Bad News from Seagate Technology Presents Opportunity in Western Digital

Shares of hard drive makers Western Digital (WDC) and Seagate Technology (STX) sold off 3% and 6.2%, respectively, following a pre-announcement warning from Seagate Monday that revenues and margins would fall short of expectations.

In the case of WDC, I believe that investor pessimism is an unwarranted overhang from the poor fortunes Seagate is having – both stocks are down about 15% year-to-date, but Western Digital looks to be a stronger company and better investment, as it has superior operating margins (8.5% and increasing to Seagate’s 4.7% and falling), better growth opportunities (plans to expand into the fastest growing segments of data storage, namely consumer electronics, with the current consensus five-year looking too low), and a more attractive valuation (WDC trades for 4.6x EV/EBITDA and 0.587x EV/Sales, with STX at 9.3x EV/EBITDA and 1.18x EV/S despite having lower margins on those sales).

Further, if the leaner business model run by Western Digital begins to challenge Seagate in additional areas of the market, Seagate’s margins will be hurt even more than they already have – something that Western Digital appears able to afford, but not Seagate. Finally, Western Digital also has a large cash reserve nearing $800 million, which will give it more flexibility than the debt-carrying Seagate to make acquisitions, increase R&D spending, or pursue other activities to enhance shareholder value.

Although I’m not a chart reader, I can’t ignore the intraday pattern given Monday, with WDC hitting a low right near the open and proceeding to tentatively work higher the rest of the day. This might not be the absolute bottom, but with a conservative fair value estimate of $21 on WDC, I believe the current price in the $16 range provides an excellent time to consider entering a position.

STX/WDC 1-yr comparison chart

Disclosure: none

Comments

[Amit Chokshi:]

Do you think WDC's lack of exposure to flash mem vs STX is a material component for the valuation discount? I like WDC's valuation on the surface but haven't spent much time really looking at the co.

2007 Apr 11 09:22 AM

[James Cullen:]

Amit,
I think part of the valuation discount for WDC is certainly attributable to enthusiasm for flash memory stocks over HDD (Sandisk is at 10.7 EV/EBITDA, 3.1x EV/Sales on 16.9% operating margins); but the market is giving flash a premium right now that I think is irrational - flash might be the anchor of, say, cell phone data storage, but I simply don't see how it can compete against HDD on a scale of more than a few gigabytes. The primary problem with flash is that right now it is about 100x as expensive on a storage unit basis, and even about 5 years down the road the difference should still be double-digits. Then there is the problem of writelife, which is limited on flash drives and will likely prevent adoption in regular computers...
Seagate's CEO says that the average size of HDD shipped is increasing by 10% per quarter. Flash might be a nifty technology, but I don't think it will find widespread adoption for handling the huge data storage jobs the future will bring. Right now it looks like the market is pricing WDC as being dead, and I still think it has a lot of life left.

2007 Apr 11 06:16 PM

[E Baxter:]

I totally agree with James on this; I've bought into WDC heavy; even buying some calls on the last dip. The only real threat from new technology for WDC (and all drive makers for that matter) is virtualization. That technology would drastically low the per-drive need for servers. It allows all the drive space to be used by multiple platforms and with that more efficiently. Countering that is HDDs in camcorders and tivo like appliances, with is going to have an absolute boom this year. The push to Hi-definition in both these devices is going to push demand also.

2007 Apr 11 09:01 PM