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On 24th April Western Digital (WDC) reported revenue of $3.8 billion, hard-drive shipments of 60.2 million and net income of $391 million, or $1.60 per share for its third fiscal quarter ended Mar. 29, 2013. On a non-GAAP basis, net income was $514 million or $2.10 per share. This handily beat street consensus of revenue of $3.6 billion and non-GAAP EPS of $1.77, an earnings beat of 18.6%.

These results are all the more impressive in light of the recent negative news flow on the Personal Computing front, where market-research firm IDC estimated that PC sales are forecast to register a vertiginous decline of nearly 14% in the first quarter from a year earlier. IDC said it was the worst quarterly drop for PC shipments since it started tracking the data in 1994.

As outlined in my Seeking Alpha article a year ago, the Hard Disk Drive (HDD) Industry has benefited from a fundamental change in the supply dynamics, and this change has not yet been fully digested by the stock market. (See Western Digital Hitachi Merger A Huge Positive For The Former, which summarizes the rapid consolidation in the industry and the better capacity discipline that is the result.) As WDC hovers around all-time highs in what was historically a deeply cyclical industry, I believe there is still ample room for the shares to run.


(Click to enlarge)

The basis of my buy recommendation is twofold: WDC is NOT hostage to the deteriorating outlook of Personal Computers; a rerating (i.e. a P/E or cashflow expansion in multiple) that reflects the reduced cyclicality of the industry.

WDC is much more than PC's

Any reader who believes in the death of the laptop/desktop (as he squints at this article on his smartphone or elegantly sips cappuccino whilst browsing on his tablet) should review the earnings call transcript of WDC's conference call.

One of the most important statements made was by the CFO, Wolfgang Nicki:

"Over the last 5 years, the revenue contribution of our non-PC related business has grown from 35% in fiscal year '08 and is projected to account for more than 50% of our revenue in fiscal year '13. As a reminder, our non-PC related business is comprised of our Branded Products, Consumer Electronics and Enterprise business which includes SSDs."

To repeat, the majority of HDDs that WDC sells end up in gadgets other than the desktop and laptop. One must remember that the proliferation of devices, the explosion of data/photos/videos that is being created will, almost inevitably, end up being stored on a HDD, be it an external drive in your home or an enterprise server in the cloud.

As for the well-publicized "death of the hard-drive to be replaced by flash," this argument is simply groundless: for capacity starting at 100 gigabytes and going up, flash memory is still more expensive by a factor of 3 or greater, rendering it uneconomic in all but the most elitist devices. Furthermore, in response to the growing presence of tablets (most of which currently have flash-based memory), WDC has just launched a new ultra-thin 5 millimeter HDD, (Western Digital Ships World's First 5mm Laptop HDD And Hybrid Variant) which is very likely to find itself in the innards of the next generation of tablets. From the earnings call linked above, the CEO, Stephen Milligan states:

"Now you are seeing dual-drive configurations where you've got SSD in a hard drive. And so that -- but we're agnostic to that. That's okay from our perspective. The issue is that there are competing devices, for example, tablets, that are more compelling to customers that they're buying instead of PCs. And so if you go back to the 5-millimeter story or the hybrid story, what we're trying to do as a company is provide a more compelling storage alternative in a thin and light package that our customers can work around, design more compelling products to have them buy a PC or a PC-like ultraportable device and versus a tablet."

The Rerating Argument

So what kind of valuation would you give a company that has reasserted its central role in the rapidly changing technology landscape? A company whose product is the storage bedrock of the information highway, whose past was plagued by a wild cyclicality in earnings, but whose future suggests a stable outlook in margins, coupled with a gently rising trajectory in volumes.

The stars are aligned for a rerating in WDC's valuation.

Let's start with their operating cashflow ($3 billion for the year, or $750 million per quarter) and take off capital expenditure, $800 million for the year, (as stated in the conference call linked above, i.e. the regular expenditure after the 2010 Thai floods). This gives a figure of $2.2 billion as post-capex operating cashflow in a year.

The table below outlines a list of cashflow multiples and the resulting valuation, after taking account of the net cash on their balance sheet ($2.3 billion).

Cashflow calc

$ 'mln

Op Cashflow

3000

Less capex

800

Per annum

2200

Cashflow Multiple

4

5

6

7

8

Resultant Value

8800

11000

13200

15400

17600

Net Cash on bal sheet

2300

2300

2300

2300

2300

Sum

11100

13300

15500

17700

19900

shares o/s 'mln

243

243

243

243

243

Price per WDC share $

45.7

54.7

63.8

72.8

81.9

Despite WDC shares currently being at an all-time high, the upside is still very compelling. In fact, even after the major recent run, the company is still currently valued at a bargain basement multiple of 5X cashflow.

To put this into some perspective, the recent buyout offer for Dell (DELL) - whose fortunes are far more entwined with the PC - is being made at a multiple between 9-10 times. In my opinion there are few opportunities as glaring as the one above. I hope the private equity group Silver Lake Partners (which is involved in the Dell buyout with the founder Michael Dell and who curiously enough, have once already been involved in a buyout of STX, floating it subsequently at a massive profit) are taking note…

WDC is no longer a PC component supplier, it's a play on digital storage. And it's a Buy

Source: Western Digital: The New Paradigm Unfolds