Easier Times for Hard Drives

With the PC market almost past its sell-by date, hard-drive makers cozy up to consumer electronics.
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Consumer devices have come to the rescue of the ailing hard-drive industry. Hard drives, some smaller than the proverbial matchbook, are popping up in everything from

Apple Computer's

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iPod to

Microsoft's

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Xbox.

Seagate Technology

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, which had the smarts to spot this trend early on, now derives 10% to 15% of its revenue from the consumer electronics market, a total that the Scotts Valley, Calif., company figures will jump to 25% or higher by 2007.

Meanwhile, the much larger cell-phone market is beckoning

Samsung

, which has already built a phone with a tiny hard drive manufactured by

Toshiba

, and other companies are expected to follow suit. If all goes well (and it may not), game and music devices, digital-video recorders, cell phones and other consumer gadgets will eat up 164 million hard drives worth $10.2 billion in 2008, predicts technology researcher IDC. The same market in 2004 comprised 43 million drives worth $3.1 billion at the factory door.

The consumer electronics boom couldn't have come at a better time. The PC industry, the meat and potatoes of hard-drive makers, has long passed its peak growth years, and even though there has been significant consolidation in the drive space, there may still be too much capacity.

Last year, for example, shares of Seagate and other drive makers cratered as they fought to dump excess inventory, the result of overly optimistic forecasting in late 2003.

Seagate has rebounded smartly from the downturn, appreciating by 93% since bottoming in mid-August. Last week, Lehman Brothers analyst Harry Blount upgraded the stock to overweight, saying he favors vendors that are gaining share in the market for computer notebooks and consumer devices, and those that have adequate access to components.

"Of the three public

hard drive makers, we believe Seagate fits the best," says Blount, whose company does not have an investment banking relationship with Seagate.

Consumer electronics is a good fit for the drive makers, even though drives generally have to be made smaller than in the world of PCs. Still, a hard drive is just a hard drive. "R&D for CE

consumer electronics isn't that much different or more expensive than it would be for a product launch in our traditional markets," says Pat O'Malley, who heads Seagate's consumer electronics efforts.

Even so, it's worth recognizing that the technology is rather remarkable. In 1977, hard drives were all about 14 inches in diameter; today, the largest drive anyone makes is 3.5 inches, notes Jim Porter, principal analyst at market researcher DiskTrend. What's more, a technology breakthrough known as perpendicular design will, by the end of 2005, allow drive makers to shrink their products much faster than they could previously in the past few years.

Even based on the nearly outmoded longitudinal design, the drives going into music players and soon into cell phones are awfully small, at 1 inch and even .85 of an inch in diameter.

Although we think of consumer electronics devices as changing every few minutes, some of the manufacturers actually want the platform, as they call it, to be stable. The Xbox, for example, hasn't changed much in the four years or so it's been on the market, and it uses a standard PC-style drive, says O'Malley. Because ongoing expenses are less, the Xbox is "hardly a drag on margins," he says.

In fact, margins for the drives Seagate and other companies sell to consumer electronics manufacturers are generally high, say analysts, although it's difficult to get an actual number. Still, even a small bump would be significant; each full point of gross margin expansion for Seagate is worth 3 cents to 4 cents a share, figures Robert Chira of Fulcrum Global Partners, whose firm does not have an investment banking relationship with Seagate.

For now, Seagate is the only major U.S-based manufacturer that is building mini-hard drives for consumer electronics.

Western Digital

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is expected to have a product ready by the end of the year, while

Maxtor

(MXO)

won't have one ready until sometime in 2006. The real competition, though, is in Asia.

Hitachi

(HIT)

, for example, is the dominant supplier of drives for the larger flavors of the iPod.

Other drive makers aren't the only competition facing Seagate -- there's a whole other technology, known as flash memory used in cameras, cell phones and other small devices. Flash, a kind of a memory chip, is rugged and small, which gives it a striking advantage over electron-mechanical hard drives. The downside is that it's 10 to 15 times more expensive on a per-megabyte basis.

O'Malley says that by 2007 or 2008, flash will have gotten so much cheaper that it could challenge the hard drive in devices that require just 4 or 5 gigabytes of storage. But he's betting that the demand for multimedia, particularly video, will require more storage than would be affordable using flash, and that advances such as perpendicular design will keep his prices well below that of the memory makers.

IDC analyst John Buttress worries that his own forecast of growth in the CE space for the drive makers could be too bullish. "These are emerging markets," he says. "Our assumptions might not pan out."

One reason: Service providers are having trouble making money on new, memory-hungry applications such as camera phones. If they don't find a way, all the bubbly predictions of millions and millions of hard-drive-enabled cell phones will prove false, Buttress says.

Similarly, Microsoft isn't making enough money on Internet gaming to support the cost of adding a hard drive, which isn't needed for single-player action on the Xbox. Instead, the drives will likely become optional, Buttress says.

But for all the potential problems, it's clear that the hard-drive space is finally becoming interesting again.