Seagate Technology (NASDAQ:STX), one of the world's largest makers of platter-based hard disk drives (HDDs), struggled last year with slow PC sales, sluggish enterprise demand, and competition from flash-based SSDs (solid state drives), which are faster, smaller, more power-efficient, and less prone to damage than HDDs.

Unlike its main rival, Western Digital (NASDAQ:WDC), which aggressively diversified into the SSD and flash memory markets by acquiring SanDisk in 2016, Seagate still generates most of its revenue from traditional HDDs.

A platter-based HDD.

Image source: Getty Images.

This strategy insulated Seagate from the cyclical declines in flash memory (NAND) prices, but lower NAND prices also reduced SSD costs and made them more viable alternatives to HDDs. However, Seagate maintains that selling higher-capacity HDDs to cloud customers -- which prioritize storage capacities over size and speed -- will support its long-term growth.

Seagate's stock rebounded more than 20% this year on hopes for a recovery in the PC and cloud markets, but it still trades at 10 times forward earnings and pays a hefty forward dividend yield of 5%. Do those figures make Seagate an undervalued dividend stock?

Understanding Seagate's business

Seagate generated 92% of its revenue from traditional HDDs last quarter. The rest came from sales of SSDs, enterprise data storage solutions, and other products. By end market, 39% of its sales came from enterprise customers, 32% from makers of non-PC consumer electronics (like DVRs and gaming consoles), and 20% from the PC segment.

Seagate pivoted its HDD business away from drives with less than 1TB of storage, which were more exposed to SSDs, and sold more higher-capacity HDDs to enterprise and cloud customers. As a result, its average capacity per drive steadily rose from 1.8TB to 2.4TB between the third quarters of 2017 and 2018.

But that figure peaked at 2.5TB over the past year, and Seagate reported an average capacity of 2.4TB per drive in the third quarter of 2019, which ended on March 29. Meanwhile, its total exabytes shipped fell 12% annually and sequentially.

Servers in a data center.

Image source: Getty Images.

Seagate attributed that decline to competition from SSDs, Intel's (NASDAQ:INTC) ongoing chip shortage throttling the production of new PCs, seasonally slower sales of PCs, and macroeconomic challenges affecting orders from its OEM and cloud customers. However, those declines were partly offset by stronger sales of its nearline drives to its largest "hyperscale" cloud customers.

How fast is Seagate growing?

At first glance, Seagate's revenue growth and gross margins look disastrous.


Q4 2018

Q1 2019

Q2 2019

Q3 2019

YOY revenue growth





Gross margin





YOY = Year-over-year. Source: Seagate quarterly reports.

However, Seagate is a cyclical stock. During last quarter's conference call, CEO William David Mosley stated that the pause in orders from its cloud customers would be "short-lived" as they use up their inventories, that demand for higher capacity drives in the surveillance market would rise with the use of higher-resolution cameras, and that its average HDD size should increase significantly with the launch of its new 16TB drives in late March -- which will deliver its "highest revenue skew" next year.

For the fourth quarter, Seagate expects demand to remain "similar" to the third quarter, with its revenue staying roughly flat sequentially and declining 18% annually. It expects its non-GAAP gross margin to be "at least" 26.5%.

Those numbers strongly suggest that Seagate's business is approaching a cyclical bottom. Western Digital's latest guidance, which calls for roughly flat sequential sales growth and stabilizing gross margins for its fourth quarter, supports that case.

But what about Seagate's dividend?

Seagate's free cash flow (FCF) rose 81% sequentially to $291 million during the third quarter, which easily covered its $178 million in dividend payments. On a per share basis, it paid out $0.63 per share in dividends, which represents 76% of its non-GAAP EPS of $0.83.

Those sustainable payout ratios indicate that Seagate won't cut its dividend anytime soon. However, the company notably hasn't raised its dividend since 2015.

Seagate is approaching a cyclical trough, its stock is cheap, and it pays a high dividend. It's probably not an ideal dividend stock for conservative investors, but it could offer a nice combination of growth and income as its core business recovers.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.