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Seagate Selloff Probably Stems From Overstock Worries

Shares have fallen 5% in two days on fears of rising inventory.

SAN FRANCISCO --

Seagate

(STX) - Get Report

shares continued to fall Thursday, underscoring investors' nervousness about the sustainability of the company's pricing power.

Seagate shares were recently trading down 49 cents, about 1.9%, to $25.43, after closing down nearly 3% on Wednesday.

Views differ on what could be causing the selloff, with some analysts attributing it to worries about a possible hard-disk drive glut in a market where supply-and-demand factors are in a rare -- and possibly tenuous -- balance.

Investors in hard-disk drive makers like Seagate wince at the slightest notion that inventories will build up and depress prices as has happened in the past.

At the moment, however, there are few signs that an oversupply is materializing -- or even likely. In September, Seagate and its U.S. rival

Western Digital

(WDC) - Get Report

raised quarterly revenue and profit forecasts as strong sales of personal computers, digital video recorders and data storage devices pushes up demand for hard disk drives.

The growing demand has propped up hard drive prices. According to Brean Murray Carret analyst Mark Miller, Western Digital's average selling price fell just 7% over the last three years, vs. a 27% drop from 2001 to 2004.

Brean Murray Carret has not performed investment banking work for Western Digital in the past 12-month period.

The risks of an imbalance between supply and demand are increasing, however, as hard disk drives find their way into more consumer products. If, for example, PC makers expect slack consumer sales because of continued problems in the real estate market, they will scale back orders abruptly -- and leave hard disk drives makers with stacks of inventory.

Also, some investors may fear a more pronounced seasonal downturn in the first half of next year. With more sales of devices coming from consumer electronics, drive makers' fortunes are tied more tightly to volatile trends in employment, consumer sentiment and interest rates. This can exacerbate seasonal demand fluctuations.

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"While I think investors feel relatively comfortable about the unit and pricing dynamics surrounding (hard disk) drives for the remainder of the year, the real question is whether these healthy fundamentals can extend through the first half of next year," says Tony Carbone, an analyst with mutual fund manager RCM Capital.

RCM no longer holds Seagate shares.

Seagate and Western Digital are taking steps to avoid past pricing problems. Both have shown restraint in their plans to expand production capacity, which should help maintain a tight balance between supply and demand. Last week, comments from

Xyratex

(XRTX)

, which makes equipment for manufacturing hard drives, led analysts to conclude that drive makers won't begin adding capacity until 2008 or later.

What's more, further industry consolidation may dampen the inevitable post-holiday slowdown.

Hitachi

(HIT)

, for one, has been rumored to be considering a spinoff or sale of its hard drive unit, which lost $323 million in the first half of the year. Fewer players could prevent price competition from eating into profit, especially if the buyer is a private equity firm that holds the line on pricing to improve profitability.

Carbone favors Seagate over Western Digital because it can increase production to meet growing demand without adding significantly to its production expenses. As a result, more of its revenue gains turn into profit.

Both companies are similarly valued when comparing their stock price to estimates of their future earnings.

Western Digital's stock has held up amid the downdraft in Seagate's shares. Its shares were recently trading down 11 cents to $25.02.

This led Needham analyst Rich Kugele to say that the pressure on Seagate is coming from profit-taking ahead of the company's first-quarter earnings announcement later this month.

Needham has performed investment banking work for Seagate in the past 12-month period.

"These guys preannounced earnings early in the quarter and things have gotten better since then," said Kugele. "Shorting them now would be a big mistake."