Does Western Digital Have Valuation Upside?

| About: Western Digital (WDC)

Western Digital (NYSE:WDC) has rocketed higher since its lows put in a number of months ago. But does its valuation justify a higher price? We think so and peg its fair value in the low-$50s.

Our Report on Western Digital

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Investment Considerations

Investment Highlights

Western Digital earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 55.8% during the past three years.

Western Digital has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 6.9% in coming years. Total debt-to-
EBITDA was 0.8 last year, while debt-to-book capitalization stood at 22.2%.

Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company. We also think its fair value is modestly higher than where it is trading currently.

The firm experienced a revenue CAGR of about 18.7% during the past 3 years. We expect its revenue growth to be below that of its peer median during the next five years.

Economic Profit Analysis

Valuentum may be our corporate name, but it is much more than that. It is a new style of investing - not value, not growth, not GARP, not momentum, but Valuentum. We combine an extensive three-stage discounted cash flow process (creating complete pro-forma financial statements) with a relative value assessment (price-to-earnings, PEG) and then add on a technical and momentum overlay to identify the best entry and exit points on the most attractive stocks on the market today. Western Digital registers a 6 on our Valuentum Buying Index (our stock-selection methodology) -- not the best of scores, but respectable, nonetheless.

We think the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Western Digital's 3-year historical return on invested capital (without goodwill) is 55.8%, which is above the estimate of its cost of capital of 11.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Western Digital's free cash flow margin has averaged about 13.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at At Western Digital, cash flow from operations increased about 58% from levels registered two years ago, while capital expenditures fell about 3% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Western Digital's shares are worth between $31.00 - $71.00 each. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $51 per share represents a price-to-earnings (P/E) ratio of about 7.8 times last year's earnings and an implied EV/EBITDA multiple of about 4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.3% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 18.7%. Our model reflects a 5-year projected average operating margin of 14.2%, which is above
Western Digital's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 0% for the next 15 years and 3% in perpetuity. For Western Digital, we use a 11.4% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $51 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Western Digital. We think the firm is attractive below $31 per share (the green line), but quite expensive above $71 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Western Digital's fair value at this point in time to be about $51 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Western Digital's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $73 per share in Year 3 represents our existing fair value per share of $51 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Disclosure: I 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.

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