yields and clean balance sheets. However, the market is still facing several headwinds that could cause contraction after recent gains. Does the reward justify the risk? Below, I review several producers with this question in mind.

No Positive Catalyst For Seagate (NASDAQ: STX)

Seagate has been on a roll for the year to date--gaining 85% in value. It is a producer of electronic data storage devices, including hard disk drives ("HDDs"), which are used in enterprise servers, workstations, and mainframes. This is particularly interesting because (1) the gain from the 52-week low is more than double what Western Digital experienced (a highly correlated stock) and (2) the market outlook is weakening even more. Yet Seagate looks very attractive at only 4x past earnings, a 5.5% dividend yield, and a 27.4% free cash flow yield. Is it worth the risk?

What strikes me about Seagate, when I browse through all the media flow, is the absence of any real positive catalyst. By contrast, there are endless amount of negative catalysts that come out day by day--most recently, the tepid market response to Windows 8, which were so poor that NPD now estimates domestic retail sales of Windows PCs dropping 13% This follows recent expectations that PC shipments will decline 8.3% y-o-y in 3Q12, a dramatic acceleration off of -0.1% experienced in 2Q12. Weakening demand for PCs and lower average selling prices are causing component vendors to slash prices in 2013 to relieve margin woes of their consumers. With so much vulnerability after the supply chain disruptions, I recommend investing elsewhere.

Better Risk/Reward At Western Digital (NASDAQ: WDC)

While the culprit of weakening PC demand is obvious, the extent of the problem is less so. PCs are being substituted out by tablet sales and greater mobile demand. Tablet sales have become more optimistic: IDC upped their forecast of shipments from 106.1 million units in June 2012 to 117.1 million in late-September 2012. The result will be 2013 PC to tablet shipments narrowing to 2.5:1. Barclays estimates that the PC market could lose between 50 million and 100 million in annual sales by 2015 through mobile substitutes. The firm estimates a 4% decline in PC sales to 338 million units and then 311.5 million in 2015. Fortunately, WDC is better positioned to weather the storm than Seagate is.

First, as mentioned earlier in this article, Western Digital has not experienced nearly the kind of upside that Seagate has, which is unwarranted since it has had very similar media coverage. Second, Western Digital is considerably safer. For one, it has around 33% less volatility than Seagate, which has 140% the volatility of the broader market. Western Digital further has 34.7% of its market capitalization backed by cash versus 20.7% for Seagate. Third, a lot of the downside has already been communicated after the company guided for F2Q13 EPS of $1.65 to $1.85, which is substantially below the $2.43 consensus.

But, most importantly, much of the downside is limited to the Taiwanese semiconductor market. JPMorgan downgraded Seagate to "sell" largely off of the company's expected market share erosion and Thai manufacturing issues--problems that Western Digital does not face. So, if you are looking for a high risk / high reward play, Western Digital carries plenty of both but less risk than what Seagate faces.

If you want an even safer stock with still strong upside, consider EMC Corporation (NYSE: EMC). 33 of 38 reporting analysts rate the stock a "buy" or better--more than a third of which say "strong buy". No analyst is calling the company a "sell", which is a very positive sign in a highly uncertain market. Further, it generates an impressive 11.4% return on invested capital and still generates plenty of free cash flow, which is evident by the 10% yield. Margins have been on the increase, and there is still virtually no debt on the balance sheet. So, if you are going to back either Western Digital or Seagate off of a better-than-expected data storage market, it makes sense to hedge your bets with EMC.

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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