Seeking Alpha
Long/short equity, research analyst, tech, IT channel checks
Profile| Send Message|
( followers)  

Get ready for a deluge of earnings warnings.

This week, the tragic flooding in Thailand became a headline item in the world of technology. As I write this, hundreds have died, 14,000 factories are shuttered, and an area the size Connecticut is submerged. Making matters worse, in Bangkok scattered showers are forecast for most of the coming week.

Hard drive maker Western Digital (NASDAQ:WDC) became one of the poster children of the disaster when it lowered Q4 expectations, from Wall Street’s expectation of $2.6B in revenue to a range of $1.05-1.25B. (That is not a typo.) WDC’s revenue will likely be 50% of what was expected just a week ago. The situation does not figure to get better anytime soon. Many companies operating in the region, including Honda (NYSE:HMC) and Fabrinet (NYSE:FN) came out over the weekend and stated that operations will be suspended at least through year-end. The read-through is that the operations of most every company in the region will be stalled through year-end.

In addition to flood levels, which have not improved meaningfully, the country's utilities and transportation infrastructure is severly hobbled. Even when the water recedes enough for workers to get to work (6 weeks, according to current government estimates), people won't have a means of getting there, because most vehicles have been rendered unusable.

As it relates to Western Digital, the impact reaches far beyond the hard disk drive industry. In fact, my company (Pipeline Data, LLC) forecasts that the implications will be very damaging for most of the tech sector. Before I explain, let’s start with the basics.

According to WDC, 170 million HDDs will be needed to fulfill worldwide demand in Q4; Seagate (NASDAQ:STX) believes the number is 180 million. Yet, based on Pipeline Data’s latest estimate, only 110 million will be available. This is because many of the world’s HDD component makers are located in flooded regions. In other words, even Seagate, whose facilities were not flooded, will not be able to procure enough parts to make all the HDDs it could under normal circumstances. The company confirmed this on its call, saying that it will only produce 40-50 million HDDs in Q1, much lower than its 60 million capacity.

As a result, any company that requires hard drives or sells hard drive components should be preparing to suffer a significant shortage in production, orders, or both. In most cases, this will translate into a significant reduction in revenue. Unfortunately, we believe that the impact on Q1 is likely to be even worse than Q4.

The reason is simple. First of all, we are already three weeks into Q4. More importantly, WDC and STX have already stated that floods will hurt production for several quarters. What they didn’t say is that several weeks of HDDs and components supplies existed in the supply chain and inventory prior to this disaster. In aggregate, this is perhaps enough to cover half of this quarter’s 170-180 million unit demand. In addition, the supply of components from outside of Thailand will enable several more weeks of production. All of this feeds into our 110 million unit projection for Q4 and triangulates well with guidance provided by WDC and STX.

Here’s the problem. As we enter Q1, the inventory of HDDs and flood-affected components will be gone. Virtually 100% of the industry’s HDD supply hinge on the weakest link in the chain – the component in shortest supply. At this point, the #1 candidate is hard drive motors. 70-80% of the world’s supply is made by Nidec, which has been crippled by the floods and does not carry inventory in its distribution channel. The company is scrambling to divert production to its locations in other countries, but that will likely take too long to save Q1. This poses severe consequences for most of the tech sector, including:

  • Large computer and storage vendors, like Apple (NASDAQ:AAPL), Dell (NASDAQ:DELL), EMC (NYSE:EMC), Hewlett-Packard (NYSE:HPQ), IBM (NYSE:IBM), and NetApp (NASDAQ:NTAP). Apple admitted as much on its conference call.
  • Other companies that use HDDs in their products, like Oracle (NYSE:ORCL) and Tivo (NASDAQ:TIVO). Making matters worse, every vendor I have mentioned will have to pay significantly higher prices for the HDDs they can acquire. Thus, the impact on profit margins could be even worse than the impact on revenues.
  • Companies whose components go into or connect to Storage products, like Emulex (NYSE:ELX), Hutchinson (NASDAQ:HTCH) and Marvell (MVRL). These vendors face the opposite issue. There will be too much supply of their components, leading to aggressive price cuts. They will sell significantly fewer units and earn significantly less per unit.

This will also have an impact on other tech giants like Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT), because lower production of PCs and laptops also means lower sales of INTC’s chips and MSFT’s software. Similarly, numerous other software vendors will be affected, especially those with applications that rely heavily on storage.

To provide an idea of what is going on at the flooded companies, I acquired some photos of a facility in Aytthaya, Thailand. The facility is used by a company called Kumi Thailand to make molded plastic auto components. According to most reports I have gathered, these photos are fairly indicative of what has occurred at hundreds of facilities in Thailand’s affected areas.

The commentary that came with these photos was as follows:

All machinery that was powered up at the time the water had risen to the electrical control box is now useless. The longer that water sits, the more it will damage the equipment, to a point it cannot be repaired and will need to be replaced.

This is what they are dealing with -- three and a half feet of water (and rising as of the time the photos were shot). Nobody can say how long it will take for the waters to recede, but even when they do, it’ll will require a Herculean effort to clean out the mud, debris, and waterlogged items (everything on the first floor of every building). From there, the facilities will have to be thoroughly dried. In addition, the facilities will likely have to be tested for structural damage.

The impact may be unprecedented, but it wouldn’t be the first time that companies have been hit with a multi-quarter supply shortage. In fact, earlier this year (March), Japan’s tsunami wiped out much of the supply of a critical component for fiber optic cable. The impact of that is still being felt by most fiber-optic equipment vendors -- more than seven months after that tragedy. The latest proof point came on the Calix (NYSE:CALX) earnings call last Thursday, where management cited fiber cable supply as a factor in its disappointing results. Its shares have fallen from a 52-week high of $22.97 in May to a 52-week low of $6.39 on Friday.

Of course, non-Thailand production will step up to a degree, as Thailand's production will not. The damaged equipment and facilities will not be easily replaced. As one contact put it, “to manufacture certain pieces of automation for HDD manufacturing has a start to finish to delivery cycle time of about 10-14 months (assuming the company making the machine has no backlog).”

Even the perceived winners could be losers. This week, investors looked at Intevac (NASDAQ:IVAC) and Xyratex (NASDAQ:XRTX) as big winners. We would agree that XRTX’s testing-equipment business will reap a windfall, since testing machines were present in the flooded areas. However, XRTX requires a large supply of HDDs for its storage systems business. Testing-equipment revenues won’t come for several months, but its systems business is immediately impacted (and will likely remain impacted at least through the spring).

As for IVAC, its machines enable the production of HDD media (the actual disks inside the HDDs). However, much of the world’s media production is concentrated in Malaysia and Singapore. Thus, the flood may actually prove to be a negative for the company.

The Bottom Line: Tragedies like this are never timely, but this one comes at a particularly bad time. Technology companies are gearing up for the critical end-of-year push. A decline in HDD supply threatens to spoil the sector’s bread-and-butter quarter. This comes amid rising economic uncertainty. ECRI’s proprietary leading indicators have turned negative. For those unfamiliar with ECRI, it has a sterling reputation for accuracy in this regard.

Prior to this, in an early-August report, Pipeline Data warned its clients that our own proprietary technology-purchasing leading indicators had turned negative. As a result, we were already of the belief that the tech sector was at high risk of posting sub-par Q1 results.

Based on our latest accumulated data, we believe that possibility has now become a near certainty.

Source: Thailand Flooding Will Ravage Tech Earnings Into 2012