Description

I believe Komag has been oversold; making the current stock price attractive.  The hard-disk drive (HDD) industry had a mixed first quarter (solid on revenues but soft on margins).  The outlook for the second quarter (seasonally the weakest quarter) was discouraging to Wall St.  However, the growth prospects of this sector remain healthy as demand for digital storage continues its exponential growth.  Komag is very well positioned to take advantage of the growth in the HDD sector.

In summary, there seems to be a dislocation between the valuation at which Komag trades and its competitive position.  This valuation ignores that Komag has a much stronger position within its industry than at any other point during (at least) this decade.  The reason being that Komag is past the bulk of the R&D expenses and capital expenditures necessary to: a) penetrate a new sizable (65 mm disk) market, and b) stay at the forefront of technology with its successful transition to PMR.  Furthermore, Komag has become a supplier to all major HDD manufacturers and has become the largest producer of 95mm disks.

Background (Komag has been written up twice here at VIC by exdalgal896 and together with the thread cover a lot more than the following paragraph)

Komag is the leading supplier of disks (media) to the HDD sector.  For those unfamiliar with the sector, each PC has a hard-disk drive where it stores information.  Komag makes the disk (storage medium) that is inside the disk drive.  These disks look like a CD but have 200 times more capacity than a CD.  Komag sells these disks to the disk-drive manufacturers.  The HDD sector has very much consolidated over the last few years, and now four players control the market: STX, WDC, Hitachi, and Samsung.  Komag is a supplier to all of them.  As in very much all other areas of hardware technology, there is constant race to increase the capacity of these disks.  Just a few years ago each disk was capable of storing 40 gigabytes.  Now they are approaching 200 gigabytes.  The average disk sold last quarter had a capacity of more than 100 gigabytes.  On the pricing side, the average disk sells for $5.50, which has been very much the same for the last four years.  Thus the selling price per gigabyte has decreased by an order of magnitude over this period.  By comparison, solid state memory (typically in the form of NAND flash semiconductor memory) sells for around $1 per gigabyte.  That is two orders of magnitude more than disk memory.  To me the threat of NAND flash displacing HDD is not imminent.

What’s to like:

1) Komag is cheap on an absolute and relative basis (multiples based on ltm):

2) Market leader in a growing market.  (In addition to the facts here, you may look at the investor presentation on Komag’s website for a good illustration of the market opportunity.)  Komag is the largest manufacturer of 95mm disks (desktop PCs, servers, and consumer electronics like DVRs).  As mentioned earlier, demand for digital storage continues to grow exponentially driving double-digit growth in HDDs.  Demand for disks (media) is growing even more rapidly as the number of disks per drive continues to increase.

3) Major growth opportunity in 65mm market.  Leveraging its strength as the leading disk supplier to the HHD industry, Komag has an aggressive program to capture a meaningful share of the 65mm market.  This faster-growing market is currently about half the size of 95mm market.  Komag has already a few design wins that will be ramping up during 2H07.  It is very important to note that Komag is past the R&D expense peak to developing this product line and also is past the capex peak.

4) Komag is the lowest cost producer.  Similar to other computer memory, the disks that Komag sells are a commodity.  It is a big competitive advantage to be the low cost producer in a commodity market.  Komag attributes its low cost position to having its manufacturing base in Malaysia, being a scale leader, and being a technology leader.

5) Technology leader.  The need to continuously increase disk capacity has brought the industry to a technology called perpendicular magnetic recording (PMR).  Komag is at the forefront of this transition.  Similar to the incursion into the 65mm disk market, Komag is well past the bulk of R&D and capital expenditures with respect to PMR.  In addition, over the next few quarters Komag will harvest the yield benefits of the learning curve involved in this new technology.

6) Repurchasing shares, well-capitalized with no net debt ($250m 2.125% conv due 2014 @$58/shr), high ROE, all equity tangible.

What’s not to like:

1) No pricing power.  As a commodity producer Komag does not have pricing power.  However, ASP has remained stable for the past four years and management anticipates they will continue at the current level for the foreseeable future.

2) Commodity (metals in particular) cost inflation pressuring margins.

3) Cyclical, capital intensive industry.

4) Komag’s customers (STX in particular) have internal media (disk) manufacturing capacity.  To me, this is the largest risk to the stock price.  While in the long term Komag has a solid position in the industry, a downturn will most likely be challenging for them.  In the event of a significant downturn, a customer will most likely keep its internal media manufacturing running while cutting on external supply.  This, of course, assumes that the customer will be far along in the implementation of PMR or the leading technology at the time.  Thus the challenge for Komag is to maintain its technological edge to ensure uninterrupted demand for its product.  Presently, it looks like Komag is doing fine on the technology front.  Equally important would be its ability to minimize cash costs and capital expenditures when necessary.  While there are positive indicators that they should be able to do a good job on this front, is hard to know how it would play out.  In addition to a seasoned management team, who experienced bankruptcy a few years ago and who continuously speak about judiciously adding capacity, Komag should be able to timely react to a downturn because of their close integration into their customers supply chain (where Komag has one week of inventory).

In addition to the risks mentioned above, some headlines suggest that NAND flash could substitute disk memory in the laptop market.  It looks very unlikely that there could be meaningful substitution in the foreseeable future.  Granted, it could be possible for NAND flash to carve a niche in high-end ultra-portable laptops.  The reason I see this potential substitution as unlikely has to do with production cost.  Even after the recent major price declines in NAND flash memory (where very much all players are loosing money), NAND drives are at two orders of magnitude more expensive than hard disk drives for high capacity drives (and one order of magnitude for small capacity drives- typically small-form factor drives).

Conclusion

Most likely Komag will grow faster than the HDD industry due to its lead on PMR and its incursion into the 65mm disk market.  The bulk of the R&D and capital expenditures necessary for these two programs are behind them.  Productivity gains related to the PMR learning curve should help offset some/most of the commodity cost pressure.  Thus, cash flow should turn out strong.  Finally, should one expect a meaningful downturn in global IT expenditures, there are plenty of richly priced stocks that could be used to hedge this risk.

Catalyst