By Sam Stovall EMC's (EMC) recent bid to acquire Legato Systems (LGTO) for around $1.3 billion in stock has once again focused investor attention on computer storage and peripheral stocks. Recent strength in these shares has propelled this industry into the Industry Momentum portfolio -- the list of industries with top Standard & Poor's Relative Strength rankings, based on 12-month price performance.
Have the potential gains already been experienced? Yes, according to S&P computer storage-and-peripheral analyst Richard Stice. S&P's overall investment outlook for the sector is slightly negative, while its specific outlook for the storage part of the industry is neutral.
PERSISTENT PROBLEMS. Although Stice believes storage is a high priority with companies' info-tech spending initiatives, near-term growth has ceased. According to International Data Corp., worldwide disk-storage systems revenue dropped 15% in 2002, with an additional 1% decline in the 2003 first quarter.
So what's behind the gains in the shares? Stice attributes the group's strong performance thus far in 2003 to several positive earnings reports and to the fact that with many stocks trading in single digits, the rebound in prices was amplified. However, he doesn't believe this indicates an overall turnaround. Rather, he sees the industry confronting weak demand, pricing pressures, and limited visibility regarding earnings.
Computer-peripherals companies manufacture or distribute computer add-ons and/or basic components, such as storage devices, printers, and monitors. Current computers require large data-storage capacity in order to use sophisticated software, and they operate in more complex multiuser environments. S&P expects shipments of products that increase storage capacity to grow rapidly over the next few years, driven by requirements for more advanced user applications, e-mail, and the Internet.
SOME GOOD NEWS. Sales of hard-disk drives and CD-ROM optical-disk drives are closely tied to shipments of PCs, in which they're primarily installed. Prices generally trend down, notes Stice, but pricing pressures in this market have abated somewhat in recent months.
As favorable portents over the longer term, Stice sees greater unit shipments of higher-capacity drives, together with manufacturing cost-cutting and more sales devoted to wider-margin software products. He also expects to see strength in the tape-drive storage market, as more PCs use this cheaper backup method.
S&P is negative on the printer market, as demand has been restricted by the impact of the economic slowdown. The segment also remains a low priority for corporate IT budgets, in S&P's opinion. The printer market consists of the nonimpact segment -- laser, inkjet, thermal printers, and the like -- and impact printers, which have seen their share of the market decline in recent years.
Stice's top selections in the group? He has 4-STAR (accumulate) rankings on Storage Technology (STK), Imation (IMN), and Western Digital (WDC). For EMC, Stice has a 3-STAR (hold) ranking. He views the price of the Legato deal as reasonable given its proprietary technology and product margins.
Industry Momentum List Update
For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of July 3, 2003.
S&P STARS* Rank
Casinos & Gaming/Consumer Discretionary
Harrah's Entertainment (HET)
Computer Storage & Peripherals/Info. Tech.
Storage Technology (STK)
Consumer Electronics/Consumer Discretionary
Harman International (HAR)
Newmont Mining (NEM)
Health Care Supplies/Health Care
Internet Software & Services/Info. Tech.
Office Electronics/Info. Tech.
Everest Re (RE)
Philadelphia Suburban (PSC)
Wireless Telecom Svcs./Telecom Svcs.
* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (strong buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell). Stovall is chief investment strategist for Standard & Poor's