Western Digital: What The SanDisk Acquisition Means For Dividend Investors

| About: Western Digital (WDC)
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Summary

Like its sector peers, Western Digital has been battered by poor demand for its main product.

The acquisition of SanDisk, which was meant to boost Western Digital’s revenue profile, came with a heavy debt price tag.

The burgeoning debt burden is putting too much risk on the dividend to make this a buy.

Poor Fiscal Third Quarter Amidst Completion of SanDisk Acquisition

Western Digital (NYSE:WDC), which together with Seagate (NASDAQ:STX), are the two most recognizable names in the Hard Disk Drive ('HDD') business, had a lousy fiscal 2016 third quarter. Western Digital reported earnings of $1.21 a share, which was 7 cents short of the consensus analyst estimate and a decline of 26% compared to the $1.63 a share that it earned a year earlier.

The tepid results from Western Digital, which completed the $16 billion acquisition of SanDisk (SNDK) in May, was the result of continued weakness in the PC market and was in keeping with trends anticipated by Western Digital itself. Hard drive shipments contracted by 17% in 2015 - faster than the 8% contraction in PC shipments - and Western Digital forecasted that the total available market for hard drives would contract by 100 million (or around 21%) in 2016.

Dividend Impact and Outlook. As a result of its poor quarter, Western Digital shares have dropped by nearly 20% this year - and this is after an analyst upgrade (brought about by insider buying) that lifted the stock.

Of course, the real question is how the acquisition of SanDisk will impact Western Digital's ability to pay dividends. The company currently has a 50 cent per share dividend and has paid a quarterly one over the last three years. The stock's dividend yield is 4.29%, which is among the highest in its sector. That means that investors who invest $10,000 in Western Digital stand to earn $429 in passive income over a year's time.

On the face of it, the SanDisk acquisition should provide an immediate boost to Western Digital's flagging revenues. Western Digital released guidance that it expected its fiscal 2016 4th quarter revenues to reach as much as $3.45 billion - an 8% improvement compared to the same period a year earlier.

However, as a result of the transaction, Western Digital's earnings are expected to dip between 60 and 70 cents per share - 60% lower than the same period in fiscal 2015 - owing to $250 million in interest and debt-issuance costs, much of which is associated with the acquisition of SanDisk. Right here, investors can see that debt servicing could eventually become a hurdle to dividend payments, particularly if Western Digital's gross margins continue to dip as they have for the last four quarters and the savings and margin improvements that it expects from the SanDisk deal do not materialize.

Investors should note that Western Digital's earnings do not yet reflect the full impact of the $14.1 billion in debt that Western Digital issued to finance the SanDisk acquisition. Based on the $5.2 billion in new 7- and 8-year bonds that it recently issued, Western Digital's cost of debt for the SanDisk deal is in the 9.4% range - or towards the high-end for high yield bonds.

Assuming that the rest of its SanDisk-related borrowings are in the same coupon range, Western Digital is looking at a $1.3 billion per year interest bill over the next 7 to 8 years. To be sure, Western Digital anticipates that it will realize $350 in annual savings as a result of the acquisition - but it will likewise have to incur $800 million in cumulative cash expenses in 2016 ($480 million) and 2017 ($320 million) in order to do so.

Everything else being equal, this net increase in costs would cause Western Digital's working capital ratio, which is currently at a robust 3.14 to 1, to dip to 2.06 to 1 over the next year, bringing it in line with the average for its industry. In the medium term, Western Digital has suggested that it could realize as much as $1.1 billion in cost savings from the SanDisk deal, which would wipe out much of the negative carry from its new debt and bring its working capital ratio closer to its current level.

In any case, Western Digital currently has cash of nearly $5.9 billion and a quick ratio of 2.6 to 1, which is far higher than that of its peer group. Even accounting for a very large increase in its interest payments and the cash expenses from the SanDisk deal, Western Digital has the wherewithal to pay over $600 million in dividends - but until when it can do so is uncertain.

To wit, a very real source of concern is Western Digital's gearing, which currently stands at 23 cents per dollar of equity. Not considering other balance sheet additions that the SanDisk acquisition could bring, the issuance of $14.1 billion in debt will raise Western Digital's gearing to $1.70 per dollar of equity - far higher than the 30 cent industry average - and around the level of leverage that is considered normal for banks.

Moreover, despite the SanDisk acquisition, Western Digital's revenues are expected to remain flat over the next 5 years - a sign that analysts share Western Digital's dour assessment of the Hard Drive market. Indeed, analysts have downgraded their earnings forecast for the stock continuously over the last 90 days.

Conclusion

The outlook for Western Digital is clearly mixed, and we are concerned that not enough attention is being paid to its heavy leveraging, which could have very serious repercussions on its ability to pay dividends in the medium term, among other things.

While higher leverage shouldn't impact the company's ability to pay dividends over the next four quarters, when combined with the poor outlook for the sector, a very dark picture emerges for the stock, and we would recommend that investors avoid it for now - high dividend yield notwithstanding.

Disclosure: I/we 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.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.