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Storage Makers Ride Digital Wave

U.S. hard-drive makers are primed to meet rising demand for storage.

SAN FRANCISCO -- Storage-device makers have been preaching about the digital wave that's gaining momentum and fueling the need for their wares.

The most glaring sign that their words are more than just spin came last week when

Seagate Technology

(STX) - Get Report

surprised investors by dramatically

raising its first-quarter profit targets.

The company's stock rose almost 4% last week, largely from this news. Seagate was recently trading up 41 cents, about 1.6%, to $26.23.

The photos, PowerPoint presentations, digital music and movies that are sloshing around the Internet are spurring fresh demand for hard-disk drives. This content gets stored on personal computers, Internet servers and TV set-top boxes, and backed up on storage appliances -- all of which use hard drives.

Seagate and

Western Digital

(WDC) - Get Report

are the only two American companies standing after rounds of consolidation. They're also the largest in the world by production and the most likely to generate profits from the rising demand for storage.

After bloody price wars with Asian conglomerates a decade ago, these companies have built moats around their profits by bringing most phases of production in-house. At the same time, they've learned to keep output in line with current demand rather than expected demand.

Inventory levels, as a result, are running at the low end of the four-to-six-week liquidation rate, far below levels witnessed between 2002 and 2004 when suppliers held up to 10 weeks of inventory at times.

"In this industry, success depends on inventory, pricing and demand," said Tony Trzcinka, portfolio manager at Pax World, which holds approximately 425,000 Seagate shares.

"All of these are moving in the right direction, and supply seems to be in pretty good equilibrium with demand," he says.

Today, Seagate sells most of its products directly to its customers, rather than third-party suppliers. This has kept the company on its toes, making sure its output is finely tuned to customers' needs and keeping inventories at a minimum.

Dell

(DELL) - Get Report

and

EMC

(EMC)

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, for instance, generally order parts "just in time" for immediate use, rather than stacking them on shelves like resellers.

An Edge Over Asia

Seagate's lean production has also helped the company tame its operating expenses.

The last quarter shined a spotlight on how much better U.S. companies are faring than their Asian rivals. In the last quarter, Seagate earned $188 million in operating income; Western Digital earned $79 million.

Hitachi

(HIT)

, by contrast, reported a $174 million operating loss.

Western Digital's shares, which also got a boost last week from Seagate's revised outlook, were recently trading up 52 cents, over 2%, to $23.88.

Analysts and investors attribute Seagate's rosier earnings forecast to strong demand for personal computers, namely notebooks that use higher-value drives. Seagate is also making inroads with drives used in corporate data centers.

The resulting mix of products sold had a greater concentration of drives with higher prices and fatter profit margins than anticipated.

Tighter demand means Seagate is in a better position to negotiate prices in coming quarters, says Rich Kugele, an analyst with Needham. So even if prices fall in line with seasonal trends, they won't reach the levels that some investors fear.

Kugele doesn't own Seagate shares, but Needham performs investment banking work for the company.

Solid-state memory, known as flash, is less of a replacement for hard drives, as has been feared, and more of a complement. Seagate, in particular, has been designing ways to pair the two technologies.

Laptops, for instance, can use flash for a quicker start-up time and hard drives for long-term storage.

But the future's not all golden. Sales of consumer products, such as DVRs, game consoles and home storage units, are growing faster than sales to businesses. This links Seagate's behavior more closely to volatile consumer spending patterns that depend on employment trends, gas prices and home values.

A bigger problem is renewed competition from Asian conglomerates that try to mimic Seagate's success. Asian investors are much more willing to tolerate losses if their companies pick up market share -- a possibility that could spark another fierce price war.

Bill Watkins spurred rumors that a

Chinese player is maneuvering behind the scenes to acquire a hard-drive maker. Investors and analysts say that a Japanese player rather than a U.S. one might be on the block.

Hitachi, for instance, already relies on Chinese suppliers and manufacturers for its hard-disk drive production. Bringing everything under the roof of a single Chinese owner would be the first step toward replicating the steps that have made Seagate and Western Digital successful.

Technology may keep competitors at bay. Seagate's drives can come with attached flash memory, data encryption technology and software that not only stores data, but protects it and makes it easy to find.

On balance, worries about flash memory and a competition-fueled glut of hard drives have caused investors to discount the sector. Judging by the ratio of stock price to earnings forecasts, valuations of Seagate and Western Digital were actually higher in the mid-1990s when a price war was hammering profits.

"This is an industry that investors love to hate," says Needham's Kugele. "These stocks continue to trade on negative perceptions about seasonality, channel inventories and fears that flash is a replacement, not a complement.

"But if this is as bad as it gets, the U.S. companies have a lot more staying power than their competitors in Asia."