BS on Western Digital - Lowering Rating From Outperform To Peer Perform On Weaker Outlook And Reduced Expectations For Share Gain; Cutting Ests
LOWERING RATING. We're lowering WDC from Outperform to Peer Perform owing to a mixed June-qtr result and reduced outlook, more aggressive pricing (weaker margins/ASPs) as vendors jockey for share, higher inventory levels, and reduced prospects for share gains from STX/MXO. Suspending prior target - was $31.
MIXED 4Q06. While revs of $1.085bn were in line w/ Street, EPS upside of $0.38 (vs. our $0.37 est., Street at $0.35) came from lower opex. GM of 17.6% was also weaker despite a favorable reserve. More of concern, finished goods inventory rose 21% seq (vs. 4% seq decline in revs), while channel inventory was at the upper end of historic ranges. Pricing was also more aggressive, driving a 6% seq ASP decline.
POSITIVE PRODUCT INTROS. On a positive note, WDC announced volume production of an 80GB, 2.5" drive using perpendicular recording (PMR) and 160GB, 3.5" drive, though it would not disclose customers. As such, WDC could benefit from product line expansion.
PREFER KOMG. As to collateral impact, media supply remains tight thru early `07, which is positive for KOMG, though weak pricing and rising inventory are negative for S.
INDUSTRY CONSOLIDATION STILL LIKELY. Broadly speaking, we still think WDC is an acquisition candidate given desktop leadership, but timing is hard to call.
OPTION INVESTIGATION. WDC also noted that it launched an internal review of options granting practices -- below we detail some grants of concern.
LOWERING ESTS. Given a weaker outlook, lower gross margin/ASPs, and reduced share gain expectation, we're lowering EPS for FY07 from $2.10 to $1.90 and for FY08 from $2.35 to $2.05. We're also reducing 1Q07 EPS from $0.43 to $0.42 on revs of $1.165bn.
LIMITED VALUATION UPSIDE. While WDC is only trading at 9x CY07 EPS, it's consistent w/ peers (STX at 8x CY07 EPS, KOMG at 7x) and we don't see catalysts for P/E expansion. We view the HDD sector as highly volatile, leading to more ratings changes.
Lowering Rating From Outperform To Peer Perform On Weaker Outlook And Reduced Expectations For Share Gain. We are lowering our rating on WDC from Outperform to Peer Perform and lowering estimates for FY07 and FY08 owing to a mixed June-quarter result and reduced September-quarter outlook, evidence of more aggressive pricing (weaker gross margin and ASP trends) as desktop vendors jockey for share from STX/MXO attrition, higher inventory levels (particularly finished goods), and reduced prospects for share gains from STX/MXO. As we have noted before, we tend to view the HDD sector as highly volatile relative to other groups, leading to more changes in ratings, but as a "cyclical growth" industry with binary conditions (either improving or weakening), at this point, we see deceleration (as measured by our estimate reduction).
Mixed June-Quarter Result and Reduced Outlook. While WDC's revenues of $1.085 billion were in line with Street consensus and slightly above the midpoint of guidance (though below our more optimistic $1.11 billion estimate), EPS upside of $0.38 (versus our estimate of $0.37 and Street consensus at $0.35) came primarily from lower operating expenses owing to lower incentive compensation paid to employees. Further, gross margin of 17.6% (excluding a $13 million benefit) was also weaker than guidance of 18% and our estimate of 18.2% given strong demand for lower-capacity drives and pricing declines at the high end of seasonal expectations, despite a favorable "true-up" on warranty reserves of $5 million. Pricing was also more aggressive than expected, which drove a 6% sequential decline in ASP to under $57, down from $60 in the March quarter. While WDC indicated its view of a typical seasonal quarter in September (with continued ramp of notebooks and consumer electronics drives) and price declines within expected norms, its outlook (at the midpoint) was weaker than our estimates and Street consensus. As such, we're reducing our 1Q07 EPS estimate from $0.43 to $0.42 (vs. $0.31 a year ago) on lower revenues of $1.165 billion (up 15% year/year), which is toward the higher end of guidance for an EPS range of $0.39-$0.43 on revenues of $1.125-$1.175 billion (Street is at $0.42 in EPS on revenues of $1.173 billion).
More Aggressive Pricing Hurting Margins and ASPs. As we noted above, WDC highlighted that desktop pricing for June was toward the higher end of expected seasonal declines, falling 6% sequentially. Clearly, pricing heated up as the major desktop HDD vendors jockeyed for share fallout from STX/MXO integration, While WDC noted that it did not see any aberrant pricing in the quarter, it fell short of our expectations and could continue into the seasonally weak months of July/August, before some firming in September when demand increases on a seasonal basis. As to gross margin, while it was weaker than expected given mix and pricing, WDC still guided to a flat margin in the September quarter of 17.5% despite a volume pick-up, indicating that it may not get pricing leverage until September.
Increased Inventory Levels. More of concern, total inventories rose 15% sequentially (from $178 million to $205 million) compared to a 4% sequential decline in revenues, while finished goods inventory rose 21% sequentially to $120 million. WDC stated that it made strategic purchases of commodity components and allowed inventory to drift higher in its hubs to satisfy demand for HPQ and Dell given their July-quarter end. While WDC noted that it didn't see any inventory overhang, we remain concerned by the abnormal increase as well as channel inventories being at the upper end of the historic range of four to six weeks.
Reduced Prospects For Share Gain From STX/MXO. While WDC could not comment on the extent of its share gain and we have yet to see results from STX/MXO, WDC increased desktop units only 1% sequentially (versus 4% sequential growth in the seasonally weak March quarter), highlighting that both Hitachi and Samsung were more effective in taking share with more aggressive pricing tactics. Though we had been expecting healthy desktop share gain for WDC in both the September and December quarters along with margin uptick from volume, given a lack of meaningful unit upside for WDC in the June quarter and more aggressive tactics from competitors, it now appears less apparent how much WDC will benefit from the STX/MXO integration, leading us to take a more conservative approach with our assumptions.
Industry Consolidation Still Likely. As we wrote in our 5/18 note, "WDC: The Next Logical Acquisition Candidate in Hard Disk Drive Sector?", from a broader perspective, we still think WDC is the next logical acquisition candidate given its leadership in the desktop market and consistent profitability, but timing is hard to call. Previously, consolidation typically took place during downturns, but it was a problem because it was easy to shift share away from the combining companies. On the other hand, the STX/MXO merger was done during an up-cycle, which makes attrition less likely given supply constraints. While WDC could remain independent, it now faces an industry with larger players and broader resources: Hitachi, Fujitsu, Toshiba, Samsung and Seagate. As such, to remain competitive in the long term, WDC may need to join one of other leading vendors.
Announces Internal Investigation On Options Granting Practices. Separately, WDC announced that it is conducting a company-initiated, voluntary review of its historic stock option grants from fiscal 1998 to the present. While its Special Committee has not completed the investigation, based on preliminary determinations, WDC indicated that measurement dates for accounting purposes may have differed from recorded dates used for certain grants made from FY99 through FY03. Though WDC does not currently anticipate a material adjustment to its 4Q06 operating results, depending on the results of the Special Committee's review, an adjustment to WDC's financial statements may be required. WDC noted that it will provide a public statement once its review is final.
Upon our own analysis of WDC's historic stock grants from 1997 to 2003, we uncovered 27 distinct grants over this 8-year period, with four grants that are within 5% of 40-day trading low surrounding the grant date (i.e., within 5% of the minimum price during 20 days before and 20 days after grant date), and one grant that is within 10% of the 40-day trading low. Two of the option grants (11/5/99, 9/23/02) are at the exact 40-day trading low surrounding the grant date. Based on DEF14A filings, we have included a history of WDC's
executive stock option grants from 1997 to 2003 and highlighted the most "questionable" grants in the chart
below.
4Q06 EPS Upside On Lower Spending. WDC reported 4Q06 (June) post-options EPS of $0.38 (vs. $0.27 a year ago), which was ahead of our estimate of $0.37, Street consensus $0.35 and company guidance of $0.32-$0.36, primarily owing to lower operating expenses of $110 million (vs. guidance of $117 million), despite weaker gross margin of 17.6% versus guidance of 18%. Revenues of $1.085 billion were below our estimate of $1.11 billion but consistent with Street consensus estimate of $1.081 billion and slightly above the midpoint of WDC's guidance for $1.05-$1.10 billion. Unit shipments of 19.2 million were slightly higher than our 19.0 million estimate, offset by a lower ASP of $56.50 (below our estimate of $58.50). Further, WDC's September-quarter guidance of $0.39-$0.43 in EPS on revenues of $1.125-$1.175 billion was weaker than our model at $0.43 in EPS on revenues of $1.18 billion and Street consensus of $0.42 on revenues of $1.18 billion.
Slight unit upside on lower ASP. Total units of 19.2 million, up 22% year/year and 2% sequentially, were 0.2 million higher than our 19.0 million estimate, however ASP of below $57 was down almost $4 sequentially and year/year, below our expectation of $58.50, driven by mix and more aggressive pricing dynamics. WDC noted its expectations for pricing declines within the seasonal norm for the September quarter (i.e., less of a drop than in June).
Gross margin weaker. Gross margin of 17.6%, excluding a $13 million benefit related to the resolution of items that impacted amounts previously recorded as costs, was below our estimate of 18.2% and guidance of 18% owing to a higher-mix of lower-capacity drives and pricing declines at the higher end of seasonality. Moreover, WDC benefited from a "true-up" on its reserve for warranties, which added $5 million to gross profit. WDC noted its expectation for gross margin to be flat in the September quarter at 17.5%, as it typically does not get any pricing leverage until the month of September (after a weak July/August)
Operating expenses below guidance. Total operating expenses of $110.4 million were below guidance of $117 million and our estimate of $118.7 million, as WDC noted that it had lower incentive compensation expenses (i.e., paid out less compensation to employees in the form of bonuses as certain targets were not met).
Lowering FY07/FY08 Estimates. Given a weaker outlook, lower gross margin and ASP expectations, and reduced share gain expectation from STX/MXO, somewhat offset by lower spending and lower tax rate, we are lowering our FY07 post-option EPS estimate from $2.10 to $1.90 on revenues of $4.96 billion (up 14% year/year and below our previous estimate of $5.14 billion) and a lower gross margin of 17.9% (lowered from 19.4%). For FY08, we are also lowering our EPS estimate from $2.35 to $2.05 on revenues of $5.53 billion (up 11% year/year and below our prior assumption of $5.63 billion) and a lower gross margin assumption of 17.7% (down from our prior 19.6% estimate).
Reducing 1Q07 (Sept) Estimates. Owing to a weaker outlook, we are lowering our post-option EPS estimate from $0.43 to $0.42 on revenues of $1.165 billion (up 15% year/year and lowered from our prior estimate of $1.181 billion), which is toward the high end of WDC's expectations for EPS of $0.39-$0.43 on revenues of $1.125-$1.175 billion, a gross margin of 17.5% and operating expenses of $113 million.
Limited Valuation Upside. While WDC is only trading at a P/E multiple of 9x on our CY07 post-option EPS estimate, it is consistent with the peer group (STX trading at 8x our CY07 EPS estimate and KOMG at 7x our CY07 EPS), and we don't see catalysts for valuation expansion. |
