Last month I showed how investors can generate investment ideas by using the Producer Price Index (PPI) report prepared monthly by the Bureau of Labor Statistics. The idea is that industries in which prices are rising may contain companies where revenue will grow faster and/or margins will improve.
Of course, this is only a starting point. It is useful to generate ideas, but further research is needed to determine whether they are good ideas. This month, I do some of that further research, looking into the technology sector -- specifically, computer storage.
In the technology sector, prices almost never go up. But sometimes they decline at a slower rate than normal, which tends to have the same effect on sales growth and profit margins.
A month ago, the year-over-year price declines for computer-storage devices were the lowest they had ever been. Although pricing ticked down in September from that level, it is still one of the strongest readings on record.
Naming Names
There are plenty of ways to play this one, including Brocade
(BRCD)
, EMC
(EMC)
or Iomega
(IOM)
.
Several other names of interest would be Hutchinson
(HTCH)
, Quantum
(QTM)
, SanDisk
(SNDK)
, Seagate
(STX)
and Western Digital
(WDC)
. It will require a closer look to see which ones seem like the best bets.
Brocade beat earnings estimates last quarter, and although it said the industry remains competitive, the competition didn't seem to be hurting pricing. On its conference call, Brocade noted that, "From a pricing perspective, the pricing environment for the past several quarters has been more favorable than historical levels. While we believe ASP declines may eventually return to mid-single-digits per quarter, as competitors ramp their new product offerings, our current outlook is for a relatively benign pricing environment in
[the fourth quarter]
, with ASP declines once again in the low single-digits."
The competitive environment for storage continues to be mitigated by consolidation. Brocade bought McData, Seagate bought Maxtor and EVault, and Quantum's purchase of Advanced Digital Information has since been followed by the Western Digital/Komag merger.
The buzz around EMC has almost entirely been around its IPO of VMWare
(VMW)
, but that is far from all the company has to offer. Compared with the second quarter of 2006, EMC's systems revenue increased 18% year over year, led by strong revenue growth from the company's midrange information storage products.
EMC's systems revenue represented 43% of total second-quarter revenue. However, on the conference call, management said the pricing environment has always been competitive and that it doesn't "see any significant sea change here in the pricing environment."
Iomega saw 46% year-over-year revenue growth and an increase in gross margins from 16.7% last year to 20.5% this year. That would seem to support the pricing power hypothesis, but nobody seemed to notice much. Although the stock rallied ahead of that report, it has gone nowhere since.
Hutchinson is one of the disk-drive industry's top suppliers. It actually bucked tech industry norms and raised prices, stating in its third-quarter press release, "Overall average selling price in the fiscal 2007 third quarter was $0.80, compared with $0.79 in the preceding quarter and $0.84 in the fiscal 2006 third quarter."
"The increase in average selling price compared with the preceding quarter resulted from a higher percentage of newer products in the fiscal 2007 third-quarter sales mix. 'We expect our average selling price to be flat to slightly up over the next year as our sales mix continues to shift to a higher percentage of newer products,' said
[CEO Wayne]
Fortun." How's that for evidence supporting the PPI report? You wouldn't guess it from the way the stock has acted over the last year.
Quantum's GAAP gross margin rate was 31.8%, a significant increase over the 27.9% rate in the same quarter last year, and its best performance in three years. Seagate also beat estimates.
Western Digital raised guidance and gives credit to improved pricing power. "Western Digital also said its gross margin should hit 17.5%, rebounding from lows in previous quarters and above its prior estimate of 15.5%. The change reflects firmer pricing power after years of price wars with Seagate and Asian rivals like Hitachi," according to a company statement.
The only company that didn't confirm the PPI result was SanDisk, which operates in a different segment of the storage market. SanDisk's average price per megabyte sold declined 65% on a year-over-year basis and 26% sequentially.
Other than SanDisk, however, the ideas generated from the PPI report seem very fruitful. Depending on whether you like small-caps, large-caps, value, momentum or low-price strategies, there is likely a storage name for you.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Iomega to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.At the time of publication, Trent had no positions in the stocks mentioned, although positions may change at any time.William A. Trent, CFA, is a freelance equity analyst based in the New York metro area. He has been an equity analyst since 1996 and is co-author of Understanding and Evaluating Prospectuses, Offering Documents, and Proxy Statements. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Trent appreciates your feedback; click here to send him an email.
