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Many Disk Makers Have Lost Their Drive

Companies struggle with overproduction and falling unit prices, but some analysts say a rebound is coming.

April 13, 1999|EDWARD SILVER

If Internet stocks are the highfliers of the tech market, many disk drive companies are scraping along the bottom.

The contrasts between the groups say something about why drive stocks have been battered. While Net firms' balance sheets are light on inventory, drive makers, whose elegantly designed devices store and retrieve gigabytes of digital data within computers, struggle with overproduction and falling unit prices. As Internet companies double and triple their annual sales, actual revenue declines have become common among drive firms--including industry leader Seagate Technology, down 24% in fiscal 1998.

It's no surprise that investors are a lot stingier with the drive stocks. As they indulge Web advertising firm DoubleClick with a valuation that amounts to 71 times 1998 sales, drive maker Western Digital trades at a price-to-sales ratio of 0.23.

Compaq's earnings warning Friday is the latest bomb dropped by the PC sector. But the fallout has hit drive companies the hardest. In the past, pessimism over the prospects of drive makers and their suppliers usually signaled great buying opportunities for bargain-hunting investors.

This time, however, may be different. The group's future is less clear and more challenging than ever. In fact, many analysts believe the business just isn't big enough to support all the players.

So why consider investing here? Besides the potential leverage in low-priced stocks, demand for storage keeps rising and could take a quantum leap if digital VCRs and other gigabyte-sopping multimedia toys go mainstream.

"There are nontraditional applications coming in that will drive demand," said John Donovan, analyst with industry researcher TrendFocus. "But for the next one or two years, revenue growth will be difficult to come by."

More Vendors Fight Over a Flat Market

That happier times are coming remains an article of faith. Meanwhile, more vendors are battling over the $26-billion market, which is forecast to remain flat this year, at best, even as unit sales continue to climb.

Newly aggressive and efficient producers such as Maxtor, IBM and Fujitsu have encroached on longtime leaders Seagate, Quantum and Western Digital, intensifying pressure on prices. Thanks to fantastic advances in storage capacity as well as competitive conditions, a megabyte now sells for 3 to 5 cents, down from about $11.50 in 1988, according to research firm Disk/Trend.

Analysts believe that if anyone can prosper in this Darwinian environment, it is Seagate. The company absorbed rival Conner Peripherals after that company stumbled during the price war of 1994, but in early '98 Seagate itself was undermined by poor execution.

New managers restructured operations and the turnaround led to a blowout for the quarter ended in December, when Seagate earned 42 cents a share. "Being the low-cost producer enables Seagate to do well even without great market conditions," said BancBoston Robertson Stephens analyst Dane Lewis.

Perhaps Seagate's biggest competitive advantage is its strength in the market for higher-margin drives built into servers. Furthermore, it has large stakes in software companies, which typically attract higher bids from investors.

Quantum sells more drives for the desktop than anyone else, but unprofitably, analysts say. That, however, is a sideshow in the Quantum story. Fans focus on its Digital Linear Tape business, which accounts for about a quarter of revenue and 100% of earnings.

DLT owns large swaths of the market for hosting libraries of corporate backup data, generating such high margins that Quantum has proposed issuing a separate tracking stock for this portion of its business.

Lewis estimates that segment of Quantum's business will earn $1.70 a share in fiscal 2000. That's why he considers the company undervalued. "At some point investors will wake up to that," he said.

What Western Digital has going for it is a bargain-basement price, long-term ties to PC makers and a deal to buy components from IBM to upgrade its lagging product line. Western tripped over a technology transition and lost gobs of market share and money last year. Yet the 93-cents-a-share loss it posted in the quarter ended in December, however large, beat expectations, and the red ink is expected to turn to black later this year.

In these choppy seas there would be little shock if Western failed to turn its ship around. "I believe it will recover," said analyst John Dean of Salomon Smith Barney, "but it doesn't seem that it is the right time to step up to the plate" and buy the stock.

Western's woes have a lot to do with the miseries of disk drive parts makers Read-Rite and Komag. They now rely on sales to Western for half their revenue, according to Brian Goodstadt of Standard & Poor's Equity Group, because other disk drive makers are increasingly building their parts in-house.

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