After a three-month hiatus due to work commitments, I am back with a post on a business I've been looking at for quite some time (and more recently kicking myself over).
In my previous post "Thoughts on investment selection in a richly priced market" I discussed the category of investments that I call "Quality Value," which I defined as companies with similar characteristics to those that Warrant Buffett sought out in the post-Buffett Partnership phase of his career. To recap I believe that Quality-Value opportunities essentially combine the prudent, value-focused principles of Graham with the more forward-looking growth-oriented concepts espoused by Philip Fisher in Common Stocks and Uncommon Profits. Citing the example of Buffett's investment in Coca-Cola in 1998, in such opportunities, the value resides in the quality of the business, namely its consistency in terms of returns on capital and its favorable long-term prospects, which enables the Quality Value candidate company to grow (or compound) in value over time. As such, a Quality Value investment involves purchasing a business at a price that represents an attractive discount to a conservative estimate of its intrinsic value.
With this definition in mind, I believe that Western Digital Corporation (WDC), a $15.5 billion market cap hard-disk drive (HDD) manufacturer is a potential Quality Value investment. It has consistently appeared on my personal Quality Value stock screen for quite some time. When I first started looking at it some 14 months ago, it was priced at $30 - $32 per share, or a market cap of about $8 billion.
So I've been kicking myself in recent months on account of WDC's run-up in share price. The chart below perhaps best illustrates why I should be kicking myself (very hard) at the moment:
June 2012 - July 2013 WDC share price
A 120% increase in share price for an S&P 500 constituent in the space of 14 months is pretty spectacular, even in the current, abnormal QE-juiced market. In hindsight, it was clearly an undervalued business and should have been an obvious buy. For reasons I will outline below, it was then, and remains now a strong business, in a sector with favorable business prospects.
Before getting into the present situation with regard to WDC, context is useful here first: 14 months ago when it appeared on my Quality Value screen, its $30 - $32 share price implied a EV/FCF multiple of 4.0x - 4.5x, a net cash position and a 10-year track record of consistent double digit growth in revenues, net income, free cash flow and consistently high returns on unleveraged net tangible assets (10-year average to 2012 of 27.2%). Flipping the then multiple around it implied a FCF yield (on EV) of c. 21%! My take at that time was that the business was clearly undervalued, and erroneously priced for obsolescence, with a payback of 4 -5 years, with no residual or terminal value to the investment - for the (at the time) second largest HDD manufacturer in the world in a field of about 5-6 competitors. I really wish I had taken a position. Why didn't I buy? Personal circumstances meant a lack of any funds at the time to make a meaningful investment unfortunately. So I've missed out, right? Possibly not.
Reading Whitney Tilson's presentation at the Value Investing Congress from last May, his point on the three most dangerous words in investing being "I missed it" particularly resonated with me. His exact point went as follows:
"Anytime your hear yourself saying "I missed it," STOP! Re-do your work, ignore the historical price, and focus on the only question that matters: is the stock price, at today's price, an exceptionally attractive investment? If so, BUY IT!"
This point has given me cause to re-evaluate WDC at its present price of approximately $66 per share, and ask that key question of whether it is still an exceptionally attractive investment, i.e. is it available for purchase with a margin of safety below a conservative estimate of intrinsic value?
Without getting into a detailed financial analysis and valuation of the business (I will be posting a detailed investment case separately in due course), my conservative estimate of intrinsic value for WDC is a range of $85 - $105 per share, or in market cap terms (to consider the scale of the entire business rather than just per share values which can be open to manipulation), I believe it is a $20 billion - $25 billion company, versus its present $15.5 billion market cap. Some might say this is a broad range, but as Buffett has said about intrinsic value, when he buys a business he never knows exactly what its intrinsic value is, he just knows that its intrinsic value is well in excess of the price that he pays.
Why is it undervalued?
When I looked at WDC at 4.0x - 4.5x FCF some 14 months ago, it's price was depressed due to two primary factors in my view:
- The devastating floods in Thailand in October 2011 which resulted in temporary suspension of operations, as WDC's facilities there (along with those many supply chain companies to the computing and data storage industries) were forced to close, forgoing sales and incurring exceptional costs in the tidy-up; and
- Apple/tablet-mania swept over investors in a tidal wave-like manner, as Apple's share price marched from $570 to $700 per share between June and September 2012, as many commentators predicted it would become the first $1 trillion dollar company; WDC as a perceived PC-oriented, HDD company with little exposure to the newer solid-state drives used in most tablets, and only modest exposure to enterprise and cloud storage customers was viewed as heading towards obsolescence.
Both of these factors were clear signs of a flawed assessment by investors as to the true value of WDC. The first factor, the Thailand floods, were a temporary adverse event, not a permanent one - the floods did not change the fundamental operations and prospects of WDC's business. Revenues, net income and free cash flow all rebounded after the floods, to the point that WDC (aided by the intelligent acquisition of Hitachi Global Storage Technologies or HGST, at a time when all data storage businesses were depressed) is now the dominant HDD manufacturer, having overtaken Seagate (STX) in 2013.
The second factor of Apple/tablet-mania was a classic case of WDC falling heavily into the out-of-favor bin, due to the post-PC narrative that prevailed as Apple (AAPL) and Samsung (SSNLF.PK) rose to prominence and tablets started to cannibalize PC sales. While there is no disputing that PC volumes have declined sharply as tablets have soared, this viewpoint of WDC as being in the wrong place and time in terms of both the device trend (tablets vs. PCs) and the technology trend (SSD vs. HDD) was misinformed and erroneous.
In terms of the device trend, while PC units may be declining, more tablets mean more data creation, which has to be stored somewhere, i.e. the cloud. And where is cloud data stored? On large enterprise data storage platforms. Which WDC has exposure to.
In terms of the technology trend, WDC also at that time had already started to invest in SSD (since 2009 in fact), and its enterprise storage business had started to grow (again bolstered by the HGST acquisition). Moreover, not all data needs to be stored on SSD - SSD offers higher performance, essential for rapid access, but this is not necessary for all data. Additionally, the cost of SSD is significantly greater than HDD storage solutions to the point that SSD for many consumers (business and individuals) simply does not make economic sense. And with the exponential growth in digital content, HDD remains a reliable and the cost-efficient solution for most storage needs.
But investors actually did not actually understand any of these factors, and instead got caught up in the short-term noise in terms of both the temporary and longer-term factors that impact WDC's business and the data storage market more generally.
But that was then and this is now - what is the use of reviewing what happened 14 months ago and investors' flawed judgment of the company and its prospects then? To learn from such mistakes and lost opportunities of course.
Now back to the present situation. After a 120% rally, is WDC still undervalued? And if so why? And what is the catalyst for a re-rating of the business towards my estimate of intrinsic value for the company?
I believe it remains undervalued, based on my conservative estimate of intrinsic value of between $20 billion - $25 billion as indicated above, which approximates 10x - 12x maintainable free cash flow. This is also supported by DCF analysis (to be made available in a subsequent post) using a 15% discount rate (Buffett's stated after-tax targeted return). Its present market cap of $15.5 billion values it at 7.4x maintainable free cash flow, and implies a 30% - 60% discount to intrinsic value.
So if intrinsic value is $20 billion+, why is WDC still undervalued by the market?
It comes down to investors still not understanding WDC's business and it prospects. Essentially, WDC suffers from a double-fear of obsolescence:
- Firstly, it suffers from the perception that it is primarily a PC-related business, having historically been a major manufacturer of hard disk drives ("HDDs") for the PC market, and so is part of the "Death of the PC" narrative that has gained traction with the rise of smartphones and tablet computing.
- Secondly, HDDs themselves have come to be viewed as a storage medium destined for obsolescence with the increased adoption of Solid State Drives ("SSDs") that use flash memory and storage technology, which offer improved performance over HDDs and which are used in tablet devices
These perceptions of both WDC and data storage technology are in fact overly simplistic, flawed, and constitute a real misunderstanding of both the company and the data storage market itself, for the following reasons:
- Firstly, non-PC related business now accounts for 51% of WDC's revenues as of June 2013, and the company has a growing exposure to the higher margin enterprise and cloud data storage segment
- Secondly, WDC has and continues to develop a significant SSD offering, with 4 SSD-related acquisitions (SiliconSystems, HGST, STEC, VeloBit) since 2009 as well as a strategic investment in a pure-play, high-growth SSD business (Skyera)
- These acquisitions are evidence that management are transitioning the business from pure HDD to HDD and SSD, recognizing that both have a role in the continued growth of digital content and consequent storage requirements
- Therefore WDC is not actually just a HDD business, and indicates intelligent capital allocation by management to enhance its data storage offering, gain exposure to the high-growth SSD/tablet computing market and thereby combat any potential obsolescence risk facing traditional HDD storage.
- The threat of obsolescence facing HDD is overstated, as not all data needs to be stored in SSD form and not every device needs rapid SSD access. Additionally, SSD remains up to 10x more expensive that HDD technology and the continued rapid growth in data and digital content means that HDD remains the most economic and appropriate medium upon which to store the majority of data. To use an analogy, a Lamborghini may get you from point A to point B quicker than a Hyundai, but the Ford can do the same journey just as well, is cheaper to replace if it breaks down and is more practical for most road types!
- Furthermore, WDC has a consistent 10-year track record of increasing revenues, earnings and free cash flow while delivering strong returns on capital with minimal debt, to the point where it's the dominant operator in the HDD space, with a growing SSD presence
- In addition to the above company-specific characteristics, the general outlook for data storage business prospects appears to be quite positive: data and digital content continues to growth at an exponential rate, and is perhaps one of the great secular growth stories of our time - digital content growth and the corresponding growth in storage requirements are forecast to have a CAGR of between 30% - 50% over the next 5 - 7 years according to various industry and market reports. On this basis, it is clear that the data storage business is one with favorable long-term prospects, which bodes well for WDC
The above facts appear to have been lost within the clamor for all things smart/tablet-computing related in recent times however, leading to the erroneous judgment that the risk of obsolescence will be too great for WDC to overcome, hence its low valuation. All of this therefore creates an attractive investment opportunity.
So with positive prospects, a strong business and intrinsic value of $85+ a share, what is the catalyst that will move the current share price to converge with intrinsic value?
The catalyst for value-price convergence is a re-pricing of the company by investors in recognition of two key factors: (1) at the broader industry level, digital content will continue to grow at an exponential rate and which will require storage, with the additional realization that the PC will not die and that SSD is not necessarily the appropriate storage medium for all data, and (2) WDC has proven itself to be the best in class operator, with an excellent business that already offers multiple storage solutions that cater to all major areas of storage demand. At its present market cap, WDC offers a FCF yield of 14.1%. Once investors fully appreciate this, I believe WDC will be re-rated towards its intrinsic value range of $20 billion - $25 billion.