Description

Thesis

The timing of this article may have missed the first inning of Western Digital’s recovery, but I believe that this company still has significant upside potential from both its expanding SSD offerings, as well as the cost savings from its recent acquisition of SanDisk.  Digital storage drives have become a commodity and there is constant downward pressure on prices.  The exception is in enterprise and hyperscale segments where speed and reliability have lead to innovation around capacity, interfaces, and the software that manages the data.  Western Digital’s recent acquisition of SanDisk will help expand its own burgeoning solid state drive segment, while helping de-emphasize the declining, low margins, commodity hard disk drives for the PC segment.  The SanDisk acquisition is not without risk.  The significant amount of debt needed to fund the merger, combined with a cyclical industry and often irrational behavior by its players, makes the future less than certain.  However, merging with SanDisk gives Western Digital the flexibility to focus on the high-margin segments within its HDD and SSD product line.

Company Overview

Western Digital Corporation (WDC) develops, manufactures and provides digital storage solutions for consumers, businesses, governments and other organizations to create, manage, and preserve content.  Prior to 2012, when WDC purchased Hitachi Global Storage Technologies (HGST) for just under $5 billion, approximately 99% of Western Digital’s revenues were derived from hard disk drives (HDD) sales.  Even though China’s Ministry of Commerce (MOFCOM) initially required WDC and HGST to operate as two distinct, stand-alone entities, the acquisition allowed Western Digital to leverage HGST’s strong relationships and revenue streams tied to the enterprise storage segment, and over time, began to de-emphasize the contracting PC market.  By 2015, seven percent of WDC revenue was generated from the sale of solid state drives (SSD) into the enterprise segment.  

In May of 2016, Western Digital completed its acquisition of SanDisk (SNDK), a leading provider of NAND storage chips used primarily in flash drives, smartphones, tablets, and enterprise storage centers, for roughly $16 billion.  The merger creates a vertically integrated digital storage company that can provide both HDD and SSD solutions to clients across a number of platforms.  Many believe the acquisition of SanDisk to be overreaching, especially when considering the cyclicality and irrational behavior of the industry and its players (Samsung), as well as the sizable amount of debt WDC has taken on to complete the deal.  However, in order for Western Digital to remain relevant in digital storage, it needed to expand its SSD Offerings.  When looking back at recent acquisitions made by Western Digital surrounding SSD (sTec, VeloBit, and Virident), the crucial component missing was a secure supply of NAND - a key element SNDK brings to the table.

In February, before closing its merger with SanDisk, Western Digital provided a post-merger, straight line pro forma combination of the two companies based on 2015 financial numbers.  Combined revenues equaled $19 billion (65% coming HDD & 35% from SSD/NAND), gross margin in the 33% range and operating margins hitting 15%.  The company also outlined a number of actions it plans to take to eliminate costs including reducing corporate overhead, consolidating R&D, and vertically integrating its SSD segments.  When added to the cost reduction from the recent MOFCOM approval for final integration between WDC and HGST, these savings should amount to over $750 million within the first 18 months after closing the deal.  When including manufacturing synergies with these savings, the total impact could top $1 billion by 2020.  Given the expectation of strong cash flow generation, Western Digital has the means to materially reduce the debt on its balance sheet over the next five years.

Besides the expected cost savings, the merger will allow Western Digital the flexibility to focus on its growing area of expertise in the high margin, enterprise and hyperscale SSDs, while being able to cede market share in the lower margin, commoditized segments in HDD.  WDC already has a strong footprint in the SAS interface SSD, and its growing PCIe interface will be a complement to SNDK’s established market share.  The biggest disruption to hit the SSD market in recent years is the ongoing transition from 2D planar platform to a 3D NAND format.  Expectations are that 3D NAND will represent 15-20% of the industry’s total NAND capacity by the end of 2016 and will continue to grow from there.  Even though Samsung and Micron have taken an early lead in the conversion cycle, WDC is estimating that its 3D NAND capacity will hit a run rate equaled to 15% of its total SSD capacity when it exits 2016.  The benefits of 3D NAND speak for themselves:  A 48 layer 3D NAND will cost 50% more than a 2D Planar to manufacture but will yield over 100% more capacity and a higher average selling price (ASP) per gigabyte.  This is a meaningful cost reduction in SSD storage and will continue to narrow the cost/gigabyte gap between HDD and SSD.

It is important to understand that even though HDD are a slower and less efficient method to store and retrieve data than SSD, it will not be eliminated from digital storage.  Over time, it will be relegated to the long-term storage segments where cost/gigabyte is more important than speed.  An HDD’s low-cost structure combined with the ever growing demand for storage continues to make them a relevant part of digital storage for the foreseeable future.  It is estimated that for 2016, the total shipped digital storage capacity will equal 650 exabytes.  Approximately 10% of the exabytes shipped will come from SSD.  Even as SSD is becoming a larger portion of enterprise and cloud hyperscale, it still lacks the capacity needed to fully support these segments.  HDD and SSD will continue to compete in the digital storage industry as the market continues to be bifurcated between costs and performance.  WDC’s mission critical helium-filled hard disk drives, SAS and PCIe interface SSDs will continue to remain an important part of the enterprise and hyperscale platform.  Theses drives ASP are up to 6x what a comparable HDD or SSD commodity drive would sell for and is reflected in its margins.  Having 43% of the HDD market and now a major supplier of SSD/NAND into the enterprise space, Western Digital can be more thoughtful in its approach to digital storage, balancing market share with profitability.

Valuation

With the continued decline in the PC market and recent softness in the enterprise segment for HDD, revenue for 2016 is expected to come in below $19 billion.  By 2017, higher demand and ASP from the SSD will offset the HDD declines with growth returning in 2018.  By 2018, WDC will be 18 months into its integration of SNDK, and expectations are for gross margins to hit 35%, operating margins approaching 20%, and net profit margins in the 14% range.  Add in lower interest expenses from debt reduction, and by 2017, net income could top $2 billion and improving to $2.5 billion by 2018.  Historically, the storage industry has been valued on a 10 multiple leading to a share price of $72 in 2017 and growing to $86 by 2018.

Risks

There are certainly significant risks associated with the SanDisk acquisition, the predominant being the $17 billion of debt.  Western Digital’s methodical approach when integrating HGST should act as a template for its acquisition of SNDK.  The first steps will be to quickly reduce operating expenses, generating higher levels of cash flow that will be used to bring its debt down to a more manageable level.  There are also risks associated with WDC’s ongoing transitioning to 3D NAND, which is expected to provide increased storage capability at a lower cost per gigabyte.  With any significant change in platforms comes the risk that there will be delays, cost overruns, let alone failures.  Another area of uncertainty surrounds SNDK’s legacy licensing agreements for NAND which expires in August of 2016.  Even though this represents a small portion of WDC overall revenue, it has a meaningful impact on the bottom line.  The market is anticipating that the license will be renegotiated lower, but it is not clear how much lower that will be.

Summary

Western Digital is a 2017 story that gains meaningful traction in 2018.  The key to WDC future profitability and success is not predicated on the PC market turning around, maintaining its HDD market share or significantly growing its revenues.  Even with a flat to lower combined revenue stream in the near term, Western Digital can still improve its profitability and value as it begins to materially reduce its operating expenses.  New demand for NAND is also coming from the automotive industry, connected devices (medical, machine to machine communication, surveillance) and automated consumer products.  WDC is in a unique position where it can focus its attention and money on the high margin segments that are value added (mission critical drives, with a fast input/output interface, that utilizes specialty software) while choosing to cede the low margin, commoditized segments like PCs where cost is the only differentiating factor.  The recent and quick 35% rise in the share price may lead to profit taking and a decline, but I would see that as an opportunity.  Especially below $40/share.

Catalyst

Continued growth in the SSD market combined with the methodical integration of Western Digital & SanDisk operating segments.