RealMoney Silver - Hard-Drive Makers Have Growth in Store

Hard-Drive Makers Have Growth in Store
By Robert Marcin
RealMoney.com Contributor
3/25/2008 2:53 PM EDT

To find the best tech investment, think hard ... hard disk drives, I mean. That's right, in the middle of a so-called financial and economic meltdown, I believe it's time to look at the hard-disk-drive business. Some of my colleagues say I'm downright nuts for investing in this space. But let me share my thinking with you.

Despite excellent fundamentals, the stocks are cheap and compelling. Seagate (STX) and Western Digital (WDC) , the two leading global hard-drive companies, trade for about 7 times 2008 calendar earnings, with 15% and 40% revenue growth respectively. These two companies have some of the strongest absolute growth and positive earnings estimate revisions in the entire technology sector.

Yet many investors shun the space. As with many cyclical growth industries, hard-disk-drive makers are being restrained by fears of the economic slowdown. And the drive industry is known for a fair amount of pricing and profitability cyclicality on its own. Historically, a slowdown in global tech spending has been bad for hard-drive vendors and for stock prices. With current economic conditions being as they are, one would expect hard-drive makers to grind to a halt.

But they're not. Conditions in the hard-drive industry are excellent and improving. Voracious demand for storage has demand in the hard-drive business simply exploding. Global businesses and consumers purchased 500 million units in 2007, and volume should approach 600 million in 2008. Computer growth is still healthy, with emerging-market demand driving global unit growth. Once you get Internet access on your cell phone, you want it on a laptop as well. A billion new emerging-market technology consumers want their broadband, and with it the capacity to store their own photos, videos and music.

New markets such as autos, security cameras, televisions, set-top boxes, gaming consoles and external backup drives are accelerating historical growth rates. The most significant addition to the hard-drive growth story is the external backup application. For the first time in the history of the personal computer, the value of the digital content on a computer far exceeds the actual cost of the hardware. It's not just spreadsheets and documents but also music, video and photographs. And that makes a $100 backup drive a must. It's simply so cheap and easy to back up one's digital content that there's no reason not to.

I expect the attach rates of external drives to computer purchases to soar in the next few years. Right now, the global market for external drives is about 40 million units in a 300-million-unit personal computer market. As the attach rate grows to 25-35%, that application could triple demand to 120 million units in the next few years! And this says nothing about addressing the billions of computers in the installed base. The acceleration in growth has very positive ramifications for industry pricing, profitability and shareholder returns.

As the insatiable demand for storing digital content continues, the hard-disk-drive industry is finally starting to act like a business run by grown up capitalists. Despite decent returns for Seagate and Western Digital, the entire industry has been plagued by subpar profitability. Even in a reasonably healthy environment like 2007, the pretax return on sales for the whole hard-drive industry is still only mid single digits. You can thank the knucklehead, socialist bozos running Hitachi (HIT) for that. But even there, new management seems focused on pricing drives to avoid losing hundreds of millions of dollars annually. Hard-drive margins cyclically peaking? Not at 6% margins.

Significant consolidation of drive assemblers (the top three assemblers approach 80% market share) and component suppliers has generated a kindler and gentler hard-drive cycle, and investors just don't appreciate it yet. Take Western Digital, for example. The company keeps generating stunning growth and blowing away Street estimates. And yet, on their latest quarterly blowout, six analysts downgraded the stock at 7 times profits with 30% revenue growth.

These were the same analysts who missed WDC earnings by 100%! That's right, the same guys and gals who had started fiscal year 2008 with a $2 estimate in a $4 year now all think they figured out WDC enough to pre-emptively downgrade one of the best set of fundamentals and lowest valuations in the entire tech space. I must have missed the memo.

Seagate and Western Digital are good candidates for long positions. Seagate is the down and cheap stock for the bottom-fishing value types, while Western Digital should be preferred by momentum and estimate revision investors. Both are too cheap with excellent fundamentals not to own, so I happen to be a shareholder of both.

I expect the Western Digital to continue to grow strongly and blow away analysts' earnings estimates. Assuming decent demand in the tech industry, WDC should make $5 per share in the fiscal year that begins this July. Wall Street is still at $4 for fiscal year 2009. I get that significant earnings surprise with 15% revenue growth, gross margins equal to this March quarter (22% and seasonally slow one) and normal operating expense ratios. I still believe investors and analysts underestimate the growth potential of WDC.

Seagate should have a great year in fiscal 2009 as well. I have well above Street estimates for it at $3.65 vs. current consensus of $2.90. Seagate should have 13%-plus revenue growth, expanding profit margins, huge free cash flow and a major share repurchase program.

My price targets for Seagate and Western Digital are $40 and $55 respectively, or price appreciation potential of 75% to 100%. That's only 11 times profits for each on fiscal 2009 numbers. Some may question that type for valuation for hard-drive companies. But I believe it's very achievable.

Just look at the valuations of other competive commodity industries such as steel or coal to see how much valuations can expand in newly consolidated cyclical growth industry. Many metal stocks trade for 13 times peak profits today, and coal stocks typically change hands at 15 to 18 times, so an 11 multiple for hard drives is very doable. Now all we need is for the hard-drive managements and sales forces to play nice for three more months! Come on, guys, give us shareholders a break!

The technology sector is known for a seasonal trade down into summer and up into winter. Since everyone knows this, it gets discounted earlier each year. My guess is that the hard-drive stocks are being restrained by this seasonality as well as macro concerns. But that will be over shortly.

In a couple of months, big money will be buying these stocks for both cyclical and seasonal reasons. The smarter ones are already establishing positions, like Ken Heebner, growth manager extraordinaire. His latest filings revealed a starter position in Western Digital. I would like to welcome Ken to one of the best set of valuations and fundamentals in the entire technology sector. One could do far worse than following him.