Scribner/DB on HDD Pricing environment has improved versus June and demand is healthy
We believe this quarter was a typical back-end loaded C3Q, with business picking
up in September after being relatively stagnant in the summer months. Our pricing
checks suggest that desktop pricing has improved versus the June Q, particularly
for 40GB and 80GB, but that high-capacity and notebook drives continue to see
aggressive declines. We believe expectations are now very low for the group and
we expect Western Digital and Seagate to rally into the end of the year.
Our top pick into year-end is Western Digital
We believe WDC is the stock to own into the end of the year, given current low
expectations, low valuations, and the potential for upside to results. We expect
WDC to beat Sept Q expectations, but believe management will continue its
typical practice of giving conservative, in-line guidance for the December Q. The
stock is currently trading at 4-year trough valuations of 9x, and we believe current
expectations are low. We expect the stock to rally over the next 3 months on
better-than-expected PC demand and an improving pricing environment.
We Like Seagate as a longer term play
We also believe Seagate’s results will beat Street estimates, and believe
management could guide higher. Sept guidance was very conservative and we
believe the company added some cushion to account for unexpected issues
arising from the integration of Maxtor. We believe the stock could rally into year-
end, but see more upside to the stock as we move into CY07 and beyond the
Maxtor dilution. We continue to believe Street estimates are too low, and we
believe Seagate will see upside to results from its technology lead in PMR and
potential upside from the ramp of gaming devices and 1.8-inch drives in CY07.
Expect component vendors to see choppy results
We expect HDD component stocks (HTCH and KOMG) to see choppy results over
the next few quarters as a result of share shifts due to the Seagate-Maxtor merger
and as new technologies (PMR and TSA+) are introduced and begin to ramp. As a
result, we prefer the HDD OEMs Seagate and Western Digital to the component
manufacturers.
Estimate revisions and Risks
We have adjusted our Seagate EPS estimates to include the impact of higher
interest expense from its recently issued debt. Our FY07 EPS is now $1.85 and
our FY08 EPS is now $2.90 (vs. prior $1.95 and $2.95). Our model does not
include any share buybacks. We have also reduced our KOMG FY06 EPS to $4.61
(vs. our prior $4.64) reflecting lower unit volumes in the Dec. Q, but left our FY07
estimates unchanged. The hard disk drive sector is inherently volatile and subject
to market share battles and aggressive price declines. Risks include an unfavorable
supply/demand environment and failure to achieve competitive time-to-market or
time-to-volume. See Page 8 of this report for company-specific risks.
HDD stocks to rallying into year-end on low expectations
We believe this quarter was a typical September quarter, with business being very back end
loaded. Checks suggest demand picked up in September, after being relatively stagnant in
the summer months. In addition, the data points out of Asia and Taiwan indicate that
demand has picked up for motherboards (MB) and notebooks (NB), with DB’s Asia Analysts
expecting motherboards to be up 18% Q/Q (10% Y/Y), and notebooks to be up 20% Q/Q
(24% Y/Y) after weak results in C2Q06. Despite more positive data points, HDD stocks have
remained stagnant, with Seagate up just 1% and Western Digital down 9% since the end of
June. We believe expectations are now very low for the group and believe Western Digital
and Seagate will rally into the end of the year. Our top pick into year-end is Western Digital,
which is currently trading at 4-year trough valuations. We expect the stock to rally over the
next 3 months on better-than-expected PC demand, and an improving pricing environment.
We like Seagate as a longer term play, as the company moves beyond the dilution from the
Maxtor merger, and we believe the company will out perform expectations in CY07 based on
its technology lead in PMR, and potential upside from gaming devices and 1.8-inch drives.
Desktop demand is picking up and pricing has improved
After very aggressive pricing last quarter, our checks suggest pricing improved for desktop
drives this quarter, especially in 40GB and 80GB drives.
Unlike the 7% ASP declines Seagate
cited on its June quarter call, our checks suggest pricing declines on 40GB, 80GB and 120GB
drives have seen some relief thus far this quarter (see Figure 1), while high-capacity drives
have seen modestly more aggressive pricing (see Figure 2) particularly for 160GB drives. We
believe Seagate is pushing this form factor due to its technology lead, and that the company
hopes to move the desktop market to 160GB as the standard by next year. Channel
inventory started out high this quarter, but has slowly been worked down, with Seagate’s
channel inventory now below 5 weeks and the industry slightly higher.
In the desktop space, the concern is that desktop PC growth is slowing as consumers are
increasingly opting for notebook systems (35% of PCs sold in 2Q06 were laptops, versus
31% in 2Q05). While we believe desktop demand will slow, we believe this slow down will
be somewhat offset by the growth in PVR/DVR devices, which have yet to reach market
saturation. In addition, we believe demand for high-definition TVs and PVR/DVRs that support
HD will see uptake in 2007, driving units and a positive mix to higher capacity drives. We
have adjusted our desktop HDD assumptions down to 8% growth in 2006 (from 9%), which
would make this the second worst year for desktop HDD drives (the worst year was 2001
when drives declined 1%). Our 2007 estimates are for desktop HDD unit growth of 12%,
helped by an uptick in CE demand.
Notebook market is still seeing aggressive pricing
Notebook (2.5-inch) has become the most aggressive market, with all 6 of the major HDD
vendors shipping drives into this segment. Our pricing checks of the distribution channel
suggest that notebook pricing has become more aggressive in 80GB drives, but that pricing
on 40GB and 60GB drives has improved modestly versus the June quarter (see Figure 3).
However, unlike the desktop market which does roughly 50% of its business through the
distribution channel, the majority of notebook drives are sold directly to PC OEMs, which
makes notebook pricing hard to gauge.
In the past, the only driver of 2.5-inch HDD units was notebook demand. However, as seen
in Figure 4 above, 2.5-inch HDD demand has begun to outstrip NB PC demand. In 1Q06 and
2Q06, 2.5-inch HDDs unit demand was 8.8M and 8.5M units higher than NB PC demand,
respectively. This market is beginning to see a benefit from consumer electronics (CE)
growth, with the biggest driver coming from gaming devices.
In C2Q06, Seagate shipped
2.2M drives to Microsoft’s Xbox 360, with Xbox units representing roughly 40% of 2.5-inch
CE units in C1H06. Providing further uptake of 2.5-inch HDDs to CE, in November, Sony will
launch PlayStation 3 (PS3) in the U.S. and Japan with plans to ship 2M units by year-end.
PS3 systems will include a 20GB or 60GB HDD as standard, unlike Xbox, which has an option
for an HDD. If Seagate splits shipments evenly with Samsung (who is also providing PS3
drives), the company could add another 1M 2.5-inch units in 2H06. As a result of strong CE
demand from gaming and the increasing use of 2.5-inch drives in other CE devices, we have
adjusted the CE component of our 2.5-inch estimates up to 174% Y/Y growth (from 157%).
Our current Seagate model does not include any PS3 units (see Figure 5).
Negative pre-announcements: Komag, Hitachi, and Innovex
This quarter we saw three negative pre-announcements in the HDD space, Komag, Hitachi,
and Innovex. We believe Komag and Innovex’s issues were company specific and do not
indicate an overall decline in HDD demand this quarter. We believe HDD suppliers are
struggling with the shifts going on in the HDD supply chain due to the Seagate-Maxtor
merger and technology shifts (from FSA to TSA, LMR to PMR, etc.).
Hitachi’s issues are different, however we believe the company’s announcement merely
mirrors what we have already heard about aggressive pricing in the June quarter, and to
some extent reflects Hitachi’s own issues with internally developed heads. In addition, we
believe Hitachi is struggling with yield issues on internally produced heads, and that the
company has not yet been able to reduce its operating costs, putting pressure on Hitachi’s
profitability. At the same time, Hitachi has lost share in the notebook segment, which it used
to dominate and has seen the 1.0-inch market disappear. As a result, we view Hitachi’s
announcement as already reflected in HDD share prices and would not extrapolate an overall
read on the HDD industry from Hitachi’s announcement.
Seagate
We expect Seagate to beat September Consensus estimates of revenue of $2,723M and
EPS of $0.17. We believe management gave very conservative guidance for the September
quarter in order to meet expectations, and that the company included some cushion to
account for unknowns around the Maxtor acquisition. Overly conservative assumptions
included a higher tax rate, no inclusion of stock option buybacks in the company’s share
assumptions, and a 7% ASP decline assumption for the next few quarters (reflecting the
declines seen in the June quarter). As discussed above, our checks suggest ASP declines
have been less aggressive this quarter than the June quarter. In addition, we believe there
could be upside to our gaming assumptions.
We expect Seagate to guide F2Q07 higher than current Street expectations (revenue of
$3.09B, EPS of $0.43), and we continue to believe Street expectations are too low. We have
adjusted our model modestly lower to include the impact of interest expense from the $1.5B
in debt issuances this quarter. Our revenue expectations for F2Q07 remain unchanged at
$3.04B, however our revised EPS is $0.46, down from our prior $0.54. For FY07, we have
revised our EPS to $1.85, from $1.95, reflecting the impact of higher interest expense. Our
model does not include any share buyback ($2.5B approved this year), which could provide
upside to our EPS expectations. In addition, our model excludes uptake of new PS3 gaming
devices, which could also provide upside to our expectations. Overall, we believe our
assumptions for gaming units could prove conservative.
(Please see our full models at the
end of this report.)
Debt issuance and buyback
In mid September, Seagate issued $1.5B in senior debt, in three tranches. The debt was
used to repurchase the company’s $400M in 8.0% senior notes.
We have included the
impact of the interest expense from these new notes in our revised EPS estimates. While
not explicitly stated, we believe Seagate also intends to use the remaining proceeds ($1.1B)
to help fund its $2.5B share buyback program. The company has not yet announced whether
it has bought back shares this quarter, but has indicated in the past that it plans to be
aggressive. We have not included buybacks in our model in order to be conservative,
therefore any buybacks would result in upside to our current EPS estimates.
Valuation
Our $28 price target implies that Seagate trades at 15x our revised FY07 EPS estimate of
$1.85. However, we believe CY07 EPS is a better indicating of Seagate’s earnings power
post the short-term dilution of the Maxtor acquisition. Based on our CY07 EPS of $2.69, STX
is currently trading at 8.6x, which is nearing trough multiples of 7x. Based on CY07 EPS, our
price target is a conservative 10.4x. Since its IPO, Seagate’s average FTM P/E has been 15x,
with a median P/E of 12x and a one standard deviation range of 7x-22x. We rate Seagate’s
shares a Buy.
Western Digital
We believe Western Digital is the stock to own into the end of the year, given current low
expectations, low valuations, and the potential for upside to results. For F1Q07, we expect
Western Digital’s results to beat Street expectations (revenue $1.16B and EPS of $0.41) and
our estimates are at the high end of management’s guidance range ($1,125-$1,175M and
EPS of $0.39-$0.43). We believe there could be upside to our estimates, as our model
assumes only 50bps of share gains in desktop this quarter, versus last quarter, which could
prove conservative. Since the Seagate-Maxtor merger was announced, Western Digital has
gained 1-2%pts of share each quarter. We expect management to give conservative
guidance, roughly in line with the Street (revenue of $1.28B and EPS of $0.52). (Please see
our full models at the end of this report.)
WDC is currently trading at 4-year trough levels
Western Digital’s shares are currently trading near trough levels, at just over 9x. Over the
past 4 years, the stock has bottomed at roughly the 9x level before rallying (see Figure 7).
We believe expectations for Western Digital are currently depressed due to concerns around
PC demand in front of Vista and aggressive pricing in the channel. Our checks suggest
demand has been relatively seasonal this quarter and that pricing has improved versus the
June quarter, particularly in 80GB and 40GB. In addition, any upside to CE expectations could
drive higher units and better mix.
The stock historically works in 4Q
Over the past 13 years, Western Digital’s shares have average a 28% return in the December
quarter. In addition, in 10 out of the past 13 years, WDC’s shares have rallied in the fourth
quarter, with the exceptions being 2003 (high channel inventories and Maxtor was pricing
aggressively), 2000 (bursting of the tech bubble), 1997 (areal density increases on the rise).
While we do not recommend investors buy Western Digital solely on historical trends, we do
believe that current valuations are depressed and that expectations are low. As a result, we
expect the shares to rally into the end of the year.
Delay of 10K filing adds uncertainty, but is not material to future results
On September 13, Western Digital announced that it would delay filing its 10K as a result of a
voluntary, company-initiated review of the company’s historical stock option grants. We view
the delay as a modest negative for the shares, however at this point we do not believe the
announcement will have any impact on current or future reported results. The dates in
question were for certain grants issued from FY99 to FY03, which puts the issue more than 3
years behind us.
Valuation
Our $24 price target implies Western Digital trades at its historical average forward P/E of
roughly 13x our FY07 EPS estimate of $1.80. Over the past 13 years, Western Digital’s
shares have traded at an average forward P/E of 13x, with a one standard deviation range of
4x-22x. In the past, HDD stocks have traded together with a P/E range of roughly 8x-20x.
We rate WDC a Buy.
Komag
We expect Komag’s results to be in line with the company’s September 6 pre-announcement
of revenue up 0-3% Q/Q ($234-$241M) and net margin of 14-16%. For F3Q06, we expect
revenue of $236M and EPS of $1.09, which implies Komag ships 37M units and has a net
margin of 15.5%. We expect management to guide F4Q06 in line with the Street (revenue
$253M, EPS of $1.20) and we have adjusted our estimates modestly lower. We now expect
Komag to ship 40M units (down from 41M), and expect revenue of $250M (down from
$257M). Our new EPS is $1.21 versus our prior $1.24. Our FY07 estimates remain
unchanged at revenue of $1.02B and EPS of $4.75. (Please see our full models at the end of
this report.)
Negative pre-announcement not a read on overall HDD industry health
On September 6, Komag filed an 8K, taking down revenue and net margin guidance. We
believe the unit shortfall was caused by three issues: (1) over ordering of media by HDD
manufacturers in 2Q due to concerns around media tightness, which pulled business out of
the September quarter and into the June quarter; (2) Komag’s over estimation of the
business it could win as a result of share shifts due to the Seagate-Maxtor merger; and (3)
desktop share gains by Samsung who does not buy media from Komag. We believe all of
these issues conspired against Komag in the September quarter, resulting in the pre-
announcement. We expect the component companies to see uncertain results over the next
few quarters as a result of share shifts due to the Seagate-Maxtor merger and as new
technologies (PMR and TSA+) are introduced. As a result, we prefer the HDD OEM’s
Seagate and Western Digital, to the component manufacturers.
Valuation
Komag currently trades at 7x our FY07 estimate of $4.75. This is at a discount to the
company’s 3-year median FTM P/E of 10x. At current levels, we believe the stock is fairly
valued, as we expect the shares to trade at a discount to historical multiples due to concerns
around overbuilding of media capacity, potential gross margin declines, and uncertainty
around the Seagate relationship. Our $39 price target assumes Komag trades at 7.5x our
FY07 EPS estimate of $4.75, which is at a discount to its historical median P/E of 10x.
Trough valuations for Komag are 6.4x. We rate Komag’s share a Hold.
Hutchinson Technology
We expect Hutchinson’s results to be in line with prior guidance of revenue of $170-$185M
and EPS of ($0.15) to $0.15. We expect Hutchinson to guide F1Q07 lower than the Street
(revenue $195M and EPS of $0.18) and our estimates ($199M and $0.20), as we believe that
estimates have not fully factored in share losses from the Maxtor business. We are
maintaining our FY07 estimates of revenue of $794M and EPS of $0.70, although we believe
our estimates will prove aggressive. (Please see our full models at the end of this report.)
Innovex pre-announcement
Innovex is a small (less than $100M market cap) maker of suspension assemblies. The
company’s only suspension product is an FSA suspension (the circuit is mechanically
attached later), and its only customer is Seagate. On September 25, Innovex negatively pre-
announced results. However, we would not read Innovex’s weakness as an indication of
problems with HDD or suspensions demand. FSA is a declining technology that all HDD and
head makers have moved away from, other than Seagate. As a result, we view Innovex’s
issues as driven by an industry transition of technologies (from FSA to TSA and CIS), and also
driven by Seagate’s shift to TSA and CIS suspensions as it ramps up its perpendicular
technology.
Valuation
Our $19 price target assumes Hutchinson trades at 1x our steady-state estimate for
Hutchinson’s book value of $19, which we believe is appropriate given the company’s
upcoming product transition and negative free cash flow. Over the past 13 years,
Hutchinson’s price-to-book has averaged 0.6-4.4x, with trough multiples reached during peak
areal density growth and declining component counts. We rate Hutchinson’s shares a Hold.
Risks
The hard disk drive sector is inherently volatile and subject to market share battles and
aggressive price declines. While we believe market fundamentals are currently in check, a
decline in overall demand could lead to aggressive tactics by any one of the HDD vendors.
Risks include an unfavorable supply/demand environment and failure to achieve competitive
time-to-market or time-to-volume.
Specific risks for Western Digital include miss-execution ramping PMR technology, an
inability to procure enough media to meet demand, and a decline in the desktop market.
Specific risks to Seagate include market share losses as a result of the announced Maxtor
merger, misexecution integrating the Maxtor acquisition, and miss-execution in ramping its
new PMR-based drives.
Specific risk to Komag include market share losses due to Seagate’s acquisition of Maxtor, an
inability to ramp PMR-based media, slower growth in the desktop market, and the loss of any
of its top 3 customers. Upside risks include continued high utilization rates, better than
expected gross margins, and further media constraints in 1H07.
Specific risks to Hutchinson include misexecution ramping its new TSA+, inability to improve
manufacturing yields, share losses due to the Maxtor acquisition and new technologies,
continued negative FCF; on the upside, faster transition to TSA+, limited transition of Maxtor
volumes to Magnecomp, return to positive free cash flow. |
