I recently wrote a column on the froth in the technology sector, highlighting 3 tech stocks to sell and 2 tech stocks to buy. The winners? Apple (NASDAQ:AAPL) and medical software stock Cerner (NASDAQ:CERN). The losers? Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT) and Seagate (NASDAQ:STX).
As usual, a number of readers dropped me a line to disagree — but one tech expert made such a strong case in favor of Seagate that I thought it was worth revisiting and giving the other side of the story.
Mark Miller is a senior research analyst at Noble Financial Capital Markets and has more than a decade of experience covering the disk drive business, including companies like Seagate, Western Digital (NYSE:WDC) and Veeco (NASDAQ:VECO), among others. And he says popular perceptions about the move away from solid state drives to flash technology are overblown — and that disk drive stocks have been unfairly punished for flooding last year that affected operations.
I caught up with Mark to get more details on some of the reasons he is bullish on the disk drive sector generally, and the reasons that Noble Financial has a buy on STX and $35 target price:
Q: You contend that disk drives are far from a fading technology, and that there’s still a growing market. What are the most telling stats you think investors should know about these companies or this sector?
A: The demand for storage is growing at annual rate of 40%, and market research firm IDC just projected a compounded annual growth rate of 9% for drive sales from 2011-16. Flash memory only comprises about 5% of total mass storage requirements this year. While the amount of flash-based storage will grow, with 40% growth in required storage, the flash manufacturers can’t add fab capacity fast enough to take significant share from hard drives.
Q: In the short term, a lot of folks seam bearish about drive stocks simply due to seasonality. You don’t buy that argument. Why?
A: Seasonality simply doesn’t apply. Typically, the June quarter is seasonally weak and investors lose interest in the stocks. Because shipments are scaling back up from recent floods in Thailand, the drive industry is expected to post sequentially stronger results for the June quarter. We don’t see a return to normal conditions until the September quarter. Due to the flood, we estimate by the end of this year there will be cumulative unmet demand of 135-150 million units. With drive demand averaging 170-175 million units a quarter versus an estimated industry capacity of 190-195 million units by the end of this year, it will be well into 2013 before things are finally balanced.
Q: In the longer term, many are convinced that flash memory and cloud storage will steadily supplant hard drives. Without getting too technical, what are the practical drawbacks preventing this from happening anytime soon?
A: Flash will have a place, but until costs come down it will still be niche technology. The current storage capacity in a laptop drive is 500 GB. The Intel 600 GB solid-state drive (SSD) is selling for over $1,000, which is about three times the cost of a low-end laptop PC. Market studies show that tablets, which typically contain just 64 GB or less of NAND flash storage, are only cannibalizing about 20% of potential drive sales. So for 80 million tablet shipments, that comes to 16 million lost drive sales — or about 2% of total projected drive shipments for this year. To reduce storage costs for SSDs, you need to go to multilayer-cell (MLC) NAND flash, but MLC NAND flash has far worse data reliability issues than the more expensive single-layer-cell (SLC) flash. So you either use expensive SLC NAND flash or run the risk of using MLC flash.
Q: If there’s no immediate risk of obsolescence, do you think solid state drives will eventually become obsolete in the next few decades — or will they be around until 2099?
A: Both solid-state and hard drives will coexist for the foreseeable future, with hard drives still comprising a dominant share of high-capacity storage applications. I think for mass-storage applications, the industry will move to hybrid drives, which employ flash in conjunction with a hard drive. In order to meet the $600 price point consumers expect for computers, I expect hybrid drives will be the primary storage device in ultrabooks. Due to their significantly higher input/output capabilities, which mitigates the cost disadvantage, I see the biggest opportunity for SSDs being certain enterprise storage applications.
Q: You call drive stocks the “Rodney Dangerfields” of the tech space. What are a few unsung stocks you think investors should take a closer look at for their portfolios, and why?
A: Investors are being too paranoid about the effects of the flood. They are missing the power of the recent consolidation moves in the industry, and growing worldwide demand for storage. We modeled both Seagate and Western Digital after their respective mergers — with pre-flood drive ASPs and margins — and came up with a post-recovery earnings range of $5.75 to $6.60, sans flood effects. Historically, these stocks trade in a forward P/E range of 7 to 11. Not only are they cheap, but we have them generating impressive free cash flows over the next two years — $5 to $6 billion — which can be used to buy back shares or pay a higher dividend. We also believe drive suspension supplier Hutchinson Technology (NASDAQ:HTCH) is on the verge of a major turnaround.
Editor’s Note: HTCH is a microcap stock that trades on very thin volume, and a very aggressive stock. Do not consider a trade for any equity of this nature without using a limit order to protect your entry price.
Q: Even if your logic is sound on the strength of the drive industry and these individual stocks, do you have fears that, generally speaking, we are seeing a lot of overbought tech stocks? Should investors wait for a pullback, or do you think now is the time to get in despite dramatic run-ups in the last few weeks?
A: Certainly with STX trading at a P/E of 3.1 on FY13 consensus numbers and WDC at a P/E of 4.8, we don’t see either as overextended. Even with the post-flood recovery, estimates sans flood effects, the stocks are still cheap. Yes, STX is up from high single digits in October, but that low valuation was far more irrational than today’s price. We are projecting upside in the March reports for both Seagate and Western Digital. We also see several upside factors for STX longer-term, including the ramp of eight, new lower-cost products, reduced warranty costs which cut into this quarter, the internal supply of heads and media to Samsung drives which improves gross profits by $4 per drive, the hybrid drive opportunity and the improving macroeconomic picture.
Q: Any final thoughts to share that we haven’t covered?
A: Investors need to look beyond the flood and understand the long-term benefits of the recent industry consolidation moves in conjunction with the world’s ever-growing appetite for storage.
Jeff Reeves is the editor of InvestorPlace.com, and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace?.com or follow him on Twitter via @JeffReevesIP. As of this writing, Jeff did not hold a position in any of the aforementioned stocks.