Wednesday, June 22, 2011

A Likely End Game to Hostility

The hard disk drive business has been a lousy place to compete for nearly twenty-five years.  It has been the graveyard of many competitors.  Twenty years ago, there were eighty disk drive manufacturers.  By the mid-90s, there were only fifteen.  By 2001, there were eight, and today it appears there are only four.  But the fact that we are at four competitors, especially the size of the leading competitors, means that the industry is likely to come out of its recurring bouts of overcapacity and hostility. 

As 2011 began, there were five hard disk drive manufacturers.  Western Digital led the market with a 31% market share, followed closely by Seagate with a 29% market share.  Hitachi enjoyed an 18% market share, while Samsung and Toshiba shared the remaining 22% of the market.  Recently, Western Digital agreed to purchase Hitachi.  This acquisition would bring Western Digital’s potential market share to 49%.  The top two of the remaining four competitors would then have a potential market share of 78%.  The top three would have more than 85% of the market. 

Hitachi was not just any other competitor in the market.  It had a well deserved reputation for being the most aggressive price discounter in the market.  Hitachi was the major reason that pricing stayed under pressure in the hard disk market.  Western Digital’s acquisition removed the major discounter.

In the past, acquisitions among the hard disk drive manufacturers brought somewhat better margins to the remaining players, but not as much market share as the acquisition would suggest.  The reason was customers rotating other strong suppliers into their relationships to maintain low prices.  With only four players left, and a dominant leader in the market, there is little purpose for the three followers to discount against Western Digital.  A discounter might pick up some temporary share in a market saturated with “last look” arrangements, but it might face a very aggressive pricing response by one or both of the remaining leaders in the market.  No, rather than discount, the economics for all the players would argue for firm industry pricing.  That is the most likely outcome of this acquisition.

Over the years, we have studied many industries in overcapacity.  Overcapacity produces a hostile market, where returns are low and price competition remains intense.  These kinds of markets end in one of two ways, either demand picks up and sops up the industry’s overcapacity, or the industry consolidates to the point where the top four competitors control 85% or more of the industry’s volume.  The remaining players then demur from competitive price discounts. The majority of industries see demand growth pull them out of hostile conditions.

There is one potential fly in this hard disk ointment.  Computer tablets and other portable devices don’t use hard disk drives.  Instead, they use NAND flash drives.  These are solid state drives.  They are more expensive than hard disks, have a much smaller form factor and are generally more reliable.  Samsung, Toshiba and SanDisk are the leaders in this market.  It could happen that Samsung and Toshiba, two of the four remaining hard disk drive suppliers, use low prices in the hard disk market to create customers for their more expensive flash drives.  It is more likely, however, that these two companies, who are distant followers in the hard disk market, would prefer to see higher prices for hard disks.  These higher prices on a competitive product would help some customers in the market transfer alliance to flash drives.

This acquisition should be a good deal for the remaining four hard disk players.  While some analysts have argued that the hard disk drive market will slowly die under the pressure of the growth in the applications of flash drives, industry observers still see an 8% per annum unit growth for this market over the next five years.  That unit growth should come with better margins for the remaining players.

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