Description

Western Digital Corporation (Nasdaq: WDC)

WDC is a large, liquid, and cheap stock with proven staying power. WDC has been written up several times on VIC before, most recently in an excellent post last year by Jim211, who made an exit recommendation earlier this summer. Certainly an exit today seems reasonable, as WDC’s core markets and technology are coming under increasing pressure, with many predicting that the bull run for WDC is over.

For starters, consider that WDC has more than doubled since the write-up, even as WDC’s core business involves selling hard disk drives (“HDD”) to a collapsing PC market, which is expected to shrink at double digit rates in 2013. As has been discussed in prior write-ups, and obviously elsewhere in the business press, the steep decline of the PC market has been driven by the advent of smartphones and tablets, as well as cloud computing. As Jim Chanos has said, the hard drive industry is the “PC with a year lag.” Why would you want to be long against this dynamic?

Additionally, many also argue that, as occurred with tape technology before it, WDC’s core HDD technology is being overtaken by flash, or solid state drive (“SSD”), technology which will ultimately replace HDDs. Again, it’s hard to be long HDDs if the secular winds favor SSDs.

While the elements of the bear case offer a compelling narrative, we think there is more to the story, and we believe that at a 20.6% EBIT/EV yield, the stock is still cheap today, especially when we consider WDC’s overall quality and financial strength. In addition, we believe that a high degree of focus on HDD storage technology and its application within the PC market, is a very narrow perspective to bring to WDC, where there are more dimensions of the story that should be considered.

The markets for WDC’s products can be divided into three broad components: 1) the client market (mobile and desktop PCs), 2) the enterprise market (datacenters/cloud performance and capacity storage), and 3) non-computing markets, consisting of a) branded products, and b) consumer electronics. We’ll discuss each of these in turn.

Client market.  Again, the client market, consisting of desktop and notebook/mobile PCs, is the aspect of WDC that most bearish investors focus on. What the bears overlook is that while the PC is still a significant part of today’s revenue picture, that is changing fast as WDC aggressively diversifies away from PCs. As recently as 2005, 80% of the company’s revenues were PC-related. By 2008, that share had shrunk to approximately 65%, and in fiscal 2013 it was approximately half. So while PC-related revenues are being pressured, the effect of this headwind is diminishing as shrinking client market revenues are replaced by growing revenues from enterprise, cloud, branded and other solutions.

Enterprise & Cloud Storage market. Enterprise storage relates largely to datacenters providing storage for cloud and corporate applications. Underlying this market is the huge secular trend of growth in digital data.  Growth is coming from a variety of sources including user demand for multiple copies associated with photos, videos, music, social media, “long tail” content that is available after mainstream delivery (like reruns of an old movies and TV), Big Data processing, such as Kayak’s 200 billion flight reservations, gaming, mapping of the human genome, high frequency trading requirements, and the list goes on. You can review prior VIC posts and find various estimates of Exabyte growth; WDC in investor presentations has suggested an overall storage CAGR from 2013 through 2020 of 34%. We believe that demand for new storage may more than offset the decline in the PC that is hurting WDCs client business. One reason why this may come to pass is that the company is moving successfully into the enterprise and cloud storage markets.

In order to think about how WDC is competing in storage, we have divided storage into two basic categories – performance and capacity.

Performance. Performance storage relates to demanding, high-performance, mission-critical applications where you make use of data analytics, or transactional data, such as in databases, gaming, or high frequency trading.  Flash drive or SSD is largely about this type of performance – speedy, reliable transactions. In mobile applications, SSDs also offer increased reliability and battery life. WDC is making investments in SSD, including acquisitions of SSD firms sTec, and VeloBit. IDC forecasts enterprise SSD shipments shipments to grow at a 37% CAGR through 2017. So while SSD has not been WDC’s core business, the company is investing in the space.

Capacity.  Capacity storage relates to less performance intensive, often replication-based datacenter storage, cloud, content delivery, and archiving demands. HDDs are better suited for these longer term archiving demands. The reason why HDDs are remain the primary solution for these types of storage applications, and why HDDs are not going away any time soon, can be boiled down to a simple fact: they are cheap. And not only are they cheap, but HDD’s have maintained their cost advantage versus SDDs.  While SDDs are moving down the cost curve, HDDs are moving down at a parallel rate.

Another reason why HDDs are not going away any time soon is that intensive innovation is still taking place in the HDD space. Consider helium gas technology which reportedly reduces server power consumption by 20%, while lowering platter friction, thus increasing capacity by up to 50%. Plus, these HDDs last longer. Helium-based technology could be fundamental to near term cloud based storage solutions in data centers, which have cost structures driven by power use and floor space. In a recent investor presentation WDC estimated that >75% of Exabytes in 2020 will be stored on HDDs. Additionally, WDC has a large patent portfolio, consisting of more than 6,000 patents, which may enable WDC to maintain its edge in HDD technology.

In sum, while SSDs, and the high performance markets they serve, are a growing percentage of the overall enterprise/cloud market, the overall pie may be growing so fast that HDDs cost advantage may enable the technology to continue to grow reasonably quickly in absolute terms.

Branded Products/Consumer Electronics market.  The non-computing markets are made up of branded products, such as external storage units, and media players, and consumer electronics, such as DVRs, game consoles, and video recorders. While these markets make up a smaller portion of WDC revenues, individual segments are showing strong year-over-year growth. Notably, these markets offer growth for HDDs, which are used in external storage devices, consumer electronic storage, and ultra-thin notebooks.

Another industry feature that is providing a tailwind for WDC is a duopolistic/oligopolistic market structure that currently exists due to significant recent industry consolidation. Last year, WDC completed its acquisition of Hitachi GST, one of the few independent competitors in the enterprise HDD market, which involves data center (cloud) storage. Today the market is arguably a two-player industry, with WDC and rival Seagate controlling approximately 85% of the market (and a third player, Toshiba, relegated to afterthought status). WDC enjoys several advantages that accrue to oligopolies.

WDC’s market share, and size, result in economies of scale and other cost advantages in the HDD business. There are numerous barriers to entry for any would-be competitor: the industry is capital intensive, and technologically complex, requiring detailed knowledge of the design of precision mechanisms, and a technically challenging manufacturing processes. Under an oligopoly firms are not perfectly competitive, and enjoy price stickiness, as members of the oligopoly are able to coordinate pricing to a degree, which can discourage competitors. Oligopolistic firms, being heavily interdependent, can operate as a group, and discourage competitors in other ways as well; for instance, WDC and STX effectively control the channels for the supply of important components. Industry consolidation has unquestionably boosted HDD industry revenues, margins, and profitability through scale, duopolistic pricing and the general new competitor strong arming it allows by legacy competitors.

WDC management has also demonstrated over a long time frame that they are exceptionally good allocators of capital, and disciplined operators. The company has generated a normalized (trailing 8 yr) ROA of 14.1%, and a normalized (trailing 8 yr) ROC of 21.6%. Very few companies can boast this kind of consistency. Management has also stated their intention to return 50% of FCF to shareholders, which is highly shareholder friendly.

WDC is currently generating a solid 14.0% return on assets, and FCF / assets is also strong at 17.1%. WDC’s cash flow exceeded its net income, indicating that the company is not currently using accruals, the use of which we believe can sometimes indicate a willingness to play accounting games. Additionally, WDC has grown its margins, from 18.6% in 2007, to 29.2% in 2013, a geometric growth rate of 6.6%. This margin strength may be due in part to the industry consolidation discussed previously.

Management have also been good recent financial managers. WDC has also reduced leverage in the past year. The company’s current ratio also increased by 12.9%, signaling increased liquidity. WDC was also a net repurchaser of shares, which we applaud.

These are the fundamental signs of a stable and financially strong company, run by intelligent managers. The company is also showing multiple signs of operating momentum.

The company’s return on assets increased by 6.9% versus a year ago, which is another positive. Return of FCF on assets also increased versus a year ago, by 4.4%. WDC was also able to increase its gross margins YoY this past year, even as the sale of PC-related HDDs fell precipitously. Finally, WDC’s asset turnover ratio increased versus the prior year, indicating a more efficient use of the company’s assets.  

WDC is profitable, with strong returns on assets and capital, and is generating positive free cash flow.  The company is also stable, with shrinking leverage, enhanced liquidity, and it is buying back stock. The company also shows strong operating momentum, with increasing returns on assets, and FCF return on assets.  Margins are also improving, as is asset turnover. We think these factors indicate its financial strength. Finally, returning to arguably the most important variable – value – the company is undoubtedly cheap, with an EBIT yield of EV of 20.6%. 

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