Western Digital Corporation (NYSE: WDC) is the world market leading hard drive manufacturer. The company supplies a range of drives used in devices from desktop and notebook computers to data centers, gaming platforms and other entertainment devices. The company also manufactures solid state drives, which is the fastest growing area of the storage device market. The company trades (as of 11/14) for a market cap of $6.22 billion of which $3.41 billion (55%) is net cash. Furthermore, the company has averaged free cash flows after acquisitions of $846 million over the last three years, representing an excellent ex-cash yield of 30%. The company has also enjoyed returns on equity averaging 33.5% over the last decade.
Despite the company’s long track record of strong performance, its shares have taken a beating, falling by almost a third over the last six months. The market clearly believes the company’s future performance will not reflect its historical performance. It is our job to assess this for ourselves and determine whether there is a value opportunity.
First, let’s look at the company’s historical revenue growth and margins. We do this in order to identify any possible trends which could help us in our predictions. For example, it would be a mistake to value a business using long term average margins if that company was experiencing secular contraction in its margins. Likewise, it would be folly to not account for revenues that appear to be in secular decline. Fortunately, neither appears to be the case here according to the following chart.
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Western Digital Corp - Revenues and Margins, 1998 - 1Q 2012
We see that the company has enjoyed rapidly growing revenues (though to be fair, much of the recent growth has been the result of acquisitions rather than organic). Margins have been a mixed bag over the last few years, as industry participants appear to have been caught making erroneous estimates of demand, which has led several times to overproduction and falling ASPs. Looking at the quarterly margins, we see a rapid decline beginning around 4Q 2010 and only beginning to recover in the recent quarter. This was largely the result of unexpectedly low demand resulting in increased pricing competition in a largely commoditized market.
The following chart indicates the secular decline of the company’s average selling price per unit (a great example of deflation in the computing industry). At the same time, unit shipments have grown dramatically.
Western Digital Corp - Unit Shipments and ASP, 1998 - 1Q 2012
The next chart shows the dramatic growth in WDC’s market share over the last four years (source: WDC presentation [PDF]), from about 23% to around 33%. Growth in market share of this magnitude is impressive. As noted above, the company’s products are largely seen as a commodity (do you know the brand of the drive your computer? I highly doubt it.), so WDC was able to grow its share mostly as a result of acquisitions, relationships and price competitiveness (economies of scale are important here). Keep this in mind, as we’ll discuss it again shortly.
Western Digital Corp - Market Share, 4Q 2007 - 4Q 2011
The next two charts show the company’s rapid growth in free cash flow and how cash has accumulated on the company’s balance sheet.
Western Digital Corp - Cash Flows, 1998 - 1Q 2012
Western Digital Corp - Capital Structure, 1998 - 1Q 2012
Let’s sum up what we’ve see here so far. Despite the highly competitive nature of the industry, the company has managed to grow revenues and free cash flows in the face of declining ASPs. The company has successfully grown market share in this environment and maintains an extremely conservative balance sheet.
So going back to the beginning, why is the company cheap relative to free cash flows? After all, there are no obvious negative trends. Three potential reasons emerge.
1. Declining Demand
This argument has received less coverage in the last few months, but it was all the rage last year when WDC was trading for roughly the same price. Various commentators hypothesized that demand for hard drives would fall into secular decline, as solid state drives rise in prominence and laptops and netbooks are replaced by tablet PCs. In the shorter term, it was supposed that consumer demand would continue to surprise to the downside, leading to continued growth in inventory and weak pricing power. No one is really discussing this anymore, because there is little evidence to support it (at least not yet). As the company notes in its recent quarterly conference call (emphasis added):
Turning back to the September quarter, it materialized very much along the lines we expected. Industry shipments came in at 176 million units, just above the high end of our estimate entering the quarter. This is a record quarterly shipment level for the hard drive industry - demonstrating the value of hard drives in the overall digital universe – even in an environment of broad based low growth and economic uncertainty.
2. Flooding in Thailand
Beginning this past summer, Thailand has experienced the worst flooding in fifty years. I won’t rehash the full extent, but for those interested this Wikipedia article provides details. Pertinent to this discussion is the fact that two of WDC’s major manufacturing facilities and an unknown number of plants for its suppliers have been crippled. This NYTimes article provides some details about the impact on WDC and other manufacturers, and the company’s filings and conference calls have provided important information as well.
Unfortunately, WDC appears to be hardest hit of the major manufacturers (though, I have not seen anything that has taken into account the full supply chain). A few things to note. From the conference call, it appears the company is insured for this situation (though the extent of coverage is unknown).
Okay. And then just lastly, from an insurance standpoint, can you talk about to what degree you are insured against these losses? Is there just equipment inventory or is it also some level of business continuity insurance? Was it insured despite being related to hit around flood plains and such?
John F. Coyne
Yes, we carry flood insurance for both our equipment and inventory and we also have business interruption insurance.
From this, it appears we can limit the losses to lost profit as a result of the company’s inability to meet demand while reconstruction takes place. The company has been consistently confident in its ability to recover quickly, though we might expect up to a year before the company is back at full capacity (hopefully taking this as an opportunity to better diversify its manufacturing). We’ll take this into account in our model.
Some are now suggesting that this interim period, whereby competitors will be able to capitalize on WDC’s weakness in order to expand their own market share, will become permanent as OEMs and other customers decide to stick with WDC’s competitors even as WDC regains its full capacity. I see little evidence to support this. Recall above that WDC has managed to grow its market share quite rapidly throughout the recession, in the face of heightened competition and an industry-wide inventory glut. I expect any permanent shift to be quite small.
One thing to note is that this destruction in capacity might present an opportunity for the industry. In the months leading up to the flooding, analysts peppered management with questions about inventory growth and many pointed to growing inventories as a sign that ASPs would continue to fall (this goes to the doom and gloom scenario above). This temporary decline in supply has reportedly already had the effect of boosting prices throughout the industry. One might suggest that decreased capacity wouldn’t be the worst thing for this industry, and could lead to the return of pricing power.
3. Hitachi GST Acquisition
This is the big one. In March, WDC announced it had reached an agreement to acquire Hitachi Global Storage Technologies in a $4.25 billion transaction. The deal includes $3.5 billion in cash and 25 million WDC common shares (valued at the time at $30.01 each). Though the $3.5 billion is being funded in part with the addition of $2.5 billion of debt, the effect on net cash is the same. Post-transaction, the company will have $3.5 billion less of net cash (recall from above that the company has just $3.41 billion in net cash, so the effect is quite extraordinary, and in the wrong direction).
According to this investor summary (pdf), HGST is the #3 player overall (compared to #1 for WDC) and #2 in the mobile 2.5″ HDD market (compared to #1 for WDC). Additionally, this acquisition will give WDC the #2 position (currently a tiny #4) in the Traditional Enterprise market. The deal is still subject to regulatory review (as at the time of writing, though this may be resolved by the time this is published).
There should be significant cost synergies in terms of R&D, and on the recent conference call, WDC management suggested that the acquisition will help them return to full operating capacity much more quickly. Additionally, this should go a long way toward reducing the level of competition that exists in the industry, which should support pricing power.
Either way, in building our models, it is important to take into account the effect of this acquisition on the company’s valuation, both in terms of net cash reduction and expense synergies as well as our projections of units shipped and ASPs.
When I included the effects of acquiring Hitachi GST and the short-term impact of the flooding in Thailand, I find that WDC appears excessively cheap.
What do you think of WDC?
Disclosure: No position, but may initiate within the next 72 hours.