After peaking in 2011, global sales of the personal computer (“PC”) are now on the decline as a result of smartphones becoming ever more robust for users to check their email, text messages, and even manage documents. One might naturally think that the old PC hard drive manufacturing stalwarts would also see their fortunes wane. However, given the speed at which information technology is converging, one must look carefully at what is going on behind the scenes before reaching any such conclusions.

Until recently, Western Digital (NasdaqGS: WDC) and Seagate (NasdaqGS: STX) manufactured hard drives almost exclusively for PCs. Somewhat surprisingly, both of these mature drive makers – along with relative newcomer SanDisk (NasdaqGS: SNDK) – are doing very well these days despite the waning popularity of PCs. There are two primary reasons for their success:

(1) Even though PC sales are now declining they are still selling in very large quantities, so all three of these companies have plenty of revenue to fuel their future investments in innovation and growth. None of them are sitting on a cash hoard the size of Apple, but all three are in a very solid financial position having a capital surplus ranging from $5.2B (Seagate) and $5.0B (SanDisk) to $2.2B (Western Digital).

(2) All three of these companies recognize that in order to thrive they must transition into other segments of the technology industry to benefit from increasing use of handheld computing devices.  It is because all three of these companies have recognized the future and are actively investing in transitioning to “the Cloud” that we believe they will survive.

The reason why this transition to cloud computing is critical to their long-term survival has to do with what we have termed “innogration” – combining internal research and development (innovation) while acquiring the external resources necessary (integration) to create a market leading product. Any technology company that fails to innograte  quickly loses market share to those that do; a current example of this is former market leader Blackberry trying to auction itself off to the highest bidder earlier this year – unsuccessfully – as a result of its failure to match the functionality of Apple’s i-Phone.

In the case of these disk drive manufacturers, the name of the game is converting from only making hardware for PCs to creating drives capable of hosting the rapidly expanding demand for shared data storage via the cloud.  To facilitate that transition, all three companies have made major investments to move away from the spinning hard disks that were sufficient for the data storage requirements of a small PC to the solid state disks (SSD) necessary to handle huge volumes of data. SSD is essentially the result of memory chips becoming stable and large enough to store vast amounts of data. Not only does this make data retrieval much faster but it also makes the drives much more reliable.

Western Digital purchased Hitachi Global Storage for $3.7B last year. It also added sTec in June, providing itself with a major platform in solid state drives for large enterprise class computing companies. Western Digital has made the right acquisitions, so now we will have to wait and see how well it assimilates these new platforms within the company.

SanDisk has been the leader in flash memory storage for quite some time. It had acquired several leading flash drive companies over the last 10 years and has successfully integrated them within its business. In other words, long before the Cloud became trendy, SanDisk had already made the correct strategic moves to position itself for the always on-and-connected wireless world we are seeing unfurl.

Of the three, the most difficult to predict is Seagate. Though it knows how to make and market data drives, it is trying to innovate using only its own technologies rather than through acquisition and then innogration. That may cause a problem down the road, but it has been on a tear recently as its share price is up over 60% year-to-date. One reason is that Seagate has a dividend yield of 3.5%, versus 1.6% for Western Digital and 1.3% for SanDisk.  Seagate is using its large capital surplus to reward its stockholders with a dividend that is two times larger than its competitors, and buying back stock on dips.

The good news for all three companies is that it will take several years for the solid state drive market to wring out, and therefore we suspect that all three will do well into 2015.

However, since we are comparing three storage companies we feel compelled to state which one we believe will provide the best return over the next few years. In the end it comes down to innogration: Which company is mixing external and internal technologies to build the better mousetrap? Which company will be the best at execution?

For our money, the answer is Western Digital. It has shown the willingness to innograte in the past, and it has also shown that it knows how to execute these complex moves while managing a profitable company. It also stands apart in that it spans both consumer and business enterprise computing. Drawing on multiple revenue streams smooths down the bumps in the road it will encounter during such a large transition.

One of the lessons we have seen again and again in the convergence of leading edge technology is that it is very difficult to anticipate and innovate from within a single company. The cost for innovation becomes increasingly steep. The prior technology race of the twentieth century witnessed the remaining 10 or so automobile companies merge or go out of business during the 1950s. A similar dynamic is at work in the Information Age. 

The winners in the Cloud space will very likely not be much different. They will innograte by creating market leading products through a combination of internal development and purchasing/licensing innovations from outside sources.  If they do not then they will end up on the scrap heap of history, not unlike the Ford Edsel and other casualties of the relentless push towards technological convergence.

We are initiating a position in Western Digital to our “Investments” portfolio with a buy limit of $86 and a stop loss limit of $58.  We are also adding Seagate with a buy limit of $53 and a stop loss limit of $38. 

Other stocks mentioned in this article:

Sandisk (SNDK) is a ‘Hold’ at current levels.