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I have covered technology as both an equity and industry analyst for a long time, and one thing that has remained constant is that the hard disk drive industry is both fiercely competitive and prone to poor returns. It is both capital- and R&D-intensive, as drive makers leverage scientific advancement to achieve higher and higher capacity drives.

Worse still, the industry's customer base (i.e., PC makers) is not only highly concentrated, it refreshes products one and even two times a year. Moreover, PC makers benefit from this excess competition and strive to multi-source drives. As a result, the probability for an over-build of these highly fungible products is very high and inventory accretion is a frequent occurrence. This has remained the case, even as the industry has relentlessly consolidated over the years.

Now Western Digital (NASDAQ:WDC) has announced its intent to acquire the Disk Drive business of Hitachi Global Storage Technologies (HGST), which should at last bring more pricing discipline to this intensely competitive industry. The number of major participants will fall by one to four, should the deal close. (See the table below.) It surely caps a pretty good year for WD, in which it outgrew Seagate (NASDAQ:STX) on a unit basis to claim a leading 31.0% share of the market, versus Seagate’s 29.7%.

With Hitachi’s 17.6% market share, WD will now have roughly half of the market. Moreover, Hitachi’s strong enterprise offering (for servers, etc.) will round-out WD’s strengths in the PC and Consumer markets. Investors certainly took heart, sending WDC shares up 17% to $35/share. Seagate shares rose a more modest 9% with the realization that share shifts will result from the consolidation as PC makers re-jigger sourcing arrangements.

Hard Disk Drive Industry Ranking for 2010

685 million HDDs sold

Western Digital

31.0%

Seagate

29.7%

Hitachi GST

17.6%

Toshiba/Fujitsu (OTCPK:TOSBF)

10.9%

Samsung (OTC:SSNLF)

9.6%

Others

1.2%

Source: IHS iSuppli

The boards of both companies have approved the transaction and it is expected to close in the third quarter pending regulatory review and “customary conditions.” WD management expects the acquisition to be immediately accretive to earnings, excluding acquisition-related expenses, restructuring charges and the amortization of intangibles.

The prospect of lessened price competition could pose regulatory issues, though management believes the remaining market will continue to be sufficiently competitive. HGST was itself formed in 2003 through the merger of the parent’s storage business with IBM Global Storage, which it acquired for $1.5 billion. IBM’s storage business had long led the industry in technology, and Hitachi GST is a strong participant.

The deal is indeed attractive. WD will acquire HGST for $4.3 billion, including $3.5 billion in cash and 25 million WDC shares valued prior to the announcement at ~$750 million. Hitachi will retain a 10% interest in the combined company and secure two new positions on its board of directors.

The valuation seems reasonable, though its calculation is a bit laborious as we only know the December-quarter revenues for HGST ($1.543 billion). Given that the industry is notably seasonal, we note that the deal values HGST on a run-rate basis 0.70x the annualized revenue of $6.172 billion. This is comparable to WD’s valuation prior to the announcement of the deal (0.70x annualized revenues of $9.9 billion). WD plans to finance the acquisition with existing cash and a debt issuance of $2.5 billion.

The acquisition will be transformative for WD, increasing the revenue run rate by 62%. It will significantly augment the product line with Hitachi’s enterprise offering, in particular. Presently, in this more profitable market, HGST has a 28% and WD just 1% (versus Seagate’s 58% share). This richer offering should thus improve profitability (on an adjusted basis) and yield the normal operating synergies. The capital structure of the combined company will be notably more leveraged, relative to WD present capitalization (with little debt and $3.1 billion in cash).

All in all, we view the transaction favorably. Maybe, at last, the hard disk drive market will display greater pricing discipline. More to the point, it caps for WD a succession of deals in recent years that have notably broadened its vertical capabilities (adding media and heads), adding to its TAM the most attractive enterprise segment of the market. And with ~50% of the total market, the company will have a notably fortified position in the market.

Source: Western Digital to Acquire Hitachi GST