Western Digital (WDC) reported another good earnings release last week -- yet the shares still trade at the pessimistically valued PE of 4.79. It is clear that a significant portion of the market still suspects that Western Digital's future will not be as bright as its recent past.
The Near Term Future And The Long Term Future
It is true, unfortunately, that Western Digital's margins are bound to decline. As I first noted in my article on August 30th, 2012, since the 1980's the hard disc drive ("HDD") industry has developed with a two year product cycles. This gives the industry a two year trend of rising and falling gross profit margins. This can be roughly seen below:
So here we are, at the top of such a cycle. Of course, the cycle has been sufficiently disrupted from any normal course due to last year's flooding in Thailand. Further, ASPs have generally been on a decline and the major disruptions of the supply chain have caused ASPs to increase to levels not seen since 2004:
(Source: Western Digital's 10-Q, dated September 2012, p. 22)
The ASP above of $62 can be assumed to decline in the long run, back first to 2011 levels, and eventually below.
Therefore, in the near term, we can expect a continue boon for the industry -- which has basically been consolidated between Seagate (STX) and Western Digital. (See my article on Western Digital's side of the duopoly here, and my article on Seagate's side here.)
In the long-term, we can expect ASPs to decline. Also, in the long-run, we can expect increased competition from advances in solid state drives. But for now, however, solid state drives ("SSD") don't appear to be fully cost efficient for the average user (more comments on this below).
Further, and as noted in the operating results above, Western Digital's sales mix has gone increasingly to 'enterprise' -- which can be taken to mean servers and cloud. As the media reiterate to us, those are considered the growth areas of tech.
Western Digital -- and its rival Seagate -- are still undervalued by the market. There has been, I believe, undue pessimism on the future of HDD's generally -- which, coincidentally, means and undue optimism on SSDs. The optimism, in my opinion, is because some believe that consumers move continuously toward the "technologically perfect." But it seems to this author that economics and human purchases move rather towards the "economically perfect." That is, SSDs are too expensive and the added functionality, at least for now, is not worth the additional cost to many average users.
Let us take a look at Western Digital's free-cash-flow :
One can see the monstrous climb in free-cash-flow, from under $1 billion at the end of 2011, to over $2.76 billion in the last 12 months. That huge FCF equates, as one can see above, to a staggering FCF yield of a 30.9%. All this extra cash means, of course, that Western Digital is able to do things with it. For instance, for the first quarter they repurchased shares -- which, given that the shares are undervalued, will have a multiplying effect on intrinsic value per share:
(Source: Western Digital 10-Q, dated September 2012, p. 6)
With such a deeply undervalued stock, when compared to its current cash flow generating abilities, one has to believe that others really do not see a continuously bright future for Western Digital. To that, we agree. But, we think, the degrees with which it will be less good, will still represent a satisfactory return. For instance, if free-cash-flow dropped by half, the yield would be 15% at today's prices -- which, of course, is still an attractive yield.
The future will not be as bright as the past 12 month period, but it will not be as bad as current share prices suggest. Western Digital, after all, is the biggest player and is one half of the HDD duopoly.
- Free-Cash-Flow = FCF = Operating Cash Flow - Capital Expenditures