Investment Opinion from MF
>>>Disk drive investors who thought they might catch a break today were disappointed. A profit warning from Read-Rite (Nasdaq: RDRT), an all-out mashing of Read-Rite competitor Applied Magnetics (NYSE: APM) in Barron's, a product transition at IBM (NYSE: IBM), and a whole mess of downgrades from analysts on Western Digital (NYSE: WDC) and Seagate (NYSE: SEG) gave investors an overall down day for the entire cluster of drive and drive-component makers. Investors struggled to digest the sudden overflow of information, rooting through all of the contradictory information spewing out of the business media.
Investors involved in the industry have gotten a sudden, nasty lesson about deflationary economics. Understanding a business where prices for components and end products are supposed to fall rapidly -- and not always in tandem -- is a challenge. Assessing the available public information and developing a working model for how the future might play out given the past and similar situations in related industries is what investors should focus on right now. For those who slacked on their homework on the way in, it is time to break out the textbooks and pull an all-nighter.
Back in early October, Western Digital blamed lower-than-expected first quarter results on the fact that Seagate was dumping excess drives at cut-rate prices. Although both Western Digital and Seagate reduced production plans to account for the oversupply, Fujitsu has apparently jointed the price-cutting party. Potentially as a result of the recent monetary crisis in Southeast Asia, potentially as a part of its plan to increase worldwide market share to 7.6% from 5.2% in calendar 1996, Fujitsu is flooding the "grey" market with drives priced at levels Western Digital Chairman Chuck Haggarty said looked close to cost.
The sudden, unexpected fall in drive prices has forced Western Digital to transition faster than expected to magnetoresistive (MR) heads from thin-film inductive heads. This means Western Digital's main supplier of drive heads, Read-Rite, has to do the same. Although in hindsight many are accusing both companies of being behind the technology curve, it is really this sudden price drop that upset the apple cart. If a PC manufacturer could get the same or better price performance out of a thin-film inductive head because of higher yields and precision production, there was no real advantage to one over the other. With prices rapidly falling, thin-film inductive has lost any cost-efficiency almost overnight.
Unfortunately for Western Digital, Quantum (Nasdaq: QNTM) has already bought a good deal of the existing worldwide capacity for MR heads from TDK and Yamaha. With Read-Rite having difficulties in the transition and Applied Magnetics even farther behind, Western Digital's reliance on outside suppliers as opposed to the vertically-integrated, make-it-yourself models used by Seagate and IBM is now unfortunately going against it. As prices drop and make thin-film inductive less appealing on a cost-basis, without a firm supply Western Digital has become the odd man out in the drive industry.
All this bad news prompted a number of analyst downgrades on Western Digital. Needham & Co., Hambrecht & Quist, and Salomon Brothers all downgraded Western Digital's stock to "hold" from "buy," and Robertson Stephens cut its rating to "market perform" from long-term "attractive." All cited the renewed risk in the MR ramp-up due to the recent price declines as a major factor, cutting '98 earnings estimates to anywhere between $1.75 to $2.20 EPS. Read-Rite also got nailed as analysts assumed Western Digital would clamp down on the company's pricing. The accelerated move to MR also had Applied Magnetics downgraded by Salomon analyst John Dean.
The reason Quantum has not dropped as much as Western Digital and Seagate is because some believe the company could gain market share as a result of the turmoil. With an MR head supply firmed up, it has a temporary competitive advantage. Others point to the product mix, saying Quantum gets a larger percentage of its profits from the tape business. However, profits may not be the best way to look at this, because if Quantum takes a dive on its currently profitless business on the high-end, it could eat away profits from other product categories. With Western Digital forecasting a unit volume between 7.3 million to 7.5 million for the quarter, if it makes it target it should be able to retain its number two position.
Proving that any temporary turmoil brings the marginal opinions out of the woodwork, ex-Gruntal analyst Roxanne Googin took today as an opportunity to make a name for herself, doing an interview on the new CBS MarketWatch website. Dropped from Gruntal after sustained bearishness on basically everything she covered, Googin alleged all of Western Digital's woes could be traced back to the popularity of the sub-$1000 personal computer. "So what's happening really is that the PC does not have enough new innovations on it to support continued price performance in the components," Googin quipped, suggesting that the 2.1 gigabytes on low-end platters is sufficient for this emerging class of PCs. Googin neglected to explain why smaller drives on the desktop would not translate into larger storage capacity on the server-end, or how this view of the world fit with her May bearishness on high-end drives while she was still at Gruntal.
Further confusing today's story was IBM's launch of its giant MR technology, under development for the last three years. Giant MR (GMR) heads will go into drives that can store between 3.2 to 16.8 gigabytes of information. The "giant" is not because the heads are bigger, but because their areal densities are much higher. According to Dow Jones, these drives will have a list price of 5.3 cents per megabyte. This compares well with the existing price per megabyte, although the total price will obviously be more than double what users are paying right now. Although people are nervous about a new jump in head technology given that the last one has gone so poorly, IBM will certainly cross-license its patents to Read-Rite and Applied Magnetics. Ironically, if there were a jump to GMR it would actually give Western Digital a chance to jump ahead of Quantum and Seagate, as both are already pretty committed to MR.
In summation, the real question here is how fast head and media prices will fall on the desktop. Both drive prices and drive component prices fall at a pretty fast rate. Right now we have a situation where drive prices have fallen faster than component prices, putting pressure on gross margins at the drive makers. However, Komag (Nasdaq: KMAG) has too much capacity on the media side and Read-Rite and Applied are under pressure from their customers. Odds are, component prices will quickly follow drive prices after a lag, allowing all of the outsourcing oriented drive manufacturers like Western Digital and Quantum to regain equilibrium. As for the risk from Net PCs, any share lost on the desktop will probably come right back on the enterprise side. Rather than panicking over falling prices, investors need to understand which operating models capture the benefits of falling prices most quickly. The prices falling are inevitable -- it is just a matter of figuring out who is best prepared. |
