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A Tight Race As A Market Shrinks

Imagine a Formula One race with two cars lapping the rest of the field, but unable to put much distance between each other.

That's similar to the competition among companies selling hard-disk drives.

Two players, Seagate Technology (STX) and Western Digital (WDC), dominate the field, with a combined market share estimated at 80% to 85%. They make hard-disk drives, or HDDs, for desktop and notebook computers, enterprise applications and consumer electronics.

The two have spent the last year and a half battling back and forth for the top spot, while most of the other players have fallen by the wayside.

According to market researcher IHS iSuppli, Western Digital retook the lead from Seagate in worldwide HDD shipments during the June 2012 quarter. Western Digital continues to hold a slight edge, shipping 59.2 million hard drives during the December quarter vs. 58 million for Seagate.

Seagate had moved into the top spot in 2011 after flooding in Thailand hurt production at Western Digital's factory there. Seagate, which also has a plant in Thailand, fared better because its facility is located on higher ground than Western Digital's.

Although Western Digital has retaken control of the overall HDD market, Seagate still holds a lead in the higher-margin enterprise market, which caters to businesses.

But that landscape, too, appears set to change.

"While Seagate had a 48% share of the enterprise market last year, the introduction by Western Digital of its new helium (HDD) technology could catapult the manufacturer to the top at the end of 2013, dethroning Seagate in the process," IHS analyst Fang Zhang noted in a Feb. 6 report. Sealed drives filled with helium promise greater capacity and lower power consumption.

The HDD business used to have a handful of players. But that changed over the past 14 months after Seagate bought Samsung's HDD business for $1.4 billion and Western Digital acquired Hitachi's HDD business for about $4 billion.

The only other significant player of note, Toshiba, has about 10% of the global HDD market, says Jayson Noland, an analyst at Baird Equity Research.

With the playing field now dominated by two companies — and with fewer competitors involved in a price war for business — analysts expect to see prices move in a positive direction for Seagate and Western Digital.

"Given that just three manufacturers supply the world's total HDD demand, we believe recent industry consolidation may lead to a more rational pricing environment as Seagate and Western Digital both have more to lose than gain from aggressive pricing," Noland noted.

Last year, both Western Digital and Seagate updated long-term gross margin target ranges well above historical norms, he says. However, the companies will do battle in a slightly shrinking market as desktop and notebook computers continue to lose share to tablets, smartphones and solid-state drives (SSDs).

Fang estimates global HDD market revenue will fall to $32.6 billion this year from $36.7 billion last year. He expects HDD revenue to be flat for the next few years, with 2016 revenue of $32.9 billion.

From Servers To GPS Devices Hard-disk drive makers provide a number of different products with different applications and end markets.

Seagate's gear is used in everything from enterprise servers and mainframes to desktop and notebook computers, gaming consoles and digital media systems. The company also provides data storage services. Its main customers are original equipment manufacturers, distributors and retailers.

Western Digital mainly offers 3.5-inch and 2.5-inch hard drives used for performance enterprise and capacity enterprise, as well as solid-state drives for embedded applications. It also sells drives used in consumer electronics, entertainment and navigation systems, as well as external storage appliances. It sells the gear to computer manufacturers, resellers, retailers and other firms.

Both companies operate on a June-ended fiscal year. Both have also seen their financial fortunes improve over the last several quarters after watching sales and earnings decline in fiscal 2011.

During its fiscal second quarter, which ended in December, Seagate posted earnings of $1.38 a share, excluding special items. That was up 5% from the prior year and a nickel above Wall Street's forecasts. Revenue rose 15% to $3.67 billion, topping estimates for the first time in two quarters. It was Seagate's fifth straight quarter of double-digit percentage growth in revenue.

However, Seagate shares fell hard on a weaker-than-expected Q3 revenue forecast.

"Weak demand continues to be an albatross, although it's clear that constructive structural trends continue," Edward Parker, an analyst at Lazard Capital Markets, noted in a report on Seagate.

Western Digital reported fiscal Q2 earnings of $2.09 a share, excluding special items. That was up 38% from the prior year and well above estimates for $1.82 a share. Sales nearly doubled to $3.8 billion, also topping views. It was Western Digital's fourth straight quarter of double-digit sales growth. Western Digital forecast fiscal Q3 revenue in line with consensus.

"We think Western Digital has the better relative upside potential due to market share gain potential and cost takeout opportunities," noted JPMorgan analyst Mark Moskowitz, who has a neutral rating on Western Digital.

Both companies have gotten a good reception on Wall Street lately. Seagate's stock price hit a 10-year high of 37.94 on Jan. 23. Western Digital's stock reached a 15-1/2-year high of 49.50 on Jan. 28.

They are the two highest-rated stocks in IBD's Computer-Data Storage industry group, which overall has a weak ranking out of 197 groups, as well as many members with poor ratings. The other group members include data warehousing provider Teradata (TDC) and 2011 IPO Fusion-io (FIO), which has pioneered a new form of storage.

Reliant On Asia, HP And Dell Western Digital and Seagate are both global companies that draw more than half of their sales from the Asia-Pacific region, mainly selling to OEMs there.

In fiscal year 2012, which ended in June, Western Digital got 58% of its revenue from Asia-Pacific, 23% from the Americas, and 19% from Europe, the Middle East and Africa. No one client accounted for more than 10% of sales.

Seagate drew 55% of its revenue from Asia-Pacific in fiscal 2012, 26% from the Americas and 19% from EMEA. Key clients included Dell (DELL), with 15% of revenue and Hewlett-Packard (HPQ), with 13%.

The global market size for HDDs is expected to be in the $32 billion range for the next few years, according to IHS estimates. In terms of units, Western Digital sees a total addressable market of 275 million units industrywide for the first half of calendar year 2013.

"Management expects increased demand in the second half of calendar year 2013 given lean inventory levels, an improving economy, and more innovation in the PC market," analyst Noland noted.

Profit Declines Expected Most industry watchers see flat to declining HDD sales this year, partly offset by price increases. As always, a lot depends on how economies in key markets perform.

"If end demand conditions improve, then the stage could be set for upward revisions to HDD estimates," JPMorgan's Moskowitz noted. "The key hurdle will be whether one or more HDD vendors elect to make a market share grab, disrupting pricing conditions.

Neither Seagate nor Western Digital is likely to see much profit growth in coming years as the companies bump up against a flat-lining market and tougher year-over-year comparisons.

Analysts polled by Thomson Reuters expect Seagate to post a 23% decline in EPS this fiscal year. The company's earnings are seen rising 6% in fiscal 2014 and remaining flat the following year.

Analysts expect Western Digital to post EPS declines of 7% this fiscal year, 1% in fiscal 2014 and 7% in fiscal 2015.

Those consensus projections notwithstanding, some industry watchers still see positive trends.

"Despite ongoing signs of weakening demand and the receding of peak margins, we believe consolidation and the aftermath of the floods have changed the pricing dynamics of the industry," Parker noted. "We see this ultimately leading to higher and more consistent levels of profitability, driving multiple expansion for both stocks."