The Hard Drive Commodity Trap

by: Dana Blankenhorn

Not all tech earnings are created equal.

Most big company tech stocks hover in the mid-teens, in terms of multiples. Microsoft (NASDAQ:MSFT) is at the low end of the range, Google (NASDAQ:GOOG) at the high end, Apple (NASDAQ:AAPL) in the middle.

All of these companies are relatively volatile, widely held and easily traded. They rise-and-fall with the market, with the general consensus, with their earnings, but the PE multiples are stable, because that's how people feel about the companies' prospects. We understand the cloud is a differentiator, so Google's influence in that area is seen as deserving a premium. Argue about that all you want - the relative valuations of all three have remained fairly stable.

And this is the key to all tech analysis. It's our view of a company's technology that determine what we will pay for its earnings. Thus there are some companies that have the PE ratios of auto companies. They make money, sometimes they look about to grow, but they can't get respect from the market.

Two of these discussed last week are Seagate (NASDAQ:STX) and Western Digital (NYSE:WDC). Both make hard disk drives, those spinning aluminum disk systems that are the best way yet found to save a whole lot of data in very little space.

WDC trades at a PE of just 9, STX at a Ford-like 7.

I say Ford-like for Seagate because their recent results seem to mirror those of Ford. Right now life looks very good, but the company was marginally profitable just a few years ago. Its most recent quarter shows margins of 25%, although it lost of ton of money in 2009.

Things are fairly similar at WDC. Last quarter was an exception, but margins are generally a little short of 10%. Still, revenue is up over 20% from 2010's levels, the balance sheet is rich in cash, there's hardly any debt.

What gives?

One big problem, as I noted last week, is that hard drives are being pushed out of the consumer market. Devices like the iPad and Ultrabooks don't use hard drives, relying on chips for both short-term and long-term storage.

This doesn't mean demand for hard disks is going away. Clouds love hard drives. But here the drives go into expensive sub-systems from companies like EMC (EMC). They are bought in bulk, at thin margin, and it's the OEM who makes the big money.

Unfair, cry the hard drive bulls. Well, life is unfair. Businesses purchasing raw materials for larger products sold to other businesses tend to drive harder bargains than anyone involved in the consumer market.

Sure, there is a chance that hard drives could make their way into home servers, that demand might move there. But until it does, decisively, until home servers become similar to PCs in market size and news visibility, hard drives will remain a commodity.

And the companies make them will be priced like car companies.

Disclosure: I am long MSFT, GOOG, AAPL.