Blogger view that is probably pretty much in line with many here.
Link: seekingalpha.com
Western Digital: Out Of Favour, Looks Appealing
Aug. 14, 2018 5:45 AM ET
The Value Investor
Long/short equity, special situations, value
Summary
Western Digital sees headwinds to the business even after the successful integration of SanDisk.
The company's growth has been lagging compared to peers and the wider industry, as emerging headwinds create negative growth figures in the quarter to come.
With earnings power still being very high (at >$10 per share) and the balance sheet being very strong, I am attracted to current levels.
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Western Digital ( WDC) has seen a slump in the share price as of recent. Following the purchase of SanDisk the stock lost some of my attention (as I believed that shares were fully priced at the time), but the current slump warrants a review of the investment thesis.
In May of 2016, Western Digital closed the purchase of SanDisk in a massive $19-billion deal. Between the moment of the announcement late in 2015 and actual closure of the deal, shares fell from levels at around $80 per share to just $40 per share. Worries about slower demand and the leveraged balance sheet immediately after the deal was announced made investors rightfully cautious.
A reasonable integration process and continued growth made that shares recovered to $90 in the summer of last year, but as shares fell back to $65 at the moment of writing, it is time to revisit the thesis.
A Data LeaderThe tie-up between both firms in 2016 has created a $20-billion data juggernaut, active in client solutions, client devices, data center devices and data center solutions. Of course the promise of the company is that data is being created at an aggressive pace, far outpacing growth in what industry whatsoever, and that just a fraction of this data is stored.
New techniques and buzz words such as machine learning and artificial intelligence will only accelerate such trends and hence have the potential to benefit Western Digital, although cheap storage is key in making these technologies come to full fruition.
By far the biggest opportunity for the company remains in the more volatile flash market, as the HDD market is stable (for now). After clear progress in the integration process, as the deal closed two years ago, leverage has been reduced in a big way already, and expectations have come down.
Modest Growth...In the summer of last year, Western Digital reported the first annual results in which both firms were combined for the entire year. The company reported $19.1 billion in sales on which it reported operating earnings of $2.0 billion, while adjusted operating profits were essentially double that amount at $3.9 billion, with adjusted profits pegged at $9.19 per share.
Holding $6.4 billion in cash, net debt has been reduced to $6.8 billion in little over a year after which the deal with SanDisk closed. With adjusted EBITDA coming in around $6 billion, it was evident that leverage ratios quickly came down. GAAP earnings were minimal in 2017 on the back of integration expenses as investors were comforted by the thought that adjusted earnings would surpass $12 per share in the fiscal year of 2018.
The company grew sales to $20.6 billion this past fiscal year (as reported in July). Operating earnings came in at $2.0 billion, with GAAP earnings amounting to just $397 million, or $1.34 per share, largely lowered on the back of tax reform. Non-GAAP operating earnings rose to $5.4 billion, with adjusted earnings amounting to $4.5 billion.
That $14.73 per share number was far stronger than the guidance calling for >$12 per share in earnings power a year ago. The improved earnings power makes that the $6.2 billion net debt load remains very modest, as the company announced a new $5 billion share repurchase program.
The earnings number requires a closer look as the gap between GAAP net earnings of $675 million and adjusted earnings of $4.5 billion is very large. The biggest expense is a $1.2 billion impairment charge related to the deal which seems fair to add back. Other true one-time costs in connection to the deal include a $900-million debt extinguishment cost, a $1.1-billion tax adjustment and some other items. Charges which should not be excluded in my view is the $376 million stock-based compensation expense and perhaps a $215 million restructuring expense, as these are quite recurring and dilutive expenses in fast-moving industries. That said, these two items combined come in at just $2 per share ahead of tax, making that a $12.50-13.00 per share earnings number probably looks quite realistic.
Note that cash flow is pretty decent as well. The company reports $2.05 billion in D&A charges, of which $1.18 billion relates to amortisation. This shows that regular depreciation charges amount to $870 million. "Regular" PP&E investments totalled $809 million last year, but including investments related to Flash Ventures, capital spending totalled $1.55 billion. Net investments of $700 million amount to $2.30 per share, still allowing for >$10 per share in free cash flow power.
... Turns NegativeThe problem is more in the outlook. First-quarter sales for the fiscal year of 2019 are seen at $5.15 billion, plus or minus $50 million. Adjusted earnings are seen at $3.05 per share, plus or minus five cents. This makes that sales are seen flat at best versus a $5.2 billion revenue number reported last year, with adjusted earnings seen down from $3.56 per share reported a year before.
That is somewhat disappointment given the favourable economic environment and the secular growth story called date. That being said, I just pegged realistic earnings at $12.50-13.00 per share with roughly 80% cash flow conversion. Even if earnings fall 20%, that cash flow number should still be very compelling at $8-9 per share, for just a 7-8 times cash flow multiple, amidst a reasonably resilient balance sheet as well.
The concern among investors is that the lower guidance for the current quarter reflects the expectation that the NAND cycle is turning negative and the good times might be over. The good thing is that while the HDD market is flattish, it does provide for some diversification from the more cyclical flash market, something which could or should put a premium on the shares versus pure NAND plays.
Unlike Micron ( MU) which has reported much quicker revenue growth, is a different business (perhaps better positioned) and posts far higher operating margins, I am attracted to the relative underperforming of Western Digital versus peers in terms of the share price. The lag in the share price has been greater than the operational lower performance, reflective of the expectation that the HDD business will die out over time.
While Micron appears to have better prospects and operational performance, the share price has been reflective of that, as I am happy to gradually buy into Western Digital today through some outright purchases and sale of ATM puts.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in WDC over the next 72 hours. |
