Western Digital and Seagate Technology: More Bad News Arises

SanDisk's investor day led to new 52-week stock highs, but in the process it provided a disheartening outlook to the one growth driver for hard disk drive manufacturers.

May 12, 2014 at 1:30PM

Western Digital (NASDAQ:WDC) and peer Seagate Technology (NASDAQ:STX) -- which, combined, control more than 85% of the hard disk drive (HDD) market -- are trading lower following disappointing first-quarter earnings. Seagate, in particular, has significantly lagged the overall market, while Western Digital has been able to weather some of the storm due to its ability to steal market share from Seagate. Nonetheless, both have a challenging environment, and if SanDisk (NASDAQ:SNDK) is right, the long-term outlook could be worse than previously thought.

An industry forced to innovate
Western Digital and Seagate Technology operate in the business of storing data. Both companies manufacture and sell products that are found in PCs and laptops, which due to the rise of smartphones and tablets, has been a declining business for much of the last five years.

Therefore, Western Digital and Seagate have had to innovate, thus focusing on HDDs that are used for other purposes, such as DVRs, home theater systems, TVs, and, most importantly, in the cloud. Essentially, Western Digital and Seagate have been able to swap one free-falling business in laptops and PCs for the fast-growing cloud storage.

The growth of smartphones and tablets has consequently led to more data being stored via the cloud, which is then stored on HDDs. While Western and Seagate used to create the majority of their revenue from PC and laptop applications, today nearly 50% of sales come from non-PC apps.

Still, shipments of HDDs have slowed significantly on a year-over-year basis, as the industry itself faces growing pressure from the rise of solid state drives (SSDs).

The emergence of SSDs
An SSD is different from an HDD in that it contains no actual disk, but is rather an electronic form of storing data, often visual data. These are high-performance, but low margin, drives that are growing rapidly, and are used most often in smartphones and tablets.

With that said, Western Digital and Seagate have made investments in SSDs, but unlike with HDDs, neither companies have a large grasp on the industry. Specifically, Western Digital's enterprise SSD business grew 46% year over year in its last quarter, but accounted for less than 5% of total revenue.

Therefore, the business of SSDs is much more fragmented than the HDD segment, and for this fact, growth in SSDs not only means stolen drive share from HDDs, but also lost business for Western Digital and Seagate.

The fast-growing business in jeopardy
With all things considered, investors in this space watch various metrics closely to predict growth of the HDD market, but also demand for SSDs. One of the ways this is accomplished is by watching the performance of memory chip makers, including NAND and DRAM, such as SanDisk.

Specifically, NAND is used in smartphones and tablets while DRAM is used in PCs; the NAND technology is manufactured as a part of SSDs and has given manufactures the ability to cut the costs associated with SSDs.

Currently, SanDisk is up 26% this year following a very bullish investor day. In its presentation, the company predicted 30% to 40% growth for the NAND industry this year; a good reflection of the SSD market.

But perhaps most damning to the HDD market is that SanDisk sees continued SSD integration into business and consumer drives, a space once owned by HDDs. It's worth noting that the business drives include the high-growth Web/cloud providers.

Based on early data and current trends, SanDisk estimates that the business and consumer drives is 16% and 10%, respectively, owned by SSDs. But in the next three years, that share will grow to 39% and 21%, respectively, thus stealing more share from the HDD industry. Overall, this bodes well for the likes of SanDisk, but could be a new headwind for Seagate and Western Digital to encounter.

Final thoughts
When you take a step back to look at the state of the HDD market, there are a lot of problems. Aside from those implied by SanDisk's investor day, Western Digital and Seagate demonstrated those problems with their quarterly reports, as both saw year-over-year revenue losses.

With that said, Western Digital is the better-looking company in a pair that are very much the same. In late 2012, both companies had a near equal market share of the HDD market, but today Western Digital's share is more than 400 basis points greater. This shows that in a challenging environment, Western Digital is moving in the right direction, and with both stocks trading at 10 times forward earnings, it presents the better opportunity.

Albeit, investors might be best served by avoiding the space, as SSD drives and NAND chip manufacturers show to be significantly better positioned companies, which includes SanDisk.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool owns shares of Western Digital.. Try any of our Foolish newsletter services free for 30 days. 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.

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