Western Digital (NASDAQ:WDC)

Western Digital (NASDAQ:WDC)

Do you ever get the feeling you’re late to the party? Western Digital stock traded at just over $30 in 2011, and now trades at $86. In the last year alone it is up 100%. So you may wonder why I’m writing about it now. Well on the surface it still appears a somewhat attractive investment in a business trading at an adjusted Free Cash Flow yield of 9% with a historical 18% compound annual growth rate in revenues.

The business

If any of you have ever bought an external hard drive, you may be familiar with Western Digital, I myself have a 500GB hard drive in a drawer somewhere wielding the WD logo. The company also manufactures hard drives for Original Equipment Manufacturers (OEMs) in the PC business and private businesses who need to store data either for themselves, or as a cloud provider. WDC hard drives are also part of the Xbox One and PS4 consoles.

WDC manufacture HDD’s which are hard drives that use a spinning disc. An alternative exists, known as a Solid State Drive (SSD) which are used in mobile devices and tablets due to them being faster, smaller, less prone to faults and less battery intensive. SSD’s are also making their way into the PC business although not as well, because all these great features come at an increased price, roughly 10x the cost per GB of a HDD.

The industry

Sales of HDDs to the PC market are falling in double digit percentages and have been for a few years, due to the rise of tablets and smartphones, people are not buying as many PC’s. In 2012 there was a big consolidation in the HDD industry, both WDC and Seagate (NASDAQ:STX) bought out competitors to become virtually the only two remaining manufacturers of HDDs in the world.

There were floods in Thailand (where HDD components are manufactured) around the time, that led to a global shortage of HDDs which increased prices dramatically. Due to the hold the two main competitors have over the industry they have been able to keep prices from returning to normal levels. WDC gross margins as a result have increased from ~18% pre 2007 to 26% in 2013.

The cloud industry on the other hand is growing rapidly, and due to the large cost differential between HDD and SSD, it has favoured HDD to fuel expansion of storage capacity. Researchers are almost universally bullish on this trend continuing, people’s need for data storage is forever increasing as new technology demands ever more GB and TB to store data.

WDC Financials

WDC has strong free cash flows, which have exceeded reported net profit by 20% over the last 10 years. Below is a tearsheet of the summary financials. I have picked out the information I see as important.

Tearsheet

  • Excluding exceptionals the cash adjusted P/E ratio is 12
  • Excluding exceptionals, the Return on Invested Capital in TTM is 25%
  • Strong balance sheet with Net cash of $2.3bn
  • Large share buybacks in 2011/2012 when the share price was weak
  • Free cash flow / net profit over 10 years is 122% but around half of cash flows have been spent on acquisitions – i.e. not all growth has been organic
  • One negative is the share count has been increasing, suggests generous executive share options scheme

Despite these attractive financials however, there is a more negative underlying story. In 2012 WDC completed the acquisition of Hitachi, and this boosted revenues. If we exclude this from top line figures then the underlying performance of the business over the last 4 years suddenly looks poor.

2010 2011 2012 2013
9,850 9,526 9,378 9,097

Revenue is actually in decline, a FCF yield of 9% suddenly doesn’t look as attractive in a declining field.

Hybrid hard drives

WDC and Seagate have been working on a hybrid HDD/SSD drive to try to access the tablet market. It means you can have the benefits of a fast SSD drive for the most commonly accessed files while also allowing for cheap large storage capacity. If it takes off it could open up a new market for them, but personally I have my doubts it will ever be adopted. As a tablet owner, I don’t really see the need for more storage as most of my content is stored in the cloud. For videos I stream, and the few GB I have is enough for travelling etc. But this article has a bullish case for it, I suggest you also read the comments too though.

Conclusion

WDC is in an industry that has had a lot of negativity surrounding it in the last few years. It has been dragged higher by the market and is up 100% over the last year. If it was still around $30 I would be a buyer, but at todays prices I would probably sell.

I felt it was worth covering this stock however as it appears to be well run, and if it ever falls out of favour again with the market could trade at some very distressed levels. I will be adding it to the watchlist.

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Investing Sidekick

Founder of Investing Sidekick. Works as a research analyst and is an avid value investor, always searching for undervalued shares. An SA certified writer.

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