Data Stocks: Still A Worthy Investment?

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 |  Includes: BRCD, STX, WDC
by: Fusion Research

The increasing need to manage data has created huge demand for data storage devices and services. Among these devices, the demand of solid state drives, or SSD, is rising with the consumer shift to tablets. Also, in order to manage enormous amounts of data, corporates are shifting towards cloud technology, which is major ongoing trend in data storage. To meet the demand and changing trends, the companies in this industry are coming up with new and upgraded storage devices that will enable the users to manage their data more efficiently. In this article, we analyze three data storage companies that are launching new products and adopting cost cutting strategies to drive their earnings and investors' confidence.

Enhancing SSD portfolio

SanDisk (SNDK) recently enhanced its SSD portfolio with the power efficient SanDisk X210 SSD. The company started offering SSD products earlier this year and received positive response from its business customers who benefited from incorporating its SSD into their notebooks and tablets. Looking at this, the company introduced the new fast and cost effective storage solution, X210 SSD, within its existing SSD portfolio. It provides storage capacity up to 512 GB and offers 505Mb per sec read up and 470MB per sec write up speed. The company expects that the total contribution from SSD will be around 25% of total revenue in 2014 compared to 16% in second quarter of 2013.

The SSD market is expected to grow at an annual growth rate of 30% in next three years, and SSD shipments are expected to reach 64.6 million, up by 87% from 2012. The company's market share in SSD was 16.8% in the first quarter of 2013 and ranked number two in total SSD shipment. We believe that the new product offering will enhance its customer base and provide an opportunity to gain additional market share in the fast growing SSD market. Looking at the growth in the SSD market, and SanDisk's position, we expect the revenue guidance given by the company is quite achievable.

SanDisk is focusing towards returning cash to the shareholders with the initiation of its first ever quarterly cash dividend of $0.225 per share. In addition to its dividend initiative, it also expanded its share repurchase authorization by an additional $2.5 billion, totaling the authorization to $3.75 billion. A part of this repurchase will be done through its Accelerated Share Repurchase, or ASR, agreement of $1 billion. ASR is method under which the company buys shares from an investment bank, which in turn borrows the shares from the clients. This is used for a fast paced buyback. Under this agreement, the company will initially receive approximately 14.5 million shares in the third quarter of 2013.

In the table below, we are calculating the impact of share repurchase on third quarter EPS. Assuming, the same net income of $262 million as in the second quarter 2013, the share repurchase of 14.5 million shares will reduce the outstanding shares to 231 million and will increase EPS by $0.07 in the third quarter. The growth in net income will further increase the EPS.

Impact on third quarter EPS

Second quarter 2013

Third quarter 2013

Net income ($ million)

262

262

Outstanding Shares (In millions)

246

231

EPS

$1.06

$1.13

Click to enlarge

The company is currently trailing at a PE of 18.83, and its forward PE is 10.44. A decline in forward PE indicates that a company's earnings are expected to grow significantly. Further, its PEG ratio is 0.75. A lower PEG ratio, or near to one, means a company's stock is undervalued and is expected to appreciate in the future with earnings growth.

Growth in enterprise and cloud storage division

With the rise in data usage on cloud, demand of servers is increasing to support higher input output operation per second, or IOPS, that have faster hard disk drive, or HDD. IOPS is a performance measurement of storage devices like HDD. Looking at this, Seagate Technology (STX) introduced two enterprise class HDDs named 'Seagate Terascale HDD' and 'Seagate Enterprise Performance 10K HDDv7' in July 2013. These drives are compatible with emerging cloud infrastructure and large scale data centers since they have high storage capacity in a low power configuration. Terascale has capacity of four Terabyte, which is the highest available in the 3.5 inch enterprise HDD category, and it operates at one of the lowest HDD power consumption rates of around 4.8 watts. Seagate's '10K HDDv7' is equipped with 1.2 Terabyte data storage.

The storage on cloud application was 25% in 2011 and over the next eight years is expected to double, which we assume would be growth at a CAGR of 9.05% over the next eight years. The company is trying to capture the opportunities in cloud storage with new drives that currently contribute around 9% in total revenue, or $1.34 billion. Assuming its revenue will grow in line with the growth of cloud, it is expected to reach $1.46 billion this year.

The company's revenue declined 24% year over year to $3.43 billion in the fourth quarter ended in the June 2013 because of lower PC demand. HDD unit shipments in the quarter were 53.9 million units compared to 65.9 in the same quarter a year ago. According to IDC, weakness in the PC market was due to lower demand in emerging markets, slowdown in mature markets, and cuts in IT spending globally. The demand is expected to improve in the second half of the year with economic recovery and routine upgrades by enterprises and individuals. The company expects revenue to grow around 5% quarter over quarter to $3.6 billion in first quarter ending September 2013. The recovery in PC demand would lead to moderate total addressable market, or TAM, growth in the September quarter, which is expected to reach around 140 million units in the September quarter compared to 133 in the June quarter.

Looking at valuation side, Seagate's trailing PE is 7.97 and its forward PE is 6.52, implying earnings are not expected to grow significantly. Further, its PEG ratio is 6.88, indicating that the stock is overvalued compared to its earnings growth.

Cost cutting on track with recovery in storage demand

Brocade Communications Systems (NASDAQ:BRCD) reported operating margin of 21.6% in the third quarter ended July 27, 2013, up 2.1% year over year. The improvement in margin was due to the company's cost cutting plan. In the third quarter, the company cut the operating expenditure, or opex, around $15 million, representing a $60 million run rate for the year. It has reduced expenses across non-strategic areas like eliminating certain marketing programs and events, and an increased reduction in headcount. The company has reduced the headcount by 83 in the quarter to 4,565. With these initiatives, the company expects to achieve $100 million annual reduction in opex by the second quarter of fiscal year 2014. We are optimistic that the company's cost cutting plan will maintain at least the current level of operating margin of around 21.6% but could drive the margin upward.

The company's storage area network, or SAN, business reported revenue of $369.2 million in the third quarter, which declined 2% year over year. This decline is modest compared to 7% the year over year revenue decline in the second quarter. This improvement in revenue was driven by improvement in storage spending and strong adoption of the company's Gen 5 Fibre Channel product. The original equipment manufacturer, or OEM, inventory level in the quarter was 1.5 weeks; a lower inventory level indicates improvement in end user demand. For the fourth quarter inventory is expected to be in the range of 1-2 weeks. With improving OEM inventory level and end user demand, Brocade expects revenue to grow 1%-4% quarter over quarter in the fourth quarter of 2013.

We expect recovery in storage market will strengthen the demand of its storage product like Gen 5 Fibre channel, as it provides high performance and reliability needed in cloud computing and storage capacity expansion. Looking at the valuation side, its twelve month trailing PE ratio is, 17.21, and its forward PE is 9.75. The drop in forward PE is implying that company's earning is expected to grow in future. We are optimistic that cost cutting and SAN product demand will support the company's earnings growth.

Conclusion:

SanDisk's expansion of its SSD portfolio with new power efficient drives and its initiation of dividend payment along with the share buyback plan will drive long term value for shareholders. The stock is attractive and exhibits significant earnings growth.

Seagate's growth in its enterprise and cloud division will offset the current weakness in the PC market. The PC market is expected to recover in the second half of the year, which will lead to a moderate increase in TAM. We are optimistic about Seagate's future growth in cloud but uncertainties in the PC market remain a concern. Thus, we recommend hold for Seagate.

Brocade's progress in its cost cutting plan and recovery in the SAN business is expected to drive its revenue, earnings, and the stock price too.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Fusion Research is a team of equity analysts. This article was written by Rohit G., one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.