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Seagate Technology (NASDAQ:STX) and Western Digital (NASDAQ:WDC) effectively form a duopoly controlling the hard disk market. The companies are similar in size as measured by market capitalization and sales. They share many of the same challenges, specifically in terms of the slowdown of PC sales and the emergent solid state drive innovation. The opportunity they share is in the growth of the "cloud" for storing the massive amount of data generated each day. Analysts have cut forward earnings estimates for both companies. The question is does one of these companies represent a better buying opportunity than the other?

Seagate Technology reported record fiscal fourth quarter revenue of $4,450 billion at the same time it reduced its own estimate of calendar year sales. Sales for FY4Q12 are up about 65% from the year-earlier period. On a trailing twelve month basis, sales grew 36.2%. EPS in FY4Q12 jumped to $2.48 from the year-ago quarter of $0.21. Year-over-Year, EPS diluted jumped 491.7%. This growth can be attributed, in part, to last year's flooding in Southeast Asia where Western Digital was hit hard. The company reduced its calendar year revenue forecast to $17 billion from $20 billion. Seagate provides guidance of $8.44 for FY2013 EPS, up from $6.75.

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Seagate's gross margin expanded to 31.4% in FY12 from 19.6% in FY11. Operating margins grew to 20.8% from 7.3% and net margins expanded to 13.2% from 4.7% in the prior year. Inventory to sales dropped to 5.6% in FY12 from 6.6% in FY11. The company closed the year with cash and short-term investments of $3,151 billion against long-term debt of $2,952 billion. The log-term debt to capital ratio is 43.8% and the long-term debt to equity ratio is 77.9%. These debt ratios seem high, but we note that long-term debt is less than 3X free cash flow and less than 1X working capital. These indicate that debt is well under control.

The company declared a quarterly cash dividend of $0.32. The indicated dividend is $1.28 per share generating a yield of 4.3%.

The company is highly profitable as measured by return on equity. In the past, Seagate's profitability has been very volatile. For purposes of valuation, we focus on EV/EBITDA. The current EV/EBITDA of 3.54X is very low and implies a big upside potential. We also look for confirmation from the EV/Free Cash Flow and EV/Sales ratios.

The quality of earnings is also very important. To confirm earnings quality, we look to free cash flow. Free cash flow is $1,479 billion. We also look to Cash Flow to Invested Capital. Seagate has a CFROI of 22.63%, which is very strong.

Capital allocation is another important factor. Seagate is paying a substantial dividend and it is also buying back shares. The company expended $1.2 billion to buy back 45 million common shares. These actions accrue to the benfit of stockholders.

Western Digital Corporation suffered last year when floods in Thailand disrupted the company's operations and supplies. Since then, conditions have dramatically improved leading WDC to report record results. Western Digital's revenue nearly doubled in the recently completed quarter. Sales jumped to $4,754 billion from the year-ago quarter of $2,403 billion. Shares of WDC soared more than 20% after the quarterly report was released. Besides recovering from the flooding, Western Digital is also benefiting from its acquisition of Hitachi's hard disk operations.

The company provides guidance of $10 per share in earnings for the current calendar year. For the period ended June 29th, WDC reported net profit of $745 million, or $2.87 a share, up from $158 million, or $0.67 per share in the year-earlier period.

Western Digital also reports a jump in gross margins. GM expanded to 29.2% from 18.8% in FY11. Operating margins expanded to 14.2% from 8.2% and net margin grew to 12.9% from 7.6%. We see that inventory to sales increased to 9.7X from 6.1X. This may indicate that WDC expected greater sales growth and had built-out inventory in anticipation of this growth.

EV/EBITDA is a very low 3.33X, suggesting that WDC is undervalued. We have confirmation of this from the EV/Sales and PS ratios. WDC has cash and short-term investments of $3,208 million and long-term debt of $1,955 million. WDC generates enough free cash flow to pay off its debt in less than one year.

WDC is currently solidly profitable with a ROE of 24.1% and CFROI of 23.85%. Free cash flow is $2,350 million, which is greater than reported net profit. Western Digital does not pay a dividend and we note that the company is increasing the number of shares outstanding every year for the last seven years.

Conclusion

The two companies appear to be very similar in profitability, free cash flow and debt. What appears to differentiate these companies from one another is their approach to capital allocation. Both companies are making acquisitions, but where Seagate is rewarding shareholders with a healthy dividend and share buybacks, Western Digital is issuing more stock and diluting shareholder returns. We think this difference is significant over the long term. The market seems to agree with us. Both companies had a pop when their quarterly reports came out, Western Digital was trading at the low end of its trading range. Seagate is now trading close to its 52-week highs.

Source: Buy Seagate, Sell Western Digital