A week ago, Western Digital (WDC, Financial) reported a 20.6% year-on-year drop in its sales at $2.8 billion and 80.7% year-on-year drop in profits at $74 million (source). In return, Mr. Market punished its shares by roughly 17% post earnings release.
To quote the current chief executive, 52-year-old Steve Milligan:
"We continue to manage our business effectively in a dynamic storage demand environment. Computer usage continues to shift from PCs to mobile devices, and enterprise workloads are moving increasingly to cloud-based architectures. Our strategy to become a broad-based provider of media-agnostic storage solutions anticipates these and other trends. After we complete the acquisition of SanDisk (SNDK, Financial), we will be better positioned to address and capitalize on these changes and opportunities with the storage industry's broadest set of products, a rich technology portfolio and an experienced team in both rotating magnetic and nonvolatile memory."
Western Digital does not appear to be the only company experiencing this cloud nine and falling PC demand endeavors. For example, look at IBM’s (IBM, Financial) and Hewlett Packard’s (HPQ, Financial), among others, declining revenue. In addition, Seagate Technology (STX, Financial) also reported a 22% year-on-year decline in sales and 89% year-on-year decline in profits (source). Mr. Market did not fail to punish Seagate’s shares. Seagate’s market price declined a hefty 19% since the earnings announcement on April 28.
Correspondingly, Mr. Market gave Western Digital Thursday’s p/e valuation of 11. At the same time, the company is expected to maintain its dividend policy while suspending its buyback program secondary to a recent Sandisk acquisition, which was announced in October 2015 (source). Western Digital currently yields 4.8%.
With such bargains, one can easily assume that Mr. Market is just having this myopic vision that Western Digital would rather experience declining sales and profits over time and never be able to recover again to its average earnings.
Western Digital has a trailing 12-month (ttm) earnings per share (eps) of $4.85. In contrast to a three-year average (2014 ttm) of $5.90 per share, ttm earnings is lower by roughly 18%. Applying the current industry p/e median of 17.25 and Standard & Poor's 500’s p/e valuation of 19.1 to Western Digital’s $4.85 eps, I still get to attain a value of $83.7 and $92.6. This indicates a big margin of safety if these calculated values were to be used as Western Digital’s possible intrinsic values.
A conservative investor would probably have already bought in Western Digital given this bargain. However, reviewing ongoing business endeavors may facilitate a push toward the breaks, at least momentarily.
Western Digital earns primarily through selling hard disk drives, the largest and main data storage hardware in a computer. As of Western Digital’s recent 10-K filing, the company earned 59% of its revenue from shipping HDDs for PC use.
One can assume that as PC or laptop/notebook sales go up, sales for HDD will head the same direction. In contrast, portable smart devices, such as smartphones and tablets, use totally different types of data storage devices, or chips. These chips, or system-on-chips (soc), are provided by a different group of companies compared to the likes of Western Digital. The list of soc suppliers can be viewed here (source).
Western Digital and its peers were recently hit by the decline in PC and laptop demand, brought by increased tablet and smartphone orders.
Here are some valuable images from Statista exhibiting some patterns in this industry being discussed, in the following order: global smartphone shipments, global PC shipments and global HDD shipments.
(source Statista)
Smartphone sales have been increasing over the years. In contrast, PC and HDD global shipments have been on a moderate decline. Further, a better view of the HDD market was provided by IHS (source).
The image above should definitely worry any Western Digital investor. In addition to the cloud-moving pattern brought by innovation and improved demand of smartphones, the company also has to face the already increasing demand of solid-state drives (SSDs). SSDs are a somewhat new technology, less prone to breaking (during an accidental device drop), faster in processing, therefore more capable of running apps in PCs. A catch is that SSDs may prove costly and at times may not have the longevity compared to an HDD (source). Here is the list of SSD manufacturers.
Nevertheless, Western Digital already had proactively reacted to this SSD trend and would be spending $19 billion to acquire its competitor SanDisk. According to Statista, SanDisk is the second-leading SSD manufacturer with 12.7% market share. Samsung leads the SSD business with 46.8% market share. The expected completion of the SanDisk acquisition would be in the second quarter of this year.
Some insights into SanDisk: SanDisk is a global leader in flash storage solutions with a strong history of innovative products. Flash storage technology allows digital information to be stored in a durable, compact format that retains the data even without power (source). These flash memory storage chips are used not just in PCs and laptops but also in smartphones and tablets.
One thing to consider with SanDisk is that Apple (AAPL, Financial), in mid-2015, decided to order some of the flash storage products from its competitor Samsung (source). According to SanDisk’s 2014 10-k, Apple accounted for 19% of its total sales. Interestingly, SanDisk grew its sales figures by 3% to $1.37 billion and profits by 100%Â –Â from $39 million in the first quarter of 2015 to $78 million in the first quarter of 2016 (source).
Western Digital announced that It will spend $18.9 billion to acquire SanDisk. According to the Journal, the offer was valued at $78.50 a share as of February, which is a 4% premium to Thursday’s price of $75.13. Determining how much exactly Western Digital would be paying for each SanDisk share was confusing secondary to other deal requirements, such as "adjustment to the mix of cash and stock consideration" (more information here).
Nevertheless, SanDisk's margins (three-year averages) were also attractive. Arranged in the following order –Â gross, operating and profit margins, 44%, 20%, and 13% –Â SanDisk looks like it does have a good business. Lastly, analysts project annual synergy of $525 million post closing.
(source Barron’s)
Here are some more financial numbers.
Du Pont’s return on equity (ROE) analysis
Du Pont’s ROE analysis assesses a company’s operating and asset use efficiencies and financial leverage. In addition, tracking a company’s ROE numbers over time seems informative, too. An increasing profit margin and turnover, while a declining or steady financial leverage manifests in strong companies. In this case, Western Digital’s ROE has been declining for the past decade.
Debt-to-equity ratio and shares outstanding
Western Digital’s debt appears to be climbing at a moderate pace but has been at least less than 50% of its total market capitalization. Another thing to consider is the company is to stop repurchasing its shares as it pledged in its SanDisk acquisition.
Further, Western Digital had issued $5.2 billion senior notes with $1.9 billion at 7.38% rate and $3.35 billion at 10.5% rate according to an April report (source). Those rates appear to be issued at far above the risk-free premium rate of 1.72% (May 5). Ceteris paribus, adding $5.2 billion in the company’s total debt in 2015, would yield a debt-to-equity ratio of 0.77.
Net shareholder return
Interestingly, Western Digital only started issuing dividends in 2013. That marked the more than 100% payout from profits that year in the above chart. Nevertheless, the company has continued issuing dividends lower than 100% in either profits or free cash flow while achieving a 36% growth.
Valuations
Traditional price to earnings and book value revealed that Western Digital is being taken for granted by Mr. Market.
(Source Nasdaq)
Possible contributors to the underappreciated Western Digital shares are the shorts. Shorts (bears) have been piling up on Western Digital shares recently. The company has the most days to cover (the longer the more bearish the shorts are) within the past year. A lot of bears have piled up betting Western Digital shares would go down further.
Betting short on a company is riskier than buying its shares over the long run. That is, “there’s no limit to how much money you can lose if the shares rise. If the share price increases soon after you place a short position, you could quickly 'cover' by buying back the shares and returning them to the investor you borrowed them from” (source). In this case, Western Digital shares may just have an added boost when its market price heads onto recovery.
Nevertheless, it’s obvious that Western Digital would not just go away because of these technological shifts. The company’s management seems to have experience that extends beyond the struggling HDD business. The company has been adapting slowly and steadily as it builds its presence in the SDD market as well. I do not expect Western Digital shares to propel from its current lows in the next few months. I am willing to wait for its business to recover and grow again while receiving dividends on the side. Further, I do not fear Western Digital taking too much debt on the SanDisk acquisition.
Happy investing.
Disclosure:Ă‚ Long Western Digital Company.
