I recently experienced a hard drive crash on my Mac. While getting it replaced, I noticed that solid-state flash drives have come down in price since I looked at them a year ago, whereas the more traditional hard drives with which we are all familiar have become more expensive. Those price increases can be attributed directly to the floods in Thailand earlier this year that impacted production capacity from Western Digital, one of the three remaining large-scale hard drive manufacturers. This has created a shortage that has been affecting computer makers around the world.
So I decided to install a solid-state drive with the promise of better performance and stability, but this also meant sacrificing storage space. A few weeks into this upgrade, I can now tell you that from my perspective the death of the traditional hard drive is still way down the road. I have had to use external drives to augment the lack of storage space in the solid-state drive. That got me thinking about the three traditional hard drive suppliers in the market: Seagate Technology (NDQ: STX), Western Digital (NYSE: WDC), and Toshiba.
As I did more research into solid-state drives I came across an interview with the chief executive of Seagate, Stephen Luczo. He makes a strong case that flash memory would be a complementary, not competitive, technology to standard hard drives, at least in the near future. He predicts continued strong demand for conventional hard drives and points out that much of the cloud storage services will also be located on hard disk drives, albeit in large, centralized locations.
If the CEO of Seagate is right about that, where is the best place to invest to take advantage of the burgeoning need for more storage, especially after considerable industry consolidation? There are essentially only three major drive manufacturers and that's down from more than eight just a few years ago. One, Toshiba, does not trade in North America. So that effectively leaves us with only two choices: Western Digital and Seagate.
To my mind, there's no contest. Only Seagate pays a significant dividend, currently $1 per share annually to yield 3.4%. The stock is trading at about four times projected 2012 earnings. Seagate has also been repurchasing its own stock aggressively and plans to reduce outstanding shares by 25% over the next year.
Seagate's factories were unscathed by the massive flooding in Thailand. That has given them a competitive advantage over Western Digital, supporting pricing and strengthening Seagate's margins in the recent quarter. Of course this advantage is only temporary and eventually Western Digital's factories will come back online. But given the consolidation in the industry all three remaining suppliers have good pricing power going forward, even when Western Digital returns to full production.
Seagate reported earnings for the third quarter of fiscal 2012 on April 17 and absolutely crushed their numbers. Gross margins for the three months to March 30 were 37%, up from 32% in the previous quarter and 19% year ago. The company sold 61 million drives in the quarter for a total of $4.4 billion (figures in U.S. dollars), which is right in line with analysts' targets. That represents a 65% year-over-year revenue gain, which generated $2.48 per share in earnings. That easily beat the Street's estimates, which were $2.11 per share. For the first nine months of the fiscal year, Seagate earned $4.16 a share. Even if it did not add another penny in the fourth quarter, the p/e multiple would only be seven! Talk about a cheap tech stock!
If you are concerned about the ongoing demand for traditional hard drives versus the solid-state drives that populate tablet computers, it should be noted that Seagate also entered that business back in 2009. They've been developing solid-state hybrid drives that combine the speed and stability of solid-state with the added storage capabilities of traditional systems.
You could make the case that this is not a super sexy business but we all store thousands of songs, videos, and photographs either on our own drives or through cloud services. The demand for storage continues to grow exponentially and if any of you have experienced a hard drive meltdown like I did, you know how necessary it is to continually back up data. I just went out and bought more external hard drives to augment the backup systems that I already have in place.
Seagate is a fast-growing company with high margins run by an investor-friendly management group. The stock, which closed on Friday at $29.21, is trading at an extremely inexpensive p/e ratio. Plus, you are getting an aggressive stock buyback plan and a healthy dividend. That's a good recipe for high returns.
Action now: Buy Seagate at current levels with a target price of $35.
Disclosure: I am long STX.