Conditions Green, HDD Stocks Red Why a Decline in Valuation Immediately Followed One of the Decade s Most Profitable Quarters.

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1 Conditions Green, HDD Stocks Red Why a Decline in Valuation Immediately Followed One of the Decade s Most Profitable Quarters. Asia Pacific, March

2 Important Disclosures Analyst Certification - The author certifies that this research report accurately states his/her personal views about the subject securities, which are reflected in the substance of this report. The author certifies that no part of his/her compensation was, is, or will be directly or indirectly related to the specific views contained in this research report. The analysts responsible for the preparation of this research report receive compensation based upon various factors, including quality of research, client evaluations, competitive factors, and firm performance, among other factors. The information presented in this report is obtained or derived from third parties by Avian Securities, LLC. No independent confirmation of the truth, correctness, or accuracy of the information presented has been made by Avian Securities, LLC. Avian Securities, LLC accepts no responsibility for any loss or damage suffered by any person or entity as a result of any such person s or entity s reliance on the information presented in this report. This disclaimer includes any actions or inactions by Avian Securities, LLC that contributed or may have contributed to any of the information contained in this report being untrue, incorrect, inaccurate or misleading. Information provided within this document is considered to be only part of the mosaic required to make investment decisions. It should be used only in conjunction with other materials, information, surveys, interviews, and research when making any investment decision and in itself does not constitute enough information for making any investment. Additional information is available upon request. This report is published solely for information purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or derivative. This report is not to be construed as providing investment services in any state, country or jurisdiction where the provision of such services would be illegal. Opinions and estimates expressed herein constitute judgments as of the date appearing on the report and are subject to change without notice. This report has no regard to the specific investment objectives, financial situation, or particular needs of any specific recipient of this report and investments discussed may not be suitable for all investors. Investors should seek financial advice regarding the suitability of investing in any securities or following any investment strategies discussed in this report. This report may contain confidential and/or privileged information and is intended only for the intended recipient. If you are not the intended recipient (or have received this report in error) please notify the sender immediately and destroy this report. Any unauthorized duplication, disclosure, and/or distribution of this report are strictly prohibited. Avian Securities, LLC reserves the right to electronically monitor the distribution and/or re-distribution of this report. Avian Securities, LLC, its officers and employees may from time to time acquire, hold or sell a position in the securities mentioned herein in this report. Avian Securities, LLC may act as a principal for its own account or as an agent for both the buyer and the seller in connection with the purchase or sale of any security discussed in this report. Avian Securities, LLC is an FINRA member and SIPC insured. Asia Pacific, March

3 CFA Test Company SeagateA Operating Margin 10 Yr (historic) 9.0% 5 Yr (historic) 9.5% Current FY 16.7% ROIC (trailing 12mo) 18.7% FCF Yield (Current FY) 20.4% Five Year Growth Historic -2.6% Estimated 11.3% Hewlett Company Packard C Operating Margin 10 Yr (historic) 7.2% 5 Yr (historic) 8.9% Current FY 11.5% ROIC (trailing 12mo) 16.0% FCF Yield (Current FY) 11.7% Five Year Growth Historic 24.9% Estimated 11.5% Western Company Digital B Operating Margin 10 Yr (historic) 7.5% 5 Yr (historic) 10.0% Current FY 15.7% ROIC (trailing 12mo) 26.5% FCF Yield (Current FY) 20.4% Five Year Growth Historic 31.9% Estimated 13.0% Company Dell D Operating Margin 10 Yr (historic) 7.5% 5 Yr (historic) 10.0% Current FY 5.7% ROIC (trailing 12mo) 21.9% FCF Yield (Current FY) 13.5% Five Year Growth Historic -6.0% Estimated 10.3% Criteria for Investment 1) Growth 2) Margins/ Profitability 3) Return on Investment Sources: Hapoalim Securities Bloomberg Consensus Asia Pacific, March

4 HDD Stocks Have Gotten Cheaper P/E Ratios Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Change '06-'10 Change '07-'10 HP % 20% Dell % 41% Seagate N/A N/A % 62% WD % 32% P/E Ratios Net Cash Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Change '06-'10 Change '07-'10 HP % 17% Dell % 44% Seagate N/A N/A % 61% WD % 49% Source: Avian Securities, Bloomberg Asia Pacific, March

5 How Did We End Up Here? Asia Pacific, March

6 Near-Term Pressure Jan 20 th - Seagate reports its best earnings in a decade! Jan 21 st - WD follows with its own blow-out report as quarterly earnings surpass $2! Jan 22 nd HDD stocks get shellacked! WD declines 10%. Seagate falls 5.6%. Asia Pacific, March

7 WDC and STX Jan 20 th Jan 21st 20% 10% 1/21/10 WD Earnings Seagate 0% WD -10% -20% 1/20/10 Seagate Earnings 1/31/10-30% -40% 1/20/10 1/22/10 1/24/10 1/26/10 1/28/10 1/30/10 2/1/10 2/3/10 2/5/10 2/7/10 2/9/10 2/11/10 2/13/10 2/15/10 2/17/10 2/19/10 2/21/10 2/23/10 2/25/10 Source: Avian Securities, Bloomberg Asia Pacific, March

8 Reaction To Good News Is Not Unique Intevac reports its first substantial tool orders in the past 2 years. Hutchinson has its first profitable quarter since December Xyratex forecasts that its Storage Infrastructure revenues will more than double the high end of Wall Street expectations. Asia Pacific, March

9 HDD Stocks Jan 20 th Feb 25th 20% 10% 1/21/10 WD Earnings 0% Seagate WD -10% -20% 1/20/10 Seagate Earnings 1/31/10 Intevac Hutchinson Xyratex -30% -40% 1/20/10 1/22/10 1/24/10 1/26/10 1/28/10 1/30/10 2/1/10 2/3/10 2/5/10 2/7/10 2/9/10 2/11/10 2/13/10 2/15/10 2/17/10 2/19/10 2/21/10 2/23/10 2/25/10 Source: Avian Securities, Bloomberg Asia Pacific, March

10 Multiple Contraction Forward P/E Multiples 01/20/ /01/2010 Note that in contrast to Seagate s overall price appreciation over the last few weeks, its price to future earnings multiples remains lower than before it provided its most recent earnings port. Western Digital does not show this dichotomy as both its price and PE multiple have deteriorated. Source: Avian Securities, Bloomberg Asia Pacific, March

11 Implications of Current Multiple Deterioration Forward P/E Multiples HDD Maker s Stock Prices The last period of multiple deterioration in 2007/2008 foreshadowed an end to a cyclical uptrend. In our view Wall Street is concerned that the business cycle has again peaked and is anticipating another imminent trough. Source: Avian Securities, Bloomberg Asia Pacific, March

12 Wall Street Fears Cyclical Peaks Eventually oversupply is inevitable. With oversupply comes product ASP compression. Lower pricing invariably slows or even reverses revenue growth. The effect of ASP declines on earnings is even more dramatic as declining margins multiply the impact of revenue compression. Asia Pacific, March

13 Seasonality Cyclicality $50 $45 $40 $35 $30 $25 Hitachi to Purchase IBM's Drive Division Seagate WD Maxtor May - Oct Apr - Aug Seagate to Buy Maxtor Toshiba to Buy Fujitsu HDD Ops Dec -Apr Down 55% Seasonality has historically weighed on the drive stocks each spring, but the exact timing and the extent of the downwards trend has been unpredictable. $20 $15 $10 Jan - May $5 $0 1/1/02 7/1/02 1/1/03 7/1/03 1/1/04 7/1/04 1/1/05 7/1/05 1/1/06 7/1/06 1/1/07 7/1/07 1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 7/1/10 1/1/11 7/1/11 Source: Avian Securities, Bloomberg Asia Pacific, March

14 Contrast in Outlook Timothy Leydon Western Digital CFO: Obviously we have to go through the softest period of the year, which generally is not necessarily a calendar quarter, but it actually is the three month period for March, April and May. Speaking on 2/24 at the Goldman Sachs Technology and Internet Conference Steve Luczo Seagate CEO: I mean, for March we're sold out. January we just had our best first month ever. Certainly, and June is starting to firm up very well with I think pricing that will probably be much less than would be typical erosion. Speaking on 2/08 at the Thomas Weisel Partners Technology and Telecom Conference Asia Pacific, March

15 Reasons to Expect A Strong 2H 10 1 Constrained HDD Supply through Late 2009: 2 Strong PC Demand Outlook for 2010: Corporate refresh; Windows 7; Attractive pricing due to 2009 ASP compression; 3 Potential Competitive Missteps: More difficult areal density transitions; More specialized products; e.g. Hitachi s lack of a 320 GB/platter 5,400 RPM notebook program; 4 Capital Constraints: Even though more capital is being allocated, those capital allocation levels are in-line with historical norms and likely below what is necessary given tight conditions in 09 and strong PC demand trends in 10; 5 Slowing Areal Density Growth: Slowing transitions as manufacturers struggle with yields are likely to place more pressure on the component supply chain. Asia Pacific, March

16 Capital Spending IVAC Tools IVAC Tool Shipments XRTX Storage Infrastructure Sales $450 $400 $350 $300 $250 $200 $150 $100 $50 $0 Xyratex Sales ($M) Intevac and Xyratex sales/shipment forecasts are well within historical ranges e Planned Seagate and Western Digital capital expenditure levels are in-line with spending trends. Source: Avian Securities, Company Reports $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 STX Capex ($M) WDC Capex ($M) e Asia Pacific, March

17 The Other Side of Seasonality $50 $45 $40 $35 $30 $25 $20 Hitachi to Purchase IBM's Drive Division Seagate WD Maxtor Seagate to Buy Maxtor Toshiba to Buy Fujitsu HDD Ops Down 55% History also suggests that the investment community will soon start looking ahead to the back half of the year, a shift in perspective that historically has benefited HDD stocks. $15 $10 $5 $0 1/1/02 7/1/02 1/1/03 7/1/03 1/1/04 7/1/04 1/1/05 7/1/05 1/1/06 7/1/06 1/1/07 7/1/07 1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 7/1/10 1/1/11 7/1/11 Source: Avian Securities, Bloomberg Asia Pacific, March

18 What Longer Term Issues? An examination of stock price trends over the last seven years suggests periods of over performance and under performance, but does not at first glance imply any longer-term concerns Source: Avian Securities, Bloomberg Asia Pacific, March

19 Those Longer Term Issues Forward P/E Multiples Price to earnings multiples have not just contracted over the last few months; Rather a look at a longer time series shows multiples have been declining steadily over the last five years Source: Avian Securities, Bloomberg Asia Pacific, March

20 Why do Multiples Compress? 1. Declining Gross Margins 2. Declining Growth 3. Increased Perceived Risk Asia Pacific, March

21 35% 30% 25% 20% 15% 10% 5% 0% Improving Margins Asia Pacific, March Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Gross Margins Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Western Digital Seagate Source: Avian Securities, Bloomberg

22 Despite Blips, Growth Continues $14,000 60% $12,000 Western Digital Revenues Seagate Revenues 50% Revenues (M) $10,000 $8,000 $6,000 $4,000 Western Digital Growth Seagate Growth 40% 30% 20% 10% 0% Annual Sales Growth -10% $2,000-20% $ e 2011e -30% Source: Avian Securities, Bloomberg Asia Pacific, March

23 Perceived Growth Potential ; Market Risk While Hard Drive market growth has always been primarily tied to PC growth, perceptions of additional market opportunity and market risk have changed. Potential Opportunities 2001 HDDs in every TV 2004 Smart Phone Penetration Potential Risks 2007 SSDs Asia Pacific, March

24 HDD Vendor Options Invest in SSD Development 1. Design an SSD everyone is moving on this path 2. Buy/subsidize Fab Capacity ala Apple 3. Own interntal NAND Production Samsung and Toshiba are already here. Should others follow? Rather concentrate on improving execution lifting gross/operating margin, cash generation, and cash balances; all factors which lift stocks if not multiples. Asia Pacific, March

25 Western Digital Sets an Example Asia Pacific, March

26 Conclusion Seasonally softer demand and longer term concerns have created attractive valuations for the HDD stocks As seasonality reverses, we anticipate strong industry trends through the 2 nd half should reverse the more recent stock deterioration and multiple contraction There is no simple solution to alleviating apparent investor concerns around longterm industry prospects, but execution will almost inevitably be rewarded. Asia Pacific, March

27 Questions/Comments Contact: Asia Pacific, March