Western Digital: Merger With SanDisk Provides New Hope For An Industry Leader

| About: Western Digital (WDC)

Summary

Western Digital has a strong case as an undervalued stock with considerable upside.

Past declines in Western Digital's stock price represent an overreaction to market trends and have left WDC trading below its fair value.

Future outlook for WDC remains bright, brighter than competitors with the recent acquisition of SanDisk.

Click to enlarge

(Image Source: Company Website)

Western Digital Corp. (NYSE:WDC) provides hope as an industry leader in the failing Hard Disk Drive (HDD) Market. The hope does not come from conditions the market, but rather from the company strategy, and their recent merger with SanDisk, whose main streams of revenue come from markets ready to capitalize on the fall of HDD.

Hard Disk Drives, or HDD, are metallic drives, made from a magnetic disk that rapidly spins, which allows for the storage and retrieval of information. Hard Disk Drives were created in the early 1950s, and became the standard for secondary storage for most computers in the early 1960s. Hard disk drives have continued to evolve and grow in effectiveness since their inception, and are now found most prominently as internal and external storage devices for most computers and laptops. Hard Disk Drives were favored in these devices primarily because of their storage capacity, as the devices are capable of storing upwards of 1,000 GB of data. The primary creators of Hard Disk Drives are Western Digital Corporation , Seagate Technologies (NASDAQ:STX), who own about 40% of the market share each, and Toshiba (TYO JPY), who own about 20% of the market share.

The market for Hard Disk Drives however, has been declining, as Solid State Drives (NYSE:SSD) and Flash technology have come into existence. Newer laptops and computers now use this technology as their primary source of storage, because SSD and Flash technologies have superior data transfer rates, and are more reliable than HDD. At the moment, HDD technology is only superior to SSD and Flash technology when it comes to storage costs, and as a result, in certain situations SSD and Flash technologies are utilized where in the past HDD would normally have been used. The HDD market is expected to decline in the coming years, and most analysts predict it will decline anywhere from 2-5% over the next five years. WDC will likely suffer from the decline in revenues, as will Toshiba and Seagate, however, the market itself is unlikely to decline to a rate where HDD is completely unused. HDD continues to be used, and should continue to be used in secondary storage, as the cost-effectiveness associated with HDD will likely keep the technology relevant, and the need for greater storage capacities will greatly inflate the perception associated with cost per unit storage that HDD provides.

The Solid State Drive industry, and Flash Drive industry are set to capitalize on this decline in the HDD industry. Overall need for storage systems in computers and external drives is still important, and is set to grow, but whereas the HDD market is on the decline, the SSD and Flash market are growing rapidly. Solid State Drives use integrated circuits to store data, as opposed to some kind of moving drive like a Hard Disk Drive would. In fact, these Solid State Drives have no moving parts at all, making them more durable, and quieter than their moving counterparts. The Solid State Drives utilize the Flash technology as well, and run in many machines that HDD drives cannot operate in. The key players in the SSD market are Samsung, SanDisk, Micron, and Intel, with Samsung retaining a 44.7% market share, SanDisk an 11.1% market share, Micron a 9.7% market share, and Intel an 8.9% market share. What is interesting to note is that WDC retains a considerably smaller market share, and derives most of its revenue from the sale of its Hard Disk Drives, making it a seemingly irrelevant player in the SSD market. SSD has taken over many laptops, and is especially prevalent in tablets, and industry that continues to grow every year. The SSD market is projected to grow at a 30-40% CAGR over the next five years according to analysts.

WDC earns its strength in the SSD market through the acquisition of SanDisk. The deal closed for $15.1billion and just under one quarter of a share for every share of SanDisk on May 12, 2016. While the debt load that WDC assumed to finance the deal seems immense, the company was able to properly restructure their existing debt in order to lighten the overall debt load, and to insulate themselves, so that most of the debt obligations would not be paid until after a successful integration of SanDisk. The main concern from the deal comes from SanDisk itself, and its technology of NAND-Based Flash. The company produces 2D NAND-Based Flash in a market that is quickly and rapidly growing into 3D NAND-Based Flash, and the main concern is the timeline SanDisk has set for their own 3D NAND-Based Flash devices. However, the general consensus at the time of the deal was that SanDisk's technology should be able to produce 3D NAND-Based Flash, and even since the finalization of the deal, reports have been more positive, that 3D NAND-Based Flash is not far off. Essentially, the outlook on the merger has improved recently, despite only closing a few months ago, on May 12.

Valuation

WDC on its own is stronger than its comparable companies. Using a comparable companies analysis, we were able to analyze the fact that WDC has lower multiples than its competitors, even though it is in a highly commoditized industry. To add to this, WDC's Hard Disk Drives are seen as slightly better than its competitors, which in turn gives them a slight edge over the competition. And yet, with the Comparable Companies analysis, we returned a price target of $105.63, which accounts for 127% upside. We believe that the price target obtained here is not feasible in any capacity, but it does reflect in general terms our beliefs on the company. The reason for the high price target is that WDC trades at a significantly lower value than its peers, with most of its multiples less than one-half of those retained by other companies. We also believe that this may be a symptom of WDC being constantly undervalued and Seagate Technologies and other peers being simultaneously overvalued. Similarly, its closest peer, Seagate Technologies, has multiples that are 2x or even 3x or greater than WDC. For this reason, we believe in the underlying concept obtained in our Comparable Companies model, in that WDC, who sells a competing and even superior product to Seagate Technologies, should trade at a similar level to Seagate Technologies, and yet doesn't. However, we also believe that WDC is intrinsically very strong as well, and this intrinsic strength.

The strength in WDC comes from a few key places, which in tandem make for a fantastic investment opportunity in the company. The first strength of the stock is in its recent decline. Over the past year, WDC has declined by around 50%, falling from prices in the low $90 range to the mid $40 range. The main reason for this drop was in the fear of the declining HDD market, and while some of those fears were justified, the stock price decreased by more than what we feel would be considered a fair value of the industry leader. Using conservative valuation methods with a Discounted Cash Flow analysis, we believe that WDC on its own with its predominantly HDD based revenue would be fairly valued at a price of just over $65. This price target was obtained using conservative growth values of an average of -5.9% over seven years, and holding gross margins and costs at similar levels over the next seven years, which would be in line with a highly commoditized product. It should be noted that we used our comparable companies median EV/EBITDA multiple, which was 6.03. We also used a very conservative perpetuity growth rate of -7%, which would account for a higher level of revenue decline than is predicted by most analysts, and will ultimately bring revenue down toward $0, which most analysts agree will most likely not happen, as there is should still be a need for HDD in the future, just not as strong of one as seen in the past.

However, the real strength of the company lies in its recent acquisition, its merger with SanDisk. SanDisk has been a key player in the SSD marketspace, one in which WDC has been losing its HDD customers to. What is interesting in this deal is that WDC was able to restructure its debt, and should be able to easily pay off the debt once it has successfully integrated SanDisk into the company. Another positive about the acquisition is that we can almost safely say "once it has successfully integrated SanDisk into the company", rather than "if", because SanDisk is such a similar company to WDC. Even though SanDisk and WDC focus on different products, SSD for SanDisk and HDD for WDC, their products are direct competitors, and have the same functions in computers and other devices. Furthermore, though small, WDC does have an SSD product line that is similar to SanDisk's. Because of the similarities of the companies, the merger should go very smoothly, and WDC should reap the benefits in terms of synergies associated with cost cutting. In fact, WDC has predicted that it should have close to $1billion of annual synergies by 2020, and close to $500M annually within the first year. While the deal was worth more than $15billion, the synergies are nonetheless staggering. To account for the deal, we used two different versions of the discounted cash flow analysis, one in which previous SanDisk revenue is counted for WDC, and one in which the revenue is not counted toward WDC until 2016. In both models we got a price target of $68.27, which represents 46% upside. One thing to note about this valuation, is that we used a Terminal multiple of 6.80, which is in line with most analysts, and we used a perpetuity growth rate of 0.45% to offset the declining revenue of HDD and the growing revenue of SSD, which by the final year of the model at are similar levels. These numbers gave us very different valuations in the long run, with the perpetuity growth method outweighing the Terminal Value output. However, we believe that the chosen 0.45% perpetuity growth rate is appropriate, as over time we feel that Western Digital's newfound SSD line should eventually overtake and outpace revenue coming from its existing HDD line, and we feel the focus will also shift into the company's SSD line. By doing so, this should increase the growth rate in perpetuity to follow closer to the normal 2-2.5% normally seen by mature companies. However, we feel the risk associated with the successful installment and capitalization on the SSD market does factor into the decision, hence the lower multiple and output for the Terminal Multiple method. Regardless, we feel confident in Western Digital.

Overall, we believe Western Digital Corporation is undervalued, and is in reality worth closer to $60, representing about 30% upside from its current position of $46.59. This takes into account all of our conservative models, and places heavy emphasis on the more negative results. As a result, we feel confident that WDC presents a potentially favorable investment with little downside, and the capability for significant upside in the future.

Disclosure: I/we 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.