(FORTUNE Magazine) – THE COMPUTER industry's most dramatic shakeout is still going strong after nearly two years. The victims are a score of young companies that make compact hard-disk drives -- record-player-like devices that store millions of bits of information on iron-oxide-coated platters with diameters of 5 1/4 inches or less. One-third of those companies have withdrawn from the market, merged, or gone bankrupt. Analysts say fewer than half a dozen may be left by the end of next year and they're not betting on which -- if any -- will prosper. Part of the industry's troubles arose from the surprising slowdown in sales of computers that use compact disks -- personal computers, office systems, and other desktop machines. Sales of the drives boomed at a 320% rate, compounded annually, from 1981 through 1984, according to Disk/Trend Report, a market research firm based in Los Altos, California. This year, though, the industry should grow only 26%, to about $1.2 billion, and the sales of the largest companies have dropped. The sharp decline in revenue growth and a blood bath of price cutting have clobbered earnings and bitterly disappointed investors. An index compiled by Peter E. Heymann, a security analyst for Drexel Burnham Lambert, shows that shares of the industry's nine leading public companies are trading at about 30% of their 1983 highs. The business is fearsomely volatile even in good times. Jumping in is relatively easy -- it's mainly a matter of assembling components bought from a handful of specialized suppliers. Ten to 15 huge customers, such as IBM, Digital Equipment Corp., and Hewlett-Packard, buy over 80% of the industry's production. A contract with one of them, especially IBM, can turn a struggling ( newcomer into an instant star; losing the contract can mean quick death. Technological obsolescence is swift. The average compact disk drive has a short life -- it yields fat profits for two years or less -- and those who make it big with one product usually spend so much time and money managing explosive growth that they lose out to competitors using newer technologies. ''It's a very low inertia industry,'' says Terry Johnson, founder and former chairman of Miniscribe Corp., a disk-drive company in Longmont, Colorado (it is one of the few disk-drive companies not based in California). ''You can blow your way into it and get blown out of it very quickly.'' To keep from being blown away, disk-drive makers tend to follow one of two strategies: producing commodity-type drives for run-of-the-showroom PCs or specializing in advanced drives. The biggest companies, Tandon Corp. and Seagate Technology, focus on the commodity segment of the business, as do some smaller companies such as Miniscribe and Computer Memories Inc. Commodity companies are intent on becoming low-cost producers, and they're willing to slash prices to get high sales volume. Both Tandon and Seagate strive to manufacture most of their own components. They are, for example, the only independent disk-drive companies that make their own electromagnetic recording heads for sending information to and from disk platters. Vertical integration, the commodity companies believe, is the only way to stave off the Japanese. Over two dozen Japanese companies already dominate the market for floppy-disk drives, which record information on flexible plastic disks, and they're waiting in the wings to jump into the low end of hard-disk drives as soon as the technology stops evolving so fast. Integration may also help Tandon and Seagate keep manufacturing costs low enough to sell to IBM, which probably bought $300 million of compact hard-disk drives last year but has since geared up production of its own drives. Yet vertical integration can be a curse. Early this year IBM, facing a shortfall in sales of its personal computers, started stretching out its purchases under a multi-year agreement to buy $310 million of floppy drives from Tandon. Tandon kept its component factories running and cut prices almost 50% to move inventories. The company has been forced to take so many inventory write-downs that it's likely to report a $60-million loss on sales of $275 million in the fiscal year that ended September 30. % Technological change could also derail Tandon's strategy. Sirjang ''Jugi'' Tandon, the company's flamboyant founder, has invested many millions in a plant for plating disks with nickel and cobalt, which allow the platters to hold more information than disks that have been smeared with iron oxide. Plated disks, though, aren't well suited to the emerging technology of vertical recording, in which the charged metal particles that hold information on a disk's surface are squeezed together more tightly by being stood on end. In a flourish of mixed metaphors, one of Tandon's competitors says, ''Should vertical recording come in fairly soon, Jugi's got a white elephant hanging around his neck.'' SEAGATE is as committed to integration as Tandon, though recently it unintentionally demonstrated the virtues of not making everything in-house. IBM, which accounted for half of Seagate's sales in the first six months of last year, virtually stopped buying from the company in the middle of 1984. Like Tandon, Seagate cut prices -- by 35% -- but its principal tactic for averting losses was to walk away from contracts with suppliers of components. That course of action will get harder as the company brings more work inside. A gaggle of smaller companies like Quantum Corp., Priam Corp., Micropolis Corp., and Microscience International specialize in making leading-edge drives, many of them for expensive machines such as DEC's MicroVAX II, an engineering computer that sells for $20,000 to $70,000. Their goal is to be first with new technology, and they abhor vertical integration. ''We want to be fast on our feet and pick the best suppliers,'' explains James Patterson, co-founder and president of Quantum, adding that he'd be foolish not to take advantage of the over $200 million that venture capitalists and others have sunk into disk manufacturing. Preferring small market segments that promise fat margins, Quantum and other high-end companies refuse to chase high volumes and rock-bottom production costs. So far that's meant staying away from IBM: ''We're as greedy as anybody,'' Patterson says, ''but we want to make money over a period of years, not just for the six months of an IBM contract.'' Instead, Quantum has spread its business across many customers and several channels of distribution. In October the company took its first step into the retail market with a tiny disk drive that is mounted on a 4-by-13-inch printed circuit board. Called Hardcard, the board plugs inside the back of a personal computer and can * double the storage capacity of many systems. The virtues of staying lean can be seen in financial reports. Quantum gets about $150,000 of sales per employee, compared with an average of $80,000 for Tandon and Seagate. Quantum's gross profit margins hover around 37%, vs. an average of 20% in good times for the two giants. The downside, of course, is that no company like Quantum has grown as large as Tandon or Seagate. The best reason for staying small and fleet-footed is that no manufacturer can be sure it has the right product at the right time. Since there are scores of potentially popular designs for products and only a dozen or so major buyers, luck plays a large part in the equation. Provided they're both well managed and lucky, companies like Quantum and Microscience are likely to survive and possibly even prosper. That's not true for most of those that have worshiped at the altar of volume. The smaller ones, like Computer Memories, seem unlikely ever to grow large enough to achieve economies of scale and probably will vanish. Even Tandon and Seagate, whose sales have already declined, are likely to emerge from today's fiery furnace as smaller, more flexible companies. BOX: INVESTOR'S SNAPSHOT TANDON SALES (LATEST FOUR QUARTERS) $309.9 MILLION CHANGE FROM YEAR EARLIER DOWN 23% NET LOSS $51.0 MILLION CHANGE PROFIT YEAR EARLIER RETURN ON COMMON STOCKHOLDERS' EQUITY -26% FIVE-YEAR AVERAGE 24% RECENT SHARE PRICE $3.50 PRICE/EARNINGS MULTIPLE N.A. TOTAL RETURN TO INVESTORS (12 MONTHS TO 10/25) -56% PRINCIPAL MARKET OTC

BOX: INVESTOR'S SNAPSHOT SEAGATE TECHNOLOGY SALES (LATEST FOUR QUARTERS) $254.3 MILLION CHANGE FROM YEAR EARLIER DOWN 26% NET PROFIT $3.1 MILLION CHANGE DOWN 89% RETURN ON COMMON STOCKHOLDERS' EQUITY 1.8% FIVE-YEAR AVERAGE 24% RECENT SHARE PRICE $5.50 PRICE/EARNINGS MULTIPLE 78 TOTAL RETURN TO INVESTORS (12 MONTHS TO 10/25) 3% PRINCIPAL MARKET OTC

BOX: INVESTOR'S SNAPSHOT QUANTUM SALES (LATEST FOUR QUARTERS) $128.0 MILLION CHANGE FROM YEAR EARLIER UP 35% NET PROFIT $22.2 MILLION CHANGE up 47% RETURN ON COMMON STOCKHOLDERS' EQUITY 25% FIVE-YEAR AVERAGE 12% RECENT SHARE PRICE $21 PRICE/EARNINGS MULTIPLE 9 TOTAL RETURN TO INVESTORS (12 MONTHS TO 10/25) 8% PRINCIPAL MARKET OTC Explanatory notes: page 200