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Tough Times for Disk Drives

By Richard Stice, CFA We at S&P believe this has been a challenging year for the makers of hard disk drives. Shares of the three major independent providers, Maxtor (MXO

; hold; recent price: $4.50), Seagate Technology (STX

; avoid; $11) and Western Digital (WDC

; hold; $7), have declined by an average of 47% so far this year through Aug. 4. We believe the sell-off is largely attributable to severe pricing conditions within the industry, which resulted from inaccurate projections of end-market demand.

The origin of these circumstances began in late 2003, in our view, when disk-drive companies ramped up production in anticipation of a strong holiday selling season. However, demand did not materialize as expected, resulting in a supply imbalance in the marketplace. Compounding the issue was the fact that, in the succeeding months, customer interest tapered off during the typically slow period for the industry. With the excess supply weighing on the sector, the disk-drive outfits began to discount prices to derive some value from their bloated inventory.

While the pricing conundrum is expected to linger over the next several months, we believe the industry's longer-term growth potential is encouraging. One particularly intriguing area, we believe, lies within the consumer-devices market, where hard drives are being employed in a variety of applications that have developed a mainstream following. Products such as PC notebooks, personal gaming devices, and portable digital music players are a few examples of this growing trend.

2005 TURNAROUND. Despite the favorable future outlook, however, we're concerned with existing industry conditions, as they have significantly reduced profitability for the group. Companies have seen their financial stability weaken, which may prolong or even jeopardize their ability to turn around their businesses. This is evidenced, in our view, by the most recent quarterly results reported in late July.

Maxtor's revenues declined 10%, while gross margins narrowed by more than 7 percentage points to 9%, as a result of lower volumes and acute pricing pressures. This translated into a GAAP loss per share of 11 cents, compared with earnings per share of 3 cents in the prior-year period. For all of 2004, we anticipate that Maxtor will report an 11% decline in revenues, to $3.6 billion, with gross margins narrowing about 6.6 percentage points to 10.5%, and a loss per share of 37 cents.

We expect a turnaround in 2005, as improving demand trends should boost pricing levels. We see Maxtor's revenues growing 3% in 2005, to $3.7 billion, and a loss per share of 4 cents. Our 3-STAR, or hold, recommendation is based on our view that although recent results have been disappointing, the company's industry position will allow it to take advantage of any meaningful pickup in IT spending. Our 12-month target price of $5 is based on relative price-to-sales and discounted cash flow analysis.

SEACHANGE. Seagate Technology's June-quarter results reveal an even less flattering picture, in our opinion. Revenue declined 14% and gross margins contracted by more than 10 percentage points, to 17.1%. These metrics corresponded to a loss of 7 cents per share, in contrast to EPS of 33 cents in the year-ago quarter. Furthermore, given the company's uncertainty with respect to near-term demand and pricing, it declined to offer any guidance for the September quarter.

In fiscal year 2005 ending in June, we anticipate Seagate's revenue decreasing 10%, to $5.6 billion, and forecast an operating EPS reduction of 63%, to 33 cents. Our 2-STAR, or avoid, opinion results from our view of poor visibility, seasonal weakness, and an unappealing valuation. Our 12-month target price of $10 is based on a historical average price-to-sales metric and an intrinsic value calculation based on discounted cash flow analysis (our assumptions include a weighted average cost of capital of 12.5% and an expected terminal growth rate of 3%).

Although Western Digital's quarterly earnings results were also below the prior year, the degree of the shortfall was less pronounced than its peers. In fact, revenue actually rose by 10%, on a 19% rise in unit shipments. But despite the positive impact of higher volumes, gross margins still narrowed during the quarter mainly because of lower pricing. The company's EPS of 14 cents declined 7% from the previous year.

EARNINGS DISPARITY. For fiscal year 2005 ending in June, we expect Western Digital's revenue to increase 9%, to $3.3 billion, aided by new product introductions. However, we believe that gross margins will continue to diminish and, as a result, we forecast EPS of 60 cents, a drop of 14% from fiscal 2004.

We view Western Digital, ranked 3-STARS, or hold, as possessing an advantageous industry position and financial structure. The company continues to generate free cash flow and buy back its stock, with 1.9 million shares repurchased during the June quarter. However, with the cutthroat-pricing climate showing no signs of abating, we would be reluctant to add to positions at this time. Our 12-month target price of $9 combines discounted cash flow analysis with a relative p-e valuation metric.

Our Standard & Poor's Core Earnings methodology reveals notable disparities between reported and Core EPS. For Maxtor, Seagate, and Western Digital, we forecast differences of 51%, 34%, and 23%, respectively, with the primary influence being stock-based compensation expense. For Maxtor, this estimate is related to anticipated 2004 results, and the Seagate and Western Digital projections are for fiscal year 2005.

For Maxtor and Western Digital, risks to our hold recommendations and target prices include a greater-than-expected decline in average selling prices, the inability to keep up with changing technological trends, and instability in overseas markets. For Seagate, our avoid ranking could be affected by abating pricing pressures, gains in market share, and an upturn in demand for personal computers.

Note: Richard Stice has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. (SPSI). Affiliates of SPSI received non-investment banking compensation from Western Digital during the past 12 months. Price charts and required disclosures for all STARS-ranked companies can be found at Analyst Stice follows storage companies for Standard & Poor's Equity Research

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