Puffing Along the Road to Web 2.0

As the first month of the New Year gives way to the month in which we acknowledge if not quite honor past presidents and the patron saint of lovers, bee keepers and happy marriage, the Market is going through the motions of a long overdue pause. Volatility seems to have gone on sabbatical even as the media labors to amp of the drama of Greece’s refinancing. This will be a week to see if, as we have suspected in the previous Musings, that concocted boogyman that is the European debt crisis has started losing its power to trigger tradable “risk-off” days. Based on its frozen rope trajectory of the past several weeks, the Market is certainly vulnerable to a bout of profit taking, but it keeps showing the kind of resiliency that makes this long time observer feel that this is a Market that really wants to go up.

Much of that resiliency is due to what the earnings releases have been showing a global economy that took a licking and kept on ticking. Sure, there were exceptions, there always are, where the earnings came up a little short of expectations and the stock has a real bad day ahead of what will likely be a months long stay in the proverbial doghouse. Within the “major bets” of High Road Value, our aerospace bet hit just that sort of “miss”- induced air pocket. At least within the high-end metallurgy world, where Allegheny Tech and Precision Castparts are our chosen vehicles. My strong sense here, informed by having followed the likes of PCP since it was PCST and had only a couple of million shares, is that companies didn’t so much miss as the analysts guessed too high. There was strong momentum in the industry in the June and September quarters as the OEMs started stepping up production rates on (mostly narrow-body) legacy commercial programs. This marked an early phase of a long ramp up that, strictly speaking, is neither a step function nor a continuous function, but a slightly unpredictable blend of the two. The momentum rendered palpable by the midyear acceleration did not abate in Q4, but it didn’t pick up speed either (That will be coming along shortly.) So couple a little overestimation of a ramp rate with the undoing of a squeeze in raw material prices (i.e., nickel reverting to a more normal price, which provides an incentive for customers to purchase as little as possible ahead of quarter-end surcharge adjustments) and you get the kind of disappointment that just sent a few marginal holders to the exits. Pity them. We are still in the very early innings of what is shaping up to be the greatest commercial aircraft build rate ramp ever, with “bump-ups” coming like clockwork more or less every quarter for a couple of years at least.

A more sanguine picture emerges around earnings reported by the companies that make up our rather old school bet on Web 2.0. Specifically, that part of the tech food chain defined by Intel, its enablers (capital equipment providers) and hangers-on. But as impressively as Intel has been at confounding its naysayers, the most lip smacking piece of the pie has been our bet against the imminent demise of the hard disk drive (HDD). To be fair and honest about it, the outsized nature of my present bet (about 18% of my investable assets in STX, WDC and supplier HTCH) is more than anything due to Seagate having quite literally been at the right place at the right time (i.e., unlike WDC, Hitachi and Toshiba, having all of its production outside the flood zone in Thailand). Completing its acquisition of Samsung’s HDD assets, which cemented an alliance between these technology leaders that will get very interesting over the next few years, as well as the first moves in a broad, impressive and seemingly long overdue product refresh, helps a lot, too. But hats off to WDC and its suppliers, including HTCH, for a magnificent recovery from the adversity of coming in and finding a big portion of one’s equipment under 6+ feet of greasy, stinky water. Much work remains to be done to bring the HDD supply chain back to normal, a projects that including the rebuild of buffer stocks will carry into next year. The Market has already applauded the adroit execution that has taken prior “worst case” scenarios off the table. The question is what will there be to applaud about once things are back to normal.

My sense is that the Thai Flood Crisis has lent even more impetus to the idea that the HDD world will find itself with a new and improved “normal” on the other side of the ongoing consolidation. We, and most importantly, the customer base, just got a whiff of just how not-to-be-taken-for-granted the availability of hard disk storage might become. One would think that the big buyers of HDD got a glimpse of what the world would be like if this supplier base which they have used and abused for so many years unto decades were to lose its ability or will to re-invest in itself. The consolidation was about to make it clear that a price-taking HDD industry can no longer be taken for granted. The flood induced shortage is driving home that point.

Pricing and so margins will recede as capacity comes back into balance and inventories are replenished. This is not a question of Whether or even When but to Where relative to what in the era consolidation (wherein aggressive pricing might have long term, strategic benefit to compensate for short term pain) was considered normal. “Normal” is going to be very different when Seagate and WD have upwards of 80% of the market. Even if WD’s “remedy” for the EU’s purported concerns about the HGST acquisition (just how a discrete increment of capacity can be severed from such an integrated undertaking remains to be seen) were to spawn a new competitor, it would still be a technology follower at a single capacity point with marked economic disadvantages. The big drama over the next several quarters, the one that will be hyped for all its worth by the multitude of analysts who follow this industry, will be couched in terms of where ASPs end up relative to before the flood. And that, in my estimation, is in the hands of the management team of the producer presently at the margin, which is WDC. I believe it will boil down to whether they are sufficiently competent and judicious to manage the latter phases of their recovery in a way that balances the near term needs of the customer base with the long term growth in value for the owner base. Having listened in on the last dozen or so conference calls (and sized up more managements than I care to even think about), I am as confident as an investor can be that Messrs. Coyne, Leyden and Nickl are more than smart enough to split this difference in a way that the Market will stand up and cheer. If so, then for at least that three-to-five year future that purportedly matters so much for serious investors, the new “normal” is likely to be gross margins in a narrow band not far off of 30%, rather than that recent range that tended to drift down into the teens and get stuck there, and commensurately higher net margins and so EPS. End users will continue to benefit from, and probably take for granted, that this industry has made data storage “almost free and getting more so”, and are not likely to notice that they are paying a few dollars more per device. And who knows, these stocks might even find their way of their bizarre parallel universe where a single digit P/E ratio is considered normal for a growing, dominant and cash rich enterprise.

Obviously, such a margin re-set, coupled with even modest growth in units and adroit deployment of surplus cash along the lines of what Seagate is already doing (dividend boost and aggressive share repurchase) should boost both WDC and STX much further than recent analyst “Target Prices” would suggest. But what about suppliers like HTCH? Owing to a long list of surprises, this one has ended up being one of those “problem children” we always seem to have at least a few of. Potentially life threatening challenges have been met and largely overcome, albeit at the cost of the balance going from seemingly pristine to a source of concern. HT’s position with the customer base appears to be programmed to improve in each of the next several quarters, which in my estimation will drive the volume necessary for a return to profitability. The flooding may have been a setback in their plan to become the low cost producer of suspension assemblies, but it was only a setback. Indeed, the value of their diverse locations gained currency as a result of the flood. Assuming that HTCH continues execute on its debt refinancing plan, recognition should start to set in that HTCH does not deserve the “left for dead” status implicit in its recent share price. I am expecting “back from the dead” appreciation over the next couple of years akin to what happened in the latter half of 2009.

Investing in HDD companies right now could be compared to finding a very old cigar butt. The naysayers (led by investment bankers who would rather shill for companies that need gobs of capital rather than ones that have too much of it) say that at 50+ years old it is a worthless has-been that should be tossed away. Like the “visionaries” I recall from thirty years ago who said that technology would bring about a “paperless office” and so doom the paper industry, someday they will be right, and disk storage will go the way of the crank starter on automobiles or the mimeograph. But that someday is nowhere in sight, and there are even signs that the purportedly supplanting technology is actually boosting demand for mass storage the way things like faxes, cheap printers and then email did for a couple of decades before “paperless” starting happening in earnest. If HDD is an old cigar, it still has at least one might fine puff left on it.