Western Digital: A Well Run Company That Is Overvalued

| About: Western Digital (WDC)

Western Digital Corporation (NYSE:WDC) is a global developer and manufacturer of electronic storage products. The company offers a range of products which include hard disk drives, solid state drives, and solid state hybrid drives. Western's management used the cash from operations to invest in acquisitions that should improve the firm's results of operations, such as the acquisition of Hitachi Global Storage Technologies Holdings Pte. Ltd., HGST.

The electronic storage industry is cyclical and benefits from expansionary monetary policy. That, expansionary monetary policy, and key strategic acquisitions have helped Western's share price increase almost 100% since December of 2012. The company's historic returns have beaten the S&P 500 by a wide margin, which could suggest a period of underperformance may be coming.

That said, I think the company's results of operations in fiscal 2013 will be adversely impacted by declining PC sales; that will act as a headwind to already extended valuations. But, declining PC sales could be offset by strength in the Enterprise and Non-Compute segments as well as new offerings in the mobile space.

I think the management of Western's cash flow is providing it with a competitive advantage to rival Seagate (NASDAQ:STX). But, based on my models, the common equity shares are overvalued, and I can't put money to work long the stock unless it declines 20+% -- assuming the valuation stays the same.

Risks

  • From time to time the industry has experienced periods of imbalance between supply and demand. To the extent that the disk drive industry builds capacity based on expectations of demand that do not materialize, price erosion may become more pronounced.
  • The bargaining power of customers and suppliers could adversely impact the results of operations.
  • The increasing demand for cloud compute services is decreasing consumer demand for storage capacity.
  • The share price will continue to be volatile and investors could lose a portion or all of their investment.

Recent Developments

  • Western Digital acquired privately held VeloBit, a provider of high-performance storage I/O optimization software. VeloBit enhances storage system performance with its software technology by adding a transparent acceleration layer utilizing solid state drives [SSDs]. The move bolsters Western's offerings and should be accretative to operating results.
  • Western Digital announced that they entered into a definitive merger agreement with sTec, Inc. (NASDAQ:STEC), an early innovator in enterprise solid-state drives.
  • The company demonstrated its solid state hybrid drives [SSHD] and 5 mm ultra-slim hard drive technologies in tablet and other thin-and-light devices at the COMPUTEX TAIPEI 2013 trade event. Rival Seagate is ramping production of a 2.5-inch solution for the slimmest devices in the back half of 2013.

Business Profile

Western Digital is an industry-leading developer and manufacturer of storage products that enable people to create, manage, experience and preserve digital content. The company designs and makes storage devices, networking equipment and home entertainment products under the WD, HGST and G-Technology brands. Western serves each of the primary markets addressing storage opportunities -- enterprise and cloud data centers, client, consumer electronics, backup, the Internet and other emerging markets such as automotive and home and small office networking.

Western's principal products are hard drives, which use one or more rotating magnetic disks to store and allow fast access to data. Hard drives are today's primary storage medium for digital content. Further, hard drives are used in desktop and notebook computers, multiple types of data centers including private and public cloud data centers, home entertainment equipment and stand-alone consumer storage devices. Western also offers solid-state drives, home entertainment and networking products and applications for network backup, smart phones and tablets.

The company mainly sells its products in Asia and its distribution channel is primarily comprised of OEMs, but includes distributors and retailers.

There are three main operating segments: Compute, Non-Compute, and Enterprise. Most of the unit shipments are generated from the Compute segment, with Non-Compute representing the second largest segment.

During the quarter ended March 29, 2013, 45% of Western's revenue came from sales to its top 10 customers. Those customers have bargaining power as they have a multiple suppliers to select from and therefore the company lacks pricing power and the ability to pass increases in costs along to customers.

Western Digital purchases supplies from a limited number of suppliers. Thus, its suppliers have bargaining power, which could result in a higher cost of revenues and a lower gross margin and cash flow from operations. Also, shareholders' equity and EPS wouldn't increase as much as it would if the company's suppliers didn't have bargaining power.

Consumers traditionally have stored their data on their PC, often supplemented with personal external storage devices. Most businesses also include similar local storage as a primary or secondary storage location. This storage is typically provided by hard disk drives. Over the last few years, cloud computing has emerged whereby applications and data are hosted, accessed and processed through a third-party provider over a broadband Internet connection, potentially reducing or eliminating the need for, among other things, significant storage inside the accessing computer. Cloud computing poses significant potential downside risks to Western Digital's results of operations.

Also, Western's customers' storage needs could be satisfied at lower prices with lower capacity hard drives or solid-state storage products that the company does not offer, thereby decreasing Western's revenue or putting the company at a disadvantage to competing storage technologies. As a result, even with increasing aggregate demand for digital storage, if Western fails to anticipate or respond timely to developments in the demand for storage, its ASPs could decline, which could adversely affect operating results.

SSDs have no moving mechanical components. This distinguishes them from traditional electromechanical magnetic disks such as hard disk drives [HDDs] or floppy disks, which contain spinning disks and movable read/write heads. Compared with electromechanical disks, SSDs are typically more resistant to physical shock, run more quietly, have lower access time, and less latency. However, while the price of SSDs has continued to decline, SSDs are still about 7 to 8 times more expensive per unit of storage than HDDs.

Hybrid drives or solid state hybrid drives [SSHD] combine the features of SSDs and HDDs in the same unit, containing a large hard disk drive and an SSD cache to improve performance of frequently accessed data. These devices may offer near-SSD performance for many applications.

Most of the advantages of solid-state drives over traditional hard drives are due to their ability to access data completely electronically instead of electromechanically, resulting in superior transfer speeds and mechanical ruggedness. On the other hand, hard disk drives offer significantly higher capacity for their price.

SSDs have faster start-up times, random access times, read latency times, and data transfer rates than HDDs. Also, SSDs can tolerate higher temperatures and use substantially less power.

There continues to be a rapid growth in devices that do not contain a hard drive, such as tablet computers and smart phones. As tablet computers and smart phones provide many of the same capabilities as PCs, they have displaced or materially affected, and may continue to displace or materially affect, the demand for PCs. That could cause demand for Western's products to decrease.

Western Digital acquired Hitachi Global Storage Technologies Holdings Pte. Ltd., HGST, from Hitachi Ltd. for $4.7 billion. HGST is a developer and manufacturer of storage devices. Goodwill represented 38% of the purchase price, a fair amount compared to other acquisitions.

Financial Performance Forecast

The acquisition of HGST added $3.1 billion to net revenue in fiscal 2012; absent the acquisition, net revenue would have declined to $9.4 billion from $9.5 billion in fiscal 2011 and $9.85 billion in fiscal 2010. Revenue in fiscal 2013 increased to $15.35 billion from $12.48 billion in fiscal 2012. Fiscal 2012 includes only half a year of HGST operating results; fiscal 2013 includes a full year of HGST operating results. In an attempt to compare apples to apples, revenue declined from $4.75 billion in fiscal fourth quarter of 2012 to $3.73 billion in the fiscal fourth quarter of 2013; I expected declining revenues as hard drive sales decline on softer demand. The increase in revenue because of the acquisition masks the weakness in demand for the firm's products. But, industry consolidation is a positive for valuations longer term as consolidation could increase pricing power.

The impact of the acquisition makes it more challenging to model this company's results for fiscal 2014. That said, I think there will be continued weakness in desktop and notebook sales; but, I think consumer electronics and branded enterprise could show strength. Overall, I think revenue could decline 3% to 5%; that would put fiscal 2014 revenue between $14.58 billion and $14.89 billion.

Relative to fiscal 2013, I think the operating margin will contract from 15.7% to 13%, which is slightly below the low end of the company's guidance. But, I think the net income margin stays roughly the same at about 11%. Consequently, I am looking for operating income in the $1.9 billion to $1.94 billion range and net income in the $1.6 billion to $1.64 billion range.

The financial performance in fiscal 2014 should act as a headwind to the valuations. That said, Western Digital is liquid and solvent. The company keeps a larger cash pile than rival Seagate, which I think is better for the long-term prospects of the company. For example, Western was able to spend $4.7 billion acquiring HGST, which was accretive to operations. In terms of cash management, I think Western has the competitive advantage.

Valuations

I'm going to use discounted cash flows and multipliers to value the common equity shares of Western Digital. In fiscal 2013, the company paid $1.00 of dividends; I think the payout ratio is on the low side. Thus, I am modeling a 25% percent increase in the fiscal 2014 dividend to $1.25/share.

Discounted cash flow models are sensitive to changes in the assumptions. Given the facts surrounding this company, I think the most reasonable estimate of intrinsic value using discounted cash flows is $62.50.

Moving on to the justified value, I estimate the justified price/earnings ratio as 10. Currently, the price/earnings ratio is 9.92. Thus, the intrinsic value using this metric is $68.85.

Now, I will use the historic multiplier model valuations to value the common equity shares. Using the price/earnings ratio, the intrinsic value is $58.77. The intrinsic value using the price/book ratio is $53.92 and is $54.64, using the price/sales ratio. The intrinsic value using the price/cash flow ratio is $55.49. Consequently, the average intrinsic value using this model is $55.71.

The average intrinsic value of the three models and the intrinsic value of the common equity shares of Western Digital Corporation is $62.35. Western Digital Corporation is overvalued by 9.5%. I would use a 20+% decline in the share price to accumulate shares, $54.64 or less.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.