Western Digital (WD) is a leading manufacturer of digital storage devices, namely hard disk drives or HDD. Western Digital recently acquired Hitachi Global Storage Technologies, and achieved strong results from the most recent fiscal year, in spite of floods in Thailand. The story of Western Digital appears quite attractive given some significant secular trends, the company's array of products and scale, and the attractive company valuations. Yet further analysis reveals other significant secular trends and industry characteristics that put Western Digital in a precarious situation. Additionally, there are company specific aspects that are worrisome moving forward. While the company would be a poor short given the company low valuations and managements desire to engineer shareholder value, it is a questionable long term investment because there is a significant risk for business deterioration
Recent Results And Relative Valuation
The company had a very successful fiscal 2012. Revenue increased about 30% while net income more than doubled yoy, in spite of the Thailand flooding. The company experienced an average selling price of $62 compared to $45 in 2011, while keeping costs from rising as fast gross margin. The company's success over the past year has led to the following attractive valuations.
The impressive numbers are somewhat misleading because the company benefited from higher average selling prices, which go almost directly to operating profits. Free cash flow was additionally helped by significant positive changes in net working capital from inventory draw downs due to the flood, and greater depreciation and amortization add backs from the HGST acquisition. Further evidence for the one time spike is reflected in Seagate's (STX) valuations. Nonetheless, the company has consistently generated significant free cash flow over recent history (>$600MM the past 5 years and >$1B over past 3 years). This indicates a more reasonable estimate of a minimum 10% FCF yield which is very healthy. With this, the company announced a $1.5B shareholder repurchase which equates to about 15% of current outstanding shares, in addition to the stock's 2.5+% dividend.
The storage industry appears promising in the coming years. The demand for petabytes is expected to grow at 33% CAGR through 2016. This is reasonable given major trends in the industry. Personal devices and consumer electronics from smart phones to tvs are consistently using more and more memory. The proliferation of social media and the growth of the internet will continue to require more storage space. Finally, cloud computing represents a major overhaul of electronic infrastructure for servers, which will need to be replaced while storage needs rise. These ideas support strong long term performance in this space.
Traditional HDD producers, such as Western Digital and competitor Seagate, may be ill-suited to take advantage of this trend compared to companies such as Micron (MU), SanDisk (SNDK), and OCZ (OCZ), which have a greater focus on solid state drives, or SSD. SSD is superior to HDD in the areas of data transfer rate, data read rate, search speed, power consumption, and operating temperature. The main advantages of HDD are reliability, because HDD failures are reversible, and price: SSD, on a $/GB basis, is approximately 10X more expensive than HDD. Prices of SSD are falling very quickly, but price competitiveness is not expected in the near future. However, the differences in performance imply that SSD can be more expensive than HDD and become the storage of choice. Western Digital admits this weakness in its most recent 10K:
"Alternative storage technologies like solid-state storage technology have successfully served digital entertainment markets for products such as digital cameras, MP3 players, USB flash drives, mobile phones and tablet devices that cannot be economically serviced using hard drive technology."
The company will be unable to take advantage of the need for memory in the personal device space. In fact about 73% of the company's revenue comes from the PC business, meaning Western Digital is tied to slower growth areas. Additionally, it appears HDD will lose market share to SSD in the server industry as cloud computing takes hold. Cloud computing allows a server company to host the servers of multiple company's on one larger server, implying servers will grow in size. Companies will still demand the same performance for their servers in terms of speed. If these servers used HDD, their size would cause sluggish performance because the system has to mechanically look for information. However, SSD performance is largely independent of size because data storage is electronic, allowing SSD to scale without sacrificing speed. This idea is promising for the aforementioned SSD manufacturers, but negative for predominant HDD producers.
Market Structure And Western Digital's Position
Another major negative for the whole industry, and especially, HDD producers, the market is purely competitive, as quality is similar and price is the main point of competition. The SSD and HDD markets do not just compete on price, but within the SSD market, price is the major point of competition. Although Western Digital claims to compete on customer service, reliability, storage capacity and other ways, in addition to price, anecdotal evidence from online tech forums indicates similar levels of satisfaction from Seagate and Western Digital consumers. If either company provided a better experience, this should manifest itself in higher selling prices; but after examining online retailers, there is no appreciable difference in price between drives of similar specs. This indicates that storage is essentially a commodity.
There are companies, such as Coca-Cola (KO), Under Armour (UA), Exxon Mobil (XOM), or Wal-Mart (WMT), that have survived as sellers of commodities and achieved disproportionate profitability. Coca-Cola has established an incredible brand name, and customer loyalty through longevity, and successful marketing. Under Armour was the first mover in the performance apparel market, allowing its name to be synonymous with performance apparel. Exxon Mobil has succeeded because of its vertical and horizontal integration allowing it to produce at lower costs than competitors and to access resources that require immense capital that others do not have. Wal-Mart has been successful because it has monopolized its market allowing it to squeeze its suppliers, which allows it to undercut competitors while still profiting. These ideas allow these companies to either sell the commodity at a lower price than competitors while still profiting, or to sell the commodity at a higher price while still experiencing demand.
None of these principles applies to Western Digital. As mentioned earlier, consumers are split between makers of hard drives; there is no brand loyalty or the ability to charge inflated prices. Western Digital, if anything, is the industry follower because it has historically released similar technology after Seagate, precluding a reputation of prowess. Western Digital is not experiencing economies of scale as margins are mainly a function of average selling price and not great production. Western Digital's costs of production are essentially fixed. Western Digital produces the heads and magnetic media and already achieved all appreciable cost reduction. These parts are made from rare earth metals, putting Western Digital at the whims of global supply and demand of these metals. Western Digital gets other parts from unique suppliers with many customers, allowing these companies to squeeze Western Digital. The company is forced into $6.5B, or 2/3 of last year's gross costs of purchase obligations for the coming year. The company is heavily dependent upon research just to remain competitive, and the company has old machinery, as the cost value of its PP&E, after taking out land values is about $6B, while accumulated depreciation is over $3B. Cost reductions in these areas are unlikely. Additionally, Western Digital is squeezed by purchasers; more than 50% of the company's revenue comes from ten OEMs. Customers can cancel orders at almost any time and demand price protection deals from Western Digital.
Average Selling Price: The Engine Of Profitability
The company's fortunes depend on average selling price more than any other factor. Significant volume expansion is unlikely because increased storage demand is matched by equal improvements in storage technology. Every change in average selling price travels almost directly to the company's bottom line. For example the company's average selling price climbed by about 37% and the company's gross margin and net income more than doubled from the prior year. In 2010, the average selling price was 11% higher than 2011, leading to net income that was almost 90% higher in 2010. The problem is that Western Digital has zero ability to raise average selling price. The market is oligopolistic companies would be better if they jointly produced less to drive up the price, but game theory dictates they produce more than they should. In some respects, the floods in Thailand were a blessing to the company's fortunes. This supply shock allowed Seagate and Western Digital to achieve oversized profits by shrinking supply. Although these prices may remain elevated in the near future, in time they will fall back in line with averages. From there, prices will likely grow slowly or even decline, as it did from 2010 to 2011. Storage technology is constantly improving from fierce competition. But it is very difficult to raise prices because costs have not risen. If SSD becomes more price competitive, HDD average selling prices will also decline. An investment in Western Digital is inherently a bet on average selling price of storage, which in the long run has numerous factors working against it.
Company Specific Issues
In addition to these issues affecting Western Digital and some of its competitors, there are areas specific to Western Digital that cause worry about the future. The acquisition of HGST is one of these. HGST has been one of the major HDD producers, but Hitachi was willing to sell of this business, possibly seeing some of the aforementioned industry headwinds. Western Digital justifies the acquisition in its most recent 10K (p.84) by saying:
"The $1.8 billion of goodwill recognized is primarily attributable to the benefits, subject to compliance with applicable regulatory conditions imposed on the Acquisition, the Company expects to derive from a more efficient and innovative customer-focused storage company with significant operating scale strong global talent and a broad product lineup backed by a rich technology portfolio."
HGST will remain a subsidiary with independent production until the Chinese Ministry Of Commerce approval, which is at least 2 years away. Consequently, scale, if possible will not be achieved for at least this time period. Even if the merger is approved, operating synergies are unlikely because Western Digital has already reached scale. The only promising aspect of the deal is some of the new SSD technology of HGST; nonetheless HGST is dominated by HDD unlike a company such as Micron. This deal realistically just increases market share but at a hefty premium.
Western Digital's research and development has lagged behind Seagate's. Although the company has consistently spent nearly 10% of revenue on R&D, the company has regularly finished second to Seagate. Seagate is currently on its third version of a hybrid drive, which combines aspects of SDD and HDD, while Western Digital is just introducing its first version. Western Digital's recent technological breakthrough is helium filled drives which promises significant less energy consumption and an increase of almost 50% storage capacity from today's standard 4GB platters. However, Seagate's Heat Assisted Magnetic Recording technology has the potential to increase storage capacity of these standard drives to 50GB. Western Digital has been successful at following. However, there is no guarantee Western Digital will be able to in the near future. Additionally, Seagate's technology appears more disruptive than Western Digital's, implying that even if Western Digital is able to replicate the technology, the time period Western Digital does not have the technology, will present few profits.
The company also has a very beneficial tax situation. In fact, $2.98 of the company's 2012 EPS, and similar figures for prior years, was the result of tax holidays for foreign operations. If these countries decide to raise taxes from these incredibly low levels, it will significantly impact Western Digital's profitability. This situation could easily not come to pass; however, it is a negative asymmetric situation.
Finally, the company may be facing increased costs from employee compensation in the future. At the time of issue, the company prices stock options to employees based upon the Black Scholes model. After issuance, however, the company values in the money options as the difference between the current price and the strike price. This is not an issue when options are short term and very in the money. However, a significant volatility and time premium exists for long term options just in the money. The weighted average remaining life of employees' options outstanding is 4.3 years, with many having strike prices above $30 compared to the current price of approximately $38. This generous accounting is not egregious, but it is not practiced at every company and should concern an investor.
It is worth reiterating that Western Digital could easily outperform the markets in the near future given elevated average selling prices resulting from the Thailand floods, the cheap valuations of the company, and management's commitment to squeeze out shareholder value. However, a HDD producer is not well suited to take advantage of major storage trends. Furthermore, Western Digital operates in an extremely competitive arena, forcing it to operate at the wishes of suppliers and consumers, and causing its fortunes to depend upon the average selling price. Western Digital has already achieved economies of scale and the HGST acquisition will likely not improve efficiency. Finally, the company has had a relatively poor history of innovation and could face increased costs from changes in the tax system and growing employee compensation costs. It is recommended that a long term investor choose not to purchase shares of Western Digital.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.