| | | From JPM this morning.......
Western Digital Initiation Overweight WDC, WDC US Powerhouse in Storage and Strong Technology Leadership, But Diversification Underappreciated - Initiating Coverage at OW
We are initiating coverage of Western Digital (Ticker: WDC) with an Overweight rating and Dec 2018 price target of $120. Western Digital's market leadership in storage solutions (#1 market share leader in HDD, #2 market share leader in SSD, #2 market share leader in NAND Flash memory when combined with JV partner Toshiba) and its strong technology IP portfolio is an enabler of computing, networking and connectivity performance increases. Although underappreciated in our view, with a diversified storage portfolio (end-markets, applications and products), the company is set to drive stable revenue growth and margin profile with strong free cash flow generation. Given its scale and technology leadership, we believe the company will focus on small tuck-in acquisitions and focus more of the free cash flow on capital return. As the company delivers consistent earnings and FCF growth, we anticipate earnings upside and multiple expansion to drive the stock higher from current levels.
Investment Thesis Western Digital is a powerhouse in storage solutions with a #1 position in hard disk drives (HDD), strong #2 position in solid state drives , and solid position as the 2nd largest NAND flash memory supplier (when combined with its JV partner Toshiba). Although underappreciated in our view, with a diversified storage portfolio (endmarkets, applications and products), we believe the company is set to drive stable revenue growth and margin profile with strong free cash flow generation. Continued strong demand for capacity optimized cloud HDDs, combined with a solid technology/performance roadmap (Helium drive transitioning to MAMR technology at 16TB capacity node) should enable WDC to take advantage of the strong growth trends in this segment and continue to drive cost/bit lower (and maintain 10x cost advantage versus SSD). The company’s strong technology/cost leadership roadmap for capacity optimized (cloud) HDDs will continue keep WDC the performance/capacity/cost leader in this segment of the market, in our view. The company’s innovative MAMR (MicrowaveAssisted Magnetic Recording) HDD technology should enable the company to continue to drive improvements in areal density (# bits per unit of disk area) over the next decade (to 40TB drive capacities) and continue to drive cost per bit declines of ~ 20% per year and maintaining a ~10x lower cost/bit ratio versus NAND SSD. We believe WDC will use MAMR technology at the 16TB capacity HDD node.
Despite normalization of NAND flash memory supply/demand/pricing trends, we believe that WDC's flash GMs will remain relatively stable as their 3D NAND manufacturing leadership enables them to drive cost/bit at the upper half of their target range and offset near/mid-term price declines and disciplined capacity investment/focus on profitability by competitors. Given the team’s progress on driving solid yields on their 3D NAND 64-layer manufacturing process and making the transition to 96-layer this year, we see the team driving cost/bit reductions at the upper end of their cost/bit range or around 20- 25% versus an outlook for ~25% ASP declines over the next four quarters, and therefore feel confident about the sustainability of NAND gross margins over the next 12 months. Mix and diversification are bigger factors, in our view, in maintaining a more stable GM profile and this is underappreciated by the market. Despite the market’s focus on NAND memory pricing concerns, we believe the market is overlooking the diversity of the company's business (end-markets, product types) and mix-related impacts, which we believe is a big factor in driving margins. For example, we believe a majority of the gross margin decline this quarter (~200 bps decline) is due to a the seasonal mix shift towards lower margin products like game console HDDs (seasonal mix is up around 40% Q/Q), higher smartphone MCP mix within the NAND portfolio and a higher client (PC) SSD mix. In the 2H of the year, we believe that continued strong cloud data center spending trends will drive sustained strength in capacity optimized HDD and cloud/enterprise SSD (higher than corporate average GMs) and the higher GM profile of these products will offset the impact of NAND price/cost differentials.
We believe the market is focusing too much on supply-side trends and overlooking healthy compute (cloud, enterprise and client) demand trends, continued memory content increases in mobile devices and proliferation of storage/memory into new applications. Cloud data center spending on compute, networking, and storage infrastructure is expected to grow ~30% this year (top 7 cloud service provider (CSP) capex estimates), cloud/enterprise SSD shipments at ~15-20% growth this year, NAND content per smartphone at ~25-30% growth and client SSD attach rates up from 40% last year. We believe the PC market (which was responsible for the 2015-2016 downturn) has stabilized and expectations for total PC shipments remain flattish this year. Continued optimization of the capital structure and strong free cash flow generation sets the stage for the company to remain a technology leader and flexibility to drive more focus on capital return. Earlier this year, the WDC team significantly optimized their capital structure, bringing down gross debt, refinancing two high yield bonds (used to finance the SanDisk deal back in 2016) and authorizing a $500M share repurchase program (to reduce the impact to the stock on convertible offerings). We estimate that gross leverage dropped from about 1.9x to around 1.7x and annual interest expense has been reduced by ~$350M per year. All-in, assuming they use the remaining ~$350M in repurchase authorization, we estimate this should drive 7-8% of annualized accretion and the company will still have around $1.7B of repurchase authorization to tap into going forward.
Valuation We introduce a $120/share Dec-18 price target assuming that WDC trades at a 9x multiple (historical range ~6.0x-11.5x) on our forward F19 EPS estimate of $13.47/share |
|
