1

What Wall Street WantsCan HDDs Ever Be “Investments” or Only “Trading” Stocks?

Rob Cihra

Hardware Analyst, Managing Director

Fulcrum Global Partners LLC

September 2004

2

My Bio

• Senior research analyst covering Computer Systems/Storage markets for past 7 years (previously w/ ABN AMRO, ING Barings)

• Fulcrum a 3yr old NY-based institutional research-driven securities firm w/ 30 analysts

3

Wall Street’s Driven By:

1. IN-DEPTH FUNDAMENTAL ANALYSIS– Investment thesis– Competitive positioning– New product developments/technologies– Valuation

2. EMOTION– Greed– Fear

Wall Street wants PROFITS, GROWTH and CONSISTENCY…and will REWARD them

4

Investors Seek Out Returns on Their Capital

5

Now for the HDD Sector

6

Relative 13-Year Stock Performance: Logarithmic Scale to be “Kind”(DELL, EMC, S&P vs. MXO, STX, WDC)

Source: Fulcrum Global Partners.

HDD stocks relatively under-perform

1

10

100

1000

5/20

/91

10/0

8/91

2/27

/92

7/17

/92

12/0

4/92

4/27

/93

9/15

/93

2/02

/94

6/24

/94

11/1

1/94

4/04

/95

8/23

/95

1/12

/96

6/03

/96

10/2

1/96

3/12

/97

7/31

/97

12/1

8/97

5/12

/98

9/30

/98

2/22

/99

7/13

/99

11/3

0/99

4/19

/00

9/08

/00

1/30

/01

6/20

/01

11/1

3/01

4/08

/02

8/26

/02

1/15

/03

6/06

/03

10/2

4/03

3/17

/04

8/06

/04

Relative Stock Appreciation (1991-Aug'04) -- LOG SCALE

MXO/MXTR

DELL

WDC

EMC

STX/SEG

S&P500

Maxtor non-public

DELL

S&P500

EMC

STX

WDC

MXO

HDD stocks relatively under-perform

7

Relative 13-Year Stock Performance: Actual Scale to be “Realistic”(DELL, EMC, S&P vs. MXO, STX, WDC)

Source: Fulcrum Global Partners.

Compare the current valuesof $1 invested in 1991

Compare the current valuesof $1 invested in 1991

Compare the current valuesof $1 invested in 1991Compare the current valuesof $1 invested in 1991

1

51

101

151

201

251

5/08

/91

9/16

/91

1/23

/92

6/02

/92

10/0

8/92

2/17

/93

6/25

/93

11/0

2/93

3/11

/94

7/21

/94

11/2

8/94

4/06

/95

8/15

/95

12/2

1/95

5/01

/96

9/09

/96

1/16

/97

5/27

/97

10/0

2/97

2/11

/98

6/22

/98

10/2

8/98

3/10

/99

7/19

/99

11/2

3/99

4/03

/00

8/10

/00

12/1

8/00

4/30

/01

9/06

/01

1/22

/02

5/31

/02

10/0

8/02

2/18

/03

6/26

/03

11/0

3/03

3/15

/04

7/23

/04

Relative Stock Appreciation (1991-Aug'04) -- ACTUAL

MXO/MXTR

DELL

WDC

EMC

STX/SEG

S&P500

S&P500

DELL

EMC

STX

WDC

MXO

Compare the current valuesof $1 invested in 1991

8

HDDs as Stocks

• As products/techs, HDDs have been a phenomenal success • As stocks, they’ve been a long-term disappointment

• Vicious cycle of boom/bust • Rapid commoditization, Irrational competition• Since 1995, cumulative Sales of STX+MXO+WDC = $116

billion but Profits just $322 million or 0.3%

• Today Investor disbelief/distrust– Even if macro environment changed can the companies

change too?– Can HDDs ever be “investments” or are they simply “trading”

stocks?

9

In Defense: Victims of Own Success

• Massive increases in areal density enabled massive per-drive cost/BOM reductions

(e.g., 3 platters/6 heads down to ½ platter/1 head)

• More bang for the buck

• With “blended” ASPs falling 15-20% per year it’s tough to grow revenues

10

The HDD market doesn’t lack Unit growth

Source: Company reports and Fulcrum Global Partners estimates.

0

50

100

150

200

250

300

350

400

450

500

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004E 2005E 2006E

Total HDD Units (mil)

Actual Estimated

1994-2003Unit CAGR = 16%

11

The HDD market doesn’t lack Unit growthThe HDD market doesn’t lack Unit growthBut ASP declines have been brutal

Source: Company reports and Fulcrum Global Partners estimates.

0

50

100

150

200

250

300

350

400

450

500

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004E 2005E 2006E

Total HDD Units (mil)

$0

$50

$100

$150

$200

$250

Average Selling Price

Actual Estimated

HDD Blended ASP ($)

12

…keeping total Revenue from growing

Source: Company reports and Fulcrum Global Partners estimates.

$0

$5

$10

$15

$20

$25

$30

$35

$40

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004E 2005E 2006E

HDD Revenue ($mil)

$0

$50

$100

$150

$200

$250

Average Selling Price

Actual Estimated

HDD Blended ASP ($)

From 1994-2003Revenue CAGR Just = 2%

13

…and Gross Margins erratic

Source: Company reports and Fulcrum Global Partners estimates.

0%

5%

10%

15%

20%

25%

30%

35%

Q19

2Q

292

Q39

2Q

492

Q19

3Q

293

Q39

3Q

493

Q19

4Q

294

Q39

4Q

494

Q19

5Q

295

Q39

5Q

495

Q19

6Q

296

Q39

6Q

496

Q19

7Q

297

Q39

7Q

497

Q19

8Q

298

Q39

8Q

498

Q19

9Q

299

Q39

9Q

499

Q10

0Q

200

Q30

0Q

400

Q10

1Q

201

Q30

1Q

401

Q10

2Q

202

Q30

2Q

402

Q10

3Q

203

Q30

3Q

403

Q10

4Q

204

HD

D M

arke

t G

ross

Mar

gins

Composite Mkt WD

Seagate Maxtor

Composite Gross Margin calculated using Maxtor, Quantum, Seagate and Western Digital -- HDD Operations Only

14

2003 Set Up the Golden Chance for Redemption

• Moderation in per-drive cost/BOM declines from historical double- to just single-digits, as sweet-spots down to 1 platter/head

• New capacity/tech transitions tougher to hit• PC market rebound from 2-year slump• New CE apps (e.g., Xbox, PVR, mp3) finally become

primetime and expand demand beyond PCs• Seagate IPO restarts investor interest

15

Recent HDD Stock History: Started Working Late ’02 - early ‘03

Source: Fulcrum Global Partners.

$0

$5

$10

$15

$20

$25

$30

$35

2/14

/01

3/20

/01

4/23

/01

5/24

/01

6/27

/01

7/31

/01

8/31

/01

10/1

0/01

11/1

2/01

12/1

4/01

1/18

/02

2/22

/02

3/27

/02

4/30

/02

6/03

/02

7/05

/02

8/07

/02

9/10

/02

10/1

1/02

11/1

3/02

12/1

7/02

1/22

/03

2/25

/03

3/28

/03

5/01

/03

6/04

/03

7/08

/03

8/08

/03

9/11

/03

10/1

4/03

11/1

4/03

12/1

8/03

1/23

/04

2/26

/04

3/30

/04

5/03

/04

6/04

/04

7/09

/04

8/11

/04

MXO

WDC

STX

S&P500 (rt axis)

Maxtor buysQuantum

Seagate IPO(raises investor interest)

Maxtor product/mfghurdles limit supply,market ASPs jump

Fujitsu exits desktop mktXbox launched

IBM+Hitachi(early moves hurt

mkt pricing)

PC market begins to recover/

Stock market rebounds

Maxtor 80GB/pstruggles

Q2 HDD blended ASP down just 1%Y/Y

StocksFinallyWorking,

ButWait…

16

First 9 Months of 2003

• Blended HDD ASPs down just 5% Y/Y• Combined profits of MXO+STX+WDC up 216% to

$819 mil from $259 mil• Combined operating cash flow of MXO+STX+WDC

up 34% to $997 mil from $745 mil• Combined market capitalization of MXO, STX, WDC,

HTCH, KOMG up 140% to $20.4 bil from $8.5 bil !

17

$0

$5

$10

$15

$20

$25

$30

$35

2/14

/01

3/22

/01

4/27

/01

6/04

/01

7/10

/01

8/14

/01

9/25

/01

10/3

0/01

12/0

5/01

1/11

/02

2/19

/02

3/26

/02

5/01

/02

6/06

/02

7/12

/02

8/16

/02

9/23

/02

10/2

8/02

12/0

3/02

1/09

/03

2/14

/03

3/24

/03

4/29

/03

6/04

/03

7/10

/03

8/14

/03

9/19

/03

10/2

4/03

12/0

1/03

1/07

/04

2/12

/04

3/19

/04

4/26

/04

6/01

/04

7/08

/04

8/12

/04

800

900

1000

1100

1200

1300

1400

1500

1600

MXO

WDC

STX

S&P500

Maxtor buysQuantum

Seagate IPO(raises investor interest)

Great Q3's reportedBUT HDD inventories up

HDD Inventory Hangover

Maxtor product/mfghurdles limit supply,market ASPs jump

Fujitsu exits desktop mktXbox launched

IBM+Hitachi(early moves hurt

mkt pricing)

PC market begins to recover/

Stock market rebounds

Maxtor 80GB/pstruggles

Q2 HDD blended ASP dow n just 1%Y/Y

Recent HDD Stock History: Until 2H03!

Source: Fulcrum Global Partners.

18

We’d argue moderating Cost declines “SHOULD” have enabled moderating ASP erosion

Source: Company reports and Fulcrum Global Partners estimates.

$0

$5

$10

$15

$20

$25

$30

$35

$40

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004E 2005E 2006E

HDD Revenue ($mil)

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

Actual Estimated

Y/Y Revenue Growth

Y/Y ASP Erosion

19

…and Gross Margin stability

Source: Company reports and Fulcrum Global Partners estimates.

$0

$20

$40

$60

$80

$100

$120

$140

$160

$180

$200

Mar

-96

Jun-

96

Sep

-96

Dec

-96

Mar

-97

Jun-

97

Sep

-97

Dec

-97

Mar

-98

Jun-

98

Sep

-98

Dec

-98

Mar

-99

Jun-

99

Sep

-99

Dec

-99

Mar

-00

Jun-

00

Sep

-00

Dec

-00

Mar

-01

Jun-

01

Sep

-01

Dec

-01

Mar

-02

Jun-

02

Sep

-02

Dec

-02

Mar

-03

Jun-

03

Sep

-03

Dec

-03

Mar

-04

Jun-

04

Sep

-04E

Dec

-04E

ASP

-30%

-20%

-10%

0%

10%

20%

30%Gross Margin

Desktop HDD ASP ($)

Desktop HDD Avg Gross Margin %(MXO, STX, WDC)

Moderating ASPdeclines "should"

help Gross Margins

Actual Estimates

20

Missed a Golden Chance!

• “Frog and Scorpion” story…is it simply in their “nature”?!

• Overbuilding 2H03 led to massive Inventory overhang (e.g., 8-9 mil too many HDDs built 2H03)

• Ultra-aggressive pricing• The usual finger-pointing (“other guy”, “channel”,

“grey market”, etc.)

21

The Result? WIPE OUT!

• 4Q03 - 2Q04 Wiped Out:– Profits– Credibility– $8.7 bil (43%) of combined market cap between

MXO, STX, WDC, HTCH, KOMG

• Leaving investors to once again ask “are HDDs ever an investment or simply trading stocks?”

22

Most Recurring Investor Questions:

1. Near-term data points? (e.g., channel inventories, pricing)

2. Product/Tech developments? (e.g., 40->80GB/p transition, now 120/160?, impact of perpendicular, etc.)

3. Aren’t HDDs just commodities? Substitutability by design means “roughly yes,” but MOST tech markets have some degree of commoditization, yet it doesn’t mean they all self-destruct

4. Further Consolidation?

5. CE opportunity?

6. Ever act Rationally?

…more on 4-6…

23

4. Further Consolidation?

• Consolidation is NO panacea if dynamics/attitudes don’t change• 7 major vendors not necessarily too many• Can help those who don’t consolidate (e.g., WDC when

MXO+QNTM, since 1+1 = something < 2) but NOT mkt itself• Traditional SCSI/Ent perhaps needs < 4 mainstream vendors

since premium costs + ltd size/growth means should be cash-cow biz

• But markets like 2.5in Notebook, while some say getting too crowded, unrealistic to expect anything other than ALL Desktop vendors ultimately being involved

• Either way, limited supply simply attracts expansion by incumbents or even new entrants as assembly capacity just too cheap/easy to add

24

Top-3 Desktop HDD vendors already consolidated Market Share

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Mar

-96

Jun-

96

Sep

-96

Dec

-96

Mar

-97

Jun-

97

Sep

-97

Dec

-97

Mar

-98

Jun-

98

Sep

-98

Dec

-98

Mar

-99

Jun-

99

Sep

-99

Dec

-99

Mar

-00

Jun-

00

Sep

-00

Dec

-00

Mar

-01

Jun-

01

Sep

-01

Dec

-01

Mar

-02

Jun-

02

Sep

-02

Dec

-02

Mar

-03

Jun-

03

Sep

-03

Dec

-03

Mar

-04

Jun-

04

Desktop HDD Mkt Share

Seagate

Quantum

Maxtor

Western Digital

Maxtor buys Quantum

FujitsuFujitsu exit

Samsung

Hitachi/IBM

25

5. CE Opportunity?

• New apps finally expand HDD market beyond PCs• Incremental 5% in ’02, 7% in ’03, and we estimate

13% in ’04E, 17% in ’05E• But does this help?

– Bottom line…more Units have NEVER been the problem (e.g., a zillion times $0 is still $0)

26

6. Will HDD Vendors EVER Act “Rationally”?

• Back to frog and scorpion• 2003 showed glimmers of hope but ended with overbuilding,

inventories…2004 crushed, pricing > cost declines, dumping• HDD assembly mostly a Variable cost model, so why overbuild?• Channel “share” means nothing• Most tech markets have elements of “commoditization” but they

don’t all self-destruct• Remember investors seek out Returns on their Capital • Wall Street wants Profits, Growth and Consistency and will

REWARD them (2003 proved that). But without them HDDs will NEVER be “investments” and only “trading stocks”

27

What Wall Street WantsCan HDDs Ever Be “Investments” or Only “Trading” Stocks?

Rob Cihra

Hardware Analyst, Managing Director

Fulcrum Global Partners LLC

September 2004