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Western Digital (WDC) Value Analysis on Demand

February 27, 2012 | About:
Company Overview: Western Digital Corporation (WDC) provides solutions to collect, store, manage, and protect digital content. The company’s primary product is commodity hard drives using rotating magnetic disks. The company also produces solid state drives, home entertainment, and networking products.

The company gets 64% of revenue from the compute market (desktops, notebooks, etc.) with the remaining revenue from home entertainment and networking. The company has virtually no exposure to the enterprise market (only 5% by unit shipment volume).

The hard drive business is a commodity business and as such the average selling price (ASP) per drive continues to drop. In 2011 the ASP was $45 compared to $50 in 2010 and $51 in 2009. Thus the hard drive industry depends on increasing shipment volumes and improving operational efficiency to generate increasing profit. Hard drive shipment volumes for WDC and the industry have continued to increase up until the Thailand floods. WDC shipped 207M units in 2011.

WDC has pursued the status of lowest cost manufacturer by vertically integrating its supply chain. The two most important components of HDDs are the read/write head and the magnetic media. This components determine the areal density (and thus capacity) and speed of the drive. By producing these components in house the company is able to achieve higher performance and lower costs.

The effects of this business strategy can be seen in WDC improving margins.

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There have been occasional price wars in the HDD industry but as the number of competing firms have dropped the risk of another price war has dropped as well.

The hard drive market was previously divided among five firms with WDC and Seagate (STX) controlling the largest share.

WDC 30%

STX 30%

Hitachi GST 18%

Samsung 12%

Toshiba 10%

Then WDC announced plans to buy Hitachi GST for $4.3 billion and Seagate bought Samsung for $1.4 billion. With announced purchases the market breakdown is now:

WDC (plus Hitachi) 48%

STX (plus Samsung) 42%

Toshiba 10%

The Hitachi purchase allows WDC to deploy some of its overseas cash intelligently. The purchase of Hitachi allows WDC to take some capacity out of a commodity industry, makes WDC by far the largest manufacturer, gives WDC access to the enterprise market which it previously did not have, and expands WDCs SSD capabilities.

Thailand Floods

The flooding in Thailand will have no long term impact of WDC’s operations. WDC and the hard drive industry is likely to be back to normal manufacturing capabilities by the end of 2012. Additionally, WDC has multiple forms of insurance that cover a substantial portion of the losses in the flooding including business interruption insurance. Therefore we have not modeled any changes in the business due to flooding in the valuation models.

Future of Business

The increasing popularity of mobile computing devices (tablets, smart phones) and small form factor devices (ultrabooks) is leading to increased usage of solid state drives (SSD). There is ample evidence that these new devices are cannibalizing PC sales to some extent. Additionally, the increasingly popularity of cloud based services has lead to the need for ultra high performance servers utilizing SSDs rather than traditional HDDs.

SSD vs. HDD

SSD HDD
Price (per GB) ~$1 - $3 ~$.10 to $.20
Projected 2012 price (per GB) ~$1 and up ~$.05 and up
Power consumption Approximately half of comparable HDD High
Speed Twice as fast in low end consumer applications to several hundred times faster in high end enterprise applications. Slow
Form factors Same form factors as HDD or smaller 3.5” or 2.5”
Reliability Higher tolerances than HDDs Excessive vibrations, shocks, or temperature extremes can damage or degrade drives
Key markets Mobile devices, tablets, ultra books, high end/high performance notebooks, ruggedized computers, high performance enterprise storage desktop computers, notebooks, low performance enterprise storage


Future

Because of their low cost nature and ability to store massive amounts of data HDDs are likely to survive in perpetuity for applications where performance isn’t critical and large storage volumes are needed. This would likely be low end to mid range desktops, entertainment and media storage applications, low end enterprise storage including backups.

Threats

The biggest threats to traditional HDD storage are the rise of mobile computing and cloud computing.

Mobile Computing

Mobile computing (especially tablets) has been taking market share from the traditional PC and notebook market. While mobile devices are great for content consumption there is ample evidence that they are poor replacements to traditional computing products for content creation. Traditional computing products are likely to coincide side by side with mobile devices for many consumers. The threat of the increasing usage of mobile devices is one of the biggest reasons to like WDCs purchase of HGST since HGST gives WDC access to the crucial enterprise market which is less likely to be adversely affected by cloud and mobile computing.

Cloud Computing

Cloud computing is likely to not be much of a threat to traditional HDDs. While users are moving there storage from local machines on to the cloud and consumer HDD sales are declining enterprise HDD sales should increase as the volume of data stored “in the cloud” increases. Every piece of user content uploaded to the cloud needed to be backed up on multiple drives/server across multiple datacenters which greatly increases the need for cheap storage solutions.

The only area where cloud computing is a threat is likely in streaming media services and high performance enterprise server running applications that are served up through the cloud. In these applications the performance increase offered by SSDs is necessary. However, many companies are moving toward a hybrid SDD-HDD setup where some information is chached to fast SSD drives while the large volume of data is stored on traditional HDD drives.

Finally, with the seizure of MegaUpload and the subsequent unavailability of user data it remains to be seen if cloud storage and cloud applications will completely replace local solutions as cloud solutions expose clients to a whole new set of risks.

In summary continued content growth points to continued need for large cheap storage.

Valuation

The following valuation assumes that WDC’s purchase of Hitachi Global Storage Technologies (“HGST”) for $4.3 billion goes through. HGST’s TTM revenue run rate was $6 billion and the unit generated EBITDA of $800M.

DCF Method

We estimate the combined WDC and HGST entity will generate revenue north of $16 billion. Over the past five years WDC had an average FCF margin of 9.7%. This gives us FCF of around $1520 million using a 9.5% margin.

We use a 15% discount rate since it is a commodity business and there is some risk regarding future revenues. We use a 10-year short-term growth rate of 5% and a long term perpetual growth rate of 3%. After adjusting cash and debt for the HGST purchase we get a value of approximately $55 per share.

EV/EBITDA Method

The five-year average EBITDA margin for WDC was approximately 16%. Assuming EBITDA of $2560 million (off of the same $16 billion in revenue we assumed in the DCF case) and a 6x multiple we get an EV of $15.3 billion of approximately $58 per share (after adjusting cash and debt for HGST purchase).

Disclosure: Long WDC, SNDK

About the author:

Ben Strubel
President and Portfolio Manager of Strubel Investment Management, LLC a value oriented, independent, fee-only Registered Investment Advisor (RIA) based in Lancaster, PA.

Visit Ben Strubel's Website


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