Western Digital (WDC) was founded in 1970. The company designs, develops, manufactures and sells hard drives (HDDs). HDDs provide data storage using magnetic media (spinning platters) and magnetic heads. These devices are used in desktop computers, notebook computers, servers, network attached storage, storage area networks, and video surveillance equipment. Hard drives are also used in digital video recorders and set-top boxes.
Western Digital has agreed to buy Hitachi Global Storage Technologies. The transaction is a major consolidation in this industry. The combined company has a 50% market share. Seagate comes in second with 30%. The boards of both companies have approved the deal, and it’s expected to close in the third quarter subject to normal regulatory approvals.
Western Digital will pay Hitachi $3.5B in cash plus 25 million shares of WDC stock worth about $800m. The company will fund the transaction with cash on hand and $2.5B of new debt.
Seagate (STX) and Western Digital have always depended on the price differential between HDD and SSD to protect their market; this time is not different. Consider Apple’s Macbook pro. Apple imposes a price premium of $ 1200 for a 500GB SSD. A 500GB HDD is standard. The difference is sufficient to relegate the flash-equipped MacBook to niche status; for now.
REVENUE & COMPETITION
In 2010, disk drive manufactures shipped 653 million new HDDs. Western Digital shipped about 200 million. Seagate Technology (STX) shipped just less; about 195m. Hitachi GST shipped about 112m. Western Digital and Hitachi GST, together, account for about half the HDDs shipped worldwide.
99% of WD drives end up in consumer products like desktop and mobile PCs, set-top boxes and video game consoles. This area is impacted by the increasing sales of tablets and netbooks that use SSD storage instead of HDDs. Unit growth for HDDs is expected to come from demand in enterprise areas; “the cloud”. This area is currently dominated by Seagate (STX).
65% of drives shipped by Seagate and 27% of drives shipped by Hitachi GST end up in enterprise solutions. The acquisition of Hitachi GST brings WDC the product portfolio and experience required to compete in this market segment.
SSD unit sales in 2010 were about 9m. Unit growth of SSDs is impressive, doubling every year or so. The capacity of a typical SSD is however about 10% of the capacity of a HDD. The market share of SSDs, by capacity, is therefore less than 1%.
FUNDAMENTALS & OUTLOOK
A HDD munufacturer needs the scale, the technological know-how and an established track record for quality. It is impractical for a customer to wait till a HDD is proven. That is why customers choose to buy from a proven manufacturer. By the time the drive itself is proven, it's too old, too small and too slow. The world is probably not going to see a major new HDD manufacturer.
SSDs consists of a stacks of NAND chips that the SSD controller uses to store data written to the SSD. The cost of one standard 4GB chip using multi-level cells (MLC) is approximately $7, and the controller for the stack is the same price as for hard disks; about $15.
NAND chips benefit from the increased density over time according to Moore's Law. Hard disks also benefit from exponential increases in density, it’s called Kryders law. If both laws continue to hold, SSDs will not overtake HDDs. However, at some point, the premium is very small relative to the advantages of SSD. You probably won't pay $ 1500 extra for a SSD in your laptop now, but you may be willing to pay $100 extra by 2015. SSD is faster, less noisy and runs cooler while consuming less power.
So, SSDs, over time, will take share from HDDs. The HDDs end up “owning” a smaller slice of an ever larger storage pie. SSDs started out in small niches (planes and industrial applications,). Now it’s tabets & netbooks….. the niche technology becomes mainstream.
The reverse will happen to HDDs. They will be slowly relegated to niches where cost per GB matters more than speed and noise. You can see this in practice at home. People have tablets, smartphones, media players….. and a mass storage device with a couple of HDDs tucked away somewhere.
Something similar is happening in enterprise enviroments. Users with a large appetite for media will require the low cost storage of HDDs for a long time to come.
Western Digital and Seagate have both been reluctant to invest in SSDs claiming that these SSD drives aren’t currently worth the price and effort. Global NAND production capacity is about 7B gigabytes; doubling annually. 90% of that capacity goes into cameras, media players etc.
In 2010, about 75 billion GB of HDD storage (250m laptops x 300GB) were produced just for laptops.
A mega-fab capable of producing the NAND chips for 4 billion Gigabytes of storage per annum is about $ 10B. You would have to invest $ 180B today if you want to equip all the laptops out there with SSDs instead of HDDs… ouch !
Assuming the chips themselves (Moore’s law) double in capacity every 2 years, that same $ 10B mega-fab will spitting out the chips needed to equip all laptops with SSDs by say… 2020. This estimate assumes laptops, in aggregate need twice as much storage in 2020 as now.
In short, you need to invest $ 10B today in order to cover the laptop disk drive business by 2020. WD currently dominates that particular market with its HDDs.
We can do similar calculations for the enterprise market area but you get the picture… there will probably be demand for HDDs in 2020. STX and WDC can cater to much of that demand just by maintaining their current unit capacity and growing the capacity of the individual HDDs organically through R&D; Kryder's law.
CAPITAL STRUCTURE & MANAGEMENT
WDC issued $ 2.5B of debt and 25m shares to finance the acquisition of Hitachi GST. The combined company will have 255m shares outstanding.
Pro forma, the new company has $3B of long term debt and $1B in cash. WDC alone had $ 1B of FCF while spending record amounts (500m) on R&D. WDC has a bullet proof balance sheet now and will be adequately capitalised after the acquisition. We assume FCF stays flat; no contribution by Hitachi GST.
Western Digital recenty appointed Tim Leyden as COO. Wolfgang Nickl succeeds him as CFO. Both of them report to John Coyne former COO and CEO since 2007.
Mr Leyden has worked at WD for more than 20 years in a variety of positions. He left briefly to serve at the Sage Group. He returned in 2007 to serve as vice president and CFO.
Mr Nickl joined WD in 1995 from IBM. He served as vice president of finance since 2005.
It’s a good leadership team with an excellent record of creating shareholder value.
VALUE & PRICE
I use rough numbers.
WD & Hitachi GST, together produce roughly half of the worlds HDDs. Replacing that production capacity with SSD NAND mega-fabs would cost about $90B. The deflationary nature of the industry means the replacement cost of current per production capacity is reduced to $5B by 2020. Let’s be pessimistic and estimate that:
- The replacement cost of WDCs production capacity, by 2020 is $20B. This assumes WDC makes the same number of HDDs but with four times the capacity.
- Hitachi GST does nothing for FCF of WDC. The combined comany continues to produce $1B of FCF.
- 10 years of R&D at 500m per annum is worthless.
We end up with 10 years x $1B of FCF and $20B of residual value. We discount this value with a 50% haircut => $15B
I Using replacement cost leads to a value of of $15B – $5B of liabilities + $1B of cash = $11B.
WDC bid $4.4B for Hitachi GST. Hitachi had a 17% market share. The combined company with a 50% market share should be worth at least 50/17 x $4.4B.
II The bid for Hitachi GST implies WDC is worth $12B.
TPG Capital recently bid $7.5B for Seagate + $2B of debt. Seagate refused. Seagate has a 30% market share….. 50% is worth more. http://www.engadget.com/2010/12/05/seagate-reportedly-turned-down-takeover-bid-from-western-digital/
III The bid by TPG implies the combined company is worth $13B
Assuming 255m shares post the acquisition, the market capitalisation of the combination is $8.5B. We add back 2.5B of debt, subtract $1B of cash and conclude mr. Market offers us the company at $10B. A 10% discount to my most pessimistic estimate of intrinsic value.
Tsunami. HDDs are assembled from many components produced all over the world. Disruption of the production of a component is a disaster.
Customer concentration. The customer base is concentrated and refreshes products about once a year. Inventory accretion at the HDD suppliers is a frequent occurrence. Consolidation of the industry doesn’t change this.
Market risk. Hitachi dumps its 25m shares in a hurry to raise cash.
No position in any of the companies mentioned.
Any and all comments and questions welcome as usual.