Western Digital's (NASDAQ:WDC) stock recently plunged after the hard drive maker followed up a first-quarter earnings beat with mixed guidance and the announcement that CEO Steve Milligan would retire. However, investors seemed to ignore some clear signs that this cyclical data storage stock is finally on the cusp of a turnaround.

Understanding WD's core business

Western Digital is the world's top maker of platter-based HDDs (hard disk drives). HDDs face tough competition from flash-based SSDs (solid-state drives), which are smaller, faster, more power-efficient, and less prone to damage.

Four platter-based HDDs.

Image source: Getty Images.

To keep pace with SSD makers, WD bought SanDisk, one of the world's largest makers of flash memory (NAND) chips and SSDs, in 2016. However, both the HDD and SSD markets were slammed by cyclical headwinds over the past year.

WD's HDD business, which generated 60% of its revenue during the first quarter, struggled with soft enterprise demand, lower PC sales, and competition from SSDs. Its flash memory business, which accounted for the remaining 40%, struggled with a global decline in NAND prices.

Spotting the turnaround

Instead of expecting year-over-year growth, investors should be looking for sequential growth and milder year-over-year declines. Both green shoots appeared during the first quarter.

Western Digital's revenue fell 20% year over year to $4.04 billion, but that marked 11% growth from the fourth quarter and beat consensus estimates by $120 million. All three business lines -- client devices, client solutions, and data center devices and solutions -- grew sequentially.

The company's HDD revenue dipped 3% annually and improved 13% sequentially as its flash revenue fell 36% annually but improved 8% sequentially. The non-GAAP gross margins at both businesses contracted annually but expanded sequentially, and Milligan declared that "the flash industry has passed a cyclical trough":

Non-GAAP gross margin

Q1 2019

Q4 2019

Q1 2020

HDD

32.1%

28.1%

28.5%

Flash

43.8%

18.7%

19.3%

Total

38%

24.2%

24.8%

Source: Western Digital.

As a result, WD's non-GAAP net income dropped 89% annually, but more than doubled sequentially, to $101 million, or $0.34 per share, beating estimates by four cents. This indicates that WD's precipitous earnings declines likely bottomed out in the fourth quarter of 2019:

YOY growth

Q1 2019

Q2 2019

Q3 2019

Q4 2019

Q1 2020

Revenue

(3%)

(21%)

(27%)

(29%)

(20%)

Non-GAAP EPS

(15%)

(63%)

(95%)

(95%)

(89%)

YOY = Year-over-year. Source: Western Digital.

WD expects its second-quarter revenue to rise 4% sequentially (at the midpoint) and remain roughly flat year-over-year, which matches Wall Street's expectations. It expects its non-GAAP EPS to fall 62% annually (but to rise 62% sequentially) at the midpoint, but analysts had expected an annual drop of just 48%.

That projected EPS shortfall was disappointing, but it's mainly due to higher variable compensation spending which will boost its operating expenses, rather than issues with its gross margin -- which should still expand sequentially to 25%-26%.

Two SSDs placed atop a platter-based HDD.

Image source: Getty Images.

A rosy industry outlook and a leadership change

Western Digital expects the growth of exabytes in the HDD market to accelerate from nearly 30% this year to the mid-30s next year, and for bit growth in the flash market to jump from the mid-20s in 2019 to the mid-30s in 2020. It also expects the gross margin of its flash business to eventually rebound to 40%. Those forecasts suggest that WD's stock -- which trades at just 8 times forward earnings with a forward dividend yield of 3.2% -- could rebound significantly in 2020.

WD's rival Seagate (NASDAQ:STX) trades at 11 times forward earnings but pays a higher forward dividend yield of 4.4%. However, WD expects most of its growth to be driven by the improving flash market next year, while Seagate generates most of its revenue from HDDs -- which suggests that WD could outperform Seagate next year.

Steve Milligan's decision to retire after leading WD for over six years was surprising, but he'll remain onboard until a successor is appointed and will stay in an advisory role until Sept. 2020. The company's core business seems headed in the right direction as the cyclical headwinds wane, so investors shouldn't fret too much about the CEO change.

The bottom line

WD's first-quarter report wasn't perfect, but the strengths clearly outweighed the weaknesses. The company's revenue and earnings are rising sequentially, and it expects demand for both HDDs and flash memory products to improve next year. Therefore, WD's post-earnings dip looks like a promising buying opportunity for patient investors looking for an undervalued income stock.