The bones of an article
On November 16th, 2011 there just wasn’t enough time to do everything – something had to give. We were packing our bags for our trip to Istanbul, we had to be at the airport by 6:30 p.m., we were making last minute preparations, scribbling out notes for an article on Western Digital (NASDAQ:WDC) and stuffing investors' accounts with their shares as fast as we could. After listening to their Q1 2012 CC call twice [and then Seagate's (NASDAQ:STX)] and having read all of their 10Qs and annual reports for over a year, we were more convinced than ever that WDC had by far the superior management team, and with a confirmation of full insurance coverage including business continuity (that is to say, lost income) after the floods in Thailand, there was no doubt left in what we were doing with investors' money.
Although we only needed the typical hour to knock off the article, it just wasn’t in the cards. By 2:30 p.m., amidst a flurry of phone calls and emails, we gave up on the idea that the article could be published that day, having scribbled out only the framework of an article.
WDC was hardly new to us. Having studied it for over a year, including publishing two separate articles on the company (in one the future price of the shares was accurately forecast), and having purchased the shares in the past with what could be called at least “better than average” returns for investors, we just didn’t think we would see sub-25 pricing again in our lifetime. Then came the historic floods in Thailand.
The timing of the sell-off in the shares of WDC was almost perfect - if irrational - we had just unloaded huge positions in Force Protection (NASDAQ:FRPT) even though we felt General Dynamic's (NYSE:GD) tender offer was too low. The way we saw it, our investors would just have to live with the 39.2% annualized return (47.6% better than the S&P 500) on the shares of FRPT we had just gotten them. Now sitting on a ton of investors' capital because of the highly concentrated position in FRPT and the related return, we had a very good idea about where to put at least part of it.
We didn’t mind dumping the FRPT shares at only $5.52, although we understood there was a good chance the 17 or so shareholder lawsuits which would ultimately amass may well force GD to offer a price which more accurately reflected the correct appraisal of the company. The correct appraisal was published in several Amvona articles during 2011, and so amongst the other phone calls we were receiving that morning, we were also hearing from securities lawyers (who had read the Amvona articles) about the FRPT sale.
We’re used to speaking to lawyers, but usually foreclosure defense lawyers. This has especially been the case after our legal analysis of the Bevilacqua case appears to have reached about ½ million people, thanks at least in part to Seeking Alpha featuring it twice on their home page (once in "Market Currents" and again as an “Editor's Pick”) and thus exposing it to their 50 million unique monthly readers. Countless other sites did the same and the article received many thousands of shares on Facebook as a result. We definitely weren’t making any apologies for the opinion either, especially when MA attorney general Martha Coakley's action vindicated nearly two years of our advocacy on behalf of MA homeowners.
There appears to be an inverse relationship between how Amvona stock picks move up, and big banks stocks such as BAC, C, JPM, and WFC move down – perhaps the legal analysis (and the related readership) has contributed in some small way to the phenomenon.
Lamenting that the WDC article couldn’t be published, and knowing the shares would soon rise, we got on our plane. When we arrived late in the evening at the Holy Monastery of Halki, on the Prince Island of Heybeliada - we went directly to greet our dear friend the Abbot, Metropolitan Elpidophoros of Bursa. By God’s providence, there was a Western Digital 2TB Caviar Black hard drive sitting on his coffee table (reminding us of the original Amvona article on Western Digital that pointed out that hard drives often need to be replaced). Picking up the drive we remarked to the Bishop that we had just started writing an article on the company that morning, but failed to get it published. We indicated that because of the floods in Thailand the price of HDDs would soon rise, and that the shares of the company were on sale without good cause (thinking of WDC's superior management and complete insurance coverage). He joked that maybe he should sell the drive; with a laugh, we suggested eBay.
Put your life on it®
That’s WDC’s tag line - although we would have been equally satisfied with, "Put pictures of your son watching TV with the Ecumenical Patriarch on it". Admittedly, the only problem with our suggested catchphrase is that it might be a little long for letterhead and business cards. Either way, it’s not hard to imagine that with such a slogan, the brand might involve at least some consumer trust and loyalty. Yet, the company books only a pittance for “Goodwill” on their balance sheet.
So what is the real value of the company? At $25.65 per share the enterprise value (the important figure to a potential acquirer) of the company is only about 2.5 billion. Would anybody offer that price to acquire the entire company thinking it reflected reality? So why are buyers, or better yet sellers of "shares", so different?
A few points to consider:
1. Goodwill alone may be worth as much as 9 figures - how do we know? Because you wouldn't back up your home movies and financial data to an “Acme” hard drive either.
2. At FYE 2011 the company threw off 756 million in free cash and almost the same amount in net profits – at that rate the buyer at the above price recoups his investment in 3.3 years – that is to say, they are generating 30% of their enterprise value each year in free cash flow (and 2011 wasn't an extraordinary year).
3. Demand is growing, prices are rising and the industry is consolidating.
Buying shares in a company through the stock market means acquiring a part of the entire business. Curiously, this often happens at a discount for no other reason than the fact the company has been divided into “shares”. That is to say, an outstanding business such as WDC can often be purchased on any given day at a pro-rata price well below what it would take to buy 100% of the company. When there is a shock to the company, even if its effects are fully insured, the market responds sometimes by "giving away the farm."
A note on profitability
A business’s profitability is determined by these three things:
1. Its return on assets
2. The cost of its liabilities
3. If and how it uses “leverage.” This is to say the degree to which its assets are funded by liabilities rather than equity.
Since there will soon be only two major players in the storage business (STX and WDC), it is worth comparing the two on these three basic points. We do not want to go into all the details here because the information is readily available online for free, but suffice to say, there really is no comparison.
We don’t mean to scandalize the readers - but our $67 per share appraisal of WDC’s business on a day when shares were selling in the 25s had much less to do with crystal balls than with deductive reasoning.
By the time we returned to work on Nov. 29th, the shares had already risen substantially so we didn’t publish the intended article. Instead, we published our third article on Skechers (NYSE:SKX), which we had been buying for investors from our cell in the Monastery.
The shares of WDC have now climbed about 30% since we started buying just over two weeks ago (although, as pointed out, they are likely nowhere near their real value, having told investors on Nov. 16th what we thought the company is worth). Nonetheless, we cannot relish in the glory because the article didn’t actually get published before the rebound, but our time at Halki more than makes up for the ego fest we would have enjoyed otherwise.
In those days we saw such beauty and felt such peace as can scarcely be believed to exist any longer. We were blessed to have the opportunity to celebrate the liturgy in the chapel of the Holy Monastery with Metropolitan Elpidophoros and the Ecumenical Patriarch, witnessing the ordination of a worthy young man to the office of deacon, an event which had not taken place at the monastery for years (because of the Turkish government's enforced closure in 1971). Hardly a week later Vice President Biden would be there meeting with the Patriarch - the reopening of the school becoming a central theme of the discussion on freedom in the Arab world. It was like a miracle for Orthodoxy – it was to be part of history. Later we would also be privileged enough to be at the elevation of the first Metropolitan of Singapore in a marathon of Orthodox Liturgical beauty – we still could not believe that men with Constantine’s character and innocence still existed.
One member of our party bemoaned the fact that we scarcely left the monastery, and therefore did not have an opportunity to visit the usual tourist sites such as Agia Sophia – but that meant nothing to us - for watching the innocence of a child encountering the living church in the person of the first Bishop of Eastern Orthodoxy was to understand more fully that where the bishop is, so also is the church. So it was that empty buildings and egotistical articles came to mean nothing, and with this conclusion we decided to publish our article anyway - having first safely backed up the images from our trip onto a Western Digital hard drive.
Here is what the benchmarked returns for WDC look like as of Friday December 2nd, 2011:
S & P 500
The following are the rough notes that would have been our article on WDC back on November 16th, 2011 (it is entirely in rough form). It was frantically scribbled out (as partial thoughts or incomplete sentences) – it is the unedited and unrefined way we think about securities when they are purchased and before they are packaged for mass consumption into nice neat articles… perhaps those fragments still have some small value. Most of what was seen so clearly on that day (as below), has since come to pass precisely as envisioned.
On August 11th, 2010 we acquired shares of Western Digital for investors at $24.15 per share, explaining our reasoning in our article “640K ought to be enough for anybody…” WDC vs. STX” . That investment ultimately returned ~38% (and ~140% annualized) to investors which we explained in our update article one year later. When we sold the shares at $33.40 in November of 2010, we didn’t think we’d have a chance to purchase them again at the discount we had initially.
The tragic floods in Thailand have disrupted WDC business, shuttering two production facilities. WDC’s chief competitor however STX, did not have their facilities damaged. The result is that in the last thirty days STX has climbed about 55% while WDC has declined about 5% - a delta in performance of about 60%. However, this is not rational or justified.
Today, we purchase the shares again for investors at $25.65, we believe at this price the shares are essentially trading at the equivalent of a five year low.
Almost exactly three years ago to the day WDC traded at a five year low in the midst of the financial implosion that we call the fall of 2008. The shares sold for only $10.38 on November 17th, 2008. That is less than half the price today, but the equity in the company was also about half at the time.
One key difference however is that in the fall of 2008 the company was seeing long term weakness in demand in the HDD business – the opposite is true now.
With the tragic floods in Thailand disrupting...
WDC superior management
Shipments and gross margins improving before catastrophe
Natural catastrophe could make great management team even better
Temporary boast to ok management team may only make them weaker in the long run (STX)
The disaster is really not the death nail to WDC and the boost to STX that the market maybe perceiving.
New products at WD are exciting (e.g. sentinel DX400)
Brief discussion of financial condition
The company is worth twice what it is selling for today – STX which is not a better company and weaker financially is selling at 3x book value while WDC, the superior concern is selling for 1 x.
2 x book value is probably in the neighborhood of minimum fair value for WDC – puts price at $50
Over 50% of share price in networking capital
Conservative estimate of goodwill and intangibles
Argument against the Hitachi unit integration
When have they ever not executed (WDC)?
Restatement of the argument:
If we are wrong about the overview above and WDC is really adversely affected by the disaster, than at least we can fall back on the full insurance coverage – business continuity coverage as we understand it means loss of income, the assets and equipment and facilities are all fully insured according to the Q1 2012 CC (not to mention in the CC they mention moving the most important equipment out of harms way in time) - we’ll have to remember to send Needham and Co. a Christmas card for helping serve up such a great value.
As it turns out after the rather large and expensive experiment, hard drives do not float after all, and the principles of physics are safely affirmed. However, one bi-product of the experiment nonetheless was the discovery that insurance companies will still buy them along with the factories they are made in (even soaking wet) when required to.