NEW YORK (CNN/Money) -
With how well tech stocks did in 2003, most seem to be trading at nosebleed valuations. It's best to steer clear of those and look for those in more sane territory.
And what do we have here? Shares of companies that make hard disk drives, the devices used to store data in computers, are trading at dirt-cheap valuations.
Maxtor, Western Digital and Seagate -- the big three in this field -- are all trading around 13 times 2004 earnings estimates, despite healthy prospects for earnings growth.
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The S&P 500 is valued at 18.5 times 2004 earnings estimates, and the Nasdaq at 28.
Kevin Landis, chief investment officer of Firsthand Funds, an asset management group that specializes in tech investing, jokes that the disk drive companies are the tech industry's version of airline stocks. That is, nobody on Wall Street trusts that the companies can do well for the long haul since the business has been characterized by brutal price competition.
But he owns Western Digital and Maxtor, and thinks that the perception of disk drive stocks is due for a change. So do many analysts who follow the group.
Companies staying away from price wars
Consolidation has helped. In the past few years, Fujitsu has exited the business. IBM has essentially done the same, forming a joint venture for its disk drive operations with Hitachi. And tape cartridge storage maker Quantum sold its disk drive division to Maxtor.
As a result, only three companies, Maxtor, Western Digital and Seagate, are fighting for the lion's share of the industry, as opposed to seven. That's helped pricing.
"The disk drive market is structurally in better shape than it has been in past seven years," said Robert Cihra, an analyst with Fulcrum Global Partners.
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Another knock on this industry has been that companies were constantly spending heavily on ways to increase storage capacity on disk drives and release new products in order to outdo the competition. In addition, there were price wars. So it was a classic market share grab that merely led to a glut of drives on the market -- and low profit margins for the disk drive makers.
Christian Schwab, an analyst with Craig-Hallum Capital, says it appears the top three drive makers have finally learned from the errors of their ways. Instead of constant upgrades and aggressive pricing, the companies are focusing more on keeping costs down and inventories lean.
As such, profits for the three firms are now expected to increase at about a 10 to 12 percent clip annually for the next few years. That's a healthy change. Western Digital lost money in fiscal 2000 and 2001 while Maxtor was in the red in 2001 and 2002.
"Better inventory control and longer product cycles have helped lead to pricing stability," Schwab said. "The difference between the disk drive industry being oversupplied and equally supplied is massive."
Consumer electronics leading to stronger growth
That's all well and good. How about the fundamentals? The disk drive companies clearly should benefit from the pickup in demand for PCs, especially as the popularity of notebooks increases.
What's more, these companies are no longer solely dependent on the stodgy PC business. A large number of new consumer electronics devices, such as video game consoles, digital video recorders and MP3 players, require hard drive storage space.
Mark Miller, an analyst with Hoefer & Arnett, estimates that consumer electronics devices currently account for less than 10 percent of the big three disk drive makers' total sales but that over the next few years, this component could wind up increasing to 30 percent to 40 percent of total sales.
Add this all up and it's hard (pardon the pun) to justify such a low multiple for these stocks. Even though all three did enjoy sizable gains in 2003, it appears that investors are still punishing these companies for their past sins.
"The key overhang for these stocks is investor skepticism about whether this can be a rational industry," said Dan Renouard, an analyst with Robert W. Baird & Co.
Still, Renouard and other analysts said that the companies deserve to trade at higher valuations since their worst days are behind them. So what's a reasonable multiple? Ranges went from the mid teens to as high as 20 times 2004 earnings estimates. For argument's sake, let's say then that a P/E of 17 times estimates is fair for these companies.
At that valuation, Maxtor has about 30 percent upside potential while Seagate and Western Digital could rise at least another 35 percent. Plus, this assumes that earnings estimates for this year don't increase from current levels.
And as long as these companies hold firm and don't resort to price wars again, then it looks like estimates will have to head higher...and these stocks may finally be able to shed the image of being the tech industry's perennial losers.
Fulcrum's Cihra and Baird's Renouard do not own any of the stocks mentioned in this story and their firms have no investment banking relationships with the companies. Hoefer & Arnett's Miller owns shares of Maxtor but his firm has no investment banking ties to any of the companies. Craig-Hallum's Schwab does not own any of the companies but his firm has been an underwriter for a recent equity offering by Seagate.
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