Better Buy: Western Digital vs. Texas Instruments

Western Digital (WDC -0.53%) and Texas Instruments (TXN 5.64%) both sell key components of electronic devices. WD is one of the world's top makers of platter-based HDDs (hard disk drives) and flash-based SSDs (solid state drives), and TI produces analog, embedded, and other types of chips for various end markets.

WD and TI have both been struggling with cyclical headwinds. WD faced sluggish PC sales, weak enterprise spending, and cyclically low flash memory (NAND) prices over the past year. TI's growth slowed as macro headwinds throttled spending from its automotive and industrial customers.

Image source: Getty Images.

But some of those headwinds are gradually waning, and investors expect both companies' declines to bottom out in the near future. As a result, shares of WD and TI rose about 75% and 33% over the past 12 months, respectively, compared to the S&P 500's 24% gain.

WD was clearly a better buy than TI over the past year, but will it maintain that lead? Let's take a closer look at the growth of both companies to find out.

Western Digital's strengths and weaknesses

WD generated 60% of its revenue from HDDs last quarter, and the remaining 40% came from sales of SSDs and NAND chips. Its total revenue has fallen annually for five straight quarters.

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

Sluggish PC sales and data center spending hurt its HDD business, and tumbling NAND prices slammed its SSD and flash memory business. Lower NAND prices also reduced the price gap between cheaper HDDs and pricier SSDs, resulting in softer demand for lower-capacity HDDs.

But during last quarter's conference call, CEO Steve Milligan declared that the NAND market had "passed a cyclical trough," and expects WD's revenue to stay nearly flat annually and rise 4% sequentially in the second quarter. Wall Street expects WD's revenue to stay roughly flat this year and rise 9% next year, which indicates that its business has finally bottomed out.

Texas Instruments' strengths and weaknesses

TI generated 75% of its revenue from analog chips last quarter. Embedded chips accounted for 19% of its revenue, while "other" chips accounted for the rest. TI's revenue has also declined annually for five straight quarters.

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

During last quarter's conference call, TI's investor relations chief Dave Pahl noted that the company's sales to the industrial, personal electronics, and communications markets dipped sequentially, automotive sales remained "about even," and enterprise sales rose in the "low single digits." However, Pahl also noted that demand was "stabilizing" across all sectors except the communications equipment market.

For the first quarter, TI expects its revenue to decline 10% annually and 3% sequentially (at the midpoint). That tepid guidance indicates that TI's declines are bottoming out, but it's not primed for a rebound yet. TI's revenue fell 9% for the full year, and analysts expect a 1% decline in 2020.

Margins and profitability

WD's non-GAAP gross margin plunged from 38% to 24.8% between the first quarters of 2019 and 2020, due to the aforementioned pressures in the HDD and SSD markets. However, it expects its gross margin to expand sequentially to 25%-26% in the second quarter.

Image source: Getty Images.

TI's gross margin fell from 64.8% to 62.6% between the fourth quarters of 2018 and 2019. Its gross margin remains high since it shifted its analog chip production from the 200mm manufacturing process to the less capital-intensive 300mm process, but it'll likely keep contracting until its revenue growth rebounds.

Analysts expect WD's earnings to decline 45% this year, but rebounding HDD and SSD demand could boost its earnings 153% next year. That growth is lumpy, but WD's low forward P/E of 10 and forward dividend yield of 2.9% indicate should set a floor under the stock.

TI's earnings declined 6% in 2019, and analysts expect a milder drop of 2% in 2020. However, the stock's forward P/E of 26 makes it significantly pricier than WD, and it pays a slightly lower forward yield of 2.8%. Another key difference is that TI consistently repurchases its stock, while WD hasn't bought back any shares over the past four quarters.

The winner: Western Digital

WD should continue outperforming TI this year, for three reasons: Its revenue and margins are rising sequentially, it trades at a lower valuation, and it pays a slightly higher dividend. TI's diverse business and traditional of returning "all" its free cash flow via dividends and buybacks still make it a good long-term investment -- but investors should wait for clearer signs of a bottom before starting a new position.