Article on Seeking Alpha that says what most of us already know.
Link: seekingalpha.com
Why Western Digital Trading At Under 5 Times Future Earnings Is A Gift
Sep. 6, 2018 9:29 AM ET
John Windelborn
REITs, dividend growth investing, value, arbitrage
Summary
Shares have plummeted 44% off of their 52 week high in mid-March.
I believe worries about commoditized pricing pressure are overblown, much like they were in 2015 and 2016.
Balance sheet is improving, as WDC has reduced and restructured debt.
Dividends and share buybacks present a margin of safety to a longer term investor.
Readers of past articles are familiar with my favorite characteristics for a stock to buy, which are deep-value, contrarian, dividend-paying stocks. I believe that forecasting the future is incredibly difficult, so we can succeed at a higher rate by buying companies that have a good track record and have dropped for less-than-compelling reasons.
I find the present market oddly devoid of such stocks, whereas only a few months ago there were many such value targets to be found. One outlier to this notion is Western Digital Corporation ( WDC). I believe that shares are presently a bargain and may possibly go lower in the meantime, but have a good chance to recover over the long-term.
On 9/4/18 I purchased 50 shares at $59.05 in my Roth IRA as part of my buy-and-hold long-term holdings plan. I will reinvest the dividends so long as shares appear massively undervalued.
Recent Developments
Image from finviz.com
Western Digital has plummeted ~44% from 52-week highs in mid-March, which looks downright catastrophic. This is the type of share price movement that signals major problems with the company.
The main culprit? Declining prices for NAND flash has caused panic that we are going to experience another cyclical downturn which spells doom for all companies involved in the commoditized product.
Image taken from flashbay.com
This pricing pressure will obviously affect WDC’s bottom-line, but to what extent? On the most recent earnings call, management guided for FQ1 19 EPS of $3.00 to $3.10, a ~15% decline YoY from FQ1 18 and 16% off of their most recent earnings.
Image taken from WDC investor presentation 7/26/18
I encourage readers to note that margins still remain a very healthy 38-39% overall (some people think this is a conservative estimate), and while that is not quite as high as a company like Micron ( MU) with an approximate 56% profit margin, it still beats other storage companies like Seagate ( STX) with a 29.6% margin. In fact, Micron’s storage product margin is only around 14%, which is comparing apples to apples.
As you can see from the stock price chart below of WDC and STX, it appears that we are truly in a cyclical downturn. The question remains though, how closely will this pricing pressure in 2018 and 2019 mirror that of 2015 and 2016?
Cycle History and Valuation
Image from Yahoo Finance
From the beginning of 2015, at the top of the last cycle to the bottom in the summer of 2016, WDC’s earnings per share declined from $2.26 to $0.79 (-66%) and revenue dropped from $3.9 billion to $3.49 billion (-11%). Shares went from about $113 to under $36, or -69% in that time span. Wise investors at that bottom would have nearly tripled their investment in the following two years.
Fast forward to today, where we have already experienced a 44% drop in share price on a current 9% drop in earnings (from the top of 2018), and a further future predicted drop of 15% for next quarter. In other words, investors have already bailed on the sector because they think that this pain will continue. While certainly possible, WDC trades for a ridiculous valuation. If management proves accurate in their guidance, WDC is presently changing hands for a 4.9x forwards P/E.
Uses of Cash Flow
Image taken from WDC investor presentation 7/26/18
Western Digital was quite universally chastised for their debt-heavy purchase of SanDisk a few years ago, and financial weakness is a common concern here on the Seeking Alpha comment boards. In FY 2018, WDC addressed this issue by not only reducing overall debt by 2.8 billion, but by improving their interest expense by retiring and restructuring expensive debt.
Image taken from company 10-K issued 8/24/18
Having their debt at much lower interest rates has approximately halved the amount of interest expense WDC pays per quarter, down to about $100 million. I think that this was a prudent use of cash, and will help make up for the current and future pricing weakness. Strengthening the balance sheet heading into a market downturn is smart.
WDC also announced a new $5B share repurchase program to replace the old one, and this $5B represents ~28% of the current float. As you can see below, past share repurchases have ended up being detrimental due to purchasing at far above today’s price. However, this is another tool whereby investors can sleep easier, knowing that the company will stand to benefit even if share price declines further.
Image taken from company 10-K issued 8/24/18
SummaryWestern Digital is a risky short term play, but in my eyes, a guaranteed out-performer in the long term due to its rock-bottom valuation, decent 3.3% yield, large share buyback program, and historical trends pointing to inevitable recoveries in pricing. I might have bought shares too early this week, but opportunities like these are hard to come by when the rest of the market appears overvalued.
Disclosure: I am/we are long WDC.
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