Accumulate Western Digital After The 12% Dip

Summary

• Western Digital stock fell after the company cut dividends.
• Management gains from financial flexibility.
• Stock undervalued again.
• Looking for more stock ideas like this one? Get them exclusively at DIY Value Investing. Get started today »

When Western Digital (NASDAQ:WDC) announced a dividend cancellation alongside its third-quarter 2020 earnings report, shares fell by 10%. Revenue rose by a healthy 14%, driven by strong demand for high-speed solid-state storage. Management saw evidence of the stay-at-home order from COVID-19 hurting traditional hard drive demand. WDC shareholders have no choice but to accept that the stock is no longer an income play. Is this sacrifice worth it for the debt reduction, de-leveraging, and investing back into the business?

Positive Highlights

Western Digital earned 85 cents a share (non-GAAP). Net revenue rose 14% Y/Y to $4.2 billion but fell 1% sequentially. Despite home PC demand for mechanical drives falling, WDC is driving 16- and 18-terabyte storage.

Source: Western Digital

The company has little room for profit growth, due to stagnant revenue in three of the last five quarters. The coronavirus pandemic shifted storage demand away from end-user computers and towards the cloud. So, Western Digital must rely on a continued shift toward client SSD devices to offset the weaker parts of its business.

Higher flash pricing, strong SSD sales, and a growing need for notebook solutions will offset the near-term weaknesses. As the work-from-home movement becomes permanent or more frequent, gross margins from the flash business will increase.

Gross margins already increased sequentially last quarter:

WDC needs average selling prices to increase to more than offset the gross margin decline from the hard drive business:

Although the 14-TB and 18TB sales may pick up steam, the need for high-performance SSDs will matter more for its business. For example, on its conference call CFO Robert Eulau said "We're still very bullish on the enterprise SSD market….We've got goals to get up to 20% market share there."

Higher NAND prices, or material costs, may weigh on results in the current (fiscal fourth) quarter. If WDC passes the higher costs to customers without hurting demand, the company's profits should not fall. Investors cannot predict how costs play out. NAND and hard drive prices change monthly.

Opportunity

Just as other companies in various sectors plan one quarter at a time, WDC is doing the same. If the outlook for the second half of the year improves, the company will adjust its investments accordingly. Eliminating the dividend alienates income investors while giving the company more flexibility. Fortunately, the company's near-term prospects are improving as talk of a re-opening of the economy gathers steam. The stronger cash flow from the dividend cut, balanced with a healthy factory utilization, and stable supply chain positions the business for a rebound.

By anticipating a potential downturn in the business cycle, WDC is working to cut its $6 billion gross debt ($3 billion in net debt). As evidence of a rebound in demand builds, the storage company may adjust accordingly. This includes ramping up storage for the smartphone market should sales increase later this year.

Investors should model a seasonally weak period ahead, lasting one or two quarters. As smartphone sales improve, lifted by a re-opening in stores in the U.S. and China currently, WDC's revenue will bounce back. Lower profits sent the value and growth scores for WDC stock lower.

Data courtesy of Stock Rover

The overall rebound in the stock set sentiment to a positive score of 82/100. But after the 12% drop following the earnings report, WDC stock will fall back to deep value territory. The debt-to-equity ratio is not a concern since interest rates are zero. The company could re-finance debt at favorable rates. It has enough cash flow to re-invest strategically in research and development. For now, the company may turn its focus on launching high-capacity storage drives, SSD, and notebook solutions.

Your Takeaway

The one-day drop in Western Digital stock created another buying opportunity for value investors. It may drift lower alongside a stock sell-off. But the deep discount decreases the risk of owning the stock for the rest of the year.

Management is paying down debt as investors are forfeiting the regular dividend income. The long-term trade-off is worthwhile for shareholders. The sacrifice of a 12% drop in the stock following the quarterly report might follow with the share price recovering. By 2021, if the economy recovers, so too will WDC stock.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in WDC over 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.

Comments

[herder1981]

What's your take after the management gives a disappointing Q1 outlook? Thank you.

[Chris Lau]

@herder1981 $WDC is 1 of 3 stocks sitting on our DIY "wait to buy." The weak outlook is a disappointment. We're more interested on its value.

WDC Post-Market: $39.20-5.27 (-11.85%)

[alpine]

@Chris Lau Just went thru' their earnings presentation slides, and flash/SSD business seems very healthy, so why is WDC stock price collapsing? Grateful for your views....

[Chris Lau]

@alpine I'm going through the conference call. Did you see $MU fall below $50 in AH trade on the WDC news?

Markets are tired of WDC's strong business yet outlook is lower.

[southbuckeye]

WDC should have cut, but not suspended its dividend. No dividend implies very bad news. Also, some institutional outfits won't invest in any company that does not pay a dividend.

[fisherham23]

"WDC is working to cut its $6 billion gross debt ($3 billion in net debt)" - Should be $9B and $6B.

Thanks for the summary

[BouncePass]

A question about demand fundamentals. For years I have seen reports of hard disk drives being supplanted by solid state drives. While that may be true for basic desktop/laptop needs, does not the cloud and company data centers cause a net increase in demand? Where is all the "data" being stored in this era of "big data" and increasing numbers of mobile devices with bigger camera sensors, increased video surveillance, etc. Doesn't that increase the demand for all storage devices, especially spinning hard drives from Western Digital and Seagate? Or is there a whitebox disk drive market? I have a tiny long position in WDC.

[globalopp]

The development of 'cloud' data storage has actually increased hard disk drive demand. Not in terms of total units but more in terms of total exabytes shipped. More than a million disks are needed in each massive data center. Though you can also find some SSDs in some of the data centers, enterprise-quality HDDs for cloud storage are still more economical.

[Chris Lau]

@BouncePass When data centers grew during the Facebook growth years (2010 onward) this lifted demand for HDDs. Then came the security video market. That largely peaked (see $ARLO).

PCs and notebooks will need more SSDs, the primary driver for growth. SSDs in data centers are trending and handle faster I/O for processing more transactions.

$WDC and $STX would benefit if cloud storage demand increased and SSDs in enterprise increased.

[Just Myself]

@globalopp @BouncePass

Didn’t cloud storage somewhat change the location of data storage & HDD’s....from each company/person doing it locally to a centralized model? If so, then one could argue the centralized model is a bit more efficient (less ‘unused’ space) although overall data keeps increasing.

[raising rusty]

they are not breaching any debt covenants. read thru entire conference call.

[raising rusty]

bought as well. not that many players in their space. expect more selling next week.

[mk1992]

Rookie management mistake. Instead of cutting the divi to zero, should have cut it to 1 cent. Financially no difference, but huge diff in SP. Cut it to zero, and all the funds that cannot hold stock with no divi will be forced to unload it. Disclosure: bought in yesterday.

[mk1992]

Truly amazing from the view point of an ex 25 yr Si valley memory engineer. Not a single word in the article or in any of the comments that memory is a cyclical business. And from the way management cut divi to zero, I doubt they know that either.

For memory, one bubbles along, hopefully not losing too much and once shortage comes, prices/ASP go through roof and one makes money hand over fist for divi/buy back/pay down debt/takeover whatever. I suspect with the sudden boom in cloud work at home, much tks to the virus, and also manufacturers finally throwing in the towels and cutting capex, we are entering a boom. Ala now is the time to buy the stock.

Peezees and enterprise/cloud sales are through the roof. Mobile sales pull back is temporary and seeing how people can't live with their phones for one minute/rather get run over crossing the street before they give up reading their phones, 5G coming up next, by eoQ3/Q4, the pent up demand for new phones will be something to see.

Last CEO wasted the last up cycle by using the money for divi and stock bb, inflecting SP at the cost of an unhealthy balance sheet. Famine came and this new CEO, not knowing anything about the biz nor Wall Street, cut divi and bombed the SP for nothing. Just at the start of the next up-cycle. Sigh.......

Only thing to watch out for is the Chinese. They may only take 5% to 10% of the market, but that will unbalance the supply/demand and crunch the whole NAND market.

[Chris Lau]

@mk1992 I am watching $MU Micron closely for a potential supply/demand NAND crunch. Micron said the market is in balance. If MU stock falls, it will take down others with it.

[DesiLou]

Company has been mismanaged at the top since John Coyne retired.

[Chris Lau]

Update: WDC's sentiment score revised lower following yesterday's ER and drop. Per Stock Rover, www.stockrover.com/... see new fair value.

Model a 15% revenue drop this year and 5% for the next four years and the stock is ~fair value: finbox.com/...

[VictorN]

WDC couldn't afford the quarterly $0.50 dividend anyway. Its suspension is the direction the new CEO wants to go: he wants the flexibility to grow, not stuck into paying the dividend.

[Chris Lau]

Poll: Buy $WDC only after a re-test to $27 aff.whotrades.com/...

Other thoughts
The mechanical drive business is competing with cloud storage. Enterprise sales matter more for WDC.

WDC doesn't have a Micron touch with 3dxpoint. To get there, it would have to buy a company which weighs on its debt/equity. Best chance it has is growing SSD sales on all notebook and device sales.

[testfd]

Chris great article as always....thankyou..however with the divy cut i would reprice wdc...I would think close to 30 or sub 30 would be some fair value.

Mu is better in my opiion of the two...I will wait for a while and watch ..

[Chris Lau]

@testfd I teach DIY subscribers to run correlation on stocks. Use Stock Rover*. $MU held up in the last month. The correlation on MU/WDC is 0.92. Very high: they move in the same direction.

* www.stockrover.com/...

[alpine]

@Chris Lau I "feel" WDC's best days are behind it, and Mr. Mulligan left the Company because he could see what was coming. WDC's HDD's business is de facto dying a slow, painful decline, and it is going to be impossible to reverse its fortunes in the years ahead. Its ex-Sandisk acquisition, for which it paid a huge premium, is in trouble, because of what has happened to its previously very Japanesely-loyal partner Toshiba, which almost suffered 'sudden death' some 3 years ago. To ensure its survival, Kioxia, as it is now known, is no longer an exclusive partner with WDC, but its "JV" owners are companies like Seagatealong with Apple, and countless extremely greedy and hungry venture capital partners who all want the max. returns from Kioxia, as quickly as possible.
Due to this "extreme squeeze", I worry that WDC is having major problems with its only future business SSDs, and without core internal engineering, design, manufacturing and integration skills to develop its own products, it is in big trouble, and this is likely to worsen in the years to come.
Among American players left in this key area, the only one which deserves respect is MU. Yes, I feel STX should also be avoided.

[wilsonwheel]

the institute holder will drive this stock price to south for next few months..will foresee hitting $35 in next weel and $25 in 2 months ...sorry to said the dividend cut make the stock not attractive anymore. good luck the rest

[Jonathan Kg]

On costs, one of the issues raised during the earnings call was higher supply chain costs due to the global disruption of commercial passenger flights (fyi: about 75% of air freight shipments are flown on passenger fights). Market data shows that passenger flights will be on the rebound soon, although international capacity would still be highly constrained at least toward the end of Q3 2020. With this, higher costs should gradually come under control and come down with a net positive impact on profitability.

[qwerty11]

Yeah of course, because this is the absolute low of the market. After today, the only way is up!!

[Sikhurity Alpha]

Your own article made a point to not to own this sucker. Increasing prices at this time isn’t viable, and there are better plays to put your money in. Although it can rise, there is better value elsewhere.

[kevn1111]

@Sikhurity Alpha tell us what you like. Helps the entire community as then we can do our DD on those. Appreciate it.

[Sikhurity Alpha]

Fair enough. I like Nvidia and Adobe. Both can pull back some more from the current levels, but well worth owning.

[kevn1111]

Added around $33 the first time. Way over-sold. Revenue still projected higher. Sooo, what price? I will add below $37.50. I do think the dividend will begin in 18-24 months, but the stock will be higher by then. I think they will go for a 2.5% when it restarts, so don't expect the same rate.

[Tarheeboy9712]

No thank you. I’m not into S&M.

[trader7175]

Not long ago it dropped to $27 and still with dividends. Now without it what’s the fair price?

[babagigi]

Dear, don't confuse price with value.

[testfd]

the market crashed it was 27 with the divy cut wdc last year came to 33..I would think that should be taken out and 20 percent disoucnt on that putting it at 25 to 30...we will see...

[zito]

I agree that we need to wait before getting back in. The earnings announcement said everything was good: market demand, pricing and liquidity. Then they cut the dividend not by half but to zero. They must be very worried about something

[kazt.md.phd]

Thanks for the tip, just bought 100 and will add more if it drops lower than $40ps.