Western Digital – Key Takeaways
Some of you connected to me on LinkedIn may be familiar with a hypothetical portfolio that I am tracking from 2/21. The objective behind that hypothetical portfolio was to encourage investors to step in during the February and March time frame to start building or adding on to positions patiently and with a long term focus. Some of my friends have been ribbing me about a portfolio that has gained 35% or so when there are single stocks that move 40%+ in a week! In response, I often emphasize that this was not meant to be a get rich quick portfolio where you can expect to double or triple your money in short order. Rather, the focus was on constructing a portfolio considerate of risk-adjusted-returns, allowing you to take measured participatory risks and still increase your odds of beating the benchmark (which is the S&P 500).
One of my recent mentions was Western Digital (WDC). I suggested WDC as a possible add on 4/22 (after competitor Seagate (STX) reported earnings). My expectation was a pull-back in WDC in sympathy with STX on 4/23, which played out as I expected allowing a possible entry point in the 39$ area. The stock then surged to the mid 40’s area in the next few days along with the market. My second presumption was a possible pull back after WDC reported earnings on 4/30 mostly due to supply chain disruptions. Though the stock pulled back after earnings, what I was completely blindsided on was the suspension of the dividend. The stock pulled back 10% + the day after earnings, again allowing for a possible entry point in the $39 area. Before going into some key takeaways from the earnings, here is a synopsis of WDC and its key business segments:
Business Summary
Western Digital was founded in 1970 and operates in the data management and storage industry. In terms of the technology underpinning the storage, there is a bifurcation: rotating magnetic technology for hard disk drives (HDD’s) and semiconductor oriented flash memory (used in Solid State Drives or SSD’s). With the advent of the cloud and explosive growth in gaming, personal devices and social media data – individuals and corporates derive immense value in dense data storage. That is, more data needs to be stored and retrieved from a smaller form factor with due consideration on performance, reliability and energy efficiency. The key competitors are Seagate Technology and Toshiba in the HDD market; and Intel, Micron, Samsung and Sk Hynix in the flash market.
In terms of the reporting segments, there are 3:
1) Client Devices: Includes storage (both HDD and SDD based) for desktops, laptops, gaming consoles, security surveillance systems. The flash based devices also span smartphones, edge computing devices, wearables, Internet of Things, connected home and memory wafers/components. This segment also includes the embedded products like the multi-chip package solutions combining flash (non-volatile memory) and DRAM (volatile memory) in one package.
2) Data Center Devices and Solutions: This segment includes HDD’s and enterprise class SDD’s geared towards the fast growing data center market. Scalability of storage, performance, cost and reliability are key aspects of the solutions here.
3) Client Solutions: This segment includes HDDs and SSD’s included in removable devices (cards, USB drives and wireless drives). A lot of the increase in digital storage from a consumer perspective has a direct impact on this segment
Below are some key charts across the reporting segments and technologies.
Takeaways
Here are some key takeaways from the earnings:
- Overall Strategy: With the new CEO, what in hindsight should have been fairly apparent was a possibility of recalibration in terms of how to position the company for the future and capitalize on strengths while maintaining fiscal discipline. More specifically, given the cyclical nature of the business there seems to be absolute focus on deleveraging and cash flow.
- Net revenue of $4.2B down 1% sequentially and up 14% from the prior year period.
- The goal is to manage leverage from 1 to 3.5 times EBITDA through the business cycle with the third quarter debt to EBITDA reading closer to 5 (which btw was 5.7 earlier). Suspending the dividend gets them closer to that target ratio but management has made it clear that, as things stand, there is plenty of wiggle room to meet debt covenants. So this move should not raise any red flags there. Just for background, much of the debt on the balance sheet can be attributed to Western Digital’s $19B acquisition of SanDisk in 2015. Gross debt outstanding at the end of the third quarter was $9.8B. The goal is to get the gross debt down to $6B and net debt down to $3B.
Here are the debt tranches and Interest Rates:
- WDC management is in my opinion doing the right thing by focusing on providing visibility on a next quarter basis. These are unprecedented times and it makes sense that they are not able to provide visibility beyond the next quarter
- There is somewhat of an offsetting effect on two sides of the business. Flash and Hard Drives. Gross Margins from the flash side of the business should increase (prices trending higher but fairly volatile) while there is bound to be near term pressure in the Hard Drives side of the business. WDC would rather focus on the Enterprise SSD side of the business to channel the good demand in the data center arena.
- Public cloud is a generational technology shift and WDC wants to position itself for the enterprise hard drive market. Expect R&D spend to drive further innovation here. Similarly, on the flash side WDC wants to position to take advantage of the progress on the edge computing side and the increasing demands for more memory intensive use cases on the edge devices
- The 18TB energy assisted drive ramp is happening on ramp and there seems to be initial indication of the data center demand but this is going to really be a multi quarter story and will take time. Some indications of market share loss in the 16TB area.
- Inventory across the board seems to be at equilibrium but there may be more of a drawdown next quarter due to supply chain challenges specific to COIVD-19.
- On the technology side, WDC seems to be making good progress with the development on internal controllers and sidestepping reliance on third party vendors. There were some promising developments as highlighted in the internal product blog here: https://blog.westerndigital.com/vertical-integration-asic-platform-defines-future-products/
- In terms of the guide, Q4 revenue is expected to be in the range of $4,25B to $4.45B with non-GAAP EPS of $1 to $1.4.
Summary
- · Though we believe in prospects for WDC in the long term, the dividend suspension will now attract a different kind of investor. This may reflect in a higher beta overall on the stock and the stock maybe more susceptible to downdrafts if the overall market moves down.
- · Some of the enterprise hard drive demand story needs to be validated over the next few quarters – especially the demand side of the 18TB drive with enterprise OEM’s and hyper scale customers
- · The guide was kind of disappointing but there may be some conservatism in the numbers
- · Deleveraging is an understandable step and free cash flow discipline needs to be applauded. On the technology side, will be keen to see R&D deployed strategically to make sure that WDC keeps innovating on the areal density side
- · Watch for smartphone market improvement to see how this reflects in the flash based numbers later in the year
Our FV estimate on WDC is $54. Please contact us for the underlying FV model.
Important: This is not meant to be specific investment advice. Always check with your Financial Advisor for suitability of any investment.
One Comment
Larry
I do agree with most of what you say but what is your relative take on Western Dig versus Seagate. Which is a better buy right now? Also, I am assuming you are saying that you can potentially buy WDC at lower prices?
Cheers bud – Larry