Steven Romick Publishes 3Q10 Letter; Comments on Western Digital Corporation

After a tough August, the stock market turned around in September, erasing its year-to-date losses. Crescent returned 7.4% in the third quarter and 5.3% year-to-date, versus the S&P 500’s 11.3% and 3.9%, respectively.

We recently added Western Digital Corporation (WDC, Financial), the second largest producer of Hard Disk Drives (HDDs), to the portfolio. Its stock price had fallen almost 50% from its high earlier this year to the low-to-mid $20s where it was trading around 6x trailing twelve-month earnings (fully taxed). If one were to adjust for their roughly $10 of net cash per share, the adjusted P/E would have been less than 4x our purchase price. Clearly, the market does not see WDC’s recent earnings as sustainable. We don’t either, but we do believe their earnings might stabilize at more than $3 per share and trough around the $2 level during this cycle.

Investors fear that tablet computing (e.g., iPad), which does not use a disk drive to store information, will cannibalize the HDD-centric netbook computer market. We have assumed that the netbook market will decline by about 75% over the next couple years — from today’s 2.7% of industry sales to 0.7%. Tablet computing will indeed eat into the netbook market, but that certainty has translated into market fear and irrational stock pricesfor HDD companies, including WDC.

Interestingly, the tablet market is not all negative for the HDD companies. Tablets, and other wireless devices such as smart phones, drive users to download new applications or apps. These apps reside on the internet and are stored on HDDs. Thus, the more wireless devices sold more apps created increased demand for HDD storage, particularly as more storage intensive video files are downloaded. We now hear that sophisticated users of tablets are purchasing external hard drives to back up files that can no longer be stored on a 64GB flash chip.

We cannot ignore the other real concern that the key market players (including Seagate Technology, Hitachi, and WDC, which together have more than 80% market share) are going to cut each other’s throats by slashing prices to either retain or gain market share. In 2004, the industry, led by Maxtor (subsequently acquired by Seagate), slashed prices to capture share, and nearly every disk drive company experienced a decline in profits, with some losing huge amounts. WDC and Seagate were the only two companies that stayed reasonably profitable, but even those two saw their respective operating profits decline 13% and 28%.

While the iPad tablet risk gets much of the headlines, we believe the competitive risks and lower selling prices could potentially do the most damage to WDC’s valuation. However, if the industry remains reasonably rational, WDC has the potential to earn in excess of $3 a share over the cycle, fully taxed, leading us to conclude that the intrinsic value could be in excess of $40 per share, if the market values it at a 10-11 P/E plus the cash. At our cost, we conclude that the upside opportunity more than justifies the potential downside, particularly since we believe that the upside is more likely. We expect continued short-term volatility as the competitive environment creates fear.