Shares of hard-drive maker Seagate (NASDAQ:STX) tumbled after the company reported earnings on Monday. Analysts had expected revenue and profit to decline, but the results came in worse than expected -- profit fell 27% while revenue was down more than 5% from the prior year.
Although Seagate raised its dividend and continues to trade at a below-market multiple, the hard drive itself is beset with technical challenges. Companies like Microsoft (NASDAQ:MSFT) are pushing cloud storage, while firms like SanDisk (UNKNOWN:SNDK.DL) offer better-performing solid-state drives.
Seagate's earnings continue to dry up
Seagate's report on Monday marks its second consecutive earnings disappointment. Back in July, Seagate shares fell 10% after the company reported a quarter in which revenue fell 24% from the prior year.
Seagate, as a PC supplier, has suffered as demand for traditional PCs has declined. This year has been one of the worst on record for the PC, as shipments of traditional desktop and laptop computers have posted the worst declines in history. Consumers, and even some enterprise users, are switching over to mobile devices in place of traditional PCs. In general, mobile devices don't use hard drives, instead relying on solid-state storage.
Solid-state drives are the future
Admittedly, Seagate does offer some solid-state drives, but it's a relative newcomer in the sector. Seagate has offered enterprise-grade SSDs for a few years, but it wasn't until earlier this year that it entered the consumer market.
While Seagate is one of three remaining hard-drive makers, the market for solid-state drives is flush with competitors, including SanDisk(UNKNOWN:SNDK.DL). And while Seagate has seen its earnings fall, SanDisk has been outperforming expectations, posting a steady string of earnings beats as shares have risen more than 60% this year.
In fact, earlier in October, SanDisk posted third-quarter earnings that more than tripled from the prior year. In particular, SanDisk cited strong demand for its solid-state drives. SanDisk's SSD appear in convertible and tablet PCs.
Although SSDs are far more expensive than similar-sized traditional hard drives, their smaller form factors and faster write times make them ideal for tablets. Analysts at Stifel Nicolaus upgraded SanDisk earlier in the month on the basis of strong SSD demand going forward.
Microsoft is pushing cloud storage in its newest operating system
Unfortunately, PCs and tablets equipped with SSDs generally don't offer the same amount of storage as those equipped with traditional hard drives, which could be problematic for some users. However, as time goes on, cloud storage is becoming far more ubiquitous.
Consider Microsoft's recent update to its Windows 8 operating system, Windows 8.1. Now, Microsoft's online storage solution, SkyDrive, is heavily integrated into its operating system. Using a feature Microsoft calls "smart files," users can keep almost all their files stored online. Tiny placeholder files sit on the local machine, and when the user needs them, Windows downloads them automatically from the web. Microsoft claims that users who take advantage of this feature utilize 80% less disc space.
While this feature may primarily benefit users with limited local storage, it also helps Microsoft further its goal of "One Windows." With most (or all) of a user's files stored on the web, PC users can jump from one device to the next, retaining the same basic setup across all machines.
Can a dividend and cloud demand offset the decline of the local PC?
Of course, those cloud files exist somewhere. Even if they're not stored on a user's local machine, they're probably sitting on a hard drive in one of Microsoft's servers. Seagate bulls have argued that growing cloud demand should be able to offset declines in the traditional PC market.
The problem is that cloud-related demand is still a minority part of Seagate's business. On its recent earnings call, Seagate estimated that 15%-20% of its drives were going toward cloud solutions -- a large minority, but still a minority.
More bullish may be Seagate's ability to generate free cash flow ($521 million last quarter), much of which has been returned to shareholders. To offset some of its earnings disappointment, Seagate raised its dividend on Monday by 13%. Despite its shrinking business, Seagate has outperformed the market in 2013, rising more than 62% year to date.
Keep an eye on cloud demand
The long-term trend away from hard drives, Seagate's bread-and-butter, appears inescapable. As more PCs are ditched in favor of mobile devices, demand is shifting from traditional hard drives to solid-state drives. Although Seagate also makes SSDs, it has to compete with a number of other companies, including SanDisk.
Whether Seagate can continue to generate so much cash will depend on cloud-related demand. As companies like Microsoft emphasize cloud storage, Seagate will have an opportunity to target that market, but it isn't yet clear if it will be large enough to offset its declining PC business.
Sam Mattera is short shares of Seagate Technology. The Motley Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.