The storage industry is going through a downturn, but while the current financials of storage stocks may look scary, remember that storage is a cyclical industry. That means these stocks could make the best buys when things look the worst...should they survive.
Storage is accomplished today with two different technologies -- hard-disk drives (HDDs) and NAND flash. There's also a third form of storage coming to market called 3D Xpoint, but it's insignificant at this point.
Seagate Technology (NASDAQ: STX) is primarily a seller of HDDs, with a much smaller segment that sells solid-state drives containing other companies' NAND flash. Seagate is also an investor in Toshiba Memory Corporation, which is Toshiba's (NASDAQOTH: TOSBF) old NAND flash business that went private last year. Western Digital (NASDAQ: WDC) too sells hard-disk drives, but it also has large exposure to NAND flash, which the company acquired via its 2016 acquisition of SanDisk.
So, which storage stock is the best bet today?
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Hard disks and flash
As NAND flash becomes cheaper, it's taking some market share from hard disks. Still, HDDs are generally cheaper and in demand for many applications. In addition, the HDD industry has consolidated to just these two players and Toshiba. That limited competition should mean that all three should find a way to manage the cycle without getting too unprofitable.
On the other hand, the NAND flash business has six major players. That has recently led to a huge oversupply of NAND as companies have ramped up their stacked 3D NAND technology, flooding supply into a soft market. Fellow NAND supplier SK Hynix (NASDAQOTH: HXSCL) just reported earnings last week and disclosed that its NAND flash ASPs fell 32% quarter over quarter.
How Western Digital and Seagate are coping
Looking at these two players, the better buy may be the company that can weather this downturn better. Looking at recent results, we can see that Western Digital's metrics have nosedived to a much greater extent than Seagate's:
As you can see, the large declines in Western Digital's revenue have caused an even greater crash in its gross and operating margins. By contrast, Seagate's results are much steadier, as HDD prices haven't been as volatile as NAND's. On its conference call with analysts, Western Digital revealed that NAND shipments were down 5%, and average selling prices fell 23% just in the quarter.
Debt doesn't help
Compounding the problem for Western Digital is its debt load. While the company used the memory boom in 2017 and 2018 to pay down some of its Sandisk acquisition debt, its debt levels still remain higher than one would like in a severe downturn.
Western Digital's net debt is 3.4 times EBITDA, and its current interest coverage ratio (EBIT to interest payments over the past 12 months) is only about 3.5. That's in stark contrast to Seagate, which covers its interest payments much more comfortably, at over 12.5 times.
That burdensome debt load could bite Western Digital going forward. For the upcoming quarter, Western Digital guided to similar numbers in terms of revenue and non-GAAP net income as the previous quarter, despite it being a stronger seasonal quarter. That's due to the continuing plunge in NAND prices. Western Digital did appear to remain profitable, logging $0.17 in EPS in the past quarter and guiding for $0.10 to $0.30 next quarter; however, non-GAAP expenses exclude things like stock-based compensation and other "one-time" expenses such as costs incurred to close factories and under-utilization charges. If you include these charges, Western Digital will likely still lose money on a GAAP basis and post negative cash flow.
Things aren't so great for Seagate, either, which also predicted flat revenue and profit in the upcoming quarter. Still, Seagate predicts non-GAAP profit of $0.83 per share, which would exactly match last quarter's figure. Unlike Western Digital, that should still enable Seagate to be profitable, even on a GAAP basis.
Seagate is safer, Western Digital a spec
Though I own a personal stake in Western Digital, it's very small -- and speculative. Just as the NAND flash market has caused Western Digital's results to deteriorate faster than Seagate's, a rebound in NAND could also lead to a much bigger bump. Western Digital had around $3.7 billion in cash last quarter against $10.3 billion in debt, so the company has some cash cushion -- though it can't depend on that forever.
In addition, all of the major NAND players have recently announced supply cutbacks, which means NAND could see a bottom in prices sometime this year. However, analysts are conflicted on that point.
Thus, while Western Digital's low valuation and NAND exposure give it more upside potential, most investors should probably stick with the safer Seagate.
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