By now, most technology investors are aware of the tragic floods that have hobbled Thailand. The impact on its populace cannot be underestimated. Similarly, the impact on global hard disk drive (HDD) supply is unpreceded.
In fact, the fallout runs so deep that most investors still haven’t fully grasped the implications.
Seagate Technologies (STX), however, seems acutely aware of them.
Since October 4, shares of STX have nearly doubled from less than 10 to nearly 20. That’s an impressive run, but a move above 30 appears to be in the making. Last week, Seagate CEO Steve Luczo presented at the Needham investor conference. There, he spoke graciously of his largest rival, Western Digital (WDC). However, he didn’t stop short of hinting that the competitive landscape has been changed for years to come.
The reason? Mr. Luczo suggests that some of WDC’s most critical equipment was damaged beyond repair. According to several sources, much of WDC’s sensitive machinery was located on the ground floor of a building that was inundated with over three feet of water. It has been widely reported that this water has since turned toxic due to an unsavory mix of chemicals, sewage, and organisms.
The waterlogged equipment is responsible for producing most of WDC’s worldwide supply of “sliders”. Suffice it to say that sliders are a necessary component in HDDs. Without them, an HDD can’t function. Before the flooding began, WDC’s Thailand operations produced 25% of the world’s sliders – roughly 75% of WDC’s personal supply.
WDC produces a small quantity of sliders in the Philippines. It also purchases some sliders from TDK, the Japanese electronics giant. However, these sources are only enough for WDC to produce about 15 million HDDs per quarter. That’s just one-fourth of normal production.
Even a 20% increase in HDD prices will leave WDC with less than $1B in quarterly revenue, far below Wall Street’s already-lowered estimates. As a capital-intensive company, the impact on WDC’s EPS will be even more dramatic, moving from large profits to large losses.
At present, many investors are only looking at this as a Q4 / Q1 event. However, based on the lead-times required to obtain new equipment, shore up its facilities, and ramp production, WDC may not be whole until the end of next year. Further, keep in mind that next year’s monsoon season could produce a repeat of this year’s disaster. Rain is obviously the root cause, but the horrific flooding was a direct result of all the roads and buildings that have been recently erected over land that once soaked up the rains. In other words, WDC can’t just dry out its facility and go back to business as usual. In fact, it may have to start from scratch.
Meanwhile, STX’s facilities and partner-channel are relatively unscathed. Because of this, the company is setting itself up to take long-term advantage of the situation. This runs counter to the view of analysts who believe WDC will quickly rebound and regain share. In reality, that will prove difficult, since STX is now signing the industry’s most important customers to multi-year supply agreements. Its value proposition is simple -- Seagate can provide them with a quantity of drives that WDC cannot. If you want those drives, you have to commit to STX as your primary supplier for the next several years.
The scenarios described above have been confirmed by data points gathered by my company, Pipeline Data. They have also been confirmed via commentary from Mr. Luczo’s presentation, along with information recently gleaned from equipment suppliers like Intevac (IVAC), Xyratex (XRTX), and Veeco Instruments (VECO).
Running the numbers, we see STX gaining significant market share and maintaining much of it even after WDC is back to full capacity. The longer-term problem for WDC is that its competitors are increasing their manufacturing capacity to narrow the supply/demand gap (which currently stands at 20 million HDDs per month). Once WDC finally comes back online, its rejuvenated capacity will soon result in a glut of HDD production. Thus the supply/demand equation will reverse, leading to steep price declines and heightened competition. For STX, this won’t be a big problem -- it will still have many large customers signed to longer-term agreements. As for WDC, it will likely find itself fighting to sell too many HDDs to too few customers. In other words, its pricing and profits will suffer.
Only a few Wall Street analysts understand this situation correctly. If you look at the current estimates for STX and WDC, you’ll find a wide gap between the optimistic estimates and the pessimistic ones.
For STX, our numbers exceed even the most optimistic Wall Street estimates, which call for $3.50 in EPS for the year ending June 2012 and $5.84 for the year ending June 2013. Conversely, our estimates for WDC are closer to the lowest Wall Street numbers, which call for a $3.27 loss in the year ending June 2012 and a profit of $0.54 for the year ending June 2013.
You wouldn’t know it from their respective stock prices. WDC is currently trading in the mid-20s, which is a P/E of 50 based on the low estimate for 2013. Meanwhile, STX is still trading in the teens, with a 2013 P/E of just 3. Indeed, it would seem more appropriate if their stock prices were flip-flopped. That would better reflect the flip-flop that appears to be underway in the long-term competitive landscape.
For that reason, we believe that shares of STX are poised to triple from its recent lows.
Additional disclosure: I am also short shares of WDC.