- Western Digital stock fell after the company cut dividends.
- Management gains from financial flexibility.
- Stock undervalued again.
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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?
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.
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.
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.
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This article was written by
Chris Lau is an individual investor and economist with 30 years of experience covering life science, technology, and dividend-growth income stocks. He has degrees in Microbiology and Economics.Chris runs the investing group DIY Value Investing where he shares his top stock picks of undervalued stocks with catalysts for upside, dividend-income recommendations with quant and payment calendar tracking, high upside plays, and research requests to help you become a better do-it-yourself investor. Learn more.
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.
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