On May 17th around 2 p.m. a call came in from a friend, he said he had just received a call from his broker, who asked him “what he wanted to do about Facebook’s IPO”. The response was intricate and subtle; “wouldn't touch it with a hundred foot pole”
The advice was to consider buying Western Digital (WDC, Financial) instead if he had to buy something. Sensing that the answer may have been a bit curt, the following email was sent shortly after the phone call:
"Thu 5/17/2012 2:02 PM
Dear [name omitted],
Thank you for the call just now. To be clear… and further to your question - would NOT buy (FB, Financial) IPO tomorrow or any other IPO for that matter. Have no idea where the price will go in the near term – but do know that the issue does NOT represent any sort of value for a buyer tomorrow.
Next, I would fire your financial advisor for two reasons:
1. For suggesting such a highly speculative investment such as FB, for which he will receive a commission but you will jeopardize your principle.
2. He is asking you what “you want to do” instead of explaining to you the rationale behind the suggestion – in other words he is getting paid while you do the thinking…
FB filed with the SEC here:
they had 4.5 B in net working capital (tangible current assets available to buttress the stock price tomorrow) at YE 2011 they had only 668 M in earnings (which declined 12% in Q1 2012) – at a 100 B market cap (expected) – owners tomorrow would need 150 years to regain their investment (100 B / 668 M in annual earnings).
Take the following value vs. speculative case of LNKD (LinkedIn) and WDC (Western Digital)
…a little food for thought:
Remember you don’t need a lot of activity to do very well investing – you do well by being right.”
In a follow up email May 21st, 2012 at 11:52 a.m. we wrote simply:
“It would worth checking on the prices of these three concerns during Q2 earnings season (mid to late July).”
Reading Facebooks S1 It seems the company would like for the reader and prospective investor to confuse “users” with “customers”. At the top of the filing are some nice pictures with what has to be at least 20 pt. font, for those who are less inclined to read. Further down are the important numbers, which needless to say are in a much smaller font.
The debacle that became known as "the Facebook IPO" is by now well known and ongoing - however the following video (courtesy of SNL) demonstrates with a few laughs that the strategy employed by investment banks is not new:
One thing did jump out on the Facebook S1 – 250 M photos uploaded a day, that’s just over 91 B photos per year. And those 845 M active monthly users with cameras in hand, are uploading them from home where they are plausibly also stored and perhaps also backed-up to a local storage device which may be mirrored to an account on the cloud – meaning that sampling of 91B photos may actually be stored on up to four different locations.
It is certain that Facebook is amplifying data storage demand. This thought seems to be confirmed by Seagate Technologies (STX, Financial) recent press release "...to protect, share and save nearly every aspect of one’s digital life"
Where in the world could all of those mirrored images be stored? The arctic circle?
Estimates of Facebook server count by 2010 was over 60K and Google almost 1 M, surely those numbers have grown substantially. These companies need hardware, a lot of hardware. Assuming these servers are raid arrays, they may have 4-6 HDD’s per server. With that sort of scale, and the finite life spans of HDD’s the cost per GB is extremely relevant especially as it relates to any discussion of the application of SSD technology. This gives rise to an interesting thought, for the “hyper scale” data center; could [OpEx] be just as critical as [CapEx]?
Facebook has invested more than $1 billion in the infrastructure that powers its social network (according to the S1 above). The company spent $606 million on servers, storage, network gear and data centers in 2011 alone, and expects to spend another $500 million this year.
According to Brendan Collins, the Vice President of Enterprise Storage at HGST:
“Storage is no longer an interchangeable, one-size-fits-all commodity. Increasingly, it is the critical foundation and enabler for your entire infrastructure as the need for online or cloud data storage grows exponentially. Analysts predict 80 percent of net new apps will target the cloud and over a third of all IT spending will move off premise by 2013. Fueled by mobile and enterprise applications and “big data,” the amount of unstructured and “semi-structured’ content is far outweighing the structured data that storage solutions and tools were originally designed to store, protect and manage…”
New HDD’s use less Power:
“One of the most significant costs in data centers is power and cooling. New 4TB hard drives available on the market use 24 percent fewer watts per gigabyte than lower capacities and support multiple power modes to reduce power consumption by up to 59 percent…”
And finally on the benefits of Increased Capacity and Density:
"Storage density is dictated by the capacity of the HDD and how many HDDs you can integrate into rack-mounted servers and storage solutions. Massive 4TB drives provide 33 percent more capacity than the previous generation 3TB HDDs. With this higher capacity, a fully loaded standard 19-inch rack can provide up to 2.4PB of data storage. There are two ways to use this capacity advantage: lower TCO by upgrading HDDs and reducing the number of servers, racks, cables and networking gear, or keep expenses flat and quadruple storage capacity… "
Although the changing design of data centers requires capital investment up front, the OpEx savings (probably the more important factor) associated with the newest drives seem to easily justify the investment in CapEx.
HDD’s have customers with deeper pockets than connoisseurs of iPads, because they are customers of the enterprise, of the cloud. And that is to say nothing of when Big Love meets Big Brother.
A relationship blossoms
Even if Facebook and their Investment Bankers were involved in a bit of monkey business during the run-up and launch of the IPO, to their credit they still have gathered nearly a billion users who upload an endless stream of content and then proceed to organize it. Facebook is willing to broker the relationship between the input device (e.g. Ipad) and the enterprise cloud (.e.g server farm) with relatively small profit.
Facebook’s services appear to be at first “free” to “users” (that is to say if the "user" places zero value on their time). However, storage for the company’s ever-growing database is not “free”, costing ~1 B just in equipment to date. Based on some quick back of the envelope math there’s about a 60% chance that your Facebook data, wherever it may reside is being stored on a Western Digital drive.
Facebook therefore is a very low cost, albeit large conduit for organizing information that is stored in the cloud. Hardware suppliers to the cloud, like CSCO, WDC and more recently AAPL (an Ipad is nothing more than remote access to the cloud) have tangible profits, because they produce tangible hardware, while the brokers (ala Facebook), have to subsist on the crumbs that fall from the table, with the expectation being that they will sell enough targeted Ads one day to make up for all the effort.
FB has also provided quite a diversion in it’s IPO – millions of prospective investors watched this albatross, selling at ~100x earnings, and well in excessive of 10x book, and did not compete to buy shares in well run company’s with long operating history selling far below intrinsic value, which are basically in the same general business - that is to say storing large amounts of information about you in a cold dark warehouse somewhere.
For money managers, and WDC itself (committed to taking back 1.5 B in shares), nothing could be more helpful, or conveniently timed, than having millions of retail investors out of the way watching a two letter ticker symbol, while they vacuum up shares in what amounts to a printing press for money.
It's just a letter
Apparently John Coyne, CEO of WD (set to earn ~3B EBITDA in the next 12 months on a sub. 7.5 B enterprise value) does not feel the same way as Mr. Zuckerberg who issued a letter to investors in advance of the FB IPO. To the critical reader, or those whose job it is to protect the interests of investor, the letter is suspect and should be handled with caution.
The following is a short review of some highlights form the February 1st, 2012 letter:
“Facebook was not originally created to be a company. It was built to accomplish a social mission - to make the world more open and connected.”
There are easier ways to have a social mission that require much less complexity. Simply look at the figures throughout history who have effected enduring change – none of them were CEO’s of major companies – this is a long shot and unconventional approach. Besides the conventional wisdom is that the original drivers behind the creation of Facebook had little to do with "social mission".
“At Facebook, we're inspired by technologies that have revolutionized how people spread and consume information. We often talk about inventions like the printing press and the television - by simply making communication more efficient, they led to a complete transformation of many important parts of society. They gave more people a voice. They encouraged progress. They changed the way society was organized. They brought us closer together.”
But it is not clear that there has been any real strides in technology or invention in the operation. Take for example, one of the more recent features Facebook launched that tracks users activities in real time at the upper right hand corner of the screen, it is the central dynamic feature of their pages. We located a patent application (METHODS, SYSTEMS AND APPARATUS FOR DISPLAYING USER GENERATED TRACKING INFORMATION) dating to 2007 that offered the same approach and even showed the user tracking information in real time in precisely the same spot on the screen - the upper right hand corner. The detailed claims of that patent describe precisely what the “new” Facebook feature offers only the patent was published about five years earlier.
“Simply put: we don't build services to make money; we make money to build better services.”
This line almost sounds like a riddle. Which came first, the chicken or the egg? Is it “social mission” or is it “services” if the end is not “money” than what is the end of the “services” ? Let’s call it the “for profit social mission service”, although we still don’t know what the service is for, we just know as investors that it’s not “to make money”. Wonder if the VC’s and other investors feel the same way or even care now that most have exited – or if that was the driver for retail investors on the day of the IPO – how many were interested in better services? Did they have the same detachment from monetary gain that that is reported in the letter?
Some other people recently brought about social change, and how services are handled, there have been thousands, including one severely burned, and ultimately dead fruit cart man in Tunisia – he brought about historic change, even revolution, his ideas about profit were also not very lofty, but unfortunately he never had a liquidity event for his somewhat less complex business which was comprised of only a cart and some fruit – in fact it was his poverty that lead to change, because stock in his business was not "worth a lot" before it's "IPO" and he did not live to see how it would enrich investors, who arguably numbered in the tens of millions vs. just "tens". You could say he had a sort of "social mission".
“And we think this is a good way to build something. These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits.”
So is the company seeking users or customers? The average user of Facebook does not think about this – to them Facebook is free (although in reality it is not), just like Google and virtually all of the other services that have “users”. In fact, there is another industry which uses the word “user” to describe it’s clients and they have similar habits to the Facebook crowd – however that industry is usually truly non-profit. The thought begs the question if Facebook employs behavioral psychologist.
“As I said above, Facebook was not originally founded to be a company. We've always cared primarily about our social mission, the services we're building and the people who use them. This is a different approach for a public company to take, so I want to explain why I think it works.”
Did Facebook really “always” care about a “social mission” – is that an accurate description of the founding drivers?
“I started off by writing the first version of Facebook myself because it was something I wanted to exist”
Is that correct? Did ConnectU write the first version? Did Aaron Greenspan?
They say the DNA and culture of a company is set early on. Lawsuits are common place for established companies in such a litigious society, but unusual to have so many similar in character in only the first year of existence.
“This is how we think about our IPO as well. We're going public for our employees and our investors. We made a commitment to them when we gave them equity that we'd work hard to make it worth a lot and make it liquid, and this IPO is fulfilling our commitment. As we become a public company, we're making a similar commitment to our new investors and we will work just as hard to fulfill it.”
This sentence directly contradicts the aforementioned – here is a translation which may be useful:
Original:
“We made a commitment to them when we gave them equity that we'd work hard to make it worth a lot and make it liquid…”
Translated:
“We made a commitment to early investors when we gave them equity that we'd work hard to make them at least fractionally as rich as the inner-circle and make it easy for them to sell their huge blocks of shares along with the core group to a less knowledgeable investing public whose odds at seeing a return on their investment anywhere nears ours is basically zero”
If social mission and better services were really the target, the IPO could have been fairly priced. For example, consider the case of Craig Newmark, the founder of Craigslists – he is truly not interested in profits (turned down a 5 B buy out offer in 2008), and provides arguably at least as useful a service to society at decidedly little profit to himself. In fact fruit cart vendors would probably have a use for Craigslist if only they all had access to it, but would likely find little profit in the use of Facebook.
The Facebook gang who got “rich quick” is now asking retail investors to consider getting rich “very very slowly” , as in by the time their great-grand kids go to college. Why? To lock-in profits, and a thoroughly ridiculous return on their invested capital at a premium that can never be justified.
For example, if the intent were truly to get the public anywhere near the same deal as the early investors, Zuckerberg could have simply come out and said, look this thing is huge already, economies of scale means it will be tough to grow in the future at the same rate we grew at in the past. Let’s put a reasonable price tag on this thing like $6 per share (which would be indicative of a P/E and P/B ratios that would be in line with blue chip tech giants who have been enormously profitable for a long time, even though FB has not been), that way I have a chance at fulfilling my stated objective of making new investors rich while I’m still walking this earth. After All when the companies market cap. exceeds 100 B, the combined retained earnings of the last 8 years equaled only 1.6% of that. If the same growth calculus persists for the next 8 years (a mathematical impossibility, because there are not enough people in the world), would the retained earnings double as well to a whopping 3.2 B? Either way at $6 a share all the insiders get fabulously wealthy at reasonable valuations, and the public has a fair shot at doing pretty well too.
910 M Batteries
Even with all that free arctic air, millions of spinning silver platters don’t have much value without trillions of read / write functions constantly editing their content, that’s where the “users” come in.
The letter to investors and the S1 filing are part of what seems to be an illusion. That is to say that although the 910 M users are not customers in the traditional sense of the word, they are useful nonetheless. The "users" are slaving away feverishly at editing what is probably not only one of the worlds largest databases, but a dynamic and constantly adapting one, a "real-time" database on consumer preferences. The database is for sale of course, but not to the “users”.
Here is the Facebook business model summed up in just four words: Labor=Free. Product=Expensive.
Maybe one day, someone will make a movie about a future where people’s consciousness is in an artificial reality, a virtual reality of software code, that keeps those “hooked up” to the system passive while they are actually being used as an energy source for computing (like editing marketing databases). This activity could be taking place in a dark cold place where there is little life, and involve tens of thousands of computers that basically have their own sort of consciousness. maybe the opening would show vertical lines of green streaming code on a black background. The movie could be called something inventive and unique, and kind of eerie sounding like “The Facebook” and perhaps the scarier sequel (that deals with investors) could be called something catchy like “The Fleecebook”. The lead role might be a "hacker" who steals software, and tries to get people who are otherwise free into "The Facebook" which is a gigantic piece of software, created to keep "users" from experiencing reality. The objective would be an old one; profit. but in the new alternate reality that the hacker creates, the "users" would think the "The Facebook" was a "service" for "social change".
Hitachi Books a profit, buys in and provides guidance on intrinsic value
HGST was founded in 2003 as a merger of the hard drive businesses of IBM and Hitachi. Hitachi (HIT) paid IBM US $2.05 billion for its HDD business.
In March 2012 Western Digital acquired HGST, for $4.8 billion, (~400 M more in cash than was originally announced on March 7th of 2011), with HGST operating as a wholly owned subsidiary of Western Digital for the short-term.
When Hitachi sold it’s HDD unit to WDC they booked a 2.4 B profit as a result of the transaction and took the 10% of WDC that they agreed to when the merger was first announced on March 11th, 2011.
According to the press release
“Under the terms of the agreement, WD acquired Hitachi GST for $3.5 billion in cash and 25 million WD common shares valued at $750 million, based on a WD closing stock price of $30.01 as of March 4, 2011.”
and
“Hitachi, Ltd. will own approximately ten percent of Western Digital shares outstanding after issuance of the shares”
As of May 4th, and the company’s 10Q filing with the SEC, WDC had taken back approximately 9 M shares in the 9 days following the earnings release - the number of shares outstanding at that time was 260 M.
Effectively, HGST was willing to pay $30 per share for the company when it’s financial profile looked much different. For example, at the time Hitachi signed up for the deal, 10% of WD represented about 750M equity stake, but the tangible equity in the company at the time, was much smaller (WDC had virtually no intangible or goodwill items on it’s own books). Today it represents about the same, only the assets of HGST are included (virtually 100% of the intangibles on WDC’s books are those of HGST), and the markets outlook is much stronger.
It is also interesting to note that between March 7th or 2011 when the merger was first announced and the closing of the deal about a year later, the cash part of the deal increased by 400M or 11.4%. This must mean that HIT's value increased by at least a commensurate amount during the time frame when the transaction was delayed for regulatory concerns. Could the additional 400M in value be attributable to HIT's long term agreements (LTA's)?
The transaction also indicates that HIT recognized at least a 50% premium over book in WDC in March 2011 (even if it's stock wasn't trading at that) and when the company was much smaller (smaller revenues, profits and less the HGST bolt-on), because they were taking 10% of a future combined company which did include 2B in intangible just for HGST (the smaller of the two concerns).
The 1.5 B repo announced on May 21st, has the possibility to take back as many as 50 M shares at the closing price of $30.11 on June 1st, 2011 (when this article was written), or a full 20% of the shares outstanding as of May 4th, 2012, effectively increasing the pro rata share for HIT to 12% of the business. The same effect would be true of course for all owners of WDC shares.
The new WD will operate with WD Technologies and HGST as wholly-owned subsidiaries. Aggregate revenues of the two companies in 2011 were $15 billion. A projection of 18B for FY 2013 doesn't seem unreasonable.
Everybody Run
On September 17th, of 2010 the article “640K ought to be enough for anybody…” WDC vs. STX was published after analysts comments prompted a sell off in the shares of HDD manufacturers when it became evident that tablets would be popular. Amvona had a position on tablet computing that went back to January 28th, of 2010 when when the article "Would the Pope buy an Ipad?" was published, and the follow up published on August 26th, 2010 entitled simply "Update: It turns out the answer is Yes!"
In could be said that the analysts theories about HDD's at the time (late 2010) could be summarized in only seven words: "On the count of three everybody run" - it's the sort of thing value investors like, especially when most didn't even wait till two.
The Amvona articles although affirming the potential of tablets as early as January 2010, did not agree with the thesis that it would spell the end for HDD's. On August 10th, of 2011 the results of that disagreement were published in the article "Update: “640K ought to be enough for anybody…” WDC vs. STX ".
Now about two years after the original article was published, analysts are still using the same story to spook investors out of the shares of HDD manufacturers. Nonetheless in an HDD world that seems to be falling apart (part deux), why not look to Book Value and the balance sheet for security? The earnings coefficient is a moving target after all – but one of course that the market prefers, unless investors gets a little skittish (not that they ever would). This is evidenced in the fact that STX, despite having a lower P/E ratio has recently fallen faster than WDC – the answer may lie in the premium over book. Until recently STX was trading at about a 3x premium over assets, while WD was around 1.5 x. Further STX P/E ratio was only lower than that of WDC because of their superior position coming out of the Thai floods, and not because they are a better run company, on the contrary WDC has historically operated on higher margins, and presumably will return to that position. So the P/E factor, again is temporary and plastic, with STX’s evident lead, only temporary, which leaves the more stable, tangible, truer and slower moving balance sheet coefficient – the price to book to ratio.
Of the 4.8 B paid for HGST, 2.4 B was booked by HIT as “profit” as stated above, this is approximately the same figure WDC then added to their balance sheet in the “Goodwill” and “Intangibles” lines after the acquisition closed. Any amount over tangible equity that a company pays for another company must be booked to these accounts.
If a similar premium was used to book WDC's intangibles based on the HGST transaction (the most recent and relevant comparable data), the entry would be about 5 B - this is a rational calculation of real equity in WDC whic is not on "the books".
Hitachi was a smaller company than WDC in every respect (with about half the revenue of WDC in 2011) at the time of the acquisition.
The market rewards scale. For this reason, larger concerns command a higher premium to book or equity.
It is interesting to note that in March of 2011 when HDD pricing was not so benign, but rather declining, that HGST a company only half the size of WDC was valued at a 50% premium to book, in the same way HIT viewed WDC, except HIT may have appreciated the missing intangibles (arguably ~5B) on WDC's books.
We know at least something about how HIT valued WDC because of the share component of the transaction. Presently HDD pricing is much more favorable to manufacturers, and although it has come down somewhat since the floods in Thailand, it remains approximately 70% above pre-flood levels, where prices appears set to stay.
The total addressable market continues to climb as well, and is expected to exceed that which existed in March of 2011. In addition the competitive landscape has shrunk from 5 to 2 players after the acquisition of Samsung’s and LaCie's hard drive businesses by Seagate Technologies. Toshiba still exists and now has the former HGST’s 3.5” mfg. capacity, but the Toshiba operation is too small to have a material impact, and the future of the 3.5” form factor to dim to be considered a “competitor”
Yet, as of close of market on June 1st, 2012 shares in WDC could effectively be purchased for less than book value alone. Although it appears that at the closing price of $30.11 there is a 6% premium over book, this is not accurate, because 2 months into the quarter the company would have already earned at least 435 M, which would have increased shareholder equity to 7.9 B or $30.38 per share at 260 M shares. However, if the share count were say, 230 M in the period ending June 30th, 2012 (given the repo), and the equity 8.1 B (660 M in FQ4 earnings) the book value per share would be approximately $35.29. this scenario is exceedingly likely, and if correct means that the buyer on June 1st, was actually paying closer to .85 x book for the shares – with the vast majority of that value purely tangible.
Here are the figures in chart form:
Here is a look at the growth in per share book value for WDC in recent years:
The aggregate growth rate in per share book value has been approximately 33% since 2007. The FQ4 estimate, with reduced share count puts book value at $35.29. The one year estimate at the same share count puts book value at $45.36. This is also the recent one year price target suggested by Bank of America Analyst Scott Craig who thinks WDC in one year should be worth no more than just it’s equity, which is nearly all tangible - meaning the company (with it's 40+ year operating history) would be worth nothing as a going concern - or 50% less (premium to book) than HIT thought the firm was worth 15 months earlier on March 7th, 2011.
If the shares traded at just a 50% premium to book in one year, which is what HGST sold for despite being a much smaller company in a less favorable environment, the shares would be worth $68 per share in one years time. However, STX which is also a smaller company and historically not as well run, recently sold for over ~3.6 x book. Even after the recent market rout, STX still sold recently for 2.76 x book. If WDC, as a larger and potentially much more profitable company sold for just half of what STX was trading for just three weeks ago, the shares would be valued at almost $80 per share. It is likely that the reason the market is not noticing this, is because of a focus on the price-to-earnings ratio, for which STX has a better showing. However, what is also likely, is that the market is over looking the fact that for two of the last four quarters the earnings of WDC were impaired by the Thai floods to a far greater extent than the operations of STX – so STX’s superior P/E showing over WDC is only temporary, and not the historical norm.
Analyst Errors
On May 1st, 2012 the article Silver Platters, Annie Oakley and “The Sidelines” was published. The article pointed to what appeared to be a remarkable error in earnings estimates for WDC by Bank of America Analyst Scott Craig in his research report on April 27th, 2012. Even more remarkable was a follow up comment made by Bank of America on May 22nd, 2012 – one day after WDC announced their 1.5 B repo. program – which makes yet another error when it overstates the size of the repo. by about 27%.
Strategic concerns
Recently the CEO of WDC John Coyne had the following to say about the HGST acquisition:
"With a significantly broadened customer base and expanded resources, the new WD is in a strong position to seize the growth opportunity in stored digital content," said Coyne. "We have acquired a strong presence in the traditional enterprise market, substantially increased our presence in the industry's fastest-growing segments - cloud and mobility- and improved our capability to address new market initiatives such as enterprise SSD, storage solutions for small business and low-profile HDDs and hybrid drives for Ultrabooks. As a result, WD is better positioned than ever for success."
Interestingly, nowhere is "PC's" or "PC flow" mentioned.
Logical Errors
Here are the supposed concerns of Analysts which echo the same concerns raised in Q1 of 2010:
Neither is actually a concern for HDD manufacturers because:
According to Richard Rutledge, SVP of Marketing at WDC:
"We are interested in hybrid drives. What you will see in an Ultrabook is an SSD, typically around 24GB along with a regular hard drive, typically 500GB and up. What will happen is your data will be cached to your SSD. So we will have an mSATA port based SSD along with a regular HDD. After that technology gets adopted in the mainstream, we can do a lot of interesting things, by bringing the SSD on the HDD..."
and on SDD Rutledge had this to say:
"According to our research from the 500,000 petabytes of data that was transferred last year, only 20,000 petabytes were using flash drives. That amounts to a mere 4 percent overall data transfer share. So that's an interesting statistic that flash is only 4 percent of the overall storage. The current SSD products we have under the WD brand were got from a company we acquired called Silicon Systems. They are focused on the embedded industrial market places, which are the closest markets to the enterprise which equates to High duty cycle, high reliability and very long life cycle. And that was the strategy.
With regards to consumer market, we are very much in support of this dual hybrid drive. We have teams working on SSD products, but we won't announce products before we are shipping. Safe to say we are investing."
Analysts also indicate that they are worried about the future of HDD pricing – but the comment that ignited the initial sell off in WDC shares had to do with LTA’s (see Silver Platters, Annie Oakley and “The Sidelines”) – which is a contradiction, because Long Term Agreements "lock-in" pricing (in some cases for up to two years), such that they are no longer fluid. Those LTA are “seriously accretive” according to WDC. STX has LTA’s as well and indicated that pricing was “benign” in their latest CC. There are three factors working against further price declines:
1. The new Duopoly
2. Long term agreements (LTA’s)
3. The growth in demand generated by enterprise storage (The Cloud)
Barclay’s is wrong
WDC booked 680 M in net profits in Q3 w/ only 3.5 weeks of HGST revenue and profits included. What will the company’s earnings be in FQ4 with 12 weeks of HGST earnings?
Barclay’s boosted their target price on shares of Western Digital from $45.00 to $49.00 on April 30th, 2012.
exactly 4 weeks later:
Barclay's downgraded Western Digital Corp. from Overweight to Equalweight and lowered the PT from $49 to $37 with Analyst, Ben A. Reitzes, saying in part:
"Downgrade to EW given several factors that could keep shares range-bound over the near term. This call is not really about the current quarter, but certain developments could impact guidance around September and December."
A look at the specific language is interesting - take for example the following:
"...that could keep shares range-bound over the near term"
Doesn't this comment refer to "price" of the shares in future time, an event Mr. Reitzes has precisely zero chance of knowing with any degree of accuracy? Wouldn't it be wiser to speak of the "value" of the company in terms of what can be known in future time with some approximate accuracy? Besides how is the term "range-bound" useful, if he does not tell us what the "range" is? for example, if the range is $35 (est. FQ4 book value) - $80 (low FQ4 13 intrinsic value estimate) per share it seems reasonable (after checking to make sure your health insurance is active), that if you don't have the cash, you might take out loans with your friendly neighborhood Mafiosi in order to buy shares of WDC at a 10:1 leverage ratio. Just to be clear your broker provides the leverage, not the initial loan - We understand the participants in this instance could be easily confused.
Next Up:
"This call is not really about the current quarter, but certain developments could impact guidance around September and December"
Could anything be more vague? The current quarter is the most tangible and immediate information available, yet, Reitzes is discarding those figures wholly in favor of "certain developments" which he does not clarify, and which etymologically must take place in an unknown future. These hypothetical events, in Reitzes own words will not affect the mysterious "range" of prices (not value) which we can only guess at, but only "could impact guidance" - but he does not clarify whose guidance, or how it will be impacted? He only provides a time frame for this exceedingly unfocused forecast, which is some six months into Amvona book value forecast which is based on actual figures.
Finally this:
"Specific factors include (Neutral to Negative) news on PC flow, increased inventories and secular concerns"
This statement of course is anything but "specific", for starters, if the news were to be "neutral" (one option provided), it most certainly would not have the same impact to "the range" as say "negative" news, which is "specifically" different. Further, the term "PC flow" is not described, nor is the relationship between "PC flow" and "storage demand". What we do know is that WDC functions to service "Storage" needs, not "PC Flow", as evidenced in the CEO's own comments above.
Then there is the very unspecific mention of "inventories", but we have no clue whose inventories (e.g. component suppliers etc)? Finally there is "secular concerns", one of our favorite terms because it almost sounds smart. According to Reitzes "secular concerns" constitutes "Certain Developments" approximately two quarters from now, a period of time when all we know is that their "guidance" might be impacted - we can find no way to reconcile the time frame mentioned in the opening remarks namely, "the near term" with "secular" (concerns) an adjective used to describe a long-term time frame, usually at least 10 years.
Incredibly, the man in 44 words has accomplished what few others could, he has said absolutely nothing while still sounding impressive.
The result is that Ben Reitzes appraisal of the company changed by nearly 3 B when he lowered his price target from $49 per share (slightly above tangible equity projections in one year) to $37 per share (in one year) or approximately 18% below the equity projection, or a P/B ratio in one year of just .82 (or 68% less premium than WDC just paid for the smaller HGST).
How can an opinion change so wildly in only 4 weeks? Do global economics really shift that quickly?
Is it possible that Dell sales (one of the events Reitzes appears to be referencing) slipped because it’s Dell and has it's own specific business model, and not because contraction in storage demand? Future AAPL devices utilizing SSD for instance will still upload to the cloud – doesn't matter how many tablets or ultra books are sold, especially since many ultrabooks will likely still have HDD’s – both are designed to have paid subscriptions to iCloud, which might as well be called iWDC.
The Future
It appear clear that WDC intends to be a major player in the ultrabook market, unfortunately they've partner with a small concern which nobody apparently has heard of, it's a little company called Intel (INTC) who recently announced their collaboration on a new 5 MM drive specifically for ultrabooks - this appears to be what Coyne was referencing in his press release on HGST above.
A 10k rpm, 5 mm hybrid HDD in a 2.5” form factor is right around the corner. Such a device seem very appealing from a technology/cost standpoint in reference to SSD's. It’s life span will probably exceed that of SDD's and it’s price will likely still be ~1/10 that of SSD's when they come to market. Given that Intel (INTC) is invested in this technology, WDC leadership position, and the fact that SSD's only have 4% market penetration, there seems plenty of “runway” for WDC to continue to transition it’s business to whatever new technology will meet future storage needs best.
The CEO of Seagate when asked about the possibility of SSD taking market share in the aftermath of the Thai floods had this to say:
"Some of it, but not very much. I think to the extent that there is a high value purchaser who can afford to pay $200 for 100 gigabytes, then that market will expand from 1-2 percent to 3-4 percent. Of the 35 to 40 percent shortage that exists, could you see a little of that get absorbed by silicon? The answer is yes. But there’s a cap. There’s just not enough of a raw supply of silicon to meet all the demand. Our industry will ship 400 exabytes this year. We would have shipped 450, were it not for the floods. Of that, 180 exabytes is notebooks. Reduce that by 30 percent, and you get about 55 or 60 exabytes. If you were to take all of the capacity from Samsung’s newest state-of-the-art flash factory, and dedicated it just to notebooks, it would only put out 7 exabytes a year. Plus, there are already other markets demanding flash, like tablets and cellphones and other things. So it’s not like you can steal from those other markets. You’re not going to take a $32 product and replace it with a $350 product. Can you do it at the edges of the market? Sure. But the threat is capped by the amount of silicon available and the price point for flash storage, which is still an order of magnitude higher."
According to Cisco's IP traffic forecast mobile traffic is forecast to grow 18x from 2011 to 2016 - a positive for vendors with strong mobile networking exposure. Cisco also sees over half of all 2016 traffic coming from Wi-Fi networks, and expects the number of global Internet users, boosted by smart phone adoption, to reach 3.4B (up from 1.9B in 2010) - that's a CAGR of 29% in the next 4 years to 1.3 zettabytes, or the equivalent of 38M DVDs per hour. By comparison, IP traffic from 1984-2012 was a mere 1.2 zettabytes.
A few highlights
Mr. Zuckerberg is right. It is very important to look after the interests of investors. After all investors hand over their wealth in a sacred act of trust. The idea is a simple one and quit old - the manager should use their "talents" to return a larger figure than was originally deposited. Being aggressive is fine, so long as it is done wisely, and truly with the investors best interests in mind and not the managers.
It is important to be open and specific on this point and to avoid any discussion that involves confusing language or motives, or subtle contradictions that might confuse. It would also nice if the manager can accomplish the task somewhere in the span of a life time - 365 days for example would be good. For this reason, between Friday June 1st and Tuesday June 12th, 2012 we continued to plow huge sums of investors capital into the shares of WDC (at around $30 per share) as we continued to build what was already large stake in the company.
Time will tell if it beats an investment in Facebook.
The advice was to consider buying Western Digital (WDC, Financial) instead if he had to buy something. Sensing that the answer may have been a bit curt, the following email was sent shortly after the phone call:
"Thu 5/17/2012 2:02 PM
Dear [name omitted],
Thank you for the call just now. To be clear… and further to your question - would NOT buy (FB, Financial) IPO tomorrow or any other IPO for that matter. Have no idea where the price will go in the near term – but do know that the issue does NOT represent any sort of value for a buyer tomorrow.
Next, I would fire your financial advisor for two reasons:
1. For suggesting such a highly speculative investment such as FB, for which he will receive a commission but you will jeopardize your principle.
2. He is asking you what “you want to do” instead of explaining to you the rationale behind the suggestion – in other words he is getting paid while you do the thinking…
FB filed with the SEC here:
they had 4.5 B in net working capital (tangible current assets available to buttress the stock price tomorrow) at YE 2011 they had only 668 M in earnings (which declined 12% in Q1 2012) – at a 100 B market cap (expected) – owners tomorrow would need 150 years to regain their investment (100 B / 668 M in annual earnings).
Take the following value vs. speculative case of LNKD (LinkedIn) and WDC (Western Digital)
…a little food for thought:
- LNKD is a social network which recently went public and has many similarities with FB
- WDC has been around for 40 years of successful and profitable operation
- WDC costs about 1.5 B less than LNKD
- WDC returns 60 x the profit to owners (and their TTM net figure is about to double)
- WDC has 14x the operating cash flow (despite ~500 M is flood recovery costs)
- LNKD trades at a ~1800% premium over equity
- WDC trades at a 36% premium over equity (and even that is overstated, b/c they have conservative entries for intangibles)
- Where do you think the data for those 910 M FB users is stored? It’s not at LNKD – it’s on little silver platters made by a company called WDC – the “cloud” wouldn't exist without them
- At today’s price and 2012 earnings it would take less than 3 years for WDC to repay for it’s entire market cap – that’s like buying a house, renting it out and the rent being so high it paid for the whole house in 2.9 years.
- Read more here: Silver Platters, Annie Oakley and “The Sidelines”
Remember you don’t need a lot of activity to do very well investing – you do well by being right.”
In a follow up email May 21st, 2012 at 11:52 a.m. we wrote simply:
“It would worth checking on the prices of these three concerns during Q2 earnings season (mid to late July).”
Reading Facebooks S1 It seems the company would like for the reader and prospective investor to confuse “users” with “customers”. At the top of the filing are some nice pictures with what has to be at least 20 pt. font, for those who are less inclined to read. Further down are the important numbers, which needless to say are in a much smaller font.
The debacle that became known as "the Facebook IPO" is by now well known and ongoing - however the following video (courtesy of SNL) demonstrates with a few laughs that the strategy employed by investment banks is not new:
One thing did jump out on the Facebook S1 – 250 M photos uploaded a day, that’s just over 91 B photos per year. And those 845 M active monthly users with cameras in hand, are uploading them from home where they are plausibly also stored and perhaps also backed-up to a local storage device which may be mirrored to an account on the cloud – meaning that sampling of 91B photos may actually be stored on up to four different locations.
It is certain that Facebook is amplifying data storage demand. This thought seems to be confirmed by Seagate Technologies (STX, Financial) recent press release "...to protect, share and save nearly every aspect of one’s digital life"
Where in the world could all of those mirrored images be stored? The arctic circle?
Estimates of Facebook server count by 2010 was over 60K and Google almost 1 M, surely those numbers have grown substantially. These companies need hardware, a lot of hardware. Assuming these servers are raid arrays, they may have 4-6 HDD’s per server. With that sort of scale, and the finite life spans of HDD’s the cost per GB is extremely relevant especially as it relates to any discussion of the application of SSD technology. This gives rise to an interesting thought, for the “hyper scale” data center; could [OpEx] be just as critical as [CapEx]?
Facebook has invested more than $1 billion in the infrastructure that powers its social network (according to the S1 above). The company spent $606 million on servers, storage, network gear and data centers in 2011 alone, and expects to spend another $500 million this year.
According to Brendan Collins, the Vice President of Enterprise Storage at HGST:
“Storage is no longer an interchangeable, one-size-fits-all commodity. Increasingly, it is the critical foundation and enabler for your entire infrastructure as the need for online or cloud data storage grows exponentially. Analysts predict 80 percent of net new apps will target the cloud and over a third of all IT spending will move off premise by 2013. Fueled by mobile and enterprise applications and “big data,” the amount of unstructured and “semi-structured’ content is far outweighing the structured data that storage solutions and tools were originally designed to store, protect and manage…”
New HDD’s use less Power:
“One of the most significant costs in data centers is power and cooling. New 4TB hard drives available on the market use 24 percent fewer watts per gigabyte than lower capacities and support multiple power modes to reduce power consumption by up to 59 percent…”
And finally on the benefits of Increased Capacity and Density:
"Storage density is dictated by the capacity of the HDD and how many HDDs you can integrate into rack-mounted servers and storage solutions. Massive 4TB drives provide 33 percent more capacity than the previous generation 3TB HDDs. With this higher capacity, a fully loaded standard 19-inch rack can provide up to 2.4PB of data storage. There are two ways to use this capacity advantage: lower TCO by upgrading HDDs and reducing the number of servers, racks, cables and networking gear, or keep expenses flat and quadruple storage capacity… "
Although the changing design of data centers requires capital investment up front, the OpEx savings (probably the more important factor) associated with the newest drives seem to easily justify the investment in CapEx.
HDD’s have customers with deeper pockets than connoisseurs of iPads, because they are customers of the enterprise, of the cloud. And that is to say nothing of when Big Love meets Big Brother.
A relationship blossoms
Even if Facebook and their Investment Bankers were involved in a bit of monkey business during the run-up and launch of the IPO, to their credit they still have gathered nearly a billion users who upload an endless stream of content and then proceed to organize it. Facebook is willing to broker the relationship between the input device (e.g. Ipad) and the enterprise cloud (.e.g server farm) with relatively small profit.
Facebook’s services appear to be at first “free” to “users” (that is to say if the "user" places zero value on their time). However, storage for the company’s ever-growing database is not “free”, costing ~1 B just in equipment to date. Based on some quick back of the envelope math there’s about a 60% chance that your Facebook data, wherever it may reside is being stored on a Western Digital drive.
Facebook therefore is a very low cost, albeit large conduit for organizing information that is stored in the cloud. Hardware suppliers to the cloud, like CSCO, WDC and more recently AAPL (an Ipad is nothing more than remote access to the cloud) have tangible profits, because they produce tangible hardware, while the brokers (ala Facebook), have to subsist on the crumbs that fall from the table, with the expectation being that they will sell enough targeted Ads one day to make up for all the effort.
FB has also provided quite a diversion in it’s IPO – millions of prospective investors watched this albatross, selling at ~100x earnings, and well in excessive of 10x book, and did not compete to buy shares in well run company’s with long operating history selling far below intrinsic value, which are basically in the same general business - that is to say storing large amounts of information about you in a cold dark warehouse somewhere.
For money managers, and WDC itself (committed to taking back 1.5 B in shares), nothing could be more helpful, or conveniently timed, than having millions of retail investors out of the way watching a two letter ticker symbol, while they vacuum up shares in what amounts to a printing press for money.
It's just a letter
Apparently John Coyne, CEO of WD (set to earn ~3B EBITDA in the next 12 months on a sub. 7.5 B enterprise value) does not feel the same way as Mr. Zuckerberg who issued a letter to investors in advance of the FB IPO. To the critical reader, or those whose job it is to protect the interests of investor, the letter is suspect and should be handled with caution.
The following is a short review of some highlights form the February 1st, 2012 letter:
“Facebook was not originally created to be a company. It was built to accomplish a social mission - to make the world more open and connected.”
There are easier ways to have a social mission that require much less complexity. Simply look at the figures throughout history who have effected enduring change – none of them were CEO’s of major companies – this is a long shot and unconventional approach. Besides the conventional wisdom is that the original drivers behind the creation of Facebook had little to do with "social mission".
“At Facebook, we're inspired by technologies that have revolutionized how people spread and consume information. We often talk about inventions like the printing press and the television - by simply making communication more efficient, they led to a complete transformation of many important parts of society. They gave more people a voice. They encouraged progress. They changed the way society was organized. They brought us closer together.”
But it is not clear that there has been any real strides in technology or invention in the operation. Take for example, one of the more recent features Facebook launched that tracks users activities in real time at the upper right hand corner of the screen, it is the central dynamic feature of their pages. We located a patent application (METHODS, SYSTEMS AND APPARATUS FOR DISPLAYING USER GENERATED TRACKING INFORMATION) dating to 2007 that offered the same approach and even showed the user tracking information in real time in precisely the same spot on the screen - the upper right hand corner. The detailed claims of that patent describe precisely what the “new” Facebook feature offers only the patent was published about five years earlier.
“Simply put: we don't build services to make money; we make money to build better services.”
This line almost sounds like a riddle. Which came first, the chicken or the egg? Is it “social mission” or is it “services” if the end is not “money” than what is the end of the “services” ? Let’s call it the “for profit social mission service”, although we still don’t know what the service is for, we just know as investors that it’s not “to make money”. Wonder if the VC’s and other investors feel the same way or even care now that most have exited – or if that was the driver for retail investors on the day of the IPO – how many were interested in better services? Did they have the same detachment from monetary gain that that is reported in the letter?
Some other people recently brought about social change, and how services are handled, there have been thousands, including one severely burned, and ultimately dead fruit cart man in Tunisia – he brought about historic change, even revolution, his ideas about profit were also not very lofty, but unfortunately he never had a liquidity event for his somewhat less complex business which was comprised of only a cart and some fruit – in fact it was his poverty that lead to change, because stock in his business was not "worth a lot" before it's "IPO" and he did not live to see how it would enrich investors, who arguably numbered in the tens of millions vs. just "tens". You could say he had a sort of "social mission".
“And we think this is a good way to build something. These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits.”
So is the company seeking users or customers? The average user of Facebook does not think about this – to them Facebook is free (although in reality it is not), just like Google and virtually all of the other services that have “users”. In fact, there is another industry which uses the word “user” to describe it’s clients and they have similar habits to the Facebook crowd – however that industry is usually truly non-profit. The thought begs the question if Facebook employs behavioral psychologist.
“As I said above, Facebook was not originally founded to be a company. We've always cared primarily about our social mission, the services we're building and the people who use them. This is a different approach for a public company to take, so I want to explain why I think it works.”
Did Facebook really “always” care about a “social mission” – is that an accurate description of the founding drivers?
“I started off by writing the first version of Facebook myself because it was something I wanted to exist”
Is that correct? Did ConnectU write the first version? Did Aaron Greenspan?
They say the DNA and culture of a company is set early on. Lawsuits are common place for established companies in such a litigious society, but unusual to have so many similar in character in only the first year of existence.
“This is how we think about our IPO as well. We're going public for our employees and our investors. We made a commitment to them when we gave them equity that we'd work hard to make it worth a lot and make it liquid, and this IPO is fulfilling our commitment. As we become a public company, we're making a similar commitment to our new investors and we will work just as hard to fulfill it.”
This sentence directly contradicts the aforementioned – here is a translation which may be useful:
Original:
“We made a commitment to them when we gave them equity that we'd work hard to make it worth a lot and make it liquid…”
Translated:
“We made a commitment to early investors when we gave them equity that we'd work hard to make them at least fractionally as rich as the inner-circle and make it easy for them to sell their huge blocks of shares along with the core group to a less knowledgeable investing public whose odds at seeing a return on their investment anywhere nears ours is basically zero”
If social mission and better services were really the target, the IPO could have been fairly priced. For example, consider the case of Craig Newmark, the founder of Craigslists – he is truly not interested in profits (turned down a 5 B buy out offer in 2008), and provides arguably at least as useful a service to society at decidedly little profit to himself. In fact fruit cart vendors would probably have a use for Craigslist if only they all had access to it, but would likely find little profit in the use of Facebook.
The Facebook gang who got “rich quick” is now asking retail investors to consider getting rich “very very slowly” , as in by the time their great-grand kids go to college. Why? To lock-in profits, and a thoroughly ridiculous return on their invested capital at a premium that can never be justified.
For example, if the intent were truly to get the public anywhere near the same deal as the early investors, Zuckerberg could have simply come out and said, look this thing is huge already, economies of scale means it will be tough to grow in the future at the same rate we grew at in the past. Let’s put a reasonable price tag on this thing like $6 per share (which would be indicative of a P/E and P/B ratios that would be in line with blue chip tech giants who have been enormously profitable for a long time, even though FB has not been), that way I have a chance at fulfilling my stated objective of making new investors rich while I’m still walking this earth. After All when the companies market cap. exceeds 100 B, the combined retained earnings of the last 8 years equaled only 1.6% of that. If the same growth calculus persists for the next 8 years (a mathematical impossibility, because there are not enough people in the world), would the retained earnings double as well to a whopping 3.2 B? Either way at $6 a share all the insiders get fabulously wealthy at reasonable valuations, and the public has a fair shot at doing pretty well too.
910 M Batteries
Even with all that free arctic air, millions of spinning silver platters don’t have much value without trillions of read / write functions constantly editing their content, that’s where the “users” come in.
The letter to investors and the S1 filing are part of what seems to be an illusion. That is to say that although the 910 M users are not customers in the traditional sense of the word, they are useful nonetheless. The "users" are slaving away feverishly at editing what is probably not only one of the worlds largest databases, but a dynamic and constantly adapting one, a "real-time" database on consumer preferences. The database is for sale of course, but not to the “users”.
Here is the Facebook business model summed up in just four words: Labor=Free. Product=Expensive.
Maybe one day, someone will make a movie about a future where people’s consciousness is in an artificial reality, a virtual reality of software code, that keeps those “hooked up” to the system passive while they are actually being used as an energy source for computing (like editing marketing databases). This activity could be taking place in a dark cold place where there is little life, and involve tens of thousands of computers that basically have their own sort of consciousness. maybe the opening would show vertical lines of green streaming code on a black background. The movie could be called something inventive and unique, and kind of eerie sounding like “The Facebook” and perhaps the scarier sequel (that deals with investors) could be called something catchy like “The Fleecebook”. The lead role might be a "hacker" who steals software, and tries to get people who are otherwise free into "The Facebook" which is a gigantic piece of software, created to keep "users" from experiencing reality. The objective would be an old one; profit. but in the new alternate reality that the hacker creates, the "users" would think the "The Facebook" was a "service" for "social change".
Hitachi Books a profit, buys in and provides guidance on intrinsic value
HGST was founded in 2003 as a merger of the hard drive businesses of IBM and Hitachi. Hitachi (HIT) paid IBM US $2.05 billion for its HDD business.
In March 2012 Western Digital acquired HGST, for $4.8 billion, (~400 M more in cash than was originally announced on March 7th of 2011), with HGST operating as a wholly owned subsidiary of Western Digital for the short-term.
When Hitachi sold it’s HDD unit to WDC they booked a 2.4 B profit as a result of the transaction and took the 10% of WDC that they agreed to when the merger was first announced on March 11th, 2011.
According to the press release
“Under the terms of the agreement, WD acquired Hitachi GST for $3.5 billion in cash and 25 million WD common shares valued at $750 million, based on a WD closing stock price of $30.01 as of March 4, 2011.”
and
“Hitachi, Ltd. will own approximately ten percent of Western Digital shares outstanding after issuance of the shares”
As of May 4th, and the company’s 10Q filing with the SEC, WDC had taken back approximately 9 M shares in the 9 days following the earnings release - the number of shares outstanding at that time was 260 M.
Effectively, HGST was willing to pay $30 per share for the company when it’s financial profile looked much different. For example, at the time Hitachi signed up for the deal, 10% of WD represented about 750M equity stake, but the tangible equity in the company at the time, was much smaller (WDC had virtually no intangible or goodwill items on it’s own books). Today it represents about the same, only the assets of HGST are included (virtually 100% of the intangibles on WDC’s books are those of HGST), and the markets outlook is much stronger.
It is also interesting to note that between March 7th or 2011 when the merger was first announced and the closing of the deal about a year later, the cash part of the deal increased by 400M or 11.4%. This must mean that HIT's value increased by at least a commensurate amount during the time frame when the transaction was delayed for regulatory concerns. Could the additional 400M in value be attributable to HIT's long term agreements (LTA's)?
The transaction also indicates that HIT recognized at least a 50% premium over book in WDC in March 2011 (even if it's stock wasn't trading at that) and when the company was much smaller (smaller revenues, profits and less the HGST bolt-on), because they were taking 10% of a future combined company which did include 2B in intangible just for HGST (the smaller of the two concerns).
The 1.5 B repo announced on May 21st, has the possibility to take back as many as 50 M shares at the closing price of $30.11 on June 1st, 2011 (when this article was written), or a full 20% of the shares outstanding as of May 4th, 2012, effectively increasing the pro rata share for HIT to 12% of the business. The same effect would be true of course for all owners of WDC shares.
The new WD will operate with WD Technologies and HGST as wholly-owned subsidiaries. Aggregate revenues of the two companies in 2011 were $15 billion. A projection of 18B for FY 2013 doesn't seem unreasonable.
Everybody Run
On September 17th, of 2010 the article “640K ought to be enough for anybody…” WDC vs. STX was published after analysts comments prompted a sell off in the shares of HDD manufacturers when it became evident that tablets would be popular. Amvona had a position on tablet computing that went back to January 28th, of 2010 when when the article "Would the Pope buy an Ipad?" was published, and the follow up published on August 26th, 2010 entitled simply "Update: It turns out the answer is Yes!"
In could be said that the analysts theories about HDD's at the time (late 2010) could be summarized in only seven words: "On the count of three everybody run" - it's the sort of thing value investors like, especially when most didn't even wait till two.
The Amvona articles although affirming the potential of tablets as early as January 2010, did not agree with the thesis that it would spell the end for HDD's. On August 10th, of 2011 the results of that disagreement were published in the article "Update: “640K ought to be enough for anybody…” WDC vs. STX ".
Now about two years after the original article was published, analysts are still using the same story to spook investors out of the shares of HDD manufacturers. Nonetheless in an HDD world that seems to be falling apart (part deux), why not look to Book Value and the balance sheet for security? The earnings coefficient is a moving target after all – but one of course that the market prefers, unless investors gets a little skittish (not that they ever would). This is evidenced in the fact that STX, despite having a lower P/E ratio has recently fallen faster than WDC – the answer may lie in the premium over book. Until recently STX was trading at about a 3x premium over assets, while WD was around 1.5 x. Further STX P/E ratio was only lower than that of WDC because of their superior position coming out of the Thai floods, and not because they are a better run company, on the contrary WDC has historically operated on higher margins, and presumably will return to that position. So the P/E factor, again is temporary and plastic, with STX’s evident lead, only temporary, which leaves the more stable, tangible, truer and slower moving balance sheet coefficient – the price to book to ratio.
Of the 4.8 B paid for HGST, 2.4 B was booked by HIT as “profit” as stated above, this is approximately the same figure WDC then added to their balance sheet in the “Goodwill” and “Intangibles” lines after the acquisition closed. Any amount over tangible equity that a company pays for another company must be booked to these accounts.
If a similar premium was used to book WDC's intangibles based on the HGST transaction (the most recent and relevant comparable data), the entry would be about 5 B - this is a rational calculation of real equity in WDC whic is not on "the books".
Hitachi was a smaller company than WDC in every respect (with about half the revenue of WDC in 2011) at the time of the acquisition.
The market rewards scale. For this reason, larger concerns command a higher premium to book or equity.
It is interesting to note that in March of 2011 when HDD pricing was not so benign, but rather declining, that HGST a company only half the size of WDC was valued at a 50% premium to book, in the same way HIT viewed WDC, except HIT may have appreciated the missing intangibles (arguably ~5B) on WDC's books.
We know at least something about how HIT valued WDC because of the share component of the transaction. Presently HDD pricing is much more favorable to manufacturers, and although it has come down somewhat since the floods in Thailand, it remains approximately 70% above pre-flood levels, where prices appears set to stay.
The total addressable market continues to climb as well, and is expected to exceed that which existed in March of 2011. In addition the competitive landscape has shrunk from 5 to 2 players after the acquisition of Samsung’s and LaCie's hard drive businesses by Seagate Technologies. Toshiba still exists and now has the former HGST’s 3.5” mfg. capacity, but the Toshiba operation is too small to have a material impact, and the future of the 3.5” form factor to dim to be considered a “competitor”
Yet, as of close of market on June 1st, 2012 shares in WDC could effectively be purchased for less than book value alone. Although it appears that at the closing price of $30.11 there is a 6% premium over book, this is not accurate, because 2 months into the quarter the company would have already earned at least 435 M, which would have increased shareholder equity to 7.9 B or $30.38 per share at 260 M shares. However, if the share count were say, 230 M in the period ending June 30th, 2012 (given the repo), and the equity 8.1 B (660 M in FQ4 earnings) the book value per share would be approximately $35.29. this scenario is exceedingly likely, and if correct means that the buyer on June 1st, was actually paying closer to .85 x book for the shares – with the vast majority of that value purely tangible.
Here are the figures in chart form:
| Book Value | $7,900,000,000 | $8,100,000,000 |
| Share outstanding | 260000000 | 230000000 |
| book value per share | $30.38 | $35.22 |
Here is a look at the growth in per share book value for WDC in recent years:
| Growth in Per Share Book Value | |||
| Year | Increase | Book Value | Share Outstanding |
| 2006 | 219000000 | ||
| 2007 | $7.84 | 219000000 | |
| 2008 | 56% | $12.20 | 221000000 |
| 2009 | 18% | $14.38 | 222000000 |
| 2010 | 44% | $20.65 | 228000000 |
| 2011 | 15% | $23.76 | 231000000 |
| 2012 Q3 | 20% | $28.52 | 260000000 |
| 2012 Q4 Est. | 24% | $35.29 | 230000000 |
| 12 month forecast | $45.36 | ||
| Avg: | 33% |
The aggregate growth rate in per share book value has been approximately 33% since 2007. The FQ4 estimate, with reduced share count puts book value at $35.29. The one year estimate at the same share count puts book value at $45.36. This is also the recent one year price target suggested by Bank of America Analyst Scott Craig who thinks WDC in one year should be worth no more than just it’s equity, which is nearly all tangible - meaning the company (with it's 40+ year operating history) would be worth nothing as a going concern - or 50% less (premium to book) than HIT thought the firm was worth 15 months earlier on March 7th, 2011.
If the shares traded at just a 50% premium to book in one year, which is what HGST sold for despite being a much smaller company in a less favorable environment, the shares would be worth $68 per share in one years time. However, STX which is also a smaller company and historically not as well run, recently sold for over ~3.6 x book. Even after the recent market rout, STX still sold recently for 2.76 x book. If WDC, as a larger and potentially much more profitable company sold for just half of what STX was trading for just three weeks ago, the shares would be valued at almost $80 per share. It is likely that the reason the market is not noticing this, is because of a focus on the price-to-earnings ratio, for which STX has a better showing. However, what is also likely, is that the market is over looking the fact that for two of the last four quarters the earnings of WDC were impaired by the Thai floods to a far greater extent than the operations of STX – so STX’s superior P/E showing over WDC is only temporary, and not the historical norm.
Analyst Errors
On May 1st, 2012 the article Silver Platters, Annie Oakley and “The Sidelines” was published. The article pointed to what appeared to be a remarkable error in earnings estimates for WDC by Bank of America Analyst Scott Craig in his research report on April 27th, 2012. Even more remarkable was a follow up comment made by Bank of America on May 22nd, 2012 – one day after WDC announced their 1.5 B repo. program – which makes yet another error when it overstates the size of the repo. by about 27%.
Strategic concerns
Recently the CEO of WDC John Coyne had the following to say about the HGST acquisition:
"With a significantly broadened customer base and expanded resources, the new WD is in a strong position to seize the growth opportunity in stored digital content," said Coyne. "We have acquired a strong presence in the traditional enterprise market, substantially increased our presence in the industry's fastest-growing segments - cloud and mobility- and improved our capability to address new market initiatives such as enterprise SSD, storage solutions for small business and low-profile HDDs and hybrid drives for Ultrabooks. As a result, WD is better positioned than ever for success."
Interestingly, nowhere is "PC's" or "PC flow" mentioned.
Logical Errors
Here are the supposed concerns of Analysts which echo the same concerns raised in Q1 of 2010:
- Tablets and ultra books don’t need HDD’s
- Hardware manufacturers like Dell aren't doing great which must mean lower HDD sales.
Neither is actually a concern for HDD manufacturers because:
- Tablets must have external storage (external HDD or backup to the cloud) and many Ultrabooks will continue to use HDD's
- The very nature of the discussion (which everyone seems to be in agreement on) involves the diminution of traditional hardware and hardware manufacturers such as Dell. Even if Tablets and Ultrabooks cannibalized all of the traditional PC boxes, they would still be getting sold with very limited SSD memory, and the whole affair would have no impact on whether storage demand increased or decreased overall.
According to Richard Rutledge, SVP of Marketing at WDC:
"We are interested in hybrid drives. What you will see in an Ultrabook is an SSD, typically around 24GB along with a regular hard drive, typically 500GB and up. What will happen is your data will be cached to your SSD. So we will have an mSATA port based SSD along with a regular HDD. After that technology gets adopted in the mainstream, we can do a lot of interesting things, by bringing the SSD on the HDD..."
and on SDD Rutledge had this to say:
"According to our research from the 500,000 petabytes of data that was transferred last year, only 20,000 petabytes were using flash drives. That amounts to a mere 4 percent overall data transfer share. So that's an interesting statistic that flash is only 4 percent of the overall storage. The current SSD products we have under the WD brand were got from a company we acquired called Silicon Systems. They are focused on the embedded industrial market places, which are the closest markets to the enterprise which equates to High duty cycle, high reliability and very long life cycle. And that was the strategy.
With regards to consumer market, we are very much in support of this dual hybrid drive. We have teams working on SSD products, but we won't announce products before we are shipping. Safe to say we are investing."
Analysts also indicate that they are worried about the future of HDD pricing – but the comment that ignited the initial sell off in WDC shares had to do with LTA’s (see Silver Platters, Annie Oakley and “The Sidelines”) – which is a contradiction, because Long Term Agreements "lock-in" pricing (in some cases for up to two years), such that they are no longer fluid. Those LTA are “seriously accretive” according to WDC. STX has LTA’s as well and indicated that pricing was “benign” in their latest CC. There are three factors working against further price declines:
1. The new Duopoly
2. Long term agreements (LTA’s)
3. The growth in demand generated by enterprise storage (The Cloud)
Barclay’s is wrong
WDC booked 680 M in net profits in Q3 w/ only 3.5 weeks of HGST revenue and profits included. What will the company’s earnings be in FQ4 with 12 weeks of HGST earnings?
Barclay’s boosted their target price on shares of Western Digital from $45.00 to $49.00 on April 30th, 2012.
exactly 4 weeks later:
Barclay's downgraded Western Digital Corp. from Overweight to Equalweight and lowered the PT from $49 to $37 with Analyst, Ben A. Reitzes, saying in part:
"Downgrade to EW given several factors that could keep shares range-bound over the near term. This call is not really about the current quarter, but certain developments could impact guidance around September and December."
A look at the specific language is interesting - take for example the following:
"...that could keep shares range-bound over the near term"
Doesn't this comment refer to "price" of the shares in future time, an event Mr. Reitzes has precisely zero chance of knowing with any degree of accuracy? Wouldn't it be wiser to speak of the "value" of the company in terms of what can be known in future time with some approximate accuracy? Besides how is the term "range-bound" useful, if he does not tell us what the "range" is? for example, if the range is $35 (est. FQ4 book value) - $80 (low FQ4 13 intrinsic value estimate) per share it seems reasonable (after checking to make sure your health insurance is active), that if you don't have the cash, you might take out loans with your friendly neighborhood Mafiosi in order to buy shares of WDC at a 10:1 leverage ratio. Just to be clear your broker provides the leverage, not the initial loan - We understand the participants in this instance could be easily confused.
Next Up:
"This call is not really about the current quarter, but certain developments could impact guidance around September and December"
Could anything be more vague? The current quarter is the most tangible and immediate information available, yet, Reitzes is discarding those figures wholly in favor of "certain developments" which he does not clarify, and which etymologically must take place in an unknown future. These hypothetical events, in Reitzes own words will not affect the mysterious "range" of prices (not value) which we can only guess at, but only "could impact guidance" - but he does not clarify whose guidance, or how it will be impacted? He only provides a time frame for this exceedingly unfocused forecast, which is some six months into Amvona book value forecast which is based on actual figures.
Finally this:
"Specific factors include (Neutral to Negative) news on PC flow, increased inventories and secular concerns"
This statement of course is anything but "specific", for starters, if the news were to be "neutral" (one option provided), it most certainly would not have the same impact to "the range" as say "negative" news, which is "specifically" different. Further, the term "PC flow" is not described, nor is the relationship between "PC flow" and "storage demand". What we do know is that WDC functions to service "Storage" needs, not "PC Flow", as evidenced in the CEO's own comments above.
Then there is the very unspecific mention of "inventories", but we have no clue whose inventories (e.g. component suppliers etc)? Finally there is "secular concerns", one of our favorite terms because it almost sounds smart. According to Reitzes "secular concerns" constitutes "Certain Developments" approximately two quarters from now, a period of time when all we know is that their "guidance" might be impacted - we can find no way to reconcile the time frame mentioned in the opening remarks namely, "the near term" with "secular" (concerns) an adjective used to describe a long-term time frame, usually at least 10 years.
Incredibly, the man in 44 words has accomplished what few others could, he has said absolutely nothing while still sounding impressive.
The result is that Ben Reitzes appraisal of the company changed by nearly 3 B when he lowered his price target from $49 per share (slightly above tangible equity projections in one year) to $37 per share (in one year) or approximately 18% below the equity projection, or a P/B ratio in one year of just .82 (or 68% less premium than WDC just paid for the smaller HGST).
How can an opinion change so wildly in only 4 weeks? Do global economics really shift that quickly?
Is it possible that Dell sales (one of the events Reitzes appears to be referencing) slipped because it’s Dell and has it's own specific business model, and not because contraction in storage demand? Future AAPL devices utilizing SSD for instance will still upload to the cloud – doesn't matter how many tablets or ultra books are sold, especially since many ultrabooks will likely still have HDD’s – both are designed to have paid subscriptions to iCloud, which might as well be called iWDC.
The Future
It appear clear that WDC intends to be a major player in the ultrabook market, unfortunately they've partner with a small concern which nobody apparently has heard of, it's a little company called Intel (INTC) who recently announced their collaboration on a new 5 MM drive specifically for ultrabooks - this appears to be what Coyne was referencing in his press release on HGST above.
A 10k rpm, 5 mm hybrid HDD in a 2.5” form factor is right around the corner. Such a device seem very appealing from a technology/cost standpoint in reference to SSD's. It’s life span will probably exceed that of SDD's and it’s price will likely still be ~1/10 that of SSD's when they come to market. Given that Intel (INTC) is invested in this technology, WDC leadership position, and the fact that SSD's only have 4% market penetration, there seems plenty of “runway” for WDC to continue to transition it’s business to whatever new technology will meet future storage needs best.
The CEO of Seagate when asked about the possibility of SSD taking market share in the aftermath of the Thai floods had this to say:
"Some of it, but not very much. I think to the extent that there is a high value purchaser who can afford to pay $200 for 100 gigabytes, then that market will expand from 1-2 percent to 3-4 percent. Of the 35 to 40 percent shortage that exists, could you see a little of that get absorbed by silicon? The answer is yes. But there’s a cap. There’s just not enough of a raw supply of silicon to meet all the demand. Our industry will ship 400 exabytes this year. We would have shipped 450, were it not for the floods. Of that, 180 exabytes is notebooks. Reduce that by 30 percent, and you get about 55 or 60 exabytes. If you were to take all of the capacity from Samsung’s newest state-of-the-art flash factory, and dedicated it just to notebooks, it would only put out 7 exabytes a year. Plus, there are already other markets demanding flash, like tablets and cellphones and other things. So it’s not like you can steal from those other markets. You’re not going to take a $32 product and replace it with a $350 product. Can you do it at the edges of the market? Sure. But the threat is capped by the amount of silicon available and the price point for flash storage, which is still an order of magnitude higher."
According to Cisco's IP traffic forecast mobile traffic is forecast to grow 18x from 2011 to 2016 - a positive for vendors with strong mobile networking exposure. Cisco also sees over half of all 2016 traffic coming from Wi-Fi networks, and expects the number of global Internet users, boosted by smart phone adoption, to reach 3.4B (up from 1.9B in 2010) - that's a CAGR of 29% in the next 4 years to 1.3 zettabytes, or the equivalent of 38M DVDs per hour. By comparison, IP traffic from 1984-2012 was a mere 1.2 zettabytes.
A few highlights
- It's AAPL (mfg. in China) vs. INTC, MSFT and WDC (mfg. in Taiwan)
- Ultrabooks will be a big bet for the latter three, one that they are probably not willing to lose
- The latter will focus on IvyBridge married to Win 8, and ultra slim HDD’s
- WDC's jettison of the 3.5” form factor to Toshiba implies future focus will be on 2.5” form factor and 5 mm thickness
- WDC now has 10K RPM 1TB 2.5” drives which approximate SSD performance at about one tenth the cost
- WDC is already in SSD business, has been for sometime, and has imminent plans that they are not yet disclosing
- According to Steve Luczo of STX, there may not be enough SSD material globally to meet demand at any price point
- Older magnetic media mediums such as Tape still represent a cost affective solution for archival storage, which is an important and large segment of “the cloud”, lending further credibility to the thought that HDD media will be around for some time to come
- WDC's acquisition of HGST indicates a new focus on enterprise storage and more specifically SSD in enterprise applications
- Tablets and ultrabooks which continue to utilize only SSD will still have limited memory (even as SSD prices fall), b/c mfg. want to sell subscriptions to cloud based storage as it represents a recurring revenue stream.
- The cloud is largely comprised of mechanical storage and will continue to be for the foreseeable future (see case of FB / Google above)
- First impressions when buying an iPad - are the choices really only 8, 16, and 32 GB of onboard memory? It’s like some sort of bad joke unless your an HDD manufacturer that is.
- WDC FQ4 net earnings are likely to be at least 700 M – of which ~466 M would have already been collected by end of May (2/3 of the way through the quarter). That means another $1.79 per share in book value in FQ4 2012 alone.
Mr. Zuckerberg is right. It is very important to look after the interests of investors. After all investors hand over their wealth in a sacred act of trust. The idea is a simple one and quit old - the manager should use their "talents" to return a larger figure than was originally deposited. Being aggressive is fine, so long as it is done wisely, and truly with the investors best interests in mind and not the managers.
It is important to be open and specific on this point and to avoid any discussion that involves confusing language or motives, or subtle contradictions that might confuse. It would also nice if the manager can accomplish the task somewhere in the span of a life time - 365 days for example would be good. For this reason, between Friday June 1st and Tuesday June 12th, 2012 we continued to plow huge sums of investors capital into the shares of WDC (at around $30 per share) as we continued to build what was already large stake in the company.
Time will tell if it beats an investment in Facebook.
