Looking at the two major hard drive companies, I'm reminded of an oft-played Vince Lombardi quote - "What the <heck> is going on out there?" It was just a few weeks ago that Seagate (Nasdaq:STX) warned the Street that its performance was going to come up short, and here we have Western Digital (Nasdaq:WDC) blowing away numbers for its fiscal fourth quarter and issuing some pretty bold guidance. One way or another, it looks like these stocks are likely to continue to offer up red meat for those inclined to trade.
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Closing the Year on a Blowout
Western Digital pretty much demolished analyst expectations for the fourth quarter. Revenue nearly doubled from last year, and rose 57% sequentially to almost $4.8 billion - beating the average Wall Street guess by more than 10%. Now maybe 10% doesn't sound like a blowout performance, but given the amount of surveillance on the end markets (PC channel checks, storage revenue from major companies like IBM (NYSE:IBM) and EMC (NYSE:EMC), etc.), it's pretty surprising all the same.
For the quarter, WDC reported that it shipped 61% more units than in the third quarter, with 81% sequential growth in drives for mobile devices. In fact, the only market that disappointed management was consumer electronics. To hear that enterprise was strong is a little curious given the news from companies like IBM and Dell (Nasdaq:DELL) in regards to their storage businesses. Blended ASPs were down 4% on a sequential basis.
Margins were also quite solid for Western Digital. Gross margin fell about a point from the third quarter, while operating income rose 49%.
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Will Seagate and Western Digital Cooperate?
With the deals for Samsung and Hitachi, respectively, Seagate and Western Digital would seem to have ample incentive to compete rationally. Judging by Western Digital's guidance, that seems like a probable outcome. There wasn't much in the company's guidance to suggest impressive end-market growth or major share shifts. Instead, the company is focusing on margins. The question then is whether both companies can or will stay rational and resist the urge to gain share in a soft patch with price concessions.
Should the End Market Outlook Worry Investors?
Western Digital's report was good for the company and its shareholders, as was the surprising guidance with regard to margins. I do wonder, though, if investors should pause a bit to consider the ramifications of the company's guidance.
Nothing that management said suggested a strong second half recovery in PCs. While investors may have basically written off the PC units as growth contributors at Dell (Nasdaq:DELL) and Hewlet-Packard (NYSE:HPQ), there still seems to be a lot of expectation for Microsoft (Nasdaq:MSFT) and Intel (Nasdaq:INTC) to prosper from new product/refresh cycles. Perhaps Microsoft and Intel don't carry the clout of former days, but they're still large tech stocks that do influence sentiment on the Street.
The Bottom Line
Trying to establish a fair value for Western Digital is no picnic. I do believe that the hard drive business is in permanent secular decline, as manufacturers and customers will increasingly choose solid state drives instead of hard drives. While Seagate and Western Digital can stave off this substitution with smaller, faster drives and pushing drives into devices that previously did not have onboard storage capability, I think that simply shifts the question to one of the slope of the decline.
The good news for investors is that Western Digital can see a 15% annual erosion in free cash flow for a decade and still be worth about $41 today. At a minimum, that gives the company ample capacity to buy back shares or otherwise return cash to shareholders and/or try to expand into new business lines. In the meantime, though, it looks like the hard drive market could be one where major swings from year to year or even quarter to quarter are not uncommon - unnerving for shareholders, but a great situation for traders.
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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.