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Since the HDD industry consolidated back in 2011-2012 when Western Digital (NASDAQ:WDC) acquired Hitachi GST and Seagate Technologies PLC (NASDAQ:STX) acquired Samsung's HDD business, the industry landscape has changed significantly. After the 2011 floods in Thailand that severely damaged HDD manufacturing facilities, prices of hard disk drives rose dramatically. Many claimed that inflated prices would plunge when capacity was brought back online, but they didn't. A de-facto duopoly had been formed and neither WD nor Seagate wanted to slash prices. And yet, a weakness of PC sales harmed the HDD TAM and consequently the duopoly revenues.

PC Unit Shipment
Quarter Q2-11 Q3-11 Q4-11 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13 Q3-13
Shipments 87.5 95.4 95.0 89.2 85.3 87.5 90.3 79.2 76.0 80.3
Y/Y Change 2.3% 3.2% (1.4%) 1.9% (0.1%) (8.3%) (4.9%) (11.2%) (10.9%) (8.6%)

The TAM was hurt so much that now WDC ships almost the same amount of drives it shipped in Q3-2011, before it acquired Hitachi. Although PC sales are plunging, exponential growth of data spurs new data centers that have massive storage needs. Let's take a look at WD and Seagate shipment data for the past 11 quarters.

|Western Digital HDD Unit Shipments
Quarter Q1-11 Q2-11 Q3-11 Q4-11 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13
Compute Units 37.8 36.3 41.2 21.2 34.0 53.9 42.7 39.0 39.9 40.1
Non Compute Units 12.1 11.1 14.2 5.6 6.5 9.1 13.7 13.5 13.0 11.8
Enterprise Units 2.3 2.3 2.4 1.7 3.6 7.9 5.9 6.6 7.2 7.8
Total Units 52.2

49.8

57.8 28.5 44.2 71.0 62.4 59.2 60.1 59.8
|Seagate HDD Unit Shipments
Quarter Q1-11 Q2-11 Q3-11 Q4-11 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13
Compute Units 32 35.5 33.3 32.7 43.8 46.3 40.7 39.2 36.6 34.7
Non Compute Units 9.3 9 10.5 7.8 9.5 11.2 10.6 11.7 11.6 10.9
Enterprise Units 7.4 7.8 69. 6.4 7.4 8.5 6.3 7.3 7.5 8.2
Total Units 48.7 52.3 50.7 46.9 60.7 66 57.6 58.2 55.7 53.8

While unit shipments are stagnant, gross margins and ASP are much higher these days thanks to the help of the HDD duopoly.

ASPs, Gross Margins, and Revenues
Quarter Q1-11 Q2-11 Q3-11 Q4-11 Q1-12 Q2-12 Q3-12 Q4-12 Q1-13 Q2-13
Seagate Gross Margin 19.5% 19.3% 19.5% 31.6% 36.9% 33.1% 28.4% 27.0% 26.9% 27.4%
WD Gross Margin 18.2% 19.5% 20.1% 32.5% 32.2% 31.0% 29.6% 27.7% 28.2% 28.2%
Seagate ASP $60 $54 $55 $67 $73 $68 $65 $63.02 $63.3 $63.66

WD ASP

$47 $45 $46 $69 $68 $64 $64.6 $64.6 $62.6 $ 62.2

Although the market took some time to react to this fundamental change in the industry both companies' stock has risen more than 160% for Seagate and more than a 100% for Western Digital since January 2012. Both companies trade at a P/E of less than 10 on their pro-forma earnings. With all the information about the exponential growth of data, why aren't these companies valued with at least a P/E of 15? The answer is simple. Realized growth. As a rough rule of thumb, a PEG ratio of 1 means a company's growth is valued fairly. The big exposure to PCs and the lack of exposure to the mobile markets anchors the companies' revenues and profits in a close to constant level, thus the market values those companies at a lower P/E ratio.

Where's the Growth?

A lot was said about the so called "death of HDDs" and "the rise of SSDs." While I think the PC market will never go back to what it was in the past, it is way too early to talk about the death of the HDD. The price difference between a SSD GB and a HDD GB makes data center builders prefer HDDs for anything that isn't mission-critical. Most of the data we create becomes "cold data," which means that most of it will never be accessed again. Yes, that forgotten video you made about your cat that is stored on Facebook (NASDAQ:FB) servers just doesn't justify being stored on flash.

(click to enlarge)

WD and Seagate have both claimed over the past year that the near-mid term future lies in SSHDD or hybrid HDDs that use a small amount of flash, mainly for cache purposes with an HDD, thus gaining the speed advantage from the NAND and the cheap capacity advantage from the HDD. In the past few months we witnessed a flow of news about the prospects of hybrid HDDs in tablets. Even Seagate CEO Steve Luczo was heard talking about these prospects in the past few months.

Steve Luczo - Chief Executive Officer

"Sure. I don't know that I view 5-millimeter necessarily as a notebook drive. I think we view 7-millimeter as probably the right platform for thin and light notebooks. 5-millimeter probably is the more compelling drive for something even more mobile like a tablet."

Source: Seagate fiscal Q4-13 earnings call

Seagate even demoed a tablet carrying an HDD. Before I'll move on with this article I want to comment about those who regularly claim that 500GB is just too much for you. As time passes, our minds can't perceive the amount of data we will need to store in the future. At one time in the not so distant past, everybody thought that 5MB was much more than anyone would ever need. I guess that 10-15 years ago even you thought that 5GB was way too much for you. Think about that again. I want to demonstrate the logic for the use of HDDs in tablets and then try to estimate the impact on WD and Seagate's business performance and financials.

Does It Make Sense?

Today we consumers suffer the most from the use of SSDs in tablets. Apple (NASDAQ:AAPL) and other tablet market leaders make a lot of profit from selling us small amounts of storage for a ridiculous price premium.

(click to enlarge)

The math shows us we pay $100 for the first 16GB addition (the default model is 16GB), and another $100 for an addition of 32GB more. The BOM shows us it costs the manufacturer, in this case Apple, about $16 to put in the tablet another 16GB, or just over $1 per GB. We pay for each extra GB (from the 16th GB to the 32nd GB) about $6.25 that comes up to more than 83% in gross margin on the storage part of the tablet, definitely a good business for the manufacturers. What is the alternative? Here it is.

(click to enlarge)

For $89 OEMs can build a tablet with 500GB of capacity. A tablet manufacturer can now lower its cost per GB to $0.18. Then, the manufacturer can charge us consumers about $0.36 per GB and still get 50% of gross margin on the storage part of the tablet while increasing the value proposition a lot, which can fuel volume sales. This is a strategy I believe many tablet manufacturers that want to take market share will adopt. This is what you can store on 500GB.

I believe we will start seeing high storage capacity tablets hitting the shelves in the near future. Microsoft (NASDAQ:MSFT) is launching the Surface 2 and Surface 2 Pro with up to 512GB of flash on October 29th. Yes you read it right, 512GB of flash. The Surface 2 Pro with 64GB is priced at $899 and the same tablet carrying 512GB of flash is priced at $1799 or $900 more. Those who'll buy the 512GB Surface 2 Pro will pay about $2 per extra GB (from the 64th GB to the 512GB). Manufacturers like Samsung, for example, which sells the Samsung Tab 3 for $299 with 16GB of storage, could use the 5mm SSHDD and offer a similar tablet with 500GB of storage for $459. A price point that I think will appeal to most "storage hungry" consumers.

For those of you that are interested in comparing the performance of this 5 mm SSHDD to an SSD can read here.

What is the Impact on TAM?

The adoption of HDDs by the tablet industry could be a game changer for both WD and Seagate. I assume both companies will share the market for tablet HDDs at a 50/50 split. Also, I assume this big storage capacity tablet market will start as a niche and slowly take over the entire tablet market as the standard. Let's take a look at the PC and tablet markets' shipments forecast.

Year 2013 2014 2015 2016 2017
Tablet Shipments 197.2 265.7 340 410 467.9

To get a clear picture, I did a side by side market size comparison.

Year 2013 2014 2015 2016 2017
Tablet HDD market size $1.75B $3.5B $6B $9.1B $12.4B
PC HDD market size $18.9B $17.5B $16.2B $15.1B $14.1B
Total $20.6B $21B $22.2B $24.2B $26.6B

Assumptions: PC HDD prices will decline 5% y/y and tablet HDD prices will remain stable. Tablet HDDS will have a 10% market share of the total tablet market in 2014 and will increase gradually.

Conclusion

If the tablet story unfolds like I demonstrated both Western Digital and Seagate could experience growth in the next few years. The PC trend coupled with the future tablet business could support healthy growth, especially if you bring enterprise HDDs into the equation. With WD and Seagate valued at a P/E of less than 10 on their last annualized quarter pro-forma earnings, I think both stocks might have significant upside. Of course, we need to closely monitor this developing story.

Source: Western Digital And Seagate: The Tablet Sweet Spot