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Quarter-End Insights

Our Outlook for the Hardware Sector

Disks or chips? Or neither.

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Any investor who has followed the technology sector for an extended time knows that today's hot new technology will likely become tomorrow's relic. Iomega is a great case study. In the mid-1990s, this young company developed a neat little gadget called the zip drive. The zip was one of the best portable data storage devices available at that time, and Iomega's stock soared on lofty expectations. Investors who bought into the hype at its feverish pitch in 1996 painfully watched their equity lose more than 90% of its value over the next five years. The theme was correct: portability. Years later, businesses and consumers continue to demonstrate their willingness to pay up for devices that allow them to safely store, move, and share their data. But the zip was the wrong technology bet. Hard disk drives and fast networks have become the dominant methods of data storage and transport.

Now, some industry watchers believe silicon-based storage drives, or solid state drives, will eventually displace the hard disk drive as the primary method of storing data. If this comes to be, it will spell disaster for the 50-year-old hard drive industry. Hard disk drives contain tiny recording heads that hover just a hair's breath over smooth glass disks spinning at break-neck speeds. Solid state drives don't--in fact, they contain no moving parts. This difference accounts for the most compelling advantages of solid state drives, including lower power consumption, faster access to data, and smaller size. Still, hard disk drives sell at a fraction of the cost per gigabyte of solid state drives, and it's still unclear when the latter will reach cost parity, if ever, for the majority of applications. Since it's still too early to declare a winner, we might ask ourselves why is it that more than 40 companies have put significant investment dollars at risk to enter the relatively nascent solid state drive industry. But first, a look at the broad hardware sector.

Valuations by Industry
As we look across valuations by industry within the hardware sector, we note that most industries are currently trading near our aggregate fair value estimates. One notable exception is the wireline equipment providers, which have been punished by sustained weakness in demand by the service providers as the trend toward mobility continues. Of course, the table below masks a number of interesting trends happening within the various industries, including our discussion of the current technology war between hard disk drives and solid state drives. 

 Hardware Industry Valuations
Segment

Current Median Price/Fair Value

Three Months
Prior
Change
(%)

Components

0.94 0.83 13.2%
Computer Equipment 0.87 0.83 4.8%
Contract Manufacturers 0.82 0.96 -14.6%
Data Networking 1.00 0.86 16.3%
Optical Equipment 0.97 0.98 -1.0%
Semiconductors 0.93 0.83 12.0%
Semiconductor Equipment 0.88 0.82 7.3%
Wireless Equipment 0.99 0.81 22.2%
Wireline Equipment 0.75 0.55 36.4%
Data as of 06-13-08.

Demand for storage is growing--and fast. Most industry watchers expect the amount of data created to roughly double every two years--primarily in the form of pictures, music, and video. Some argue that cheaper storage mediums, faster networks, and more user-friendly interfaces are driving this growth. In other words, vendors are making it easier to store our digital "stuff"--pictures, video, and music. Others argue that broad adoption of computing and Internet connectivity, richer content, and higher-value content creation are driving the growth. In other words, customers have more--and more interesting--"stuff" to store and share.

We observe an interesting cycle occurring. Individuals and businesses are creating and sharing spreadsheets, pictures, movies, and music at a faster pace than ever before. This increases demand for storage devices and networking equipment, which in turn prompts storage vendors and networking equipment providers to invest more heavily in new technologies. The resultant innovation leads to faster, cheaper, and better storage devices and networks. Individuals and businesses can then more easily store and share content, creating more demand ... and the cycle continues. In 2005, businesses purchased 2.2 billion gigabytes of networked storage capacity (a typical feature-length movie consumes about 5 gigabytes). By 2007, that number more than doubled to 5.2 billion. At its current pace, annual storage consumption will increase eightfold by 2012. We think the number could actually be much higher.

Hardware Stocks for Your Radar
The hard drive manufacturers and solid state drive makers won't reap the big rewards from this growth. Gigabytes are a commodity, and competition quickly eliminates excess profit in commodity industries. Additionally, rapidly declining selling prices should offset most of the growth in shipment volumes. These dynamics all point toward a likely outcome of uninspiring returns for shareholders of solid state and hard disk drive manufacturers over the long run. However, there are storage companies that we believe will benefit from the seemingly endless growth in storage demand. The storage vendors that incorporate commodity drives into networked systems with intelligent software that makes it easier for businesses to manage, protect, and share their ever-growing volumes of data should prosper. We think the following companies are well-positioned for the opportunities that lie ahead.

 Stocks to Watch--Hardware
Company Star Rating Fair Value Estimate Economic
Moat
 Fair Value Uncertainty

 Price/
Fair Value

Isilon $12 None High 0.41
EMC  $22 Narrow Medium 0.73
Dell $30 Narrow Medium 0.78
NetApp $27 Narrow Medium 0.86
Compellent $14 None High 0.96
Data as of 06-20-2008.

 Isilon (ISLN)
We think Isilon can increase its share of the storage market during the next few years. Isilon's storage networks are better than most at handling large files of unstructured data, such as streaming video. This capability makes its products well suited for digital media, and Isilon boasts a customer list that includes NBC, Comcast, and Kodak. The company is expanding its salesforce, moving into new markets (such as life sciences, oil and gas, and government), and building relationships among channel partners to pursue small and medium-size businesses.

 EMC  (EMC)
We think EMC will maintain its dominance in networked storage for the foreseeable future. Its customers have significant integration requirements, and it's easier for them to buy more products and services from EMC than risk disruption to their networks. As storage management becomes increasingly complex, we think customers will grow more dependent on EMC for its ability to integrate multiple solutions into their storage networks.

 Dell (DELL)
Although storage is still only a fraction of the company's total revenues, we believe Dell will increasingly benefit from its focus on providing easy-to-manage networked storage to small and medium-size businesses. Its 2007 acquisition of IP-based storage vendor Equallogic gives Dell a storage technology that is quickly growing in popularity as well as a sizable base of friendly channel partners. 

 NetApp  (NTAP)
We expect NetApp to gain share in the large enterprise market. Although best known for its network attached storage, the company now offers fibre channel and ethernet storage area networks suitable for large corporations. Also, NetApp's software unifies storage architectures, creating a pool of storage that appears as one network. We think NetApp can use its sophisticated software to increase its footprint in multivendor installations.

Compellent (CML)
Compellent, which is covered by Morningstar IPO Research Services, has been able to grow quickly by catering almost exclusively to small and medium-size enterprises. Its systems automate many recurring management tasks through a simple point-and-click interface, reducing complexity for resource-constrained small businesses. Also, customers can lower up-front costs by purchasing relatively small amounts of storage initially, adding capacity only when needed. We think the company still has plenty of room to grow.

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Grady Burkett does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.