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Rising Star Buy: Western Digital

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This article is part of our Rising Star Portfolios series.

Welcome to the new year and another purchase for the Messed-Up Expectations Portfolio. The port has just received another infusion of cash, adding some more drag to portfolio returns -- two months in and it's trailing the market -- but the $2,200 I've actually managed to put to work over the past couple of months is beating the market. Five of the six positions are positive and four of those have grown more than the S&P 500 has since we began. Today, I believe I've found another opportunity.

The industry
There are two large competitors in the hard disk drive market, sharing about 60% of the market in both revenue and shipments: Seagate Technology (Nasdaq: STX  ) and Western Digital (NYSE: WDC  ) . Hitachi's (NYSE: HIT  ) Global Storage Technologies, Toshiba/Fujitsu, and Samsung Electronics are the other significant players.

These companies sell HDDs for notebook and desktop computers, external storage, enterprise use -- that's Web servers, network storage, network communications, and digital surveillance -- and consumer electronics (e.g., DVRs, video cameras, and gaming consoles). Right now, the market is pretty bummed about this industry as PC sales are not as high as hoped, tablets are sure to cannibalize PCs anyway, and didn't you know that solid-state drives (SSDs, with no moving parts) are the future, man?

Well, yes and no. For storage, HDDs beat SSDs hands down on price, and that's expected to remain the case for several years, as both technologies see falling prices per gigabyte. Furthermore, with the proliferation of storage required by more cloud applications and just plain storage needs -- all those videos have to go somewhere, both on the server side and the customer side, for instance -- there's plenty of growth remaining in the HDD market.

Finally, industry trends are turning around. Market analyst iSuppli is predicting the second quarter in a row of sequential growth in HDD shipments, some 169 million units. Part of that is from an increased need for enterprise and external storage referred to above, but part is also from increased desktop orders from businesses upgrading their hardware. PC demand is picking up all over the world, with 10.3% year-over-year growth in the third quarter.

The choice
Both companies are being priced by the market with very little growth expected. Seagate is priced as of last night as if it would grow free cash flow by just 1.4% for five years, 0.7% for five years, and nothing after that, while Western Digital's FCF growth is priced in at 0.7%, 0.4%, and 0%, respectively (both using my 15% hurdle rate). Given the growth in the PC market and what should be an expanding enterprise market, those levels seem awfully low to me.

However, between the two of them, I prefer Western Digital, mostly because of what I highlight below.

  Western Digital Seagate Technology
Cash, MRQ $2.86 billion $2.07 billion
Total debt, MRQ $0.38 billion $2.17 billion
Revenue growth, TTM 32.9% 21.1%
Revenue growth, avg. 5 years 21.3% 7.2%
Net income margin, TTM 12.9% 13.8%
Net income margin, avg. 5 years 10.1% 1.2%

Source: Capital IQ, a division of Standard & Poor's; MRQ = most recent quarter, TTM = trailing 12 months.

While both companies have grown revenue quite handily over the past year, Seagate has had a harder time growing it over the past several years. It's also had a harder time maintaining margins over that time.

Furthermore, the balance sheet position at Western Digital is much stronger than at Seagate, especially when you consider that Seagate just added another $750 million in debt. Granted, this is most likely part of the share repurchase plan the company recently announced, but I dislike seeing a company leverage itself just to do that. Plus, the majority of EPS expansion under this scenario wouldn't be due to higher net income, but to fewer shares, a limited scenario.

The risks
Hard disk drives are a commodity business, so a price war could certainly hurt the industry, as it has in the past. However, Western Digital, with its stronger balance sheet, is in the better position to see one through.

Customers could also see a slowdown in sales of their products -- PCs and whatnot -- backing up HDD inventory and slowing down sales. I'll be tracking inventory, especially finished goods, PC shipments, and revenue growth pretty closely, and if the slowdown appears to be happening again, I will look to exit the position. I believe, however, that this would mostly be due to another recession, something I think is not as likely as it was six or nine months ago.

The move
Tomorrow, the MUE Portfolio will purchase 11 shares of Western Digital, representing a 2% starting position. If the company performs as well as I think it can, I'll be looking to add to this position going forward.

Come discuss this decision and the other companies I've purchased as I fill out the portfolio over on the MUE discussion board.

Fool analyst Jim Mueller doesn't own shares of any company mentioned. He works for the Stock Advisor newsletter service. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (18)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 04, 2011, at 5:27 PM, CMFSoloFool wrote:

    I'm in complete agreement that HDDs are still going to be needed for years to come, and that WDC is the best pick of the litter. While I already have shares of WDC (since $12), I like to add on dips because I believe they will handily beat their numbers in 2011. Also, WDC and STX haven't simply let SSD eat their lunch, they have their own offerings, both pure-play SSD as well as hybrids of SSD and HDD in one unit. The risk/reward ratio certainly looks good.

  • Report this Comment On January 04, 2011, at 9:21 PM, TMFTypeoh wrote:

    Nice find Jim!

    I enjoyed reading (on your suggestion) "expectation investing". I think that book really validates your portfolio thesis.

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