Western Digital: Highest Returning Protected Covered Call For A Value Stock

Mar.30.12 | About: Western Digital (WDC)

A protected covered call or collar search performed using PowerOptions tools seeking to find the highest returning position with a maximum potential loss of 8% for profitable value companies with a stock price in an up trend produced the computer storage company Western Digital (WDC) at the top of the list as shown below:

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Not too far behind Western Digital were information technology company Unisys (UIS) and insurance company Hartford (HIG).

The protected covered call or collar position for Western Digital has a potential return of 2.8% (44.4% annualized) with a maximum potential loss of 7.2%, and even if the price of Western Digital's stock goes to zero the maximum loss is 7.2%.

The 8% maximum loss parameter was selected for the search, as a loss of 8% or less can typically be recovered fairly quickly using option income generating strategies. A protected covered call is an income generating strategy where a call option is sold against a stock with some of the proceeds from selling the call option used to purchase a protective put option. A search parameter for Price-to-Sales (P/S) of less than one was used to include value companies in the search. Profitable companies were included in the search by selecting the Price-to-Earnings parameter greater than zero. Companies with stock in an up trend were found by including stocks having a 100 day moving average greater than the 200 day moving average.

When Western Digital Corporation was founded in 1970, a typical hard disk drive was the size of a large closet, could store about 100 MB of data and cost tens of thousands of dollars. In 2012, Western Digital's website offers a 'My Passport' 2TB sleek portable drive, measuring slightly more than 4 inches by 3 inches and less than an inch thick, for $249.99. Digital storage now extends into every corner of daily life, including fixed and mobile telecommunications and computing, entertainment and social media. Western Digital has been producing hard drives since 1988, and is now a global leader in hard drives and solid state drives for use in desktop computers, notebooks, smartphones, tablets, entertainment devices and computer networks for enterprise, telecommunications, medical, aerospace and military applications.

The hard drive market is set to explode with the growing demand for data mobility, cloud infrastructure and the increasing uptake of social media, together with consumers' expectations of ever higher capacity, speed and simplicity in a device constantly diminishing in size. Western Digital's strong focus on high performance, reliability and low power consumption combine to deliver its leadership position. The company employs around 62,000 people at its worldwide design, manufacturing and sales facilities, with headquarters in Irvine, California.

International Data Corporation (IDC), the leading intelligence provider for the IT industry, published global hard disk drive market share statistics (pdf) at the end of 2010. Western Digital led with 31% of the market, followed by Seagate (STX) with 29%, Hitachi Global Storage with 18%, and Samsung and Toshiba with 11% each. IDC has recently updated its industry forecast, predicting global revenue growth at an 8.6% compound annual rate from 2011 to 2016.

One way to eliminate competition is to buy it out. On March 8 2012 Western Digital completed its acquisition of Viviti Technologies (formerly Hitachi Global Storage Services) for $3.9 billion cash plus 25 million Western Digital shares (which will give Hitachi 10% ownership and the right to nominate two board members). The acquisition was financed by a five-year term loan of $2.3 billion, plus short-term revolving credit and existing company cash balances. Combined revenue for the two companies was $15 billion in 2011. Meanwhile, Western Digital is fighting against an order to pay Seagate $525 million in a damages claim involving a former Seagate employee and the disclosure of confidential information and trade secrets.

Western Digital's financial information for investors (pdf), published at the end of FY 2011 (year ended July 1 2011), shows steadily-rising volume sales from 2007 onwards, except for the global financial crisis provoked dip in 2009. Market share also climbed throughout this period, but revenue declined from a 2010 peak of $9.85 billion to $9.53 billion in 2011. Net income was $726 million ($3.09 per share), a sharp decline from 2010's $1.4 billion. Asia generated 55% of revenue in 2011, with the Americas and Europe dividing the balance equally. Approximately 50% of revenue comes from the company's top ten customers, and channel revenue figures attribute the same proportion of revenue to embedded drives for original equipment manufacturers. Sales through distributors account for about 30% of revenue, and retail sales for the remaining 20%.

The devastating floods in the second half of calendar 2011 in Thailand, where many global disk drive producers have major manufacturing facilities, caused dramatic disruption to the worldwide supply of drives. This had a consequent effect on Western Digital's volume sales as well as adding millions to its expenses. The company's Thailand factories were out of action for many weeks, and global industry shipments were expected to fall short of demand by 50 million units in the December 2011 quarter alone. (News article)

Western Digital completed its second quarter of FY 2012 on December 30 2011, with half-year revenue of $4.7 billion significantly impacted by low shipment volumes following the disruption to manufacturing. Net income fell to $384 million as a result of the lower revenue and flood-related increased costs, and the company's market share fell to 24% in the second quarter. President and CEO John Coyne commented in the Q2 2012 earnings press release that substantial progress had been made in restoring manufacturing capabilities, which should be back to pre-flood levels by the end of September 2012. Meanwhile the company is expanding its manufacturing plant in Malaysia.

During the Q2 2012 earnings conference call, Mr Coyne remarked that he expected supply constraints to continue through calendar 2012, and that the pipeline would not be refilled to normal inventory levels until the first half of calendar 2013. Investment in product development had been maintained through the flood period, so that Western Digital would be in a position to offer new products and advanced technology to regain its leadership position in spite of recent challenges. COO Timothy Laden spoke about the lessons learned, with the result that the company will seek a greater geographic dispersal of its own and its component suppliers' manufacturing operations to avoid the risks presented by concentration in a single area, even though this may result in some logistical cost increases. CFO Wolfgang Nickl noted that the average drive selling price had risen around 50% in the latest quarter (possibly as a result of supply shortage, although he did not say so) and that two customers, Dell (DELL) and Taiwan's Acer, each represented more than 10% of revenue.

Even with the bad news surrounding Western Digital with respect to the flooding in Thailand and the damage claim with Seagate, Western Digital's stock price is nearing its two year high which is also is all-time high as shown below:

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Western Digital hasn't announced the date of its upcoming earnings release, but it should occur sometime near the end of April, and with the stock price at a two-year high, if the company releases bad news, then the price of the stock could take a hit. To avoid a hit, an investor might consider the protected covered call position presented in the table above. The specific call option to sell is the 2012 Apr 41 at $1.89 and the put option to purchase is the 2012 Apr 37 at $0.32. A profit/loss graph for one contract of the Western Digital protective covered call is shown below:

For a stock price below the $37 put option strike price, the protected covered call does not change value. Additionally, if the price of the stock increases to around $45, the position most likely can be rolled in order to realize additional potential income.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.