Description

Western Digital (WDC), the world’s #2 hard disk drive (HDD) manufacturer, is too cheap to ignore. WDC is an $8.5b company that generated over $1b of earnings and $0.85b of free cash flow during the last twelve months. Mr. Market is offering WDC at the basement bargain price of $2.15b (TEV). That is 1.9x Ebit, 1.4x Ebitda, 2.3x Ebitda-Capex, 2.1x Net income, and 2.5x free cash flow. Given the current economic environment, it is important to note that WDC has a solid balance sheet with $0.7b of net cash (over $3/share).

It would be disingenuous to assume that WDC will deliver similar or better results over the next twelve months. The obvious consequence being that valuation multiples on current numbers might not be altogether relevant. For the reasons outlined below, it seems to me that even under conservative assumptions WDC is a bargain.

Management has shaped a business model that generates 8 to 14% operating profit margins. Assuming that over the next twelve months sales contract by 20% and margins end at 8%, WDC would generate over $0.5b of Ebit. This is approximately half of what it generated in the last twelve months. Thus, the current multiple is 4x trough operating income.

Solid state drives (SSD) are probably the biggest long term threat to the HDD business. While the current economic downturn will affect the business, SSDs are poised to capture an ever increasing share of the hard drive market in the long run. SSDs are more sturdy, use less power, and run faster; the only thing wrong with them is that they are more expensive. It is my observation that SSDs currently are approximately 10x more expensive than HDDs. The question is how long will it take for SSDs to reach the inflexion point in their penetration of the hard drive market. It seems to me that we are at least five years away. Let’s conservatively assume that SSDs follow Moore’s Law (i.e. their cost decreases by 50% every 18 months). Also, let’s handicap the rate at which HDD double areal density to every five years. In other words, to be conservative, I am giving SSDs the benefit of the doubt while handicapping HDDs. Under this scenario, five years from now the cost of a SSD would still be over 2x the cost of a HDD.

For the foreseeable future SSDs will remain in a niche. For example, Intel and Hitachi GST have partnered to develop enterprise grade SSDs. “The new generation of solid-state drive technology complements existing enterprise-class hard disk drives (HDDs) and is intended for use in storage applications that require extremely high Input/Output Operations Per Second (IOPS) performance and power efficiency.” Further, they expect their first products to be available for OEM qualification during the first quarter of 2010. Generally speaking, the sales argument is lower total cost of ownership (e.g. lower requirements in terms of cooling, rack space, etc.) The upfront cost, however, is much larger. With corporations and others looking to preserve cash, it is likely that SSDs will remain a luxury.

Demand for digital storage continues to grow at a rapid pace; and if anything it is accelerating due to the proliferation of digital content, particularly media-rich content. It is well known that “user” generated content is growing exponentially. Thus, the need for ever increasing capacity of hard drives in personal computers and elsewhere continues unabated.

The HDD industry is cyclical. It has always been. And despite the secular growth trends, it has claimed the lives of many of its participants along the years. It has, however, consolidated to a significant extent. Currently the two largest players, Seagate (STX) and WDC, account for almost 60% of the market.

WDC has done a tremendous job growing and solidifying its position as the #2 player in the $35b global HDD market. It has grown at close to 20% per annum during the last five years. With the great majority of this growth being organic; as WDC dramatically expanded its product line. In addition, it has become as profitable as STX, the industry leader. Similar to Seagate, WDC is vertically integrated. As a result, it has become a little more capital intensive (Capex ~7-8% of revenues, to sustain 10-15% revenue growth). However, its business model still delivers ROIC in excess of 50%.

With this background, it seems likely that not only will WDC be able to weather the downturn but also see another year in which it will generate $1b of earnings once the economy recovers. It is difficult for me to gauge how deep the trough will be. Given the secular trends and the industry structure, a 20% revenue contraction seems reasonable. With fast growing demand in emerging markets and with the multiple stimulus programs around the globe, there seem to be a high probability that HDD demand will resume its growth as soon as one year from now.

It is important to consider a potentially significant difference between the current downturn and the previous one (2001-2002). The previous one resulted from the dotcom crash; in addition to the build up to Y2K. The prevailing mentality prior to the downturn was that the “new economy” was taking over. Implying that demand for hardware would continue to grow uninterruptedly at a rapid pace. It was the end of the business cycle. As we know, the outcome was very different. A large number of new technology/internet enterprises who were spending heavily on hardware went out of businesses, and those that managed to stay in business meaningfully curtailed their hardware expenditures. In that environment, hardware makers were caught with significant manufacturing overcapacity and huge inventories. On top of that, many of them had borrowed heavily to expand their businesses.

The current downturn is of a different nature. First, it has been clear for a while that it would happen; although the timing and the magnitude have been and remain uncertain. With this background, many companies have not only curtailed expansion plans but also developed contingency programs.  On top of that, corporate balance sheets are in much better shape; especially in the technology sector. Second, more specifically to the HDD industry, the end markets are a lot more diversified both geographically and from a product perspective. Previously desktop and enterprise accounted for practically the entire market.  In the case of WDC, in FY08, 56% of revenue came from non-desktop sources. In terms of geographical diversification for WDC, US customers’ accounted for 24% revenues in FY08, compared to 41% in FY03 (and close to 50% in FY02). Similarly, the company has a more balanced customer base with OEM/ODMs, distributors, and retailers accounting for 51%, 31%, and 18% of revenues respectively.

For this investment to be successful, WDC has to remain cash flow positive throughout the downturn and participate in the recovery. While the previous cycle was disastrous for WDC and others in the industry, most factors point to a more benign episode this time. First, the nature of the downturn is different. Second, the industry structure is much more favorable. It seems to me that Seagate, the market leader, has to be especially cautious given the meaningful amount of debt on its balance sheet. And third, WDC has a structurally more profitable business model and is more diversified. Further, WDC is led by an industry veteran who has been with the company since 1983.

More specifically, I assume a 20% decrease in revenues for FY09. This implies a draconian 31% decrease in revenues for the last three quarters of FY09; as revenues grew 19% during the first quarter of FY09. Further, to be conservative, I am assuming that the company spends the whole $750 million of Capex that it had budgeted before the downturn:

Note: Ebitda-Capex seems to be a good proxy for free cash flow; defined as cash from operations less capital expenditures.

Finally, there are a couple of issues regarding compensation and insider ownership. In my opinion, management/board compensation seems high. To provide context, I am always hoping to find executive compensation similar to that of Berkshire Hathaway or Costco, both of which seem to be the exception. Also, insider ownership is minimal. Insiders seem to routinely sell their shares; although the selling seems to have recently abated. The previous CEO and current board member sold most of his shares (during ’06, ’07, and ’08).

In summary, I believe that at the current price WDC is a bargain. It is a strong #2 in a growing industry that has consolidated. It has a business model that generates substantial free cash flow. And it has a rock-solid balance sheet. While the risk of technological substitution is a real long term threat, it is hard to see how it could prevent WDC from generating substantial earnings as the economy recovers a few quarters down the road.

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