Another Look At The Low-Cost Building Blocks Of Storage - Part 2

| About: Western Digital (WDC)

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The Amvona (NYSE:WDC) EPS estimate could be wrong, the market may continue it's recent trend down - but if the market comes to understand the error of its ways, the price of WDC may well go up, for even a doubling of the share price would leave the stock cheap by all measures including the company's own historical values.

Consider the valuation ratios in historical context:

WDC Valuation Ratios 10 Yr. Avg. FYE 2012
PE Ratio (ttm) 10.3 4.5
Price to Tangible Book 3.2 1.6
Price-to-Free-Cash-Flow ratio 16.0 3.2
Price to Book 3.1 1.0
Free Cashflow per Share 2.3 9.3
Gross Margin % 18.4 29.2

Another way to look at it is to say if the company just earns consensus of $2.55 per share, at Sept. 30th, 2012 the company would have had approximately $33.72 in book value (or a P/B ratio of just 1.03). A P/B book of ~1 means the company as a going concerns is, well, worthless or no more than the sum of its equity, the vast majority of which is tangible. However, since more than three weeks will have passed by the time investors learn of the company's FQ1 performance, it is almost certain that the actual P/B ratio on Oct. 22nd will be something below 1.

That would mean the company is selling at just 33% of its historical 10 year avg. P/B value 3.11.

Taking another look at a DCF model, if EPS is $10 (per the company) and the growth rate is 16.6% (the historical average), with a terminal growth rate of just 4% (10 years) and a standard discount rate of 12%, it is possible to reach a DCF fair value of as high as ~$227. It seems high. However, in 2009 when Apple's (NASDAQ:AAPL) was trading at $92 per share it also seemed expensive.

The price at Friday October 19th was 34.88 per share or 15.3% of the above DCF value. Meaning it is possible that there is an 85% margin of safety at the Friday closing price.

The PC is dead

It's hard to say, but isn't it just as reasonable to think (and contrary to Citi's report) that Windows 8 may well be "a big event?" Apple for instance is a great company, they've fought like a golden gloves champ, but virtually every other hardware and software vendor in the known universe is in the other corner, and they don't look happy. If handicapping the odds that all other giants (many of whom are collaborating) will stumble, at least consider the math, if not the fact AAPL is down one team member, which everyone seems to agree was of utmost importance - with the last product he worked on just recently being launched (the iPhone 5).

Is the PC dead as Barron's seemed to recently proclaim?

A title to the article claiming "Steve Jobs is Dead" (God rest is Soul) would not have been popular, although much more accurate and easier to verify, and perhaps also impacts the dynamics at hand. After all he was a brilliant visionary, for which there is no adequate substitute.

Consider the excellent point made by "the science of hitting":

"At the end of October, Microsoft's (NASDAQ:MSFT) Windows 8 operating system will hit the market - and in some ways, this has been a more fiercely fought battle than the presidential election. Everybody has an opinion on the functionality of the new OS, its potential uptake in the PC market, its potential impact on PC sales, etc. - and the debate goes on and on. I think I might be looking at this launch a bit different than some people and would like to run you through my thought process. To start, let's look at what Apple had to say in their most recently 10-K about PC sales:

"Mac net sales were $21.8 billion in 2011, representing an increase of $4.3 billion or 25% compared to 2010. Mac unit sales increased by 3.1 million or 22% in 2011 compared to 2010. The year-over-year growth in Mac net sales and unit sales was due primarily to higher demand in all of the company's operating segments for MacBook Air and MacBook Pro, which were updated in July 2011 and February 2011, respectively. The year-over-year revenue growth for portables and desktops was 36% and 4%, respectively. Net sales of the company's Macs accounted for 20% of the company's total net sales for 2011."

Some quick math shows that unit sales for 2011 of 17 million (roughly 5% of the global total of about 350 million) were preceded by 2010 unit sales of roughly 14.1 million; for the sake of comparison, let's assume that every single Mac was sold in the back half of 2010, bringing the 18-month total to 31.1 million units. With that as our back drop, what would be considered a failure for Microsoft with the Windows 8 release? We don't have to go too far back in history to find what many consider to be an unmitigated disaster by Microsoft: the hated Windows Vista. The OS was released in January 2007 and caught some backlash in a big way - in fact, CNET would end up rating it the "Worst Tech Product of 2007." Fast forward 18 months, and we get an idea of what a disaster looks like: When the company reported their fiscal 2008 full-year results in July, Microsoft announced that more than 180 million licenses had been sold since the launch.

Thinking about these numbers is instructive - over a similar time period, Vista outsold Mac's (which naturally come with OS X) at a pace of six-to-one. And remember, when Microsoft was dealing with Vista, they weren't losing share (at least not in a huge way); they were simply maintaining their current hold on the marketplace among consumers (like myself) who decided to stick with XP. While Steve Ballmer rarely says anything worth quoting, here's something that he noted in a recent interview worth considering:

"People talk about: 'How healthy is the PC market?' There's going to be close to 400 million PCs sold in the next year, which makes it a big market. And whether it's 405 (million) or 395 (million), it's a big market, and Windows 8 will propel that volume."

I think this alone is the most overlooked point with this product launch: that vast majority of consumers will end up with a Windows 8 laptop, for the simple fact that most people don't see the rationale in paying two-to-three times as much for a Mac when it has comparable utility."

What Would Make Windows 8 a Success? (GuruFocus, October 4th, 2012)

The combined effect is about 1.3 Billion

"Now we have a development on an ongoing arbitration between the two companies, according to an SEC filing this morning. At issue is a $630 million award being vacated where Seagate had alleged misappropriation of eight alleged trade secrets by Western Digital and a former employee."

$630 Million Award Vacated in Seagate/Western Digital Arbitration (Daily Finance, October 15th, 2012)

On March 23rd of this year, the following was written in the article "Wait! That was our price target and other musings on Memory and storage"

'On February 24th we wrote in a note to investors the following:

"WDC will (contrary to media / analyst reports):

-Jump on announcement of finalization of Hitachi merger (may be accretive in Q1)

- Announce return to full production before Q3

- Despite returning to 100% capacity, ASP's will remain drastically elevated for remainder of 2012

- Announce huge insurance payment in Q2 CC

- Jump on release of Windows 8 (probably Q3) - desktop resets

- STX mediation award for 650 mln. will be thrown out" '

Most of the points made in the February 24th, 2012 investor letter and published in the related article on March 23rd, 2012 have come to pass. The insurance payments were not received in Q2 as anticipated, but it seems likely they will be in Q3. It will be known shortly if the price reacts to the launch of Windows 8 above, but the impact of the mediation award being thrown out cannot be overstated. The affect is not merely 650 M, but rather 1.3 B - it is the 650 M WDC did not lose, and the 650 M STX did not gain. 1.3 B is roughly 17% of WDC's enterprise value as of the writing of this article. The news of the judges decision, unlike the updated Citi rating, was late to make it to the news, in fact it hardly appeared anywhere, much like Deutsche Bank's upgrade to a $60 Price Target on the shares just weeks before Citi's downgrade to $32.

Thoughts on the earnings record

Earnings consistency: It's huge. WDC has it. STX not as much. The average earnings coefficient over past time is irrelevant if the company's performance is inconsistent: True Religion Apparel (NASDAQ:TRLG) is a great example of consistent earnings over time. Here is a chart illustrating the point.

TRLG chart

Although the company did not and still does not have the characteristics of a traditional value investment, the remarkable consistency in the earnings reports warranted careful evaluation, particularly in light of the "relative" value, by which Standard TRLG was by far the cheapest in it's group. For this reason, the shares were acquired on September 4th, 2012 at $22.79 per share and again on October 2nd and 3rd at $20.74 per share and $20.68 per share respectively.

On October 10th, only seven days after the last shares were acquired, they were sold in the pre-market at $26.16 per share. The results outperformed the S & P 500 just slightly as can be seen below:

Issue Date Price Date Value Perf. Months Annualized
TRLG 9/4/2012 $22.79 10/10/2012 $ 26.16 14.8% 1.2 149.9%
S & P 500 9/4/2012 1404.94 10/10/2012 1432.56 2.0% 1.2 19.9%
TRLG 10/2/2012 $20.74 10/10/2012 $ 26.16 26.1% 0.3 1192.3%
S & P 500 10/2/2012 1445.75 10/10/2012 1432.56 -0.9% 0.3 -41.6%
TRLG 10/3/2012 $20.68 10/10/2012 $ 26.16 26.5% 0.2 1381.7%
S & P 500 10/3/2012 1450.99 10/10/2012 1432.56 -1.3% 0.2 -66.2%

Companies with such characteristics are good "buy out" candidates, is the case with TRLG the company recently announced the possibility of just such an event.

TRLG was the fourth company invested in (with three out of the four discussed at length in Amvona articles), to be either bought out or taken private in the last few years (the other three being (NYSE:AM-OLD), (NASDAQ:WINN) and (NASDAQ:FRPT).

The WDC investor presentation features 10 full years. Operating history - the equivalent STX presentation only 5 - STX investors might find it worthwhile to investigate why. Further the recent earnings record appears more substantial for STX, because the company was not as impaired as WDC after the Thai floods - a temporary condition. As these impaired quarters move out of the TTM figures, the P/E ratio on a TTM basis will decline (assuming the share price remains low).

Consider, at the investor conference in late September WDC basically knew the Q1 FY13 numbers - when they affirmed a high guidance ($10 per share), they must have felt confident - if FQ1 was already looking hairy, they would not have felt confident, they could have alternatively withdrew or lowered their guidance as many companies do. Because the company is historically conservative, this should say everything. The analysts, the investors, they didn't and don't know the figures for FQ1, but the company itself had barely two weeks of operations left before closing the books - and they guided at $10 a share, a conviction so high, the company moved forward with additional share repurchases and initiated a divided. Decoupling - WDC may finally break free of the market perception about what exactly the PC food chain is - if this happens, and the old way of thinking changes, then the stock may emerge at more normal ratios comparable with other well run, established technology companies - this could easily mean a doubling or tripling of the stock price.

However the forward P/E, even at the current level is deceptive - the present showing of 4.1 is based on analysts earnings estimates of about $8.50 per share, but if the company's estimates of $10 per share are to be believed (which the company affirmed in September), the forward P/E ratio would not be 4.1 but rather 3.48.

If enterprise value is used (instead of market cap) as would be the perspective of a potential acquirer, then the ratio of enterprise value (~$31.71) to earnings at $10 per share (call it EV/E) is a mere 3.17 - this of course is based on a share count of 245 M outstanding as of the end of FY 12. However, it is already known that the company is buying shares back aggressively, so feel free to round the EV/E down to a nice even 3.

Of course FCF might be even more important to a prospective acquirer, and in the TTM that figure was about $9.33 a share. However in that $9.33 per share there exists (in addition to the impaired quarters) a mere 4.5 months of HGST cash flow in the total, when 4.5 months becomes a full 12 months, it's not hard to see where the FCF figure on a per share basis would be much higher. Surely a prospective acquirer, just as an enterprising value-oriented investor would be most interested in this "EV/FCF" ratio - after all it's where the "meat and potatoes" is at. If FCF on a full year basis with HGST's earnings power is considered it not hard to see $12 per share or a EV/FCF ratio of only ~2.6. That means the company could potentially generate enough cash to effectively pay for itself (EV being the actual company price tag) in only 2.6 years.

To recap, an argument could be made that more data is stored on WDC drives than any other form of media in existence and the data to be stored in the future is growing exponentially. WDC is a forty year old company that is extremely well run and hugely profitable.

Even Advanced Micro Devices (NASDAQ:AMD), which presently appears to be a good candidate for bankruptcy sells at a significant premium to WDC. After looking high and low it's hard to find a cheaper listing, if even basic criteria are used (like not operating at a deficit).

open compute logoIn the end it doesn't matter whose EPS figures are right, or if Win8 succeeds or fails - what matters is that sooner or later the market will realize that the entire hardware ecosystem has changed. The Open Compute Project for instance effects servers, storage and the datacenter, and at the heart of this movement is the Boeing 747 of the hardware universe - the HDD as low cost building block storage.

Disclosure: I am long WDC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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