Hard disk drive makers Seagate Technology (NASDAQ:STX) and Western Digital (NASDAQ:WDC) moved higher after recent earnings reports were better than analysts had expected. As a result of big dividends, lavish buybacks, and single-digit stock multiples, it is not surprising for investors gravitate to one or both stocks. While wise long term, the best way to preserve capital in a market such as this, while still achieving double-digit returns from your investment, is clearly to invest in SanDisk Corporation (NASDAQ:SNDK) as a storage play over either WDC or STX stock.
SanDisk is a merger arbitrage play, with Western Digital announcing its $19 billion acquisition back in October of last year. The acquisition is expected to close later this year, and while some of the merger is being done via stock, it is mostly cash. That fact serves as a great downside hedge in what has become a volatile, nasty market.
Basically there are two scenarios surrounding SNDK stock in 2016. If Western Digital is able to sell its 15% stake in China's Unisplendour then WDC will pay $85.10 per share in cash and 0.0176 shares of WDC stock to acquire SanDisk. If the sale of Unisplendour is blocked, Western Digital will pay $67.50 in cash and 0.2387 shares of WDC stock to complete the purchase of SanDisk.
Personally, I expect the former to occur. Some investors are concerned after Philips had to cancel its $3.3 billion to sell an 80% stake in Lumiled's LED lighting business following regulatory scrutiny. There is a big difference in selling 80% of a large unit versus selling a minority stake of 15%. Nevertheless, the deal is mostly secured with cash.
With SNDK stock trading at $69 it is just $1.5 short of Western Digital's worst-case scenario cash price if the Unisplendour divestment is prevented. With Western Digital having to pay 0.2387 shares in this scenario, it would value the SanDisk acquisition at $78.45 per share based on WDC's stock price at Friday's close. That is upside in SNDK stock of almost 14% this year.
If Western Digital's divestment is allowed, the acquisition price of SNDK would be nearly $86 per share. That's upside of almost 25% for SNDK stock. So clearly, it favors SanDisk shareholders for Western Digital's sale of Unisplendour to work out. But regardless, SNDK stock owners will be just fine.
Better than WDC, or STX?
Given that the S&P 500 has already fallen 8% this year, it is not wise to bet on either WDC or STX stock despite the clear earning improvements, high yield and big buybacks. The reason is because both stocks are very volatile, and in down markets, both STX and WDC shares are probably going to underperform. WDC is 36% more volatile than the broader markets whereas STX is a whopping 145% more volatile. Therefore, it is dangerous to go long either WDC or STX.
That said, if the market reverses and trades considerably higher from this point forward, both STX and WDC are likely to outperform, especially with a solid earnings report behind both companies. However, since WDC is paying for SNDK with some stock, it too will trade higher with WDC if the market reverses to shoot higher. Hence, SNDK does not have the downside risk of STX and WDC in a down market.
All things considered, so long as the deal closes this year, there is really no scenario where SNDK is lower at the end of 2016 than right now. Currently, there is upside of 14% to 25%.
Even if WDC stock falls 50% before the acquisition, then the SNDK purchase price will be between $73 and $85.50, upside of 6% to 24%.
If WDC rises 50% before the acquisition, the SNDK purchase price will be between $86.3 and $87.55, an upside of 25% to 27%.
Clearly, there are a lot of different scenarios, but none that make SNDK a particularly bad investment opportunity. Given the uncertainties surrounding the market, the relatively safe gains in SNDK stock are very appealing, much more than that of either STX or WDC.
Disclosure: I am/we are long STX.
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.