When we all ditch our PCs and live in the cloud with our tablets at the ready, what use are those old-fashioned spinning disk drives?
That view must explain some of the pessimism about Seagate Technology PLC and Western Digital Corp., the two major makers of hard-disk drives.
Despite dazzling share-price performance – Seagate has doubled so far in 2012, with Western Digital up 30 per cent this year – the two have rock-bottom valuations. Seagate’s forward price-to-earnings ratio is under three, with Western Digital below four.
The latter stock is the cheapest in all of the Standard & Poor’s 500 index on the basis of enterprise value (net debt plus market capitalization) to forward EBITDA (earnings before interest, taxes, depreciation and amortization) with a ratio of 2.07, according to S&P’s Capital IQ.
Simply put, the companies’ earnings are exploding, and the price of the shares can’t keep up. This gives investors an opportunity to latch on to two of the cheapest opportunities in the tech space.
Surely, there is concern about the future of the two companies’ primary product. The iPad, other tablets and new ultrabooks use what’s called solid-state memory, which eschews the spinning hard-disk drives at the core of the companies’ products. If you believe in the imminent death of the PC, you likely believe Seagate and Western Digital will follow.
Except none of the current numbers suggest decline. Seagate’s unit shipments of 61 million drives in the first calendar quarter were up 29 per cent on a sequential basis and 25 per cent year-over-year. Western Digital’s 44 million drives were up 55 per cent sequentially but down 11 per cent year-over-year.
Western Digital’s anomalous results were a result of it being deeply affected by flooding in Thailand, where it has major manufacturing operations and numerous suppliers. Seagate, less concentrated in the flood zone, was able to use the situation to significantly goose earnings.
Indeed, the supply shortages of drives caused by the floods helped provide better pricing and gross margins for all players. Industry skeptics fear a normalization will crimp margins and, worse, a return to the industry’s dog days of heated, profit-killing price competition.
Bulls, however, say normalized pricing may nick margins, but the old days of brutal price wars are gone for good: Evercore Partners analyst Rob Cihra, who has “overweights” on both stocks, notes that, over the past decade, six hard-drive makers have been taken out of the market through acquisitions. (This includes Samsung’s drive division, which Seagate bought last year, and Hitachi’s drive division, which Western Digital bought in 2012’s first quarter.)
Industry consolidation leaves just three major players (Toshiba is the third) and means Seagate and Western Digital each now sell about 40 per cent of the world’s hard-disk drives, he says.
There is “limited competitive motivation for dramatic pricing actions, following big recent market consolidation.” (Mr. Cihra’s 12-month target prices of $38 for Seagate and $50 for Western Digital represent 25 per cent gains from current levels.)
As for a post-flood “return to normalcy” in supply and pricing, bulls argue that for many specific drive end-users – makers of notebooks and mission-critical enterprise servers – supply has already returned to normal and pricing has remained stable.
“The bear arguments are increasingly ringing hollow,” says Needham & Co. analyst Richard Kugele, who has “strong buys” on both stocks, with a $52 target on Seagate (implied gain of more than 70 per cent) and a $61 target (50 per cent plus) on Western Digital.
Those heady projections still only imply a multiple of four times enterprise value to forward EBITDA, though, as Seagate is expected to grow earnings more than 50 per cent in the next year, while Western Digital vaults past its flood-hampered numbers by more than 100 per cent.
While Western Digital, in recovery mode, doesn’t pay a dividend or engage in major share repurchases, Seagate has an aggressive buyback program and its 25-cent quarterly dividend, up 39 per cent from 2011 levels, represents a yield of about 3.2 per cent.
All in all, not bad for an industry that’s supposedly on its way out.