Western Digital Has Meaningful Downside Protection, But Limited Upside

Summary

• Western Digital is navigating through the trough of the cycle successfully as it remains free cash flow generative.
• 2019 promises improving margins and average selling prices for HDDs and SSDs.
• However, Micron, a related player in the data management sector, is a better bet.

Investment Thesis

Western Digital (NASDAQ:WDC) makes hard disk drives (HDDs) and solid-state drives (SSDs) or flash-based memory. The latter product is manufactured under a joint venture with Toshiba Memory Corp (TMC).

Operating since 1970, the company has navigated successfully through the cyclicality of the industry. Currently, WDC is experiencing the down cycle of the industry, and arguably the bottom is about to form. In just a few quarters, the whole sector looks likely to revert to growth. Unsurprisingly, since the start of the decline, WDC remained highly profitable and committed to returns cash to its shareholders through its 5% dividend yield and buyback. Nevertheless, we are witnessing an ever more competitive market, and although we feel that WDC is a good bet in the industry, its economics are not as strong, and its margins will not expand as fast as others. We feel Micron (MU) is a safer bet.

Source: WDC, 10-K, 2018, Segments

Worst of the cycle has arrived

Before comparing with Micron, let’s have a look at what WDC has gone through and what have they done to deserve a substantial share price performance discrepancy to Microns.

Source: Yahoo Finance, Jan 2019 price chart

The peaks and troughs of the semiconductor cycle are clear from looking at the chart above. The cycle is identical at the other HDDs producers, Seagate (STX), Samsung (OTCPK:SSDIY), and Toshiba (OTCPK:TOSYY). And similarly, at the SSDs players: SK Hynix( OTC:HXSCF) ( OTC:HXSCL), Micron and Intel (INTC).

Although Micron is not the perfect like-to-like comparison to WDC as half of WDC’s revenue comes from HDDs, whereas Micron focuses on SSD solutions that combine DRAM and NAND. Nevertheless, they both compete to design and manufacture solutions for the future of data management. Both also supplies storage and memory solutions to data centers, PCs, and embedded business units. Finally, we feel investors in WDC should look into MU as an alternative investment in the sector.

Now, despite the recent resurgent of share prices and sentiment across the semiconductor industry, hard drives and memory prices are still expected to be soft. Recent Q2’19 results showed that revenue in each of their end markets declined on a year-over-year basis due to a combination of lower demand and aggressive flash pricing conditions despite healthy growth in flash bits sold. The softness is expected to continue in Q3. The reasons are because of reduced demand for mobile handsets and continued slowdown investments by hyperscale customer’s inventory adjustments at certain customers and geopolitical volatility.

WDC’s peers such as NVIDIA (NVDA), Intel and MU, have reported similar softness in their products average selling price. However, the market appears to be more rational as most producers cut CAPEX (MU -17%, SK Hynix -17% for DRAM and -66% for NAND, Samsung -60% in DRAM but +60% in NAND) and supply to support prices. In WDC’s case, they have accelerated the closing down of factories in Malaysia and lowered CAPEX.

We previously announced the reduction to wafer starts for a proportion of the Flash joint venture along with the way deployment of the capital equipment. The magnitude of these actions is a planned reduction of 10% to 15% of our bid output in calendar 2019.

We are also accelerating our Kuala Lumpur facility closure timeline by almost three quarters along with rationalizing other HDD manufacturing costs.

Source: WDC Q2 CC

Satisfactory quarter at the trough

Although the industry is at the bottom, Q2 results were not a disaster. WDC achieved $24M of FCF. In Q3, WDC is expected to remain free cash flow neutral and decline modestly in the cash balance. Additionally, WDC’s planned annual cost saving of $800M will add substantially to the bottom line.

In total, we are targeting $800 million in annualized reductions in non-GAAP cost and expenses, evenly split between the two line items. […] For cost-of-goods sold, we expect to see the full results of these efforts reflected by the end of the December quarter of 2019. And for operating expenses, we expect to see the full results reflected within the September quarter of 2019.

The long-term growth opportunities for our business remain unchanged. Transformative trends such as artificial intelligence, machine learning, autonomous vehicles, mobility, and IoT will continue to drive massive amounts of data that needs to be captured, preserved, accessed, and transformed.

Source: WDC Q2 CC (emphasis ours)

Lastly, WDC’s balance sheet remains strong, against a $4.6B cash and normalized annual FCF of $2.5B, the long-term debt figure of $10B isn’t a concern. As this is at the trough of the cycle, the balance sheet and FCF neutral situation are extremely positive.

Source: WDC 10-K, 2018, Contractual Obligations and Commitments

A step behind peers

WDC has managed to remain FCF neutral at the trough. Things could be rosy in 2019 as ASP improves and $800M cost saving kicks in. We think that WDC has meaningful downside protection. However, WDC will not benefit in the upcycle as much as Micron. Here’s why.

Firstly, in the next several years, WDC expects to develop and commercialize additional generations of 3D NAND technologies. Meanwhile, MU will be launching 3D Xpoint solutions by the end of 2019, designed to be faster than NAND and less expensive than DRAM. MU would become the only full-stack provider of storage and memory in the industry. While 3D NAND and 3D Xpoint are unrelated, they will be the most innovative step forward for WDC and MU, respectively. The difference is MU is looking to push their product to market sooner.

Secondly, as things will improve in H2, WDC’s margins will also grow with the $800M annual cost saving. However, WDC storage segment isn’t likely to bring as high margin business as MU’s memory segment.

Currently, WDC is gunning for gross margin and net margin at around 40% and 20% respectively. The levels are higher than MU’s historical value. Stepping back 15 years leading up to 2015, MU’s DRAM average gross margin was at 20%. However, in 2017, it rose to 56%, and then up again to 70% in 2018. The margin expansion at MU was incredibly impressive. MU’s CEO, Sanjay explained that although the company is experiencing a period of margin contraction, the figure for 2019 will be significantly higher than previous cycles at 20%.

In addition, Micron has also been focusing on higher value product mix such as SSD. Four years ago, Micron went from selling 80% of NAND as components to now at just 40%. Thus, at the moment 60% of NAND products are higher margin. The goal in 2021 is to revert the 80% from low-value to high-value solutions.

Meanwhile, in WDC’s case, 2019 promises greater participation in higher value markets. However, it’s hard to see that the level of margin expansion in WDC’s HDDs and SSD’s will be as high as MU’s DRAM and NAND solutions. In the words of the CEO.

I'm not happy with the hard drive margins. I'm disappointed by the level there. It's driven by two things: one, weaker or lower capacity enterprise mix, which obviously capacity enterprise hard drive carries a higher-margin profile.

And by the way we are carrying a cost burden in the HDD space, which is the reason why we're closing of Kuala Lumpur and not only the reason we're closing it, but also acceleration of that.

And so as we finalize the closure of that facility and capacity enterprise are mix improves in the back half of the year, we'll see those margin levels to return to a more acceptable and traditional level on the hard drive space.

Source: WDC Q2 CC

Moreover, WDC’s margins are restricted due to inflexibility and high reliance on Toshiba Memory Corp, who supplies WDC’s flash memories through their Flash Joint-Ventures.

Frankly, WDC products are more commodity-like compared to MU’s. Sharing the future growth in Automotive, Connected Homes and AI, yet, WDC is not going to capture as much profit as MU. Moreover, we find WDC’s communication with investors less informative than MUs’, specific numbers were not disclosed. It’s hard to pin down an estimate of how much WDC will participate in higher margin products and markets.

Finally, despite the limitations above, WDC’s valuation is also less attractive than MU’s. WDC is currently trading at 4.7x Operating Cash Flow (OCF) and 17x PE, while MU is trading at 2.6x and 3.3x respectively.

Takeaways

WDC is navigating through the trough of its cycle successfully. The management is focused on restoring the supply and demand balance to support prices. WDC is also likely to improve its margins in 2019 while participating in growth areas in automotive, connected home and surveillance categories. WDC represents a meaningful margin of safety thanks to its solid performance at the trough, healthy balance sheet, active buyback, and 5% dividend. However, we feel Micron has better economics and more dexterous in expanding margins. Finally, MU is also trading more cheaply than WDC. Thus, we think Micron has more upside at current prices. We encourage investors to look at MU as a related sector investment.

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