Forget Western Digital: Seagate Technology Is a Better Data Storage Stock

Western Digital (WDC 1.51%) and Seagate Technology (STX) are the two largest hard disk drive (HDD) makers in the world. But over the past year, shares of Western Digital plunged more than 50%, as Seagate's shares declined by a more moderate 14%.

Investors often consider WD to be a better data storage company than Seagate for two main reasons. First, WD is one of the top makers of flash-based SSDs (solid state drives) in the world, thanks to its acquisition of SanDisk two years ago. SSDs are smaller, faster, and more power efficient than HDDs, so WD is further ahead of the tech curve than Seagate -- which still generates most of its revenue from traditional HDDs.

Image source: Getty Images.

Second, declining flash (NAND) memory prices will reduce the prices of SSDs (which are pricier than HDDs with comparable capacities) and help SSDs gain more market share against HDDs. Those two headwinds could certainly hurt Seagate, but four other factors could make Seagate a better overall data storage play than Western Digital.

1. Insulated from sliding NAND prices

NAND prices peaked earlier this year, and should continue declining throughout 2019 as the market faces a constant oversupply of chips. That's bad news for WD, which generated half of its revenues from flash products last quarter.

Seagate, however, generated 93% of its revenue from traditional HDDs last quarter. Seagate produces a much smaller amount of SSDs, and it acquires most of its NAND chips through Toshiba's former memory business -- in which it gained a stake earlier this year through the Bain Capital-led consortium buyout. This means that lower NAND prices should be a tailwind for Seagate's smaller SSD business.

2. Countering SSD challenges with bigger HDDs

Instead of exposing itself to the cyclical NAND market, Seagate focuses on selling higher-capacity HDDs to cloud and enterprise customers -- which often favor cheaper HDDs with higher capacities over pricier SSDs with less storage. Seagate has also been pivoting away from sub-1 terabyte HDDs, which are more exposed to SSDs.

As a result, Seagate's exabytes sold, its average selling price (ASP) per drive, and total HDD revenue all rose year over year last quarter.

Data source: Seagate Q1 report.

WD's total HDD revenue fell 4% annually to $2.5 billion last quarter, as its flash revenue dipped 1% to $2.5 billion. WD's ASP (for both HDDs and SSDs) rose 18% annually to $72 -- but most of its exabyte growth came from SSDs, which became a liability as NAND prices declined.

3. Expanding margins and steadier earnings growth

Seagate's non-GAAP gross margin rose 200 basis points annually to 31% last quarter, while WD's non-GAAP gross margin dropped 430 basis points to 38%.

Seagate's margin expanded because it shifted toward higher-margin mass storage products, benefited from the high utilization rates of its vertically integrated factories, and wasn't heavily exposed to sliding NAND prices. Western Digital's gross margin was mostly weighed down by lower ASPs for its flash-based products.

Image source: Getty Images.

That key difference enables Seagate to generate steadier earnings growth than WD. Wall Street expects Seagate's earnings to dip 6% this year and rise 1% next year. WD's earnings are expected to plunge 52% this year before rebounding 9% next year as it cuts its wafer output and buys back more stock.

4. A higher dividend

Seagate and Western Digital are both trading at steep discounts to the market, since a deceleration in enterprise spending and uncertainties in China could throttle both companies' near-term growth. Seagate trades at seven times forward earnings, while WD has a forward P/E of 5.

However, Seagate's forward yield of 6.5% is higher than WD's 5.2% yield. Seagate hiked its dividend annually for seven straight years, and it used up just 35% of its free cash flow over the past 12 months -- so it has plenty of room for future hikes.

But does that mean you should buy Seagate?

I think Seagate is a better data storage stock than WD as NAND prices deflate, and its low multiple and high yield could set a floor under the stock. However, the stock could remain out of favor until trade tensions wane and we see clearer signs of growth in the enterprise and cloud markets, which drove most of Seagate's growth in fiscal 2018.