Western Digital posted third quarter results that surpassed our expectations and management’s quarterly guidance, making it clear that the market hasn’t forgotten about hard disk drives (HDDs). While Western Digital’s near-term prospects are better than we had anticipated, we are maintaining our stable moat rating as these opportunities are balanced by adverse secular trends that will likely limit the company’s long-term performance.

Sales in the March quarter were $3.8 billion, beating the high end of management’s guidance by nearly $100 million. We had expected Western Digital to report a lackluster quarter after PC industry shipments declined by a recordsetting 14% year-over-year during the March quarter. However, the company adeptly limited its PC exposure by enticing enterprise markets with bigger ticket, innovative products. Western Digital’s newest products–including solid state drives (SSDs), hybrid drives, and helium drives– deliver premium performance and a lower cost of ownership, which have strong appeal to businesses with robust computing needs.

While Western Digital has also developed a broad lineup of SSD and hybrid products for non-enterprise customers, the majority of consumers cannot justify the higher upfront prices, and we believe this represents a limited near-term opportunity. On the operational front, Western Digital’s gross margins grew 50 basis points sequentially due to improved manufacturing efficiency, but operating margins fell 140 basis points as a result of higher research and sales expenses.

Looking ahead, management expects unit shipments will be flat to slightly down in the June quarter, in line with seasonality, and is “cautiously optimistic” that demand could improve in the first half of fiscal 2014. Western Digital’s results indicate that demand and pricing for HDD products are more resilient than our previous estimates, but we still maintain that the continually declining price of SSDs is a secular trend that poses a significant long-term challenges for Western Digital. While we are increasing our fair value estimate, we would like to see a larger margin of safety before recommending Western Digital as an investment.

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