Western Digital's Earnings Soar As The Toshiba Saga Continues

Summary

• Excluding charges, non-GAAP Q1 net income was $1.1 billion or $3.56/share.
• Q1 was strong - driven by excellent NAND results.
• Toshiba's intent to move forward with the Bain/SK Hynix consortium means that issue will likely be settled in the courts, not in the press.
• A 9x valuation on expected EPS of $13/share values WDC at $117.

Last week Western Digital (NASDAQ:WDC) delivered powerful Q1 2018 results that beat on both the top (+$40 million) and bottom lines ($0.26/share):

Source: Q1 Supplemental Data

As shown above, gross profit increased by a whopping 43% as compared to the year-ago quarter as revenue increased by $467 million and the cost of revenue decreased by $111 million. Total operating expenses declined by 8.6% as cost-cutting and ongoing integration efforts of previous acquisitions are obviously bearing fruit. The total outstanding diluted share count increased 7.4%. As a result, Q1 per-share gross profit increased to $6.52/share as compared to $4.68/share in the year earlier period.

The Q1 $0.50/share quarterly dividend compares favorably to the net income of $2.23/share (GAAP) and even better to $3.56/share (non-GAAP). The company ended the quarter with $6.9 billion in cash - up from $4.1 billion in the year ago quarter.

Interest expense declined by $308 million. The debt and maturity schedules are shown below. The $3.35 billion of 10.5% notes stick out like a sore thumb, but note they are not callable until April of 2019.

Source: Q1 Quarterly Fact Sheet

The Client Devices and Client Solutions segments continued to deliver solid sequential growth, while results from the Data Center Devices & Solutions segment were somewhat of a disappointment. That said, total exabytes shipped were up 7.6% from Q4FY17, and free cash flow was $847 million - up 11.3% sequentially from the prior quarter:

Source: Q1 Quarterly Fact Sheet

Outlook

WDC will continue to benefit from favorable demand and NAND pricing for the coming year. Strong demand will be driven by new generation cell phone devices with higher NAND capacity. Meantime, the HDD demand curve is starting to smooth out as data centers take over from the historical PC demand-driven roller-coaster. Gross margins should be north of 40% for FY2018 as the company continues to benefit from significant cost synergies from the SanDisk and Hitachi Global Storage Technologies ("HGST") acquisitions. That said, R&D expenses are likely to remain somewhat elevated as the company continues to focus on long-term strategic technology development.

Note that DRAM and NAND memory providers rallied sharply after Samsung's (OTCPK:SSNNF) blowout earnings report was released yesterday and is more evidence of continuing strength in the global NAND market.

WDC's diluted earnings per share are expected to come in at $12.50/share for calendar year 2017, including $3.65 for Q2FY2018 (the quarter ending December 31, 2017). FY18 non-GAAP EPS is expected to be in the neighborhood of $13/share.

Toshiba

Meantime, the Toshiba (OTCPK:TOSBF) saga continues. Western Digital said on the quarterly conference call that it still plans to participate in JVs like Fab 6 if the companies can resolve differences. Yet WDC is not confident in that their differences will be resolved.

WDC has made a number of allowances to try to meet Toshiba's needs. Most notably, WDC withdrew from the INCJ-KKR consortium. This eliminated its participation in TMC equity ownership and minimized any regulatory risk. That move directly addressed key concerns of TMC's management. It has been clear that throughout the entire TMC sale proceedings, WDC has been pro-active in trying to resolve the dispute. Yet every time WDC gives an inch, TMC raises the bar just a bit higher. As a result, WDC will likely be at an advantage when the arbitration panel looks at which of the JV partners were actively trying to resolve the dispute prior to the request for arbitration.

But the bottom line is that WDC is very well-positioned from a legal perspective with respect to SanDisk's rights under the current TMC joint venture agreement. Note WDC's successful track record in the California courts in this regard. On October 5, the International Court of Arbitration confirmed the three-member arbitration panel. Shortly thereafter, WDC informed the panel of its intention to seek injunctive relief to prevent Toshiba from transferring its JV interests to SK Hynix-Bain-Apple (AAPL) consortium without SanDisk's consent. WDC believes SanDisk's consent rights under the existing JV are clear and explicit, and the company is confident in its request for injunctive relief. WDC said it expects a ruling in the first part of 2018 in advance of Toshiba's announced time frame to close the proposed transaction.

Summary and Conclusion

WDC is guiding for $13/share in earnings this year, which at the current price of $90 implies a forward P/E of just ~7x. I believe such a low P/E for a company with excellent and indispensable NAND technology means WDC is very much undervalued. The stock should be trading significantly north of $100/share - and that is without a favorable resolution to the TMC drama. Yet all previous court-related rulings indicate WDC is likely to be the winner in the upcoming arbitration. In addition, WDC says it is well positioned to receive NAND supply from the Toshiba joint venture through 2029 and targets growth of 35-45% in calendar year 2019 - regardless of the Fab 6 investment. A realistic P/E of 9x on top of $13 in expected EPS means WDC should be trading at $117. And, that price target is without a positive outcome from the arbitration panel. With an injunctive relief, I suspect WDC will rally up to $125 as the market clearly is discounting a positive (for WDC...) resolution to the JV dispute.

Meantime, the stock yields 2.2%. WDC is a BUY.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long WDC. 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.

I am an engineer, not a CFA. The information and data presented in this article were obtained from company documents and/or sources believed to be reliable, but have not been independently verified. Therefore, the author cannot guarantee their accuracy. Please do your own research and contact a qualified investment advisor. I am not responsible for investment decisions you make. Thanks for reading and good luck!