I think a lot of it was predicated on investors getting drawn to these companies because they were becoming much more prevalent within consumer applications and not just tied so much to the PC market. People saw that diversification as an attractive play for these names.

Then, in the summer, there was the big announcement by Apple to use flash-based technology in their lower-end iPod, so they discontinued their Shuffle line and introduced their nano product, which at the low end is using flash instead of disk drives (the 1-inch disk drives). People looked at that as the first salvo by flash makers to take over the storage market.

For flash, digital cameras were the primary growth driver, and now flash is being used in some of the lower-end MP3 players. And people saw that as flash expanding and getting into some of the higher-capacity products that Apple and others are providing.

But essentially, disk drives are still being used for the higher-capacity products, and I don't see that changing anytime soon. In the recent pickup, people are starting to realize that's the case. Stocks were really beaten down. If I look at what I'm targeting for calendar 2006, both Seagate and Western Digital are trading [at a price-earnings multiple] below 10 times my estimates for next year.

At the same time, SanDisk (SNDK ; ranked hold; $60) has appreciated substantially this year, by about 150%. Investors piled into the flash-based technology, but now they're taking a step back and saying there still will be applications where disk drives will be the technology of choice.

Also, disk drive makers reported relatively strong September-quarter numbers. And tech has had a nice little run recently, and that has helped these names as well because they are high-beta, highly volatile stocks. When the trend is positive, they tend to outperform.

A couple of factors. PC unit sales are forecast to rise 15% this year -- this area still consitutes 75% or 80% of revenue for disk drive makers.

But the big driver is going to be the expansion into the other consumer-related areas. I mentioned the MP3 and music players. There's also the DVR and PVR market, which is growing by leaps and bounds for some of these companies, and uses disk drives within set-top boxes that are separate from the TV and also the ones that are built into the new HD-TV sets.

We also have video-game consoles -- the new Xbox is a good example, and it's coming out this month. Within automobiles, disk drives are used in global-positioning systems and also for diagnostics to figure out any problems with the car.

Two other areas, which at this point aren't using drives but focus more on flash, would be digital cameras and cellular phones. For instance, if you want to watch video on your cell phone, with flash technology right now the maximum capacity is 8 gigabytes. But if you want to watch streaming video and store photos, or even store thousands of songs on your iPod, that takes up more memory and more capacity, and that's where the drive makers come in. So those are two other applications where you can see growth.

In the past, they've been so susceptible and so tied to the PC market that they've often been given below-market p-e's and valuations, and also because the stocks are so volatile. But now, about 25% of their business is coming from these other areas, and that will continue to grow. In the next two or three years there might be more of a 50-50 split [between PCs and other consumer products]. That will help diversify their revenue and make the stocks less volatile, less subject to one particular end market.

IDC forecasts unit growth for 2005 to be 22%. In the longer term, from 2004 to 2009, IDC sees a compounded annual growth rate of 15%. The fastest-growing areas are external hard drives that you use in the home, the consumer-electronics area, and notebook PCs.

Pricing usually declines 3% to 5% per quarter -- that would be considered normal, and that's what we saw in the September quarter. But prior to that, over the last few quarters, average selling prices were actually ticking up a little bit. That's unusual.

I think it was geared to the push into the consumer market. They were able to get higher margins, more than from their traditional PC base. Demand was just outstripping supply.

That was a limited phenomenon, and I think we'll see more of a fallback in prices into the historical range of 3% to 5%, which is reasonable and what's expected.

I would add that the amount of inventory is important to stay abreast of because it affects pricing. Normally the companies like to keep channel inventories in the four-to-six-week range -- that's the amount of supply they have on hand. That has been the case for more than a year now. If it's below that range, they can't meet all the demand. And if it's above six weeks, we usually see prices fall.

Many times some providers will be cutthroat with prices to try to gain share. But right now there's a real nice balance there. Industry inventory now stands at about 5 weeks -- that's very encouraging.

There are seven players that account for 99% of the market. Only three are independent providers -- Seagate, Western Digital, and Maxtor (MXO ) -- and the rest are part of larger conglomerates. Seagate is the overall leader in terms of market share, and Western Digital is the second. The other companies are Samsung, Hitachi (HIT ; strong sell; $64), Toshiba (TOSBF ), and Fujitsu -- these are the conglomerates with disk drive units.

Seagate is my 5 STAR in the group. Part of the reason for that: Its No. 1 market position is a big plus. Broad product portfolio is a key, especially as you have new devices that utilize disk drives, and [it has] the ability to serve that market and ramp up product quickly, whether it's a 1-inch form-factor drive or 3.5 inch form-factor, and anything in between. That allows it to take advantage of growth opportunities, and with technological innovation.

It's one of the first companies to release a product based on perpendicular recording. Bits of data on the drive are normally horizontal. There's a new concept where the bits are laid vertically, or perpendicular to the disk. That allows you to put more information on each disk. The problem before was they were running out of space. Now they can put more capacity on each drive.

Focus on companies that are looking into making a lot of progress in the consumer area -- whether they have a product there already or are coming out with something. Make sure they serve a broad range of products and focus on the latest technology -- I mentioned perpendicular recording.

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report.

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