|Maxtor's Big Recovery [Barrons 10.10.05]|
By JAY PALMER
"WARNING: WINDOWS HAS BEEN SHUT DOWN to avoid damage -- system file corrupt."
When that dreaded blue-screen message pops up on a computer, it threatens the loss of years' worth of often-irreplaceable photographs, documents and other data. The cause could be a drive failure, program glitches or a virus. And the problem is altogether too common: Some 44% of American adults have lost data in major personal-computer failures, according to a recent Harris poll.
That's why Maxtor's OneTouch II is flying off the shelves. The size of a hardback book, this external hard drive sits on the desk backing up as much or as little of your computer's own stored data as you want at the touch of a button. It also gives a glimpse of how Maxtor (ticker: MXO) could start standing out from the pack in the cut-throat market for the disk drives.
Like rivals Seagate Technology and Western Digital, Maxtor sells disk drives -- which store data by spinning small disks at high speeds -- to computer makers. But it also has a small but promising consumer electronics division, home of the OneTouch II. Though this division now chips in just 5% of the company's revenue, executives expect its sales to grow by 30% a year through 2010, versus 10% or so for the rest of the business, thanks to the heavy data-storage needs of digital video recorders, game boxes, global positioning devices and more.
The rise of the consumer unit underscores a dramatic turnaround at the Milpitas, Calif.-based firm. If the company continues to implement its plans successfully, bulls maintain, the shares, recently at 4, could easily rise by 50% and possibly much more.
The basic problem for Maxtor has been the ongoing commoditization of the hard-drive market and the distressingly frequent price wars that have cut prices by an average of over 16% year since the mid-'Nineties -- faster than the 14% annual decline in costs. Maxtor, hungry to win market share and drive up volume, helped initiate the latest and biggest round of price-cutting in 2003 and 2004, effectively wiping out the entire industry's profitability.
The company's former bosses, especially CEO Paul Tufano, blundered on other accounts too. Millions were spent to develop a new 2.5-inch aluminum hard drive (most are glass and more costly), only for Maxtor to cancel the project when rivals came out with better, higher-capacity units faster than expected. Perhaps worst of all, Maxtor let its quality controls slip, resulting in sharply reduced orders from some of its big customers, including Dell. Result: Maxtor lost $181 million last year, compared with a 2003 profit of $102.7 million.
Even before those numbers came out, Tufano was ousted. He was replaced as the company's day-to-day leader by Mike Wingert, a former Maxtor executive who had left to head a data-storage startup.
"I saw real potential in the company when I returned," says Wingert, now president. "The problems were not the market but Maxtor. We had lost markets, leadership and reputation. We were master chefs who had lost our recipe."
Wingert, 45, already is getting results. Maxtor posted a profit in the April-June quarter of this year, earlier than nearly all Street analysts had expected. That came from big improvement in the company's enterprise operation, which sells high-end storage devices to big corporations; Maxtor had brought previously outsourced manufacturing in-house, boosting margins. For the third quarter and the year as a whole, estimates vary from small losses to modest profits, but 2006 is likely to bring profits in all four quarters. Analysts expect 25 cents to 46 cents per share for all of next year, though that range could be low.
Table: Storing Up ValueThe biggest uncertainty -- and the biggest potential -- lies in desktop computers, where Maxtor earns 80% of its sales and serves makers like Dell, Hewlett-Packard, Gateway, Apple and IBM/Lenovo. Here, sales increases are driven by two factors, the first being technological advances in speed or capacity. On that score, Maxtor is highly competitive and intends to remain so.
Then there's quality. "We have rationalized our product and eliminated all the quality issues," says Wingert. But, he acknowledges, it will take time to restore the company's reputation and return the business to its previous market share. This side of Maxtor probably won't return to full glory before the end of 2006.
EVEN SO, MAXTOR STOCK LOOKS ATTRACTIVE as a recovery play. Yes, it carries a higher price-earnings multiple than shares of rival disk makers -- 15.3 times '06 earnings estimates. But it's more enticing based on its enterprise value-to-sales ratio -- Maxtor's is just 0.28, about one-third of Seagate's -- and analysts often favor that measure in sizing up unprofitable drive makers. (Enterprise value equals equity plus net debt.)
THE BOTTOM LINE
Maxtor is headed firmly into the black for '06, and its consumer division is on track to post sales growth of 30% annually for several years. Shares could easily climb 50% in a year."My price target for the short-term is 6," says analyst Rich Kugele who follows the industry for brokerage firm Needham & Co. If Maxtor merely matches the industry's enterprise value-to-sales multiple, he points out, the stock could triple or even quadruple.
But that's not going to happen until investors become happier about the industry as a whole. Though there are no signs of suicidal price wars now, hardly a month goes by without a Street analyst cautioning that one may be at hand. Moreover, though the mini hard-drives sold into Apple's original iPod never accounted for much of the industry's sales, news that the new iPod nano uses flash memory has raised concern about disk-drive obsolescence. But current flash drives are unsuitable for PCs.
The hard-drive industry, meanwhile, does have some clear trends going its favor. With high-definition TV coming of age, consumers will need bigger and bigger drives for video recorders like TiVos. Says Wingert: "There has never been a better timer to be in the hard-drive business." Maxtor investors might come to agree.