Western Digital: Solid Second Quarter Left Shares Moderately Undervalued

| About: Western Digital (WDC)
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Western Digital Corporation (NYSE:WDC) reported strong fiscal second quarter results as revenues increased 4.4% sequentially. Second quarter results were driven by accretive enterprise and consumer electronics shipments. That is a trend that is likely to continue in the current quarter.

Management is forecasting revenues of $3.65-$3.75 billion and gross margin of 29.5% for the current quarter. This would be a 7.5% revenues decline sequentially. Revenues would be flat y/y.

With WDC benefiting from SSD shipments and increasing demand for electronic data storage solutions, a P/B of 2.32 isn't pricey. The P/B level of 2.91 is the distribution level. The underlying business is healthy, but share price may catch a cold from the broader market. Additionally, Asia may suffer a slowdown if conditions in China worsen, which could adversely impact WDC's results of operations.

Recent Developments

  1. WDC reported fiscal Q2 revenue of $4B and net income of $430M, or $1.77 per share.
  2. RED Studios Hollywood deployed the Maxx Digital Evo 6G 16-bay rackmount media server. The server is powered by 4TB HGST Ultrastar 7K4000 enterprise-class HDDs and configured with ATTO Raid controllers to support capacity, bandwidth, and performance needs for streaming and screening next-generation 4k, 5k and 6k high-resolution files. A movie or TV show shot in 5k resolution can require up to 600TB+ of storage capacity and up to 2000MB per second sustained data rates for editing and post production to ensure data integrity, no dropped frames, and a quick workflow.
  3. The new Ultrastar He6 drive features HGST's innovative 7Stac disk design with 6TB, making it the world's highest capacity HDD with the best TCO for cloud storage, massive scale-out environments, disk-to-disk backup, and replicated or RAID environments.
  4. WDC and Baidu (NASDAQ:BIDU) are integrating Baidu Yun public cloud storage services with WDC's personal cloud and external storage platforms to provide Chinese consumers with a compelling hybrid digital storage solution.
  5. WDC announced the release of the WD Black2 dual drive, a storage innovation that fuses a 2.5-inch 120GB SSD with a 1TB HDD.

Business Summary

Western Digital Corp. is a global provider of products and services that empower people to create, manage, experience and preserve digital content. WDC designs and manufactures storage devices, networking equipment, and home entertainment products.

Revenues in the fiscal second quarter increased 4.4% sequentially, which followed a 2% sequential increase in the first quarter. The gross profit margin was flat sequentially in the second quarter, but a significant increase in SG&A expenditure reduced the operating margin from 14.2% to 12%. Net income declined 13% sequentially and the net profit margin in the second quarter was 11%. Additionally, EPS declined 13.7% sequentially.

The TAM increased in the second quarter to 142.2M from 140.2M, as WDC's HDD share remained flat at about 44%. HDD ASPs increased from $58 to $60 sequentially but were down from $62 the prior year. HDD ASPs have trended lower since mid-2012.

WDC's sales were boosted by its design wins in the Xbox One and PS4 gaming consoles. The impact from the new consoles should be accretive to sales during a large part of calendar 2014. Also, I expect a spike in sales during the calendar Q4 2014 as the price points on the new consoles may decline.

Enterprise and consumer electronics were relative bright spots during the quarter. Unit shipments of enterprise and consumer electronics increased 17% and 36% y/y, respectively. Branded products increased 14% sequentially on WD My Cloud. This comes as the PC market stabilizes.

Growth in SSD usage is expected to be significant in the coming years. Gartner estimates that there will be 72,000 petabytes of SSDs by 2017, which is up from about 5,800 in 2012. WDC is positioning itself to benefit from this industry trend.

The company reported an economic loss in the fiscal second quarter. This does not agree with my analysis. My equity charge is $2.54 per share for the next twelve months and WDC should easily earn my cost of equity. Management probably uses a higher discount rate.

In terms of liquidity at the end of 2013, the cash ratio was 1 and the current ratio was 1.79. Net cash at the end of the quarter was $2.315B. Total debt to equity was 0.27 and financial leverage was 1.78. Overall, the liquidity and solvency positions appear solid.

The receivables turnover ratio, on an annualized basis, was 8.11 during the December quarter. The inventory turnover ratio was 8.76. Overall, the activity of the firm was healthy. Additionally, the estimated return on equity is 20%.


  1. The share price is likely to remain volatile and investors could lose a portion or all of their investment.
  2. Investors should judge the suitability of an investment in WDC in light of their own unique circumstances.
  3. A decline the global economic growth rate and/or a decline in the pace of economic growth in the United States could adversely impact the results of operations and the share price.
  4. The technology industry is characterized by rapid technological change, which could materially adversely impact the results of operations.
  5. Competition in product development and pricing could adversely impact performance.
  6. Incorrect forecasts of customer demand could adversely impact the results of operations.
  7. Higher interest rates may reduce demand for WDC's offerings and negatively impact the results of operations and the share price.

This section does not discuss all risks related to an investment in WDC.

Valuation & Portfolio Management

The increase in the share price of WDC is in large part attributable to broad economic trends. While the company has made several key strategic acquisitions and formed key partnerships, the increase in the market-based valuation is mostly attributable to economic growth, loose monetary policy, and investor's demand for shares. This is in contrast to increases in share prices that are primarily based on company specific factors. Potential WDC investors could get an excellent opportunity to accumulate shares at a lower price point than the current share price of $83.91.

There isn't much of a diversification benefit from investing in WDC, relative to the S&P 500 (NYSEARCA:SPY). The correlation since 2009 is 0.88. Since 2011, the correlation is 0.96. And since 2013, the correlation is 0.97. All three correlations are statistically significant at the 95% confidence level, relative to zero correlation.

Thus, variations in the share price of the S&P 500 explain a substantial amount of the variations in the share price of WDC. Since 2009, the portion of the variation in the share price of WDC explained by the share price of the S&P 500 ranged from 77% to 94%. Consequently, forecasts for the share price of WDC should include forecasts for the broader market.

Is WDC likely to outperform the broader market? My model says, "yes." I place the chance of outperformance at 60%. Granted, that outperformance could mean WDC declines less than the broader market.

Including the recently released results, WDC is trading at 2.32 times book value. Factoring in the fundamentals of the company, WDC should not be trading at a substantial premium to the market. The market is priced at 2.6 times book. The WDC justified P/B is 2.44 with the distribution level at 2.91 and the accumulation level at 2.15.

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.