Hot storage

Disk drive makers are thriving due to strong demand for MP3s, DVRs and other consumer electronics.

By Paul R. La Monica, CNN/Money senior writer

NEW YORK (CNN/Money) – It`s the consumer, stupid. That might as well be the motto for Seagate, Maxtor and Western Digital.

These three firms, which make hard drives used to store files in personal computers and other electronic devices, have long been viewed by tech investors as stodgy makers of a commodity product.

Many would argue that, other than price, there`s not much difference between a 400 gigabyte (GB) hard drive made by one company and a 400 gigabyte drive made by another.

As such, competition in the business has been extremely cutthroat in the past. The companies have often run into the problem of producing too many disk drives and then resorting to brutal price wars that have cut into profits.

In addition, the three U.S. public disk drive companies also have to contend with Japanese tech giants Hitachi and Fujitsu.

But it appears that a change is brewing in the industry. The success of the hard drive companies is no longer reliant on the PC business. During the past few years, there has been an explosion of consumer electronics devices that require large amount of storage space for media files.

And the disk drive companies finally appear to be capitalizing on this trend.

``These stocks have been tied to the computing market for the past few years but now that you have consumer electronics as an area of growth, the traditional cyclicality in this industry has been offset,`` said Les Santiago, an analyst with Piper Jaffray. ``Demand is in place to set up the industry for a perfect storm in a good way.``

Happy days are here again

This week, Maxtor and Seagate both gave good business outlooks. Analysts expect a 15 percent increase in sales for Maxtor this quarter and a more than 50 percent jump in Seagate`s sales.

Western Digital has not made any recent comments about its outlook for this quarter, but analysts are predicting 18 percent sales growth.

What makes this is more impressive is that the June quarter is usually a tough one for these companies since PC sales tend to be weak.

``The consumer is where the growth is. All the hard drive guys look smart right now,`` said Seagate CEO Bill Watkins at an event in New York earlier this week.

At that event, Seagate showcased several of its new hard drives for devices ranging from cable boxes with digital video recorders and MP3 players to digital cameras and video game consoles as well as notebook computers.

``Three years ago, this room would have all been desktop PCs,`` said Watkins, pointing to all the gadgets it had on display which use its hard drives.

And during a conference call with analysts Tuesday, Maxtor chief financial officer Duston Williams said that the company has seen good momentum in consumer products. What`s more, he was cautiously optimistic that because demand is so strong, the industry won`t need to resort to its old habits of slashing prices.

``I`m pleased with discipline that hard drive industry has shown so far,`` said Williams.

Stocks are cheap and the best may be yet to come

So what`s this mean for investors? The stocks have all enjoyed nice gains this year thanks to their improved outlooks. Maxtor and Seagate are both up about 20 percent while shares of Western Digital have surged more than 40 percent.

But the stocks still look attractive. Seagate and Western Digital trade at the positively un-tech like P/E ratios of 10.5 and 12 times fiscal 2006 earnings estimates while Maxtor trades at about 21 times next year`s earnings targets.

That`s reasonable given that Seagate`s earnings are expected to increase at about a 12 percent clip for the next few years while analysts are predicting 15 percent annual gains for Maxtor and Western Digital.

``The stocks are still cheap and if the companies can continue to execute we could see further multiple expansion,`` said Harry Blount, an analyst with Lehman Brothers.

Seagate might be the best bargain though. In addition to being the cheapest of the three, the company currently has the most exposure to the hot consumer electronics market. Consumer electronics (CE) drives accounted for 17 percent of its total shipments in its fiscal third quarter.

By way of comparison, Western Digital said that about 11 percent of its hard drive shipments in it last quarter were for the consumer electronics market while Maxtor said its latest quarterly filing with the SEC that it expects sales of hard drives for consumer electronics would only be about 6 to 8 percent of total revenues this year.

``It is clear that Seagate continues to progress well towards providing newer higher margin drives in the CE and Mobile markets,`` wrote Brian Alger, an analyst with Pacific Growth Equities in a report earlier this week. ``As such, we continue to believe that Seagate can grow its top and bottom line profits.``

Of course, investors need to keep a close eye on these companies for any sign of weakening demand. A return to the price wars of the past would wreak havoc on earnings and the stocks. Last year, for example, shares of all three companies finished in the red due to weak results.

But for now, this doesn`t appear to be a cause for concern.

``Pricing should remain intact,`` said Blount. ``Times are relatively good for the drive industry and everybody seems to be behaving themselves in terms of not overproducing.``

For more about personal technology, click here.

Click here to read about how the torrid consumer electronics market is helping chip stocks.

Analysts quoted in this story do not own shares of the companies mentioned. Pacific Growth Equities and Piper Jaffray have no banking relationships with the companies mentioned. Lehman Brothers has performed investment banking for Seagate and has received non-investment banking related compensation from Seagate and Western Digital.