PC Hardware and Data Storage: Highlights from Asia Visit (LEHMAN 03/11/98 )*********************************************
During our recent trip to Asia, we visited with product and management team members from the following companies: Western Digital, Maxtor, Seagate, Read Rite, Iomega and Dell.
* As expected, drive pricing remains aggressive but distrib. inventory levels are gradually improving. The competitive environment favors Maxtor, IBM and Fujitsu. Seagate and WD remain the primary share losers.
* We learned of recent production problems with WD's 2.1GB drive which apparently led several OEMs to stop shipment of the drives for 2-3 weeks.
* We believe the inventory correction has yet to impact the drive companies and that as PC OEMs reduce channel inventory levels and slow build plans, drive demand will slow.
* Dell continues to gain share in Asia as the company's competitive advantage continues to widen. And despite a weakened macro environment, we believe Dell will post strong gains in this region.
Asia Trip Highlights We recently attended the IDEMA Data Storage Conference in Singapore and subsequently met with management and product team members from various data storage companies throughout Singapore and Malaysia. Our company visits included the following: Maxtor, Western Digital, Seagate, Iomega, Read Rite and Dell.
General Storage Themes We believe there has been limited fundamental improvements in the HDD industry. Drive demand/supply remain out of balance and pricing continues to be aggressive. Normalized price declines are approximately 6-9% per quarter. Over the past 2 quarter, however, prices have been falling at 13-16%. We expect price erosion in the March quarter will be in the low double-digits.
Positively, distribution channel inventory levels for select OEMs have started to decline. However, inventory levels at drive OEMs remain at higher than normalized levels with most drive companies holding 30-50 days vs. 20-30 days of normal supply.
Further, we believe the inventory correction has yet to impact the drive companies or their respective component suppliers. For example, Compaq's recent pre-announcement and associated build plan reduction is one example of the industry inventory correction we expect will occur for major indirect PC OEMs over the next 2 quarters. IBM, Compaq and HP collectively control approx. 30% of the PC market. We believe these players, in particular, will likely slow build plans into the first half of 98 to prepare for channel assembly/BTO roll-outs. We expect order rates into the drive and component companies will correspondingly slow as PC channel inventories clear through.
The drive companies collectively addressed the need for supply chain re-engineering to respond to the PC companies channel re-engineering. In the interim, we believe inventory is simply being shifted back onto the drive companies and into the channel in what has been more or less of an inventory shell game. The long-term objective remains to successfully reduce aggregate inventory throughout the pipeline - from the channel to the component suppliers. Such re-engineering is only now just beginning.
Lastly, we believe successful drive suppliers will need to find a way to profitably sell into the sub-$1,000 PC market. Drive companies acknowledged this industry shift and the need to address it. Currently, excess inventory is being sold into these markets. Long-term, drive companies need to redesign product to profitably address this space. We believe Quantum is currently the best positioned with its 5.25 BigFoot drive.
In addition, we believe that as corporations demand cheaper desktops with less local storage, storage demand will shift from the client to the network. As a result, drive successful drive companies will need to address the enterprise drive market. We believe Seagate, IBM and Fujitsu are currently best positioned. Emerging players include WD and Quantum.
Western Digital Enterprise drive demand remains strong with WD continuing to make strong penetration in OEM accounts. Margins have remained relatively healthy in this segment at an estimated 24%. We are projecting March enterprise drive revenues of $107 million or 12% of total revenue.
WD continues to accelerate its MR transition and expects its mix to be 50% MR by the March quarter. We believe that key OEM customers were slower to qualify WD's MR desktop offerings due to caution surrounding WD's 1st MR product launch. We believe Maxtor has gained significant share at several of WD's key OEM accounts including Compaq, Dell and IBM as a result.
While initial yields on the 2.1 GB product had been tracking strongly, we believe WD has recently experienced production problems on its 2.1GB program which led to shipments to be stopped into several key OEMs. We believe these problems are temporary, and WD has been addressing the problem. Still, we believe such difficulties may lead to additional weakness in Q3 shipments. We are currently modeling 5.2 million desktop drives will be shipped in the March quarter.
Seagate
Seagate embraced the need for supply chain re-engineering. In our meeting with both Seagate's recording media and drive operations, SEG discussed the improvements in integration and communication between the two groups which have led to inventory management improvements shortening the inventory pipeline. Still, the process is just beginning.
To reduce costs within its drive operations, SEG discussed a trend towards increased automation. On its assembly lines at its AMK facility, SEG is in the process of reducing the number of employees per line from 20 to 6 through automating certain operations.
Maxtor Consistent with other recent checks, Maxtor continues to gain strong share. Unlike its peers, the company is rapidly ramping production and expects sequential growth in the March quarter. We expect the company will ship 3.4- 3.5MM drives in the March quarter vs. 3.2MM in December.
The 2.8GB has shifted production from the pilot line in Colorado to Singapore. Initial yields are already strong at 80-85%. Management expects a strong ramp of the 2.8GB will lead to 2.8 GB drive shipments in the June quarter in excess of 1.4MM.
Current production capacity remains at 4MM drive/quarter but management believes it can expand existing plant capacity to between 5-6MM drives/quarter. In addition, the company has begun construction on its China facility which will have the capacity to ship 5MM drives/quarter.
Strong OEM share gains continue as the company maintains its leading technology position on the desktop. Quality has also significantly improved with IBM and Dell naming the company their top quality drive supplier.
Pricing trends remain aggressive, and the company expects 10% price erosion in the March quarter.
DELL We also visited Dell's Penang operation which serves as the central sales, service and production facility for all of Dell's Asia operations. Dell currently generates $259 million or 7% of sales from this region. In its most recent quarter, sales from Dell Asia increased 79% vs. Dell's peers which generally saw lackluster growth.
We believe there are several reasons why Dell is gaining strong share and posting strong growth in this environment while others note weakness.
First, like its major PC counterparts, Dell engages in an active hedging program. And while Dell's competitors are hedged, most of the indirect PC vendors' resellers, distributors and retailer partners are not. As a result, as currency devalues, many channel players - which resell indirect PC vendors product are forced to raise prices to cover costs reducing their competitiveness vs. the Dell model. Dell has gained share in this environment by being able to hold prices firm even in a challenging economic/currency environment.
Second, the economic/currency crisis has caused many resellers to go out of business or experience significant financial hurdles. Indirect PC vendors are being forced to deal with the weakened state of their reseller partners by extending credit terms, taking inventory and bearing more of the financial risk. We believe these factors are providing Dell with an advantage in the A/P marketplace and will likely lead to further share gain.
Investment Recommendation Stock prices for the drive companies increased as much as 20% over the last month as investors started to build positions on an anticipated industry recovery. We maintained that it was still too early in the cycle and that no fundamental improvement had occurred. Now, drive stocks have given back most of their recent gains. We continue to believe that it is still too early to re-invest in this sector.
First, the pure, investable names (the Big 3 Quantum, WD and SEG) are generally losing share to other players including IBM, Fujitsu and Maxtor. And with technology leadership increasingly moving towards the non Big 3 drive companies, we expect such share shift will continue.
In addition, we believe the drive and component suppliers have yet to experience the impact from the channel re-engineering which has just begun for the PC companies. We expect order rates will slow as PC companies slow build plans over the next 2 quarters.
We continue to believe Dell is tracking ahead of plan and that the inventory clearing of older PC product by indirect PC vendors will not impact Dell's profitability. With component costs continuing to decline and Dell's low level of inventory days, we believe Dell remains best positioned to leverage falling component costs. We would use any weakness in the shares as a buying opportunity for Dell shares.
DELL (DELL, rated 2, $65 3/16) Western Digital (WDC, rated 3, $16 3/16) Quantum (QNTM, rated 3, $20 7/8) Seagate (SEG, rated 3 $21 5/8) |
