Description

Company Overview:

Western Digital (WDC) was founded in 1970.  The company's primary area of expertise is in the design, development, manufacture and sale of hard disk drives (HDD).  HDD is a digital data storage device and used principally in desktop computers (PC's and Macs), notebook computers, workstations, servers, and enterprise storage products.  Recently, with its purchase of Silicon Systems, Western Digital entered into the solid state drive (SSD) segment of the storage market.

Industry:

Since its inception, the HDD market has been extraordinarily competitive and commoditized; competing products use the same components and technology to store data.  Over time, HDD manufacturers have consolidated from 300 to 50 in the 1990's, to just 5 as of today, and possibly 3 going forward (I will touch on this in a bit).  Western Digital and its competitor Seagate and each currently control approximately 30% of the roughly $30 billion a year hard drive market, followed by Hitachi with 18%, Samsung with 12%, and Toshiba with 10%.

There are four types of storage platforms in use today:  Tape, Optical, Hard Disk Drive, and Solid State Drive.  Magnetic tape is used for linear storage and is still utilized by companies with large and constant backup needs, such as Google (In February 2011, Google lost the contact, chat and email data for over 150,000 users and used its tape backup to replace all the missing data).  Optical storage uses a laser to store and retrieve data on a CD or DVD format.  An Optical drive is more durable than tape drives but is slower and offers smaller storage capacities than HDD.  Hard Disk Drive is the storage industry standard, not only for desktop and notebooks but for workstations, servers and enterprise storage products.  The storage process has been refined over the years, but its foundation remains the same.  A magnetic disk (platter) rotates at speeds from 10,000 - 15,000 rpm while an actuator arm with read-and-write heads hovers above the platter.  Over time, input/output speeds, storage space, reliability and durability of HDD have all increased.  Magnetic tape, optical and HDD all share two attributes:  Their technology was developed in the 1950's (magnetic tape - 1951, hard disk drive - 1956, and optical - 1958) and the cost per gigabyte for all three technologies has bottomed out at approximately $.10/gigabyte (The cost rises to between $.15 - $.20/gigabyte for non-enterprise internal HDD above 2 terabytes).

Solid State Drives, whose technology is 33 years old, is the new kid on the block.  SSD is a semiconductor with no moving parts.  It is non-volatile digital storage, which means that the data remains on the semiconductor even when the power to the chip is removed.  SSD is superior to HDD in many ways:  SSD has faster input/output rates, it is lighter, requires half the power to operate, ismore reliable and durable (a SSD can be dropped and continue to work properly), and does not need to "boot-up" (as soon as power is applied to a SSD it is ready for action).  These attributes make SSD a more suitable form of storage and is coveted for mobile devices, such as:  media players, mobile computers (tablets), phones, cameras, etc.  The only current drawback to solid state drives is the cost.  SSD begin at approximately $1.00/gigabyte and range up to $3.00/gigabyte and above, depending on the size of the storage.  The cost of solid state drives has remained high due to the limited demand for the product, but with the arrival of smart phones, tablet computers, and a growing array of mobile devices, SSD is having a renaissance.  The rise in demand will ultimately lower the current cost/gigabyte of SSD, but do not expect the convergence between SSD and HDD to happen overnight.  Even with solid state drives current 91% year-over-year growth and expected $4.4 billion revenue in 2011 (isuppli numbers), SSD still represents only 14% of the HDD expected revenue of $31 billion in 2011.

However, there is genuine evidence suggesting that tablet computers, like the iPad, are cannibalizing sales from what traditionally would have been sales in notebook and desktop computers.  In 2010, nearly 20 million tablet computers were sold.  Seventy-five percent of those sales (14.8 million) came from iPads which debuted in April, 2010.  If one assumes that every tablet sale was originally meant for a notebook or desktop computer, then 20 million or 3% fewer HDD were sold in 2010.  Moreover, the advent of cloud computing is radically decreasing the need for in home storage to backup personal data.  Pictures, documents, and songs can all be transferred to the cloud for access and safe keeping.  This anecdotal evidence may lead some to believe that the trend toward cloud computing will also disrupt and replace HDD.  In fact, the trend towards cloud computing, social networking, and services like video on demand is actually helping sustain the HDD (enterprise) market.  Every time a member of Facebook (and by the latest accounts there are over 700 million members) uploads a picture or video to an account, this information is copied over approximately four times to different server banks, ensuring that data is never lost or disrupted because of latency issues.  These same practices hold true for cloud services such as Dropbox, Amazon, Google, and the soon to be debuted, iCloud.  Now, consider video sites like Youtube (which boasts over 48 hours of video uploaded every minute), Hulu, and other video on demand services and you can begin to understand the increasing demand for data servers and, in turn, the need for cheap and dependable storage.

Management:

Western Digital's management has proven itself to be very thoughtful, proactive and patient stewards of the company's assets, and the company's history speaks to their capabilities.  Over the past ten years, Western Digital began the process of becoming the low cost manufacturer by vertically integrating its manufacturing process.  It began with its purchase of read-and-write head manufacture, Read-Rite in 2003, followed by the acquisition of media supplier, Komag, in 2007, and magnetic manufacture, Hoya Magnetics, in 2010.  After each acquisition, a great deal of attention was placed on optimizing plant production, which included consolidation or sale of overlapping manufacturing facilities.  Operational leverage (low cost production) has always been the key operational underpinning to Western Digital's success.

In March of 2011, Western Digital announced its largest acquisition to date, a $4.3 billion purchase of Hitachi's disk drive manufacturing unit.  At first blush, the deal may appear to be further consolidation of the HDD market.  However, taking Western Digitals 30% HDD market share and adding Hitachi's 18% market share will not produce a combined 48% market share.  Because OEMs and distributors have multiple relationships with HDD manufactures, Western Digital may actually see reduced demand from existing customers as they continue to spread out their business, so as not be dependant on a single manufacturer.

When one examines the deal more closely, it is clear that the deal is actually less about market share and more about solving three pressing issues facing the company: 1) Western Digital has significant market share in all segments of the HDD distribution except for one, the enterprise space.  As cloud computing continues to expand at a healthy rate, demand for enterprise HDD will grow in concert.  Adding Hitachi's approximate 28% market share in the enterprise space to Western Digital's less than 2%, will translate into stronger margins and profits for the HDD manufacturer.  2) The Hitachi purchase provides Western Digital with a profitable enterprise SSD manufacturing unit, moving it significantly up the production curve.  This acquisition proactively creates a foothold in the next phase of digital storage that will almost certainly replace hard disk drives as the industry standard.  3) Western Digital's purchase also eliminates the issue the company was facing with its large cash balances.  Before the announcement, Western Digital had $3.2 billion dollars in cash and short-term investments which represented 45% of its market capitalization.  Even though Western Digital is a US domiciled company, its cash was held outside the US.  Repatriating the money would lead to excessive taxes.  Management was continuously pressured by analysts and shareholders to put the money to work either through share repurchases or initiating a dividend.  Obviously, management had a more permanent plan for the cash and never acquiesced to the pressures for short-term action.

Shortly after Western Digital announced its plans to acquire Hitachi's disk drive unit, Seagate announced a $1.38 billion strategic alliance with Samsung.  In the deal, Samsung will merge its HDD operations with Seagate's, and Seagate will supply disk drives to Samsung for PC's, notebooks, and consumer electronics products.  In addition, Samsung will furnish Seagate with its semiconductor products to be used in Seagate's enterprise SSD.  The cost of the deal will be paid 50% in cash and 50% in Seagate stock, giving Samsung a 12% ownership in the company.  If both of these mergers go through, the HDD industry will consolidate once again into essentially a duopoly.

Valuation:

Western Digital's future profitability is going to come not only from increased revenue and margins (gaining traction in the enterprise space in both HDD and the fast growing SSD), but also from scaling, consolidating, and the sale of overlapping operations, which will lead to increased operational efficiencies.  Western Digital estimates that operating savings from the acquisition will offset all restructuring costs in the first six months after the merger.  Future cost savings will be applied to R&D and increasing profitability.

Western Digital's stock price, before the merger announcement, was trading at depressed levels, mostly because of the uncertainty surrounding the company's lack of exposure to SSD segment and its large cache of cash.  Today, even with its stock price 22% higher ($36.50) from the time the deal for Hitachi was announced, Western Digital remains cheap especially if one considers the potential revenue and margin expansion from its soon to be acquired solid state drive segment.

FCF Margin:

Given all the restructuring charges that WDC will face over the next year, the P/E and net profit margin can become misleading.  A more accurate method to value the company would be to use a DCF valuation.  The combined revenues of WDC and HIT should equal approximately $16 billion presupposing that there is no growth.  Taking into consideration that there will be customer overlap, 2012 revenue was reduced by 10% to an overly conservative $14.4 billion.  Over the past five years, WDC median FCF margin was 9.7%.  Employing a conservative 8.5% FCF margin produces a FCF starting point of $1.224 billion.  Using a DCF model with a modest 6% growth rate, the intrinsic value for the stock is calculated to be $63 - $66/share.

Another method to access Western Digital's intrinsic valuation would be to use the EV/EBITDA ratio.  Based on past performance of both Western Digital and Hitachi, the combined entity can conservatively generate $2.3 billion of EBITDA.  Using a historic median of 6x EV/EBITDA multiple, creates a stock price of approximately $64/share, the mid-point from our DCF valuation and a 75% premium to today's share price.

Assuming that both mergers go through, the HDD market will essentially become a duopoly, and given that Western Digital will meaningfully enter into the more profitable enterprise markets for both HDD and SSD, one should expect to see above average growth in revenues, margins and profitability.

Key Takeaways

-        WDC is the low cost and only vertically integrated HDD manufacturer

-        Further consolidation of the HDD market essentially creates a duopoly

-        Acquisition of HIT solves three issues facing Western Digital:

1.     Significant expansion into the HDD enterprise segment

2.     Creating a foothold in the SSD enterprise segment which addresses the disruptive technology impacting HDD storage

3.     Allows the company to smartly deploy its $3.2 billion of cash resting outside the US

-        Margin growth and Profitability will come both from expansion into the higher margin enterprise segments as well as through operational leverage & efficiencies

Catalyst