Seagate Technology's (NASDAQ:STX) stock rallied nearly 50% this year as investors noticed that the hard drive maker was on the cusp of a cyclical recovery. But even after that massive rally, Seagate trades at just 11 times forward earnings and pays a forward dividend yield of 4.3%. Let's dig deeper to see why Seagate might be an undervalued income stock.

How does Seagate make money?

Seagate is the world's second largest maker of platter-based HDDs (hard disk drives) after Western Digital (NASDAQ:WDC). HDDs face tough competition from SSDs (solid-state drives), which store their data on flash memory instead of platters.

SSDs are pricier than HDDs, but they're smaller, faster, more power-efficient, and less prone to damage. Western Digital expanded into the SSD and flash memory market with its acquisition of SanDisk in 2016, but Seagate stayed focused on HDDs.

A platter-based HDD.

Image source: Getty Images.

Seagate generated 92% of its revenue from HDDs last quarter. The rest came from enterprise data solutions, SSDs (via partnerships with other flash memory chipmakers), and other products. By comparison, Western Digital generated 60% of its revenue from HDDs and 40% from flash products last quarter.

Seagate's low exposure to the flash market insulated it from the big price declines in NAND (flash memory) chips, which hurt WD over the past year. However, lower NAND prices also hurt Seagate by narrowing the price gap between SSDs and HDDs. Slower sales of PCs and sluggish demand from enterprise customers exacerbated the pain.

Seagate's main strategy is to pivot away from drives with less than 1TB in capacity, which are more vulnerable to SSDs in the consumer electronics market, and launch higher-capacity HDDs for cost-conscious enterprise customers, which often favor higher storage at lower prices. It also regularly spends over 100% of its free cash flow (FCF) on buybacks and dividends to reward patient investors.

Why Seagate's cyclical downturn is nearly over

Seagate's growth initially seems dismal, with four straight quarters of year-over-year revenue declines. However, Seagate's declines have decelerated over the past two quarters as its non-GAAP gross margin stabilized.

Period

Q1 2019

Q2 2019

Q3 2019

Q4 2019

Q1 2020

YOY revenue growth

14%

(7%)

(17%)

(16%)

(14%)

Gross margin*

31.1%

29.9%

26.8%

27.1%

26.7%

YOY = Year-over-year. Source: Company quarterly reports. *Non-GAAP.

Seagate's revenue also rose sequentially over the past two quarters. It expects its revenue to stay roughly flat year-over-year (at the midpoint) in the second quarter, and rise nearly 6% sequentially. In short, Seagate's business hit its cyclical trough in the third quarter of 2019, and it's finally primed to generate positive sales growth again.

Servers in a data center.

Image source: Getty Images.

However, Seagate's gross margin of 26.7% in the first quarter missed the consensus forecast of 27.5%. Seagate mainly attributed that miss to higher-than-expected costs from ramping up its new products which reduced its gross margin by about 50 basis points.

Seagate didn't provide exact gross margin guidance for the second quarter, but it stated that it would expand as it scales up its production and its higher-margin 16TB drives account for a higher percentage of its total revenue.

Stabilizing growth with big buybacks and dividends

Seagate's non-GAAP earnings fell 41% annually (but rose 8% sequentially) to $1.03 per share. It expects its second-quarter EPS to come in at a midpoint of $1.32, which would represent a 6% decline from a year earlier but 28% growth from the first quarter.

Seagate spent $2 billion on buybacks and dividends over the past 12 months. In the first quarter, its FCF rose 4% sequentially to $309 million, but it spent $450 million on buybacks to reduce its share count by 8% year-over-year. It spent an additional $170 million on dividends, boosting its total shareholder returns to $620 million.

Seagate also raised its quarterly dividend from $0.63 to $0.65 per share, marking its first dividend hike in four years. During the conference call, CEO Dave Mosley stated that the dividend hike was a demonstration of Seagate's "confidence in our future growth and cash generation capabilities."

Seagate's excessive use of its FCF on buybacks and dividends might seem worrisome, but its FCF should also improve significantly over the next few quarters as its revenue growth accelerates again.

It's not too late to buy Seagate

Many investors are probably kicking themselves for not spotting Seagate's cyclical trough earlier this year. However, its recent first-quarter report indicates that its recovery remains on track, while its low valuation and high yield indicate that it still has plenty of room to run.