First Eagle Comments on Western Digital - Dec 05, 2018

FPA Capital Comments on Western Digital - Nov 05, 2018

Western Digital (NASDAQ:WDC)’s stock price was down 23.73% in the third quarter of 2018 and was the largest detractor of performance for the Fund this quarter. Whenever we see such a big move, we like to take a step back and reevaluate our investment thesis. As part of that process, we seek a deep understanding of the bear case, such that we can articulate the bear case even better than the bears can – a process known as ‘straw manning’.5 If we truly understand the bear case and can pose cogent arguments against its core points, we think this presents a good long-term investment opportunity. So, let us walk through the bear case as we see it:

1. Past NAND memory cycles6 are a useful guide for today’s environment.


2. Gross margins cratered during past down cycles and we believe they are likely to crater again.


3. Collapsing gross margins suggest falling earnings and that the stock will follow earnings lower.


4. If the stock is so cheap, why isn’t the company buying back shares?

The bear case, as presented, certainly sounds compelling, and many investors have obviously subscribed to it given the stock’s recent performance. But let us examine each of the arguments.

Past NAND cycles are a useful guide for today’s environment

We see several reasons to believe the current NAND cycle is different from the past. First, NAND end-markets are substantially more diversified than in the past. In 2009, nearly 80% of NAND bits went to removable products (e.g. camera flash drives).7 Today, three new end-markets, Enterprise solid state drives (“SSDs”), Client SSDs, and Mobile comprise over 80% of bit demand and each represents over 20% of the total.8 Today’s those diversified end-markets should help limit cyclicality of the business. Second, today’s products are less commodity-like than in the past. As a reminder, Western Digital is not just selling raw NAND flash, it is selling SSDs, and these products generally require more intellectual property and carry better margins. As Western Digital sits higher up in the value chain, we expect the business to perform better than a pure commodity business. Third, we believe long-term secular demand drivers are robust. Data storage is at the center of multiple megatrends (e.g., internet of things, surveillance, big data, analytics, artificial intelligence, cloud computing, etc.), and we think strong underlying demand should help rebalance any temporary supply/demand imbalance that arises. Fourth, the technology has become harder to scale, and that has placed a ceiling on potential supply growth. From 2004 to 2008, ‘bits shipped’ grew at nearly a 200% CAGR.9 That CAGR has fallen to closer to 35-45% from 2013-2017.10 This cap on bit supply growth, when paired with strong demand, fundamentally limits how far out of balance the market can get, and we believe that is a key difference compared to past cycles. And fifth, manufacturers are already acting rationally by curbing supply in the face of slowing demand. That was not always the case. On Western Digital’s last earnings conference call, Chief Operating Officer Mike Cordano spoke to this point directly, telling analysts: “We are in discussions with Toshiba Memory Corporation, our joint venture partner, to moderate the near-term pace of capital investments.”11 Bottom line, for all of these reasons, we think the current NAND cycle is likely to be less harsh than the past cycles that bearish analysts may be using to formulate their views.

Gross margins cratered during past down cycles and they are likely to crater again

While it is true that gross margins have declined meaningfully from peak-to-trough in past cycles, for the most recent cycle, the fall in gross margins was capped at about 15 percentage points (as shown in the chart below). The one glaring exception to this trend came during the financial crisis. Our view is that given all of the positive structural changes in the industry discussed above, the industry is very unlikely to see a fall in gross margins anywhere near what we saw in 2009. Instead, we expect gross margins to fall a few percentage points in each of the next several quarters while the market rebalances. One final point: As you might expect for an industry whose quality is improving, we see a general up-trend in gross margin with each subsequent cycle (higher highs and higher lows).

Collapsing gross margins means falling earnings & the stock price will follow earnings lower

If we look at past cycles, it is really no surprise that earnings per share (“EPS”) tends to follow gross margins lower. However, as shown in the charts below, the stock price doesn’t always head lower when EPS is temporarily pressured by the down-cycle. In fact, during the gross margin compression cycle from 2010 to 2012, the stock mostly traded sideways. Furthermore, the stock bottomed almost two full quarters before gross margin, and even kicked off a sustained rally while gross margins continued to fall. Said another way, even though we agree that gross margins and EPS are heading lower near-term, that does not mean the stock will continue to trend down as well.

In addition, if the stock is so cheap, why is the company not buying back shares?

The company did virtually no buybacks over the previous two years, but there were good reasons for that. First, the company was in the midst of its dispute with Toshiba (its joint venture partner).12 This dispute is behind them now. Second, the company’s debt level increased to almost $17 billion after its acquisition of SanDisk Corporation in May 2016. Since then, the company has not only decreased its gross debt level to $11 billion, but also cut its annual interest expense by over 40% via debt pay down and successful refinancing.13 The improved operational performance, coupled with the reduced interest payments, has bolstered Western Digital’s free cash flow to over $3.3 billion over the last 12 months 14.

Following these improvements in the balance sheet and free cash flow generation, the company repurchased over $430 million worth of shares (nearly 2% of shares outstanding) in the second calendar quarter of 2018. It also announced a $5 billion repurchase authorization15 – which, if executed at today’s share price, would shrink the share count by nearly a third. Furthermore, we estimate that Western Digital has already repurchased nearly 5 million shares through the first half of 3Q2018, based on disclosures in its most recent 10-K. This would put the company on pace to repurchase ~3% of shares outstanding in the current quarter alone. We believe these repurchases will be accretive to long-term shareholders and we applaud the move as a sound capital allocation decision.

When we evaluate the bear case, we take issue with essentially all of its core arguments. Additionally, the bear case entirely ignores what we believe to be a compelling current valuation for Western Digital. On a trailing 12-month basis through FY18’4Q, the stock trades at a 3.8x adj P/E and a 4.2x EBITDA multiple, and on a forward-basis it trades at a 5.0x adj P/E and a 3.7x EBITDA multiple (as of October 17, 2018). These are multiples typically reserved for dying businesses with no terminal value. In our view, they are not applicable to a thriving, growing business like Western Digital. Furthermore, even if estimates continue to fall, we believe these low multiples provide a margin of safety for our investment.

Now let us take a look back at our history with this stock. We have owned Western Digital stock and traded around our position very successfully for over a decade (as shown in the chart below). Historically, the market has provided us with many opportunities to take advantage of short-term pessimism and euphoria, and we have tended to capitalize on those periods. We believe the stock’s decline over the last few quarters represents the latest wave of pessimism. During this period, we have added to our position substantially, and we feel strongly that the downturn has presented us with yet another compelling opportunity with a company we know very well.

From FPA Capital's third-quarter 2018 shareholder letter.