Western Digital and Some Thoughts about the Current Market Position

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Jose Vasquez
Jul 26, 2012
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I posted on July 8 that I had been adding to Western Digital (WDC, Financial): Technology Bundle: Applied Materials, Dell & Western Digital

I hope someone acted based on that post. Robert Rodriguez and Steve Romick from the FPA funds have been acting for sure. They have been adding heavily to their WDC positions. If you had bought on July 8 at $31 the return by now would be 29%. It is trading at $40, up 23% after good results. I bought, some days before that post, 85 stocks at $28.8. Now I have 185 stocks at a $27 average price.

I mentioned then why I had been buying Dell (DELL, Financial) and Applied Materials (AMAT, Financial). It would be nice if they explode like WDC too. It does not really matter much when; sooner or later, they should. As long as fundamentals are sound, price will catch up. It is the first full quarter with the results from the Hitachi HDD operations acquisition. I mentioned in the post that price competition could come under control thanks to that acquisition. Fear of margins erosion has always been a "problem" with the market players that are interested in WDC. So it should be a positive point having less competition now that basically two big companies of equal size remain (the third is small).

Smart phones and tablets with solid state drives (SSDs) do not seem to be a major problem. Storage is a tiered industry and HDDs have a nice place in that ecosystem. It should not be a problem as big as perceived. If the common perception changes the market-assigned P/E multiple could go up and the stock along with it. From what I read, HDDs for the foreseeable time are way cheaper than SSDs for most storage needs and there is no capacity to manufacture enough SSDs to satisfy the enormous and fast-growing demand for storage. Seagate's (STX, Financial) CEO, Steven Luzco, said something similar recently. Building that capacity would be prohibitive. WDC and Seagate both have SDD products. Specially WDC has the cash to buy a specialized SSD company or produce more. They have a chance to get into that adjacent industry because the are already in the storage business. Especially via hybrid HDD/SDD drives that have the best of both worlds.

One respectable competitor in the SSD area is Intel (INTC, Financial). I also own some shares there. In the last conference call they said that NAND sales had fallen lately. Applied Materials (AMAT, Financial), a sizable stock in my portfolio, said the same, specifically that they have not received as many orders as expected from the NAND sector. AMAT sells machines to foundries to make semiconductors, and NAND is a part of their business, so they have a leading view on that area. No wonder, because all those smart phones, iPads and tablets come mostly with a very small amount of NAND/SSD memory. Customers do not seem to want more; probably they store their content somewhere else, in HDDs for sure.

What we need to be careful about is that Intel said in their last call that their SSD operation, being very small, is already profitable. That's already a good sign because they also said that last year it wasn't. The reason that WDC has not gotten strong on that sector is because they did not find it profitable, at least that's what John Coyne (the CEO) mentioned not too long ago. But now that Intel is talking about profitability we have to be alert, especially because Intel is a huge company and has the manufacturing capability and cash to produce SSDs. It is a very natural adjacent business for them to get in. After all, SSDs and NAND are made of semiconductors, and Intel knows more than a bit about that. It is a very complicated situation to try to predict who will be the SSD/NAND winner. Anything could happen. Who knows, maybe Intel buys WDC and ends up selling hybrid drives. That's anybody's guess, but one thing is sure, AMAT will keep on selling machines to build them.

Let's check the quarter results now:

Western Digital reported strong fiscal fourth-quarter results and projected bullish earnings for the new fiscal year as the hard-disk-drive maker benefits from its recent acquisition and its recovery from the flooding.

Its revenue and earnings set records for the quarter and year, helped by contributions from Western Digital's acquisition of Hitachi Ltd. (HIT, 6501.TO)'s hard-drive operations. The fourth quarter marked the first full period of contribution from Hitachi, and adjusted earnings and revenue were stronger than Western Digital had projected.

During a conference call, Chief Executive John Coyne said the company could report adjusted earnings of $10 a share this year, above the $8.06 a share expected by analysts, according to Reuters.

The company took into account many broad and company-specific factors, Mr. Coyne said, including a soft economy and the growing use of tablets and smartphones.

"Storage continues to be at the center of the evolving digital universe," Coyne said. "We believe a strategy of delighting customers, focusing investments on faster growing market segments, and driving strong execution in both internal operations and our supply chain will continue to deliver consistent and superior financial performance."

For the quarter, both the Western Digital and Hitachi units performed ahead of plan, he said, and average selling prices and volumes were stronger than anticipated. Industry-wide demand, meanwhile, was in line with Western Digital's forecast, Mr. Coyne said.

They paid $4.7 billion for Hitachi the latest 10Q says this:

The preliminary, aggregate purchase price of the Acquisition amounted to approximately $4.7 billion, which was paid on the Closing Date and funded with existing cash, new debt, and 25 million newly issued shares of our common stock. The cash portion of the purchase price is subject to a post-closing adjustment (an increase or a decrease) that has not been determined for changes in the working capital of HGST and certain other payments and expenses.

They paid more than what they talked about initially. If I remember well, the 25 million shares were not part of the initial talks.

Asked by Forbes magazine, this is what Seageate's Steven Luzco had to say about the acquisition:

Q: Had you looked at the possibility of buying Hitachi?

A: Not at all. WD needed to do the deal because they needed to get the enterprise business, and they werent able to do that on their own, despite trying for 10 years. They are hard products to build, it takes a lot of R&D, the customer set is different, servicing the customer is different, it is really hard. And Id say the two biggest strengths of Hitachi are their enterprise business and their core technology. They are really good in heads, which is also probably a relative weakness at WD. For us, we have a leading head company and we have the leading enterprise company, so the value for us was different than the value for WD.

Being strong in the enterprise business it is nice to see the respect that Steven has for Hitachi's business. Hitachi's HDD business has its origins in IBM, in 2002 IBM sold its hard drive business to Hitachi Data Systems. Now it's clearly impacting positively WDC's bottom line. Management's projection of $10 EPS for fiscal 2013 would be more than okay, especially given the high cash flows and the good balance sheet they have. Applying a P/E multiplier of 8 would give a price of $80! Am I wrong? Okay, let's be ultra-conservative: Supposing it just makes 8, or supposing it makes 5, the price would still be 5 x 8 = $40 for an 8 P/E multiplier. And what if the P/E is 6 and the earnings are 5 (half as projected)? Then we'd get a price of $30, but that's quite unlikely.

I trust management, I have owned shares of this company more than once since 2007. I had never been disappointed with management until when they bought Hitachi, but now it seems in hindsight that I shouldn't have. The problem was that they bought Hitachi for a price that I could not assess given that they just showed one year of Hitachi's financial results, and 2010 was a rosy year for the industry, so I distrusted. I hated the idea of giving most of their cash and more than half of their market cap to a company that showed just one year of rosy financials, and before 2010 Hitachi had losses. I never liked that and sold most of my shares at around $40, in part for that reason. Actually, I had no way of knowing anything about Hitachi's HDD business. Hitachi hardly talked about it in their reports; it was a relative minor area of their operations.

What would have been wonderful is if I had repurchased at $24 after the flood, but I never imagined they would recover so fast. That was another surprise. When I saw the pictures of the manufacturing plants under water I did not think they could fix things fast. But they did.

They apparently also reduced debt and increased cash, and the free cash flow is very healthy. Now the situation seems rosy again, or at least has the potential to start being rosy. But I am quite skeptical because this company goes up and down like a roller-coaster when margin expectations change. Earnings have had huge variations before the water flooding too. When margins and earnings fall this stock tanks, probably because everyone thinks it will not recover; they think even more that the company will disappear due to SSDs and the near "death of the HDD." The death threat of the HDD has been talked about I remember since I bought a few shares in 2007 (at $18). By then, SSDs and NANDs were much less ubiquitous. Now, five years later, there are a lot more SDDs, but even more HDDs. Correspondingly, the company doubled in many metrics, including share price. Then again, with much less competition (supplier price power) and more customer segmentation (less customer pricing power) things could change regarding margins and price wars. Now only Seagate is a meaningful competitor, and they have been losing market share.

Seagate (STX, Financial) and WDC do not have a history of getting into aggressive price competition. On the contrary, STX seems quite disciplined in its sales and has WDC as almost the only competitor now. Maybe they could talk together and fix prices, like a monopoly. I doubt it's legal, but I am sure companies manage to do those things some way or another. If they do not talk about it, but they often implicitly do it anyway if it's convenient for them.

Results this year were quite good. Western Digital Corp. reported revenue of $12.5 billion and net income of $1.6 billion, or $6.58 per share for fiscal year 2012, compared to fiscal 2011 revenue of $9.5 billion and net income of $726 million, or $3.09 per share. Non-GAAP, the numbers are $3.28 and $8.61. If non-GAAP $10 EPS management projections really materialize in fiscal 2013 we have an interesting situation. For those who like earning increases (so for the whole lot of analysts out there), this EPS series for three years would look nice: $3, $8.61, $10. If the company manages to consolidate at those high EPS levels and the EPS multiplier applied is 8, we could see an 80 share figure not bad. It is possible now that it has a foot on the profitable Enterprise HDD market since it bought Hitachi, and now Seagate will have more trouble keeping its Enterprise HDD franchise.

I will soon reassess yet once more the situation, for the Nth time, digesting the conference calls, the latest SEC fillings, etc. After all, I could buy back all the shares I sold last year at around $40 if it was worth the case. The company seems more valuable now. At least its equity and cash flows are nicely growing. But equity has some more goodwill and intangibles now as a consequence of Hitachi. Another positive thing is that they finally decided since some time ago to buy back shares, that had been quite an issue among some investors.

The company generated $1.1 billion in cash from operations during the June quarter, ending with total cash and cash equivalents of $3.2 billion. During the quarter, the company repaid $558 million of debt and spent $604 million to buy back over 16 million shares of common stock.

It has great free cash flow, this is how it was used: It repaid more than half a billion of debt and spent even more on buybacks at 37.75. I would have preferred if they bought back at around 30, but this is okay and still cheap I guess. This could definitely put a floor on the stock price. The question is if they should be using it to defend themselves against SSDs. The fact that they used 0.6 Billions on buybacks does not look to me like they fear much having problems due to SSD competition. Stocks buy backs in such scale is something relatively new for WDC. John Coyne must be quite serious saying that SSD is not a profitable business. After all they could have very easily bought an important SSD company if they wanted, like for example OCZ Technology Group Inc. (OCZ), which has 0.375 Billions of market capitalization, that would be pocket change for WDC. The message sent is strong: if they needed the money for something like that and considered it vital to their future they would not be buying back shares.

"Fiscal 2012 was one of the most challenging and exciting years in our 42-year history," said John Coyne, CEO. "While responding to two major natural disasters and completing the largest acquisition in the history of the industry, we achieved year-over-year revenue growth of 31% and more than doubled earnings per share."

You have to be careful with that comment; the reason margins are so high now could very well be precisely because there was a flood. But don't be too strict neither. Consider that margins are also higher due to the Hitachi high margin enterprise HDD business and because only two meaningful competitors are left. The industry has consolidated in the last decade from ten or more HDD manufacturers to only two big and a small one. Remember just a few years ago there were all sorts or HDD around. Just to name a few familiar brands: Lacie, Samsung, IBM, Fujitsu, Conner, Quantum and Maxtor. All exited or were swallowed by either Seagate or WDC. Logically, so much consolidation is a tailwind to their margins now more than ever.

You do need to have in mind that fast drives like SSDs are causing a change. So the fear of the bears is understandable. Imagine for the sake of knowledge an extreme logical exercise. Imagine every single personal computing device (iPads, tablets, PCs, Notebooks, Ultra books etc..) had an SSD. You would say "no, impossible! there is no capacity", and you are right. So to overcome that problem suppose that they would have a tiny storage capacity (like most have now). In such hypothetical scenario, done for the sake of understanding, the next question would be where would the data go? It can either go to the cloud or to an external drive. The part that goes to the cloud would be managed by companies, efficiently. Also suppose that the data in the cloud could be accessed very fast from the internet. The same movie or song that was duplicated in millions of computers could now be much better managed in a relatively few cloud servers. A massive deduplication of data could be obtained. As for the part of the data that goes to personal external drives, that would still be probably duplicated in lots of places.

That hypothetical situation is something that you should consider when you evaluate a company like STX or WDC. I think HDDs will indeed be needed for a very long time but not in the same way as they used to be. There could be a scenario where you have super fast consumer devices with low storage capacity that connect to clouds managed by companies like Google, Amazon etc... in a much more efficient way. In such scenario SSDs allow users to have a nice and fast experience and enable the total storage needs to be smaller than in the scenario where SSDs did not exist and data was duplicated in millions of computers.

But you should also not forget that even in that scenario there always will be people who like to have their data close, at home, completely out of the net, and most will use cheap ways to do it. Why store your movie/music collection in a 2 terabyte SSD when a 2TB HDD does the same ? And also do not forget that the companies that feed the cloud will be HDD manufacturers for quite some time. Simply because there is no capacity and, most importantly, no need, to use much SSD storage in the cloud.



PD: For more about this subject see Western Digital: Yet some some more thoughts
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I was born in Spain and lived in France, Chile, USA and Belgium. I used to work in IT and Banking. I am a family man, I have a lovely wife, 3 sons and one step daughter. I have humble tastes, I like to stay home and read about companies. I started investing before the internet bubble. I knew little and liked technical analysis so my results were bad. Fortunately I did not have much to lose. Some years later in 2006, bored of doing real state investments, I opened an interactive brokers account and restarted. This time, not wanting to make mistakes, I decided to follow a model: Warren Buffett, he was at good making money via stocks. So I started reading about him, his shareholders letters, the books that he recommended, etc... I started applying his principles, reading 10K's digesting all sources of information. I started buying good and cheap companies to hold forever unless something changed fundamentally. When the housing crisis started I was 75% cash. By then I had identified good companies at very cheap prices so I invested most of my savings in stocks. It doubled fast. By the second semester of 2009 I turned my software company into an investment vehicle and dedicated myself full time to it. I changed lifestyle and moved from Belgium to the beach, Brazil, north east coast (www.kuchita.com). The goal was to keep fixed costs low in order to be able to live with a minimum 6-8% yearly return, to move away from the inhuman life of civilization and to have some peace and sunny weather. Now I can think and study about companies 60 hours/week. I can finally do what I want full time and can say that I have never been so happy, specially also with my just born 4th son, my other great kids and my sweet wife who supports me fully while I study most of the day and patiently wait for the opportunity to make a swing ! My portfolio is disclosed here: http://www.kuchita.com/view/sumo.php For more: