Shazaam! Notes Toward a Reading of the HDD Industry in 2005

Shazaam! Notes Toward a Reading of the HDD Industry in 2005

The first half of 2005 has been extraordinary by any measure, with unprecedented, and mostly profitable, developments on many fronts. But how long can this go on?

By John Monroe, Research Vice President, Gartner

Gomer Pyle, USMC, the famous 1960s hero-buffoon of American TV, used to exclaim “Shazaam!” whenever anything inexplicable happened. Because of his good nature and dim wits, much was inexplicable to Gomer, and many inexplicably good things resulted from screwball situations in this fictional TV portrayal of the U.S. Marine Corps. For example, rational care and kindness often prevailed over irrational regulations and cruelty, and profoundly different people -- a kind and gullible hillbilly recruit and a cynical, ostensibly cruel career military man -- managed to create comic and bizarrely symbiotic alliances.

In observing recent HDD market dynamics, and attempting some kind of analysis, I’ve been tempted to exclaim “Shazaam!” many times:

·  A new shipment record was set during the second calendar quarter of the year (Shazaam!). In the past, this has always happened during the December quarter.

·  Second-quarter shipments and revenue increased sequentially by 2 percent and 1.6 percent, respectively (Shazaam!); a 2-to-8 percent decline in shipments and a 1-to-13 percent decline in revenue have been normal in years for which we have quarterly records. The only other time second-quarter shipments increased sequentially was in 2003 (by a mere 0.5 percent), but sequential revenue declined by 0.3 percent in that quarter.

·  Revenue has increased for four consecutive quarters (Shazaam!), and will likely increase again in 3Q05. In the past, HDD revenue has never increased for more than two consecutive quarters (usually during the third and fourth quarters, never at midyear).

·  Second-quarter ASP declined by less than 1 percent and remained higher than during the fourth quarter of the previous year (Shazaam!). In 2003 and 2004, second-quarter ASP declined 3.6 and 7.4 percent, respectively, compared to the fourth quarter of the previous year.

·  Some vendors increased certain distribution prices during April (Shazaam!). To my knowledge, there have never been any HDD channel price increases during April.

·  No drive maker stuffed the distribution channels (Shazaam!), and despite a sequential increase, midyear channel inventories remained mostly in balance relative to actual demand (Shazaam!).

·  Second-quarter shipments increased annually by 33.5 percent (Shazaam!) and revenue increased annually by 30.6 percent (Shazaam!); both of these annual increases are greater than in any quarter in any year for which we have quarterly records.

·  Total first-half 2005 shipments and revenue are up 30 percent (41.2 million units) and 24.5 percent ($2.7 billion), respectively, compared to the first half of 2004 (Shazaam!); these, as well, are unprecedented results.

For many years, Gartner has insisted that -- despite the dynamics of a competitive chaos and too many suppliers -- the HDD industry is capable of a maturing self-discipline that can lead to more stable and profitable market conditions even prior to further consolidation. Maturing self-disciplines were clearly evident during the first half of 2005, and market conditions improved, profitably buoyed by unprecedented developments during what is normally the most challenging time of the year.

Tables 1 and 2 below show shipment, inventory, revenue and ASP changes for the past nine quarters.

Table 1
Quarterly HDD Shipments and Inventory Changes, 2Q03 to 2Q05
2Q03 / 3Q03 / 4Q03 / 1Q04 / 2Q04 / 3Q04 / 4Q04 / 1Q05 / 2Q05
Shipments / 58,217 / 70,536 / 75,962 / 69,630 / 67,456 / 79,153 / 89,118 / 88,263 / 90,030
Change (%) / 0.8 / 21.2 / 7.7 / (8.3) / (3.1) / 17.3 / 12.6 / (1.0) / 2.0
Inventory / 15,235 / 15,890 / 17,430 / 19,256 / 20,280 / 21,539 / 20,390 / 19,889 / 21,190
Change (%) / 4.1 / 4.3 / 9.7 / 10.5 / 5.3 / 6.2 / (5.3) / (2.5) / 6.5
Inv./Ship. (%) / 26.2 / 22.5 / 22.9 / 27.7 / 30.1 / 27.2 / 22.9 / 22.5 / 23.5
Note: "Inventory" is an estimate of the combined total of drives in all distribution channel and OEM JIT warehouses only, excluding work-in-progress and finished goods in other vendor warehouses and facilities.
Source: Gartner (August 2005)
Table 2
Quarterly HDD Revenue and ASP Changes,
2Q03 to 2Q05
2Q03 / 3Q03 / 4Q03 / 1Q04 / 2Q04 / 3Q04 / 4Q04 / 1Q05 / 2Q05
Revenue (in USD millions) / 4,977 / 5,691 / 6,236 / 5,499 / 5,134 / 5,727 / 6,509 / 6,599 / 6,703
Sequential Change (%) / (0.3) / 14.3 / 9.6 / (11.8) / (6.6) / 11.6 / 13.7 / 1.4 / 1.6
ASP (in USD) / 85.5 / 80.7 / 82.1 / 79.2 / 76.1 / 72.4 / 73.0 / 74.8 / 74.5
Sequential Change (%) / (0.8) / (5.6) / 1.7 / (3.5) / (3.9) / (4.9) / 0.8 / 2.5 / (0.5)
Note: "ASP" is the average selling price for all classes of HDDs.
Source: Gartner (August 2005)

Managing with Greater Fiscal Wisdom

In June of any given year, we expect to see chronic HDD overproduction and madcap pricing follies. In June of 2005, rationally controlled HDD production and wisely modulated pricing largely defined the competitive landscape.

Market conditions are definitively better (for the moment) in 2005 than they have been at any time since the glory years of the mid-1990s, when the pace of areal density advancement was limited to Moore’s Law (which we are struggling to match today, but which we outpaced by a substantial margin between 1999 and 2003) and the hunger for high-capacity, multi-platter HDDs seemed insatiable.

Why? What has changed?

I think there has been a kind of “perfect storm” of events that has led -- at least temporarily -- to more-profitable competitive dynamics. These events include, but are not limited to, the following:

·  Demand has been exceptionally strong in all markets. At midyear, prior to the expected surge in consumer spending in the third and fourth quarters, the industry already has shipped 15.3 million sub-2.5-inch HDDs, 2.3 million 2.5-inch HDDs, and 13.3 million 3.5-inch HDDs to emerging non-PC markets. Meanwhile, the traditional demand for PCs, servers and storage systems has been surprisingly strong, enhanced by an increased penetration of evolving markets in Asia and Eastern Europe and healthy spending on system upgrades in global corporate markets.

·  The industry has blasted through the all the old mobile, desktop and enterprise shipment records –- 1H05 mobile, desktop and enterprise shipments are up 65.1, 19.3 and 24 percent, respectively, over 1H04 shipments –- and yet inventories remain in acceptable ranges.

·  Short-term component constraints have caused some temporary disruptions of supply. There are contradictory reports regarding media supplies –- some vendors claim to have no problems, while other vendors seem to be pleading for more product –- but component constraints definitely impacted manufacturing rates during the first half of the year.

·  Many HDD and supply-chain executives have consistently made strategic decisions in recent months to manage for profit, not share.

Demand continues to grow beyond expectation in most markets and supplies remain relatively tight, mostly driven by intermittent media shortages (which will soon end, or may already have ended). One can question whether all the manufacturers are behaving responsibly of their own accord or are simply held in check by external constraints, but it is certainly true that some drive makers and component suppliers are exercising sane restraint. Because many HDD and supply-chain executives have, in fact, made strategic decisions in recent months to manage for profit, not share, they have helped to create better market metrics. This is a welcome departure from the midyear tradition of surplus inventories and needless price erosion.

An Updated, Optimistic Forecast

Partially because the first-quarter good news for HDD makers continued to be evident on many fronts during the second quarter of 2005, Gartner continues to raise its near-term forecasts. Our forecast scenarios remain mostly in the same ranges, but we have increased all of our estimates.

For example: We have raised our most likely case ASP scenarios for 2005 and 2006 (to $72 and $67, respectively, up from $70 and $66); these changes, in concert with a slight augmentation in our shipment forecast, lead us to calculated increases of 3.5 percent (in 2005) and 1.9 percent (in 2006) in our most likely revenue scenarios compared to our May 2005 forecast.

We now believe at least 370 million HDDs will ship in 2005 (compared to a prior minimum of 360 million). Even in a worst-case scenario, we now believe a minimum of 409 million HDDs will ship in 2006 (compared to a prior minimum of 401 million). Despite some short-term component constraints, we now believe that HDD shipments will likely exceed 376 million in 2005 and 447 million in 2006. Industry revenue will likely exceed $27 billion in 2005 (the industry achieved $13.3 billion in revenue for the first half of 2005) and may grow to more than $30 billion in 2006.

Table 3
Gartner Top-level History (1998-2004) and Forecast Scenarios (2005-2006) for the HDD Industry
1998 / 1999 / 2000 / 2001 / 2002 / 2003 / 2004 / 2005E / 2006E
Revenue (in USD millions)
Best Case
Most Likely Case
Worst Case / 25,095 / 25,346 / 26,018 / 20,828 / 19,519 / 21,898 / 22,869 / 27,820
27,257
26,971 / 31,869
29,765
26,790
Shipments (in K units)
Best Case
Most Likely Case
Worst Case / 143,927 / 174,455 / 199,590 / 195,601 / 219,639 / 262,636 / 305,378 / 385,301
376,798
370,676 / 470,053
447,299
409,647
Source: Gartner (August 2005)

It should be noted that Gartner endeavors to forecast conservatively in order to help prevent surplus production.

Curiously Stagnant Enterprise Values

Despite the most lucrative half year in recent history, the enterprise value of Seagate, Western Digital and Maxtor, as determined by the shares times the share price plus debt minus cash, remains at depressed levels compared to September 2003, the last month in which financial analysts seemed to have some collective faith that HDD makers could engender consistent and enduring profits.

Table 4 below shows enterprise values for the dedicated, publicly traded HDD companies in August 2005 and September 2003. Note that collective 2Q05 profits exceeded 3Q03 profits by $97.7 million (41.9 percent).

Table 4
Enterprise Value Change for Seagate, Maxtor, Western Digital

(in Millions, Except for Share Price)

/ 9/30/2003 /
Seagate
Maxtor
WD / Shares
499.0
252.3
215.9 / Share Price
$27.05
$12.17
$12.89 / Debt
$743.0
$343.2
$50.0 / Cash
$1,349.0
$615.6
$285.8 / Net EV
$12,892.0
$2,798.1
$2,547.2 / 3Q03 Profit
$198.0
$29.9
$5.0 / 2Q05Profit
$280.0
$9.4
$41.2
Total / $18,237.2 / $232.9 / $330.6
8/19/2005
Seagate
Maxtor
WD
Total / Shares
510.0
255.5
222.6 / Share Price
$18.08
$5.13
$14.08 / Debt
$736.0
$384.6
$32.6 / Cash
$1,746.0
$439.5
$598.4 / Net EV
$8,210.8
$1,542.8
$2,568.4
$12,035.0 / Change
($4,661.2)
($1,542.3)
21.3
($6,202.2) / Change %
(36.31)
(55.12)
0.83
(34.01)

Source: Gartner (August 2005)
Note: Cash column includes short-term investments.

I am not sure why the HDD world looked so much rosier to investors in September 2003 than it does today. For whatever reasons -– a colorful history of price wars and irresponsible business practices? an egregious track record with respect to consistent and predictable profitability? -- Wall Street remains wary.

But with growing confidence, and mindful of our unfortunate history, I can say that at no time in my 25-year career in this industry have I seen greater opportunities for profitable HDD shipment and revenue growth.

2H05 Outlook

Swelling demand and limited supplies of key components will likely lead to profitable market conditions for the remainder of 2005. Although there is debate about the relative degree of media shortages (or if, in fact, there are any substantive shortages), it may not be possible for the industry to overproduce in any significant volume. Total shipments of 96-98 million HDDs in the third quarter and 98-100 million HDDs in the fourth quarter will probably fall short of true demand by several million units, creating a fertile ground for lucrative price controls. Media will be in somewhat tight supply for some drive makers at least through the third quarter, but if there are no component constraints at the end of the year, shipments in excess of 100 million in the fourth quarter may satiate the real global hunger for HDDs and quickly lead to more-aggressive pricing.

In any case, the drive makers need to be prepared to face a potential slackening of demand during the first quarter of 2006, at precisely the same time as planned enhancements to HDD and media production facilities become fully operational.

Profitable balances of supply and demand are delicate and can be quickly disrupted.

We should always beware Monroe’s Law II: As soon as the HDD industry can ramp production rates to fully satisfy an apparent increase in demand, the demand slackens. Whenever the HDD industry can actually test the validity of a large backlog, the backlog dissipates (often with disastrous results). This happens with disturbing frequency.

However, we also need to be aware that -– if true demand exceeds my deliberately conservative most-likely case forecasts -– we could face even more severe component shortages in the back half of 2006, as the industry begins to use perpendicular recording technologies in significant volume.