Tread Carefully With ETFs With Hard Disk Drive Exposure

It is tough to malign hard disk drive makers such as Seagate Technology (NYSE:STX) and Western Digital (NYSE:WDC).

Year-to-date, Seagate is up 26 percent while Western Digital has surged over 33 percent. By comparison, the PowerShares QQQ (NASDAQ:QQQ) is up "just" 8.8 percent. Still, some analysts are not overly enthused with the outlook for hard disk drive makers.

"Worldwide HDD shipments declined for the second consecutive year in 2012, but for only the third time since 2001," said S&P Capital IQ in a new research note. "According to independent firm IDC (as of April 2013), assuming the PC market can rebound in the second half, shipments should grow by 2.2% in 2013 and at a compound annual rate of 2.1% for 2012 to 2017. Given a modest pricing decline, IDC predicts hard disk drive revenue to decline at a 0.6%compounded annual growth rate (CAGR) from 2012 to 2017."

The culprit behind waning HDD demand, as S&P sees it, is increased demand for tablets.

"We think lower HDD shipments going forward will be largely attributable to the weakening PC market. Accounting for two-third of HDD shipments, the PC market is the largest consumer of HDDs. We believe most of the decline currently being experienced in the PC market has to do with the emergence of tablet computers," said the research firm.

S&P noted IDC lowered its HDD shipment forecast for 2013 to 591 million (April 2013 forecast) from 648 million (October 2012 forecast) and to 653 million (April 2013 forecast) for 2016 from 793 million (October 2012 forecast).So it is not surprising that the research firm has two-star ratings on Seagate and Western Digital.

On a related note, S&P Capital IQ has an Underweight rating on the PowerShares Dynamic Technology Sector Portfolio (NYSE:PTF), an ETF where Seagate and Western Digital are the top two holdings combing for just over six percent of the fund's weight.

PTF has gained 10.2 percent year-to-date, but the HDD exposure could be troublesome as S&P Capital IQ is not the only firm that sees weakness ahead. Coughlin Associates sees global HDD shipments slumping 12 percent on a year-over-year basis, according to Forbes.

Last week at the Ira Sohn Conference, Jim Chanos directly highlighted Seagate and Western Digital while calling the hard disk drive business a value trap.

In fairness to PTW, the ETF is not HDD-specific. Other top-10 holdings include MasterCard (NYSE:MA) and NetApp (NASDAQ:NTAP). eBay (NASDAQ:EBAY), Cisco (NASDAQ:CSCO) and Oracle (NASDAQ:ORCL) combine for over seven percent of the ETF's weight so it can be argued an Underweight rating is a tad harsh.

PTF is also a decent idea for investors looking for small-cap technology exposure as small-caps represent over 45 percent of the ETF's weight. PTW has $32.8 million in assets under management and an annual expense ratio of 0.65 percent.

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