Investing carefully in hard drives
Demand for hard disk drives is strong thanks to consumer electronics, but investors should be selective.
NEW YORK (CNNMoney.com) - While sales of desktop PCs are slowing down, the spike in popularity of laptops, Xbox 360s, digital video recorders and iPods has boosted hard drive manufacturers nonetheless.
The explosion of digital content -- photos, music and videos that artists and even consumers make and then upload to the Internet -- is also good news for hard drive makers, since all those large files have to be stored somewhere.
Hard drive makers shipped about 103 million hard disk drives in the fourth quarter of 2005, which was nearly a 21 percent increase over the previous year, according to market research firm iSuppli Corp.
And the stocks of these companies have performed accordingly. Shares of Seagate (down $0.45 to $26.22, Research), the number one disk drive maker in America, have climbed 54 percent in the last 12 months and 34 percent for the year to date. Shares of Western Digital (down $0.02 to $21.45, Research), which commands a roughly 17 percent market share, gained 67 percent in the last 12 months and are up 15 percent for the year.
But investors should proceed with caution. The industry is still consolidating, and with mergers come risks. Seagate is acquiring its nearest competitor, Maxtor, in a $2 billion deal that will close later this year.
"Disk drive companies have been dying for decades," said Kevin Landis, portfolio manager of Firsthand Capital Management, a mutual fund firm specializing in tech stocks. "We're down to just the toughest, craftiest, most tenacious companies."
Also, the stocks of the biggest hard drive makers have already enjoyed strong growth, raising the question of how much higher they can go.
Demand still high
Still, the need for storage should keep the hard drive makers busy for years to come; they say trends are afoot that should keep their businesses growing at a good clip.
Brian Dexheimer, senior vice president for Seagate, said the growth of laptop computers is the biggest driver of his company's growth. "As you shrink things, the technology (inside them) needs to shrink as well," he said.
That's why his company is focusing on a new technology called "perpendicular recording," which enables a hard drive to store more information by squeezing bits together more tightly on a disk. It has already shipped some high-end hard drives with this technology.
Dexheimer said the second fastest growing segment is consumer electronics.
Digital video recorders – Tivo-like devices that record programs off digital cable TV – have been a big growth business for the company in the last three years, as has the gaming industry. That's thanks in part to the success of Microsoft's (Research) wildly popular Xbox 360, which uses Seagate hard drives.
And as more consumers create their own digital content, such as photos and videos, that creates the need for more storage space for both consumers and the companies who host all this content, like Apple's iTunes music store and YouTube's video-sharing site.
"We think we are in the catbird seat relative to what we think is a digital content revolution," said Dexheimer.
He added that an increase in corporate regulation and compliance laws in the wake of Sarbanes-Oxley has also boosted the bottom lines of hard drive makers, since companies are required to retain more documents and e-mails for longer periods of time.
But hard drive manufacturers also face challenges. One is the proliferation of flash drives. These are currently used instead of traditional hard drives in such devices as the iPod nano, and manufacturers are working on making "hybrid" drives for laptops that combine the properties of traditional and flash drives.
Flash drives are smaller and use less energy, and flash prices are dropping. While computer drives aren't in danger of being replaced by flash drives, consumer electronics devices like video cameras and recordable DVDs will increasingly move to these devices, experts say.
"We're not threatened by it at all," said Seagate's Dexheimer on the proliferation of flash. He points out that the digital media that is stored on portable flash drives, like those found in MP3 players, is also generally stored on consumer hard drives and on servers run by the entertainment companies that sell the media.
Experts advise caution
Investors should still proceed with caution.
Seagate posted strong quarterly results last month, reporting a 17 percent increase in sales and a 20 percent quarterly profit increase from the year-ago quarter. But its shares took a hit in after-hours trading because of a disappointing forecast for the current quarter.
The company's merger with Maxtor is also giving some investors and analysts pause in the near-term. When the deal is complete, Seagate says the combined companies will command a 40 percent share of the market. Seagate currently has about a 30 percent market share.
"In general, mergers can be messy affairs," said Firsthand Capital's Landis, whose fund owns shares of Western Digital. "Seagate has done mergers before, but if you are choosing between two companies and one has just been through a merger, it feels safer to go with one that doesn't have room for the nasty surprise."
Seagate's smaller rival Western Digital also enjoyed a strong quarter, with a 23 percent sales increase and a 45 percent jump in quarterly profit. Both Seagate and Western Digital are trading at about 12 times expected fiscal 2007 earnings.
Analysts at Robert W. Baird & Co. recently upgraded Western Digital to "outperform," saying the company is better situated than foreign rivals like Hitachi to win business from Maxtor once the merger with Seagate is finalized. The analysts also point out that Western Digital bucked an industry-wide trend by actually shipping more desktop units in its most recent quarter than it did the quarter before.
The prognosis for the hard disk industry as a whole is healthy according to analysts and investors. Although the industry is still consolidating, Landis said that the demand for more and more storage will only increase as consumers find more stuff to download -- whether that's TV shows, songs or photographs.
Says Landis: "No one complains that their Internet connection is too fast or their computer is too powerful, and no one complains there's too much storage."
Analysts for Robert W. Baird & Co. do not own stock in the companies they cover, but the firm does banking business with Western Digital and Seagate.
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