Hard-Drive Players Ride Rise in PC Demand

Improving PC demand is driving hard-drive industry fundamentals.
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The hard-drive industry may be facing one of its most promising years in a long time with the convergence of several very favorable trends occurring in 2010.

Last year marked one of the slowest years ever for PC growth as units grew less than 2% over 2008. This brought about a lack of demand for hard drives, driving down selling prices in the beginning of the year and depressing margins throughout the industry.

However, as information spending trends have shown signs of improvement, PC forecasts have steadily risen and

Gartner

now expects to see 20% growth in unit shipments in 2010 and 14% growth in 2011. An aging installed base and declining average selling prices have led so far to a consumer-driven resurgence of PC shipments, possibly to be followed by a refresh of corporate PCs in the next year.

Improving PC demand drives hard-drive industry fundamentals. The industry shipped about 160 million units in the fourth quarter of 2009, near the limit of its production capacity. Both

Western Digital's

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and

Seagate's

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management teams went so far as to say that there was unmet demand in the quarter due to the industry's inability to produce enough drives to meet demand. In stark contrast to 2009, the industry is now supply-constrained rather than demand-constrained. Additionally, channel inventory is near a very low two weeks vs. historical levels generally held at four weeks worth of shipments.

The convergence of these trends has led to stabilizing average selling prices, which had been steadily falling with the weak demand environment. Gross margins for both Western Digital and Seagate were well above the companies' long-term margin models in the December quarter, propelled by cost improvements, product mix, capacity utilization, and ASP strength.

While the March and June quarters are seasonally lower than December, unit shipments likely will be buoyed by unmet demand, inventory replenishment, and business form original equipment manufacturers in advance of a strong second half of 2010.

Shipments later in 2010 will be contingent on a prudent expansion of capacity through the hard-drive supply chain. There has been a ceiling on shipments since facilities are operating at maximum capacity, and without an expansion substantial unmet demand could grow in the second half of the year.

The biggest uncertainty for the coming year is the ability of component suppliers to expand capacity in line with demand. Though the top hard-drive manufacturers seem to be taking a conservative approach to capacity expansion, it is yet to be seen whether upstream suppliers will match expansion to the demand trajectory.

With supply/demand conditions favorable in the hard-drive industry, margins will likely remain robust for the time being. Should the industry overshoot and flood the market with supply though, we could see a return to the selling price declines and shrinking margins of 2009. While a delicate balance must be maintained between supply and demand, the underlying drivers -- PC and server demand -- look to be improving and are pointing to a strong 2010 for the drive players.

Battle Road Research (www.battleroad.com) an equity research firm, serves fund managers, analysts and financial advisers with an independent voice on technology, health care, solar power and education stocks. Battle Road analysts place an equal weight on industry and securities analysis in an effort to seek out stocks to buy and stocks to avoid. As an integral part of our research process, we tap into a network of industry sources who provide insight into the companies we cover. We present our conclusions in a straightforward buy, hold, sell format. As a matter of principle, we refrain from investment banking, company-paid reports, and personal investment in the stocks we research. Visit us on the Web at www.battleroad.com and www.battleroadblog.com.