July 27 2020 - Western Digital: Don't Miss Out On Incredible Value
Shares of Western Digital have shed more than 30% this year on the expectation of lower demand for raw memory.
To the contrary, however, Western Digital is expecting flash prices to continue trending upward.
Read-through from Micron's most recent quarterly results through May confirm this trend.
Western Digital is trading at an unheard-of forward P/E of 7.3x, below historical averages in the low teens.
Though Western Digital has currently suspended its dividend, it previously paid out .50 per quarter - translating to just under 5% yield at current prices.
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It's getting tough to find value in the tech sector. Virtually every software and internets stock has seen tremendous year-to-date gains, and the only places where true value is remaining is in some of the older pockets of the market, like Western Digital (WDC). The maker of memory and hard drives has seen troubled times this year, as investors bet that the coronavirus would sap demand for Western Digital components and push it into a down-cycle in a famously cyclical industry.
Yet we note that while the memory stocks like Micron (MU) have nearly recouped all of its year-to-date losses (Micron is now down about 10%, faring much better than many financial and energy stocks in the Dow) - Western Digital has remained stubbornly low, off more than 35% year-to-date. This is in spite of the fact that the company has continue to turn out strong performance, and is even hinting at flash prices improving throughout the year.
Data by YChartsWestern Digital is hardly the most exciting stock to invest in. Among chipmakers, it's far more exciting to invest in names like NVIDIA (NVDA) that has seen its fortunes rise and fall with the increasing popularity of both video games and bitcoin mining, and has seen its share price nearly double this year (taking NVIDIA to a forward P/E ratio above 70x).
Western Digital, meanwhile - slower moving, but representing much better value - is a far more defensive play for investors concerned about a second wave of the market downturn. Western Digital has already lopped off nearly half of its value - and when we consider the strength in its fundamentals, I truly don't believe there's any lower for this stock to go.
Stay long here and scope out a buying opportunity.
Fundamentals faring much better than feared; Q4 is looking bright
The key message in Western Digital's near-term results is that it could have been a lot worse. In fact, when we look at the headline metrics for its fiscal third-quarter (covering the period ending in the first week of April), we don't see any red flags at all. See below:
Figure 1. Western Digital Q3 summarySource: Western Digital Q3 earnings deck
Western Digital's revenue actually increased 14% y/y to .18 billion, while the company also substantially improved gross margins by 260bps and dramatically boosted its cash flow.
When we look at the underlying business trends, we note that Western Digital's huge boost in flash revenues (now comprising about half of Western Digital's total revenue) was able to offset the expected decline in hard drive unit shipments.
Figure 2. Western Digital performance by segment
Source: Western Digital Q3 earnings deck
But even among the shipments decline in hard drives, both flash and HDD saw ASP growth in the quarter.
Of course, by now the March quarter is old news. Investors are looking ahead to fiscal Q4, which will contain three full months of coronavirus impact. But again here, there are several reasons for comfort.
The first is by Western Digital's own admission. Speaking at an analyst conference hosted by Wells Fargo in June, CEO David Goeckeler noted as follows (transcript by Seeking Alpha):
I mean, that’s really again, long term demand is strong, what we talked about. I mean obviously we are staying very close to it on a quarter-by-quarter basis. We saw flash pricing increase in calendar Q1. We anticipate pricing increases in calendar Q2, we are currently kind of in negotiations for calendar Q3. We’ll have more to say about that at the end of the quarter.
There’s a lot of long term growth opportunities out there. I think the industry forecasting 30% bit growth for the next four to five years is on target. I mean obviously as we talked about the conversation, we're going to stay close to our customers and understand demand as the mid-term to make sure we make the appropriate investments in capitals and get supply demand and balance. We think the industry has done a good job of staying on top of that and we don't expect it to change."
The key message here: flash is Western Digital's hero product, and management is currently expecting pricing to continuously strengthen. Prior memory cycles, meanwhile, have been marked by a rapid race to the bottom in pricing among the memory manufacturers and a corresponding drop in gross margins - neither of which seems to be happening for Western Digital.
The second reason for confidence is positive read-through from other memory companies. Micron's fiscal quarterly reporting doesn't line up with Western Digital's, and Micron's fiscal third quarter results cover the period through the end of May (two months out of Western Digital's Q4.) Here we saw several positive trends:
- Flash ASPs up in the high single digits, DRAM ASPS up in the mid-single digits; shipment growth in terms of bit units for both lines of business
- Gross margins improving sequentially from FQ2
- Healthy end-market demand, particularly in enterprise data centers (an area that Western Digital also serves).
Similarly, SK Hynix - a South Korean competitor to both Micron and Western Digital - also recently released stronger-than-expected fiscal Q2 results, driven again by healthy pricing.
Given both positive internal commentary from Western Digital management plus positive reassurance from other industry players, we think there's plenty of tailwinds heading into earnings season for Western Digital. Healthy pricing trends and margin improvements signal that this is hardly a down cycle for Western Digital as many investors had feared heading into the pandemic.
Balance sheet snapshot
It would be remiss and incomplete, however, not to mention one of the bearish drivers weighing on sentiment for Western Digital, and that's its huge debt position.
As of the end of the fiscal third quarter, Western Digital had a staggering .77 billion in total debt, which represents a highly leveraged 5.0x Debt/EBITDA ratio (most banks consider ~3x leverage to be a risky, highly leveraged client)
Figure 3. Western Digital debtSource: Western Digital Q3 earnings deck
Again here, however, there are counterweights that make us less concerned.
- Western Digital has .94 billion in cash, so its net debt is actually .83 billion, or 3.5x EBITDA
- At least through FQ3, Western Digital has retained positive cash flows
- The majority of its debt bears relatively low interest costs as seen in the table above, thanks to floating rates on a historically low LIBOR index
We note that Western Digital has also suspended its .50/quarter dividend in the near term to focus on debt repayment. While that's not exciting news for investors, we like the fact that Western Digital in the past has paid out /year in dividends and if it were to resume that rate of dividends (fully supported, by the way, even by this year's trough EPS expectations of .03), at current prices Western Digital would yield just under 5%.
Key takeaways
Next year, Wall Street analysts are expecting consensus pro forma EPS of .84 for this company, which represents a 20% lift from FY19 EPS of .84 (and more than double what consensus is expecting for a challenging FY20). This puts Western Digital's forward P/E at 7.3x. Historically, meanwhile, Western Digital has traded closer to multiples in the mid-teens - it hovered in the range for most of last year, for example, representing a ~13x multiple on eventual FY19 EPS of .84.
Data by YChartsI think a ~7x P/E multiple should be reserved for companies with only bad news to report - but with Western Digital's commentary on strong flash pricing and positive read-through from other memory companies, the reality is anything but frightening.
Take advantage of this price dislocation to get a really good deal on this stock.