Seagate and Western Digital: One Number Says It All

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Western Digital (NASDAQ: WDC  ) and Seagate Technology (NASDAQ: STX  ) traded considerably lower on Tuesday after the latter reported disappointing earnings. While there were strengths and positives to Seagate's report, there was one number that really stood out, giving investors a clear indication of whether to buy or sell.

Two clear market leaders
Despite a rather large sell-off in Seagate shares, the stock still trades with two-year gains of 180%, outperforming Western Digital's 130% return.

Combined, the two companies control about 85% of the hard-disk drive, or HDD, market. Recently, both companies have made large investments into solid state drives, or SSDs, which are used in tablets and smartphones, but carry much lower margins than HDDs.

Nonetheless, these market leaders have performed well, despite rapid decline in PC and tablet sales, by strategically investing and capitalizing on new markets in the cloud and lessening their dependence on the PC/laptop market.

A single leader emerges
For the most part, Seagate and Western Digital have performed the same for the last two years, trading with similar fundamentals and market caps during this period. Yet, over the last year, a leader has emerged, which is even more evident when comparing the companies' earning reports.

For the last year, we have seen a growing disconnect in the market share of these two companies. In the December quarter, both Western and Seagate estimated their total addressable market for hard drives at 142 million units. Notably, this is up about six million units year-over-year.

However, Seagate estimates its market share at 40%; in the same quarter, Western estimates a 45% market share for its business.

Why is this such a big deal?
A 5% gap between these two peers may not seem like much, but at this time last year, both companies had a 43% market share. Since then, Western Digital's share has increased 2%, while Seagate's has fallen 3%. Furthermore, this isn't just a single quarter occurrence, as the growing gap has been progressing over the last few quarters.

In July, Seagate's share was 41% and Western's was 44.4%. Clearly, this trend has continued into the most recent quarter, and it can be seen clearly in each company's sales performance.

Western Digital saw revenue growth of 4.7% last quarter, while Seagate's declined 3.8%. Obviously, if you're operating in an industry with modest growth, and you're losing market share, then revenue losses will be the result, as seen with Seagate. Conversely, if you gain market share, your revenue will rise, which we've seen with Western Digital.

Where to invest?
As stated, these are two very similarly valued companies; both trade at 1.3 times sales, but are fundamentally moving in opposite directions.

Western Digital is growing and has some room to improve its operating margin of 13%. Seagate is clearly not growing and has seen a consistent trend of margin declines in recent quarters. In particular, Seagate has seen its gross margin fall from the mid-30% range in late 2012 to the current 28% level. While one reason is a higher mix of low-margin storage devices, its lack of growth isn't helping profitability, either.

It seems reasonable that if you're willing to invest in this space, Western Digital would be more deserving of a premium over Seagate. Simply put, Western Digital has proven over a one-year period that its growth is not a fluke, but rather a consistency that's been created from better execution in the marketplace.

What about other storage investments?
While Western may be the better investment, a debate surrounding whether other storage segments present more upside has also been discussed.

In particular, many investors have favored EMC Corporation (NYSE: EMC  ) . The company is primarily engaged in cloud virtualization, but offers storage solutions aimed at data centers and computing applications.

EMC works with large corporations in communications, energy, financial, retail, and most other major segments of the market. Therefore, it has operated with consistent growth over the last four years, and has operating margins of 18.4%, significantly higher than traditional HDD companies.

However, EMC faces a significant threat from cloud service providers that build their own storage systems. Corporations switching to cloud service providers might indirectly benefit the HDD/SSD business, as those systems store data on such products, while directly negatively impacting EMC.

Final thoughts
With an 85% market share, Seagate and Western Digital are their own biggest threat. On the other hand, EMC faces a slew of competitors, from both cloud service providers and the likes of Oracle and IBM. Therefore, predicting long-term performance for EMC is challenging.

With Seagate and Western Digital, the latter has proven its dominance in the industry by stealing market share from its competitor. The fact that these two companies were neck-and-neck with market share 12 months ago, and Western Digital now has a 5% advantage, is an incredible feat.

To invest in this space, the best choice is clearly Western Digital.

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Read/Post Comments (3) | Recommend This Article (1)

Comments from our Foolish Readers

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  • Report this Comment On January 29, 2014, at 3:19 PM, prmartinezus wrote:

    I've worked in data recovery and seen many WD drives come through for recovery. The WD drives fail right off the shelf. However, Seagate drives rarely fail and if they do they are old and a total crash. WD has cheaply priced drives. Seagate drives are more expensive and better made. If you want unreliable, cheap hdd buy WD. If you want reliable, well built hdd buy Seagate.

  • Report this Comment On January 29, 2014, at 3:46 PM, assisgnmeaname wrote:

    Does the author have any comment about the fact that WDC was playing catch up the last 5 or 6 quarters after the Thai floods of 2012 wiped out a lot of their capacity?

  • Report this Comment On January 29, 2014, at 5:12 PM, procurman4 wrote:

    of course the other thing you could look at is the market shares the companies had before and after the consolidation. WDC/HGST was at 53% STX/Samsung 37% and Tosh 10%. Now WDC at 44, STX at 40 and tosh at 16. So Stx has actually gained share, as has Toshiba (only in retail), and WDC has lost a ton in retail and notebook and has held their own in enterprise. the more important point is that the industry is operating at 1000 bp higher than previously and both companies are relatively cheap to market multiples. Seagate has a much higher payout ratio, wdc has potential cost eductions post mofcom. no reason to straddle as owning both is a better risk adjusted investment. especially with STX stronger mar q outlook.

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Brian Nichols

Brian Nichols is the author of "5 Simple Steps to Find the Next Top-Performing Stock: How to Identify Investments that Can Double Quickly for Personal Success (2014)" and "Taking Charge With Value Investing (McGraw-Hill, 2013)". Brian is a value investor, but emphasizes psychology in his analysis. Brian studied psychology in undergrad, and uses his experience to find illogical value in the market. Brian covers technology and consumer goods for Motley Fool. Brian also updates all of his new and current positions in his Motley Fool CAPs page. Follow Brian on Twitter and like his page on Facebook for investment conversations and recent stories.

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