JPM on Western Digital - Hanging Tough; Solid Outlook in Spite of Recent Chatter; Adj. Ests.
• Stock view: we continue to recommend adding positions in
WD shares. We expect the shares to begin retracing recent losses in coming weeks. The company disappointed the bears, offering inline results and a sturdy, seasonal outlook for September. There were some blemishes with respect to mix and gross margins, but these issues are more a reflection of moving through the toughest period of the year, which should render any overhang as temporary. We reiterate our Overweight rating.
• WD Delivers Inline June Results and Offers Seasonal
Outlook. On the balance, the company supported our view that
the results and outlook would not be sub-seasonal. As we
previewed, WD avoided any major disappointment with respect to revenue and earnings for the June quarter and the outlook. Barring any incremental declines in blended ASPs or margins, we contend that WD remains in a strong position to benefit from seasonal patterns and industry consolidation without the integration risks.
• Incremental Positive: WD Announces Volume Production of
New Products Utilizing Advanced Technologies. The company
surprised us with the announcement of initial volume production of 80GB/platter PMR notebook drives and 160GB/platter LMR desktop drives. Moreover, both products will utilize recording heads developed internally at WD. In our view, this development should dampen the bite of the bears that increasingly have contended WD is slipping behind the industry in moving to advanced technologies. Clearly, these roll-outs will take a few quarters, but we reiterate our belief that such technologies will not reach widespread adoption until 2007.
A Mild Concern: Voluntary Review of Stock Options Initiated.
It is important to note that WD announced it has initiated a
voluntary review of its stock options program. The company has notified the SEC and has involved independent counsel. While preliminary, WD has discovered discrepancies in measurement dates but noted that the reporting differences should not lend to a material restatement of results. While investor reaction to the broader stock options frenzy typically has been negative, we take consolation in WD being able to present full financials for June. Should the company's 10-K filing be delayed later this summer, then our view could change. While making slight adjustments, our EPS estimates for the September quarter and calendar 2007 remain unchanged. Gross margins are coming down, but there is an offset in the company’s ability to maintain flexibility in the OPEX structure. For September, our revised revenue estimate is $1.175.3 billion, versus $1.174.8 billion previously. Higher units but lower blended ASPs are the key levers behind our slight adjustment. Our gross margin assumption is 17.6%, versus 18.7% previously. The rest of our operating estimate changes are highlighted in the earnings strip of this note.
We maintain our Overweight rating on WD. At 9x our calendar
2007 EPS estimate, WD trades below the peer group average of
10.5x. Overall, we continue to believe that Western Digital's stock should outperform the HDD peer group, owing to its opportunity to add meaningful share gains onto sound operating metrics and market execution over time. The company continues to deliver results in line or above the Street consensus despite moving through the toughest period of the year. Equally important, we believe that WD's announcements regarding advanced technologies should improve investor perception of the company's longer-term competitive positioning.
Key Investment Points
WD Delivers Inline June Results and Offers Seasonal Outlook
On the balance, the company supported our view that the results and outlook would not be sub-seasonal. As we previewed, WD avoided any major disappointment with
respect to revenue and earnings for the June quarter and the outlook.
Now, there were some blemishes in terms of slightly lower margins and a stronger mix shift to lower capacity drives. The latter point did weigh on ASPs in the June
quarter, but overall, we submit that WD’s operating trends and industry commentary support our constructive stance on HDDs heading into the back half. Indeed, WD anticipates normal seasonal patterns entering the historically stronger part of the year, and while somewhat evasive on specifying the channel inventory levels, the company expressed comfort with 1) current inventory levels and 2) the prospects of ASPs
improving.
September Outlook Should Bring a Welcome Relief
In our view the September outlook should begin to place WD shares on a more upward trajectory. The company's September revenue range of $1.125 to $1.175 billion suggests 4-8% growth sequentially, which is within normal seasonal patterns.
While expected gross margins of 17.5% are lighter, the company's tight cost controls still lend to EPS (incl. stock options) range of $0.39 to $0.43. In short, the revenue
and EPS outlook is sturdy exiting the toughest period of the year, and this should offer some relief as investors had increasingly expected WD to guide lower.
We highlight the company’s June performance in Table 1. We also present our new September operating estimates. In June, unit shipments came in at 19.2 million, versus our target of 18.2 million. As expected, PVR and notebook drives delivered strength in the quarter, posting 2.2 million and 1.6 million units, respectively, and representing sequential growth of 31% and 14%. Meanwhile, by our estimates, desktop drives declined 1.8% versus the prior quarter to 15.4 million units, but much less of a decline than recent chatter had intimated.
A Mild Concern: Voluntary Review of Stock Options Initiated
It is important to note that WD announced it has initiated a voluntary review of its stock options program. The company has notified the SEC and has involved independent counsel. While preliminary, WD has discovered discrepancies in measurement dates but noted that the reporting differences should not lend to a material restatement of results. While investor reaction to the broader stock options frenzy typically has been negative, we take consolation in WD being able to present full financials for June. Should the company's 10-K filing be delayed, then our view could change. At this point, we believe that the overhang will be minimal unless the matter worsens. To point, there was little interest on the call, and it would appear that the risks of WD’s issues may not carry the heavy magnitude of the bigger offenders thus far.
Soft ASPs WD’s blended ASPs of $56 represented a $4 sequential decline. The company commented that like-for-like declines were at the high-end of normal patterns, i.e., 2-5%. We had previously warned that pricing pressures could have an impact, but that the rates would not push far from the 5% range and there would be the offset of higher than expected units. It appears that this was the case, which should be a
positive heading into the stronger back half. In addition, WD’s blended ASPs were impacted by a strong shift to lower capacity drives. At this point, it appears that the driver was more specific to WD and its low-cost model. This latter point will be worth monitoring in coming months.
Gross Margins Reflecting Summer Effects, Mix Shift WD reported gross margins of 17.6% when excluding certain one-time benefits. We had been expecting 18.2%. Clearly, the summer pricing conditions and the lower capacity mix shift played a role. WD indicated that similar gross margins of 17.5% will occur in September. At this point, we believe that the company is being cautious ahead of the oft-challenging month of August. WD did comment that industry pricing conditions historically improve in September and December, and the company did not provide any insight that would derail this view so far. Going forward, it will be important to monitor the pricing dynamics and also the level of lower capacity drives as part of the mix.
WD Announces Volume Production of Advanced Technologies
The company surprised us with the announcement of initial volume production of 80GB/platter PMR notebook drives and 160GB/platter LMR desktop drives. Moreover, both products will utilize recording heads developed internally at WD. In
our view, this development should dampen the bite of the bears that have contended WD is slipping behind the industry in moving to advanced technologies. Clearly, these roll-outs will take a few quarters, but we reiterate our belief that these new technologies will not reach widespread adoption until 2007. So, it appears that WD will not miss the party, but it will be important for the company to demonstrate that
its efforts in both products will not lend to any yield deterioration.
Earnings outlook
While making slight adjustments, our EPS estimates for the September quarter and calendar 2007 remain unchanged. Gross margins are coming down, but there is an offset in the company’s ability to maintain greater flexibility in the OPEX structure.
For September, our revised revenue estimate is $1.175.3 billion, versus $1.174.8 billion previously. Higher units but lower ASPs are the key levers behind our slight up-tick. Our gross margin assumption is 17.6%, versus 18.7% previously. The rest of our operating estimate changes are highlighted in the earnings strip of this note.
Valuation and Rating Analysis
We maintain our Overweight rating on WD. At 9x our calendar 2007 EPS estimate, WD trades below the peer group average of 10.5x. Overall, we continue to believe that Western Digital's stock should outperform the HDD peer group, owing to its opportunity to add meaningful share gains onto sound operating metrics and market execution over time. The company continues to deliver results in line or above the Street consensus despite moving through the toughest period of the year.
Equally important, we believe that WD's announcements regarding advanced technologies should improve investor perception of the company's longer-term competitive positioning.
Risks to Our Rating
Our favorable view on Western Digital and HDDs assumes that the Seagate-Maxtor combination lends to improved industry economics. Should this better environment not occur, then our thesis on Western Digital could prove to be too optimistic. We also assume that industry unit growth patterns and pricing conditions do not deteriorate heading into the stronger half of the year. Should a severe decline in the demand environment or economics manifest, then our view could be at risk to the downside. Lastly, we assume that WD’s solid market execution and product quality could lend to favorable share gains and volume-driven margin improvements over time. Should the company encounter execution or customer challenges, then our view and estimates could be at risk to the downside. |
