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Storage Takes the Stage

Kevin Kelleher

More freedom demands more space.

That truism has played out so many times that it's become a cliche -- from the Pilgrims in New England to the homesteaders in the Old West to commitment-phobes in relationships today. But it bears repeating at least one more time, because it's playing out yet again, thanks to digital media.

Music and video lovers, long chained to restrictive schedules of commercial-ridden broadcast media, are increasingly throwing off their shackles and downloading albums, movies and TV shows. Apple's (AAPL Quote) success in offering programs such as Lost on the iPod, and TiVo's (TIVO Quote) plans to allow transfers of shows it records to portable devices are only the latest steps toward a world in which consumers get their media where they want it, when they want it.

But Apple, Creative Technology , Matsushita's(MC Quote) Panasonic and other makers of portable media players stand at the very visible tip of the iceberg. Having the freedom to download your favorite content demands more space -- storage space.

And Wall Street is only starting to wake up to what this is going to mean for the sleepy storage industry, returning some shine to long unglamorous stocks such as Western Digital , Seagate Technology and Maxtor .

For every iPod or portable media player purchased -- and some 30 million of them have moved off the shelves so far, according to Apple -- consumers need a desktop or laptop to store another copy of the song, video clip or digital photo that iTunes will upload to the music player. Those who have either the foresight or the unforgettable nightmare of a crashed hard drive will have a second hard drive for backup copies of their beloved media.

So, in addition to offering loads of business to companies such as Samsung, Apple has been a boon to disk-drive makers of PCs as well. PC shipments increased more than 17% in the third quarter, according to IDC, as users took advantage of low prices to replace aging PCs, many of which have small hard drives. This may represent the first cycle of upgraded PCs that is driven less by new operating system software and more by the need for larger hard drives.

The storage boom is reflected in the surprise guidance upgrades from Seagate and Western Digital. Earlier this month, Seagate said that better-than-expected demand for storage products in desktops and notebooks, combined with supply constraints in some raw materials, would push revenue to $2.2 billion in the December quarter, up from $1.8 billion in the year-ago quarter.

Earnings would fall between 49 cents and 53 cents a share. Before that, analysts had been expecting $2.07 billion in revenue and 49 cents a share. Seagate, which has beaten its numbers for the past five quarters, tends to offer conservative guidance.

That followed an announcement from Western Digital, which said similar circumstances would boost December-quarter revenue to between $1.04 billion and $1.075 billion, compared with $955 million in revenue a year before. The company raised earnings guidance to between 36 cents and 39 cents a share from the previous range of between 33 cents and 39 cents.

Meanwhile, Maxtor, which didn't change its guidance, acknowledged strong demand for its drives.

Those pieces of news prompted Bear Stearns to raise its ratings on Seagate and Western Digital, and prompted Deutsche Bank and Goldman Sachs to boost their ratings on Seagate. Seagate's stock is up 38% since late October, and it still trades at 10 times its forward earnings. Western Digital, up 35% in the same time period, trades at 11.5 times its forward earnings. And Maxtor hasn't been left out of the fun. It's risen 39% since Oct. 28. Maxtor trades at 466 times its minuscule earnings, but only 0.3 times its sales.

The brighter outlook for hard-disk-drive makers is all the sweeter because the arrival of the iPod nano, which is powered by flash memory, had led many investors to imagine the death knell for old-fashioned disk drives, which are known to die at the worst possible moment. If flash didn't snuff out the market for hard drives, the long-awaited trend of online storage would.

But the pessimists overlooked two important facts: Hard drives are cheaper than flash and will be for a while, and all those iPod nano users would need to back up their music, video and photos elsewhere. So the flash rage pumped new life into hard drives, rather than sucking it out. And consumers have proven all too impatient to back up their media files onto remote online servers: Broadband speeds may be increasing, but media files are getting fatter at a faster rate.

Most analysts are favoring Seagate as having the brightest prospects in the industry, even though its valuation is below that of Western Digital.

"A transition from desktop computers to notebook computers should drive unit growth in notebook drives, where Seagate has increased its market share to 12% [in the third quarter of 2005] from 5%" in the year-ago quarter, wrote Kaushik Roy of Susquehanna Financial Group, who recently initiated coverage on Seagate with a positive rating (and whose firm has no underwriting relationship with Seagate).

Needham analyst Richard Kugele says Seagate is likely to enjoy a good run through 2006 with its 160-gigabit hard drive -- four times as large as the drives in most notebooks sold today. "After years of significant R&D expense, Seagate's investments are on the verge of offering the company its first multiquarter technological advantage," through the 160-gigabit product, he says. Needham has no underwriting relationship with Seagate.

The $23 billion disk drive industry has its share of long-term problems: It's a cutthroat business that demands huge capex investments; it could, in a few years, face tougher times should flash memory become cheaper and more powerful; and it's just not a very sexy industry.

But the dim view many tech investors take of the sector has grown so dark -- and at a time when things are, for now, looking a bit brighter -- that it's creating a chance to get in on one of the last, overlooked corners of the digital media boom.

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