Seagate Technology (NASDAQ:STX) and Western Digital (NASDAQ:WDC) are among the most unloved of the despised tech sector (justifying the "ugly sisters" label). The stocks are trading at ridiculously low price earnings multiples, which imply that they are on the verge of going out of business. What is interesting about these two companies is that, partly through acquisitions, they have each grown to a similar size. The two of them now dominate the hard disk drive industry, with a third smaller competitor (Toshiba) tagging along.
This duopoly plus a small fry pattern seems to characterize a number of industries and, once this market structure is attained, it seems to stabilize and be hard to change. WDC and STX are similar in other ways. They both have fiscal years ending at the end of June (June 29 this past year) which makes comparisons easier. They both recently acquired a large competitor (STX acquired the hard disk drive operations of Samsung: WDC acquired the hard disk drive operations of Hitachi). In each case this greatly increased capacity and sales volume. They each have been targeting some acquisitions upstream to better control input costs.
Anyhow, the table below provides per share data based on the full fiscal year ending this past June. The net cash and share count data are based on the most recent financial reports (for the quarter ending September, 2012) filed with the SEC. The other data is based on the annual reports for the fiscal year ending June 29, 2012, as filed with the SEC.
|Price||Div.||Div. Yield||Rev.||Inc.||Net Cash||Share Count|
WDC has elected to use cash flow to pay down debt and build up balance sheet cash while STX has been more aggressive buying back stock and paying dividends. They each have plenty of cash flow for all of these purposes so it will be interesting to see what they do with their cash in the next couple of years. STX recently bought a large competitor by issuing a lot of stock and they have already bought back more than enough stock to offset the extra issuance. STX's price earnings ratio based on the last full fiscal year is an amazing 4.1. In fairness, it is universally acknowledged that fiscal 2012 was somewhat of an anomaly because of shortages and high prices for disk drives created by idiosyncratic circumstances and that this level of earnings is not sustainable. The table below provides consensus projected total revenue and earnings per share for the two companies for the present fiscal year (the year ending June, 2013, and the fiscal year ending June, 2014 from Yahoo Finance.
STX is certainly headed for a decline, but the consensus decline would still leave it trading at a little more than five times earnings. WDC is a bit larger and - because of its net balance sheet cash - actually has a lower Enterprise Value (WDC=$7.79B; STX=$10.94B). But. of course, STX has a much more generous dividend. You may hear investors debate the comparative merits of these two stocks. I think it is a silly debate and that an investor who is not so pessimistic about the sector's future prospects that he believes the low PEs are justified should just buy them both. By doing so, an investor minimizes competitive risk (the risk that WDC or STX will gain a big market share and margin advantage over the other) and can make a "bet" solely based on his view of whether the pricing is overly pessimistic given the prospects of the sector.
So the real issue is the fate of this sub-industry. The conventional wisdom is that the industry's fate is inexorably tied to the PC and that PC's are in decline as users switch to tablets which will not need hard disk drives. So, these valuations reflect the consensus "Short the PC!" sentiment which is very strong in the market right now. On the other hand, there are external storage needs for hard disk drives that seem to be growing and conventional storage is still cheaper than flash memory. WDC and STX are also in the solid state drive and hybrid drive markets as well. Consensus projections do not seem to foreshadow dire financial results and the normal decline one might see in margins and prices with lower demand may not materialize due to the recent changes in market structure. It will be interesting to see how the duopoly works out. Will the companies pile up huge cash hoards in order to deter one another from aggressive price action the same way incumbent Congressman raise lots of campaign money to deter primary opposition? More importantly, will the other demands for external storage assure a relatively "soft" landing?
In that regard, I have been hearing that the disk drive business is about to come to an ignominious and financially disastrous end for a number of years now and it appears that a number of smart investors as well as the consensus of analysts believe that a "soft" landing is more likely. It is sure nice not to have to count on growth in order to have one's investment thesis pay off and, with the above numbers, all you really need is a slow, rather than a fast, decline. Quarterly financial reports should be carefully analyzed for directional trends in revenue and margin and to determine each company's strategy for deploying free cash flow (share repurchases, build up of balance sheet cash, debt retirement, etc.). Based on current prices, I am long both of these. Of course, these stocks shouldn't sell for 15 times earnings, but 5 times earnings is just a little too cheap.