Income, Share Gains Beckon for Seagate

NEARLY THREE YEARS ago I recommendedWestern Digital's (WDC) stock at $13. It has performed splendidly, although at $30 in March I decided it "might stall out for a while," and it has since mocked me by climbing another $3.

Consider what has happened during this time to rival hard drive maker Seagate (STX). It had three times Western Digital's market value when I recommended the latter in 2005. No longer, since the stocks have taken decidedly different paths. In the past six months alone, Western Digital has gained 21% while Seagate has fallen 23%. Some of that is deserved, but regardless, Seagate is starting to look cheap. The company is now valued at $8.7 billion. That's just 19% more than Western Digital's market cap, even though Seagate will likely produce 60% more sales this year.

Both companies have delivered stellar profit growth in recent quarters, but Western Digital has grown faster. Earnings per share in its fiscal third quarter (which for both companies runs through the end of March) jumped 132%, vs. a 62% increase for Seagate. That gap seems likely to widen. This quarter and next Western Digital is seen growing its earnings by 113% and 24%, respectively, vs. a year ago. For Seagate, forecasts call for just 11% growth this quarter and a 14% decline next quarter. Analysts say Western Digital has developed a lead of a few months in bringing higher-capacity notebook drives to market. That gives it first shot at some of the industry's most lucrative sales, and leaves Seagate having to cut prices to clear out inventory.

Part of the advantage may be owed to an acquisition. Both companies have made big ones in recent years, but while Seagate merely bought a rival hard-drive maker (Maxtor) in 2006, Western Digital last year bought a company (Komag) that makes the magnetic media at the heart of hard drives. That reduces manufacturing costs and helps engineers ensure that mechanical parts mesh nicely with the disks, reducing the number of drives that must be discarded upon testing. Seagate, meanwhile, must buy media from a multitude of suppliers. "Light a candle for the head/disk integration team," wrote Richard Kugele, an analyst for Manhattan investment bank Needham & Co., in a mid-June research note.

Don't count Seagate out over the long term, advises Kugele, noting the company's long history of success and its "extremely low" valuation. For now, Seagate may outsource a bit of its notebook drive work while spending up on research to narrow its technology deficit, Kugele believes.

Of course, solid-state drives, which operate at faster speeds and have no moving parts, threaten to supplant mechanical drives altogether, but that revolution might be years off. Internal drives with 64 gigabytes of capacity retail for around $800, and ones with 128 gigabytes sell for more than $3,000. Mechanical drives with 500 gigabytes of storage can be had for $100. (Moreover, a late June report by Tom's Hardware, a web site for computer enthusiasts, raises doubts, for now, about one presumed advantage of solid state drives: their reputation for conserving power.) Seagate doesn't seem to be fretting the outlook for mechanical drives. In April it noted that it sold its billionth one after 29 years, and that it expects to sell another billion over the next five.

Shares of Seagate fetch less than 7 times forecast 2008 earnings, about half the broad market's price. The company produces far more cash than it needs right now. Shares carry a free cash flow "yield" of better than 13%. That seems more than enough to fund the stock's 2.7% dividend yield, giving investors further incentive to tuck shares away today and await better times.

Seagate turned up recently in a stock screen for companies with ample dividends and potential for share price gains. Have a look at all eight survivors if you like or use SmartMoney's stock screener and the full list of search criteria to run the screen for yourself.

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