Hard drives and flash memory are two types of storage that are essential parts of any computing system. This includes everything from your personal computer to huge cloud data centers. The overall semiconductor and storage industry is currently facing a cyclical decline, but I believe this represents opportunities for long-term value. In this discussion, I will break down my top two stocks in the industry that are poised to benefit.
Seagate
Seagate Technology Holdings PLC (STX, Financial) is the market leader in hard-disk drives with approximately 43% market share, according to data from Statista. Seagate and its closest rival, Western Digital Corp. (WDC, Financial), dominate the market with 80% share.
Both companies are key suppliers to the cloud storage market, which includes the “hyperscale” customers such as Amazon Web Services, Azure and Google Cloud.
Although the cloud industry has experienced slowing revenue growth over the past year, this has mainly been driven by macroeconomic concerns. Management has focused on doing “more with less” and reducing capital expenditures across the board. However, I believe this is a short-term pullback in spending as the cloud industry is still forecasted to grow at a 20% compounded annual rate, according to Fortune data.
Therefore, as the industry rebounds, I expect Seagate to benefit.
Financials with cyclical headwinds
On the face of things, Seagate reported terrible revenue of $1.86 billion in the first quarter of 2023, which nosedived by 34% year over year.
A positive is sequentially, its revenue has only dipped by 1% and thus could indicate stabilization in the industry. Another good sign has been an increase in overall shipments by 8% sequentially to 104 exabytes.
Of course, lower demand and a supply glut has meant prices have remained depressed as inventory is written down.
Moving onto profitability, Seagate reported an operating loss of $295 million, which was substantially worse than income of $429 million reported in the prior year.
Again, this was driven by the cyclical decline in the industry as well as lower prices per unit. In addition, the company’s facilities operate more efficiently at scale, and thus when operating at lower volumes, profitability can be impacted.
The good news is management has been proactive and reduced its operating expenses by 8.3% year over year to $2.17 billion. In addition, many of its expenses in the quarter were in relation to an eye-watering $300 million settlement paid to the Bureau of Industry and Security following export compliance issues.
For income investors, Seagate pays a strong 4.49% forward dividend yield. This is well covered by its strong $264 million in negative free cash flow.
Seagate’s balance sheet is fairly stable with $766 million in cash and marketable securities. Its total debt is high at $4.8 billion, but the vast majority of this is long-term debt. The company also has over $1 billion in excess inventory, which can of course be converted into cash as it is sold.
Valuation
Seagate trades at a price-sales ratio of 1.51, which is 1% higher than its five-year average.
Further, the GF Value Line indicates a fair value of around $56 per share. Thus, the stock is fairly valued at the time of writing based on its historical ratios, past financial performance and analysts' future earnings projections.
Guru interest
In terms of guru investors, Seth Klarman (Trades, Portfolio)' Baupost Group purchased 136,000 shares, which traded for an average price of $64 each in the first quarter. PRIMECAP Management (Trades, Portfolio) also purchased shares at a similar level, which could be an indication of value.
Western Digital
Western Digital (WDC, Financial) is the second-largest supplier of hard-disk drives with around 37% market share, according to data from Statista.
The company operates with a very similar model to Seagate in that it is vertically integrated with regard to its production and footprint of manufacturing facilities.
The unique thing about Western Digital is it also runs a flash memory business after its acquisition of SanDisk for a staggering $19 billion in 2016. SanDisk is, of course, known for its memory cards that are used in cameras and mobile phones.
In 2022, activist firm Elliott Management took a $1 billion stake in Western Digital and urged a spin off of its flash memory business.
This makes complete sense as, over the past couple of years, shareholder value looks to have been destroyed. Let’s take the SanDisk acquisition as as example. It was acquired for $19 billion and Western Digital’s entire market capitalization has fallen to close to $13 billion since then.
Relative to management's investor day targets set in 2016 and 2018, the company has missed on all metrics. For example, one forecast was a 4% to 8% revenue CAGR, which has been missed. Its non-GAAP operating margin forecast of between 20% and 25% has also been missed.
Either way, Elliott Management has used this situation as a catalyst for encouraging a spin off or merger. A positive is Western Digital’s management seems to have listened as Reuters recently reported talks with joint venture partner Kioxia were accelerating.
Kioxia is the second-largest supplier of flash memory with a 19% market share. Therefore, a merger with Western Digital’s flash business, which has a 14% market share, could be incredibly lucrative. This would create one of the largest flash memory companies in the world with a 33% market share, bringing it close to the leader Samsung (XKRX:005930, Financial), which has a 34% share.
Financial challenges
In the meantime, Western Digital is facing financial challenges at its revenue of $2.8 billion was down 36% year over year in the fiscal third quarter. The only silver lining is this metric was $115 million better than analysts were expecting.
Breaking revenue down by end application, its cloud segment reported $1.2 billion in sales, which was down 32% year over year. As mentioned, this was driven by cloud companies and enterprises scaling back capital expenditures.
Its client segment reported a similar trend with a 44% year-over-year drop in revenue to $1 billion. This was driven by an industry-wide pullback in the PC and gaming market, which I have seen across many companies, including Microsoft (MSFT, Financial), and PC equipment suppliers such as Corsair (CRSR, Financial).
Moving on, the company reported a loss of $432 million in the fiscal third quarter, which was substantially worse than the $534 million reported in the year-ago quarter.
The good news is its operating expenses have begun to stabilize, with a $138 million reduction reported. Further, its earnings loss of $1.82 per share surprisingly surpassed analyst estimates by 6 cents.
Western Digital’s balance sheet has a solid liquidity position with $2.2 billion in cash and short-term investments. Its debt is fairly high at $7.1 billion, but the majority of it is long term.
A merger with Kioxia and a spin off of its hard drive business should help to lower the company's cost of capital and improve financing costs, assuming the deal can get past antitrust regulators.
Valuation
Western Digital trades with a price-sales ratio of 0.89, which is fairly valued relative to its five-year average. A positive is this figure is lower than its primary competitor, Seagate.
Guru interest
Guru investors Steven Cohen (Trades, Portfolio), Jerome Dodson (Trades, Portfolio) and Jim Simons (Trades, Portfolio)' Renaissance Technologies were adding to their positions in the first quarter. Shares traded for an average price of $39 each, which is close to where the stock traded at the time of writing.
Final thoughts
Seagate and Western Digital are very similar companies. They both dominate 80% of the hard drive market and are experiencing challenges due to the industry pullback. Western Digital is the cheaper option on a relative valuation basis and has the potential for a spin off to act as a catalyst. However, if investors want income from this investment, then Seagate’s 4.6% forward dividend yield is enticing.
