Jim Jubak

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Posted 7/6/2005

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 Jubak's Journal
5 buy-on-the-dip opportunities

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An analyst's report pushed down disk-drive stocks. But investors are ignoring the good news, which eventually will push up the stocks again.

By Jim Jubak

In the stock market, worry often trumps hope. This is especially the case if the stocks in question 1) belong to a "seasonal" group, and 2) are coming off strong gains. With investors worried about a seasonal slump in revenue and looking for reasons to take profits, stocks can fall on the slightest bad news, even in the face of good news.

If the bad news is wrong, however, the drop is a solid buying opportunity that should generate profits as soon as 1) prices sink enough from recent highs to bring in the bargain hunters, and 2) the good news gets significant confirmation.

That's exactly what's about to happen in the disk drive sector.

In that sector, stocks, after hitting highs in May and June, have plunged following a June 17 report from an analyst saying that inventory was building and hard-drive prices were under pressure. The report was enough to take stocks down in this sector by 10% or more. Western Digital (WDC, news, msgs) dropped 9%, Seagate Technology (STX, news, msgs) fell 13%, and Komag (KOMG, news, msgs) declined 13%.

Those declines occurred even though just a few days earlier sector leaders Western Digital raised its quarterly revenue projections and Seagate told analysts it was in a multi-year growth period.

The good news that the market overlooked in its rush to take profits will get confirmed by the sector's earnings reports that come out from July 19 through July 27. And that'll give these stocks a solid lead in to the traditionally stronger second half of the year for disk-drive makers.

The right strategy
To make sure that you're buying stocks on a temporary triumph of worry over hope that's soon to be reversed, rather than stocks that have stumbled as a prelude to a serious tumble, you need to understand exactly what worries pushed these stocks lower.

The recent 10% pullback for the sector was triggered by a report that a price war had broken out with declines of 5% to 10% driven by a sales channel inventory buildup. Customers, the story went, had been double and triple ordering early in the quarter to make sure they had enough drives but then were canceling the duplicate orders.

The report sent every other analyst scrambling to check the story. It wasn't an easy story to check, either, since the hard disk drive industry had been struggling with a component shortage that had resulted in scarce supplies of some sizes and had produced some double ordering. As well, the end of the June quarter is typically weak as customers slow the pace of orders in the month's last half.

But the consensus of analysts after talking to distributors and manufacturers was that inventory levels were normal, with four to five weeks of supply in the distribution channels, and that prices on the sector's bread and butter 40GB and 80GB drives were unchanged from the quarter's beginning.

So why the hub-bub, bub?

Leaking air
First, the hard disk drive industry itself is partly to blame. The industry has been busy talking up the opportunity presented by the iPod market. Think of it, the story went, a small disk drive in every music player, to be followed, closely, by a disk drive in every wireless phone.

But the air has been leaking out of that story pretty much from the start. Falling prices for larger capacity flash memory chips started analysts thinking about 2GB or 4GB flash memory replacing disk drives in the iPod. So instead of gaining sales from the iPod phenomenon, the sector's sales of small capacity disk drives to that market were in peril.

Second, there have been significant price declines in one visible part of the market, the 40GB drives that go into laptops and the 250GB drives that go into desktops.

But the price declines aren't a sign of rising inventory or weakness in demand. The 40GB price decline is largely a response by one manufacturer, Seagate, to a shift in the computer market toward laptops and away from desktops. Seagate had been selling its laptop drives for a sizeable premium and the company lowered that premium (but retained some of it) to gain share in a part of the hard drive market that's more lucrative than the desktop segment.

And in that desktop segment, the 250GB drive price drop was a result of a move toward larger 400GB drives. Like the changes in the 40GB market, the shift from to 400GB from 250GB drives actually increased profit margins at the hard disk drive companies, even if unit prices were lower.

The quick sale
Third, most stocks in the sector had hit new 52-week highs at the end of May or in early June. Everyone on Wall Street knows that this is a highly seasonal and volatile sector and no one wanted to watch profits vanish in a swift correction. At the first whiff of possible trouble, investors sold.

Now it looks like that sell-off may have created a profitable buy-on-the-dip trading opportunity. Western Digital raised its revenue guidance June 13 to $900 million to $915 million from an earlier $875 million to $900 million. That's a very positive statement since the end of June usually produces softer-than-expected revenues. A 5% to 10% revenue decline from the March period is typical but this year the drop at Western Digital looks more like 1%.

On reflection, most analysts now say that the iPod/MP3 market really isn't large enough to make a significant difference one way or another. A worst-case scenario calculated by Needham & Co. shows a decline of 3.9 million 1-inch drives for music players over the next four quarters. This is a drop in the bucket compared to Seagate's total projected unit sales of 110 million this year.

As these companies report results, it's likely that they'll provide higher guidance for the traditionally strong third quarter.

In my 11:20 a.m. ET Wednesday appearance on CNBC's "Morning Call" this week I offered these three picks.

Getting stronger
  • Western Digital raised its revenue guidance because strength in the consumer electronics (personal/digital video recorders) and notebook markets offset the typical softness in the desktop computer market. Those segments should just get stronger for the rest of the year since the company's new products for notebooks, introduced just last October, are still gaining traction.

    Analysts figure the company grew earnings by just 2.4% in the fiscal year that ended with the June quarter but then will show earnings growth of 25% in fiscal 2006. The stock trades at just 16 times trailing 12-month earnings, a low multiple for the bottom of a growth cycle. The company announces June quarter results on July 28. Our StockScouter rated the stock 7 out of a possible 10 on July 6.

    A turnaround
  • Seagate looks like it could actually show sequential growth in unit sales in the June quarter and an increase in average selling price across its product lines. The selling price increase would represent a huge turnaround from a year ago, when it dropped by 20% in the June quarter. It came about because Seagate has aggressively launched new products for the consumer electronics and mobile media markets that have enabled it to gain market share.

    At the same time, the company's has pushed to increase the capacity of its largest (a new 500GB drive for desktops) and smallest drives (a new 8GB 1-inch drive for MP3 players and digital cameras).

    Wall Street estimates that earnings will grow by 39% in the fiscal year that ends in June and 46% in fiscal 2006. If those earnings come through, the price-to-earnings ratio will drop from 22.2 on trailing 12-month earnings to 13.4 on fiscal 2005 earnings to 9.2 on fiscal 2006 earnings. The company announces quarterly results on July 19.     Our StockScouter rated the stock a 7 on July 6.

    A capacity play
  • Komag makes the disks that go into hard-disk drives, which makes its stock a direct play on the increasing capacity of hard-disk drives since higher-capacity drives require more disks. During the March quarter, the company announced plans to increase quarterly production to 26 million units from 24 million. Efficiency gains enabled it to expand production, and Komag likely ran at full capacity in the June quarter. This is great news for a company with high fixed costs since, according to the company's mid-quarter guidance, it'll push margins to 15% from the 13% to 15% range in prior guidance.

    Komag also announced plans to increase capital spending by $70 million to push capacity to 30 million units by the end of the fiscal first quarter. I can't be certain but it looks like a recent agreement between Western Digital and Komag "commits" Western Digital to taking most of that new production.

    Wall Street estimates that Komag will earn $2.90 a share in 2005, up 70%, which gives the stock a P/E ratio of 9.7 on projected 2005 earnings per share. The company announces quarterly results on July 27.     Our StockScouter rated the stock a 9 on July 6.

    Exclusive picks
    And, as always, I have two more exclusive picks for CNBC.com on MSN readers.

  • Maxtor (MXO, news, msgs) is riding the same trends as Western Digital and Seagate, but as a turnaround story with a lower stock price, these shares give investors more bang for the hard drive buck -- if the story is positive this quarter.

    As indicated by the shares' higher beta, a measure of a stock's volatility, Maxtor is 10% more volatile than Western Digital and 17% more volatile than Seagate. This is all to the good if the news is positive, but look out if the news is bad.

    The company announces results on July 27. Analysts estimate that it'll post a loss of 3 cents a share for the June quarter before returning to the black in the September period. The big projected jump comes in 2006 when Wall Street believes earnings will rise to 27 cents a share from just 3 cents in 2005. Our StockScouter rated the stock a 5 on July 6.

  • Hutchinson Technology (HTCH, news, msgs), like Komag, is a pick-and-shovel company in the disk-drive sector. Hutchinson makes the suspensions that keep the heads floating above the disks as they read the digital information. And like Komag, Hutchinson gets an extra boost from increasing drive capacities since the number of suspensions per drive increased to 2.5 in December from 2.3 in June 2004 and likely hit 2.7 in the June quarter, according to the company. This gives Hutchinson the ability to grow its unit sales at a higher rate than the hard disk drive industry.

    In March the company announced that it would spend an extra $100 million to expand capacity to 20 million units a week from 15 million. It'll pay for that increased capital spending out of cash flow and cash on hand. Hutchinson projects revenue growth of 11% to 17% for the June quarter, a period that typically shows a 10% revenue decline. Wall Street expects that the company will grow earnings by 92% in the fiscal year that ends in September. The stock trades at 15.3 times 12-month trailing earnings. The company announces quarterly results on July 21. Our StockScouter rated the stock a 4 on July 6.


    Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.

    E-mail Jim Jubak at jjmail@microsoft.com.

    At the time of publication, Jim Jubak didn't own or control shares in any of the equities mentioned in this column. He doesn't own short positions in any stock mentioned in this column.

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