Value Idea Contest - Western Digital Corp
Price: $35.18
Diluted Shares Out: 236 million
Market Cap: $8.3 billion
Net Cash: $2.9 billion (April 2011)
EV: $5.4 billion (estimated)
WDC SELECTED FINANCIALS 2001-2010
Note: All figures in millions except for EPS.
Company Description:
Western Digital Corporation ("WDC") was founded in 1970 and is headquartered in Irvine, California. WDC primarily engages in the design, development, manufacture, and sale of hard drives worldwide. The company's hard drives are used in desktop computers, notebook computers, enterprise storage products, servers, workstations, video surveillance equipment, networking products, digital video recorders, satellite and cable set-top boxes, and external storage appliances. It also offers hard drives as stand-alone storage products for personal data backup, and portable or expanded storage of digital music, photographs, video, and other digital data. In addition, the company provides solid-state drives under the SiliconDrive and SiliconEdge brand names for use in the embedded systems and client PC markets; and media players under the WD TV brand name. It offers its products to original equipment manufacturers and original design manufacturers, as well as to distributors, resellers, and retailers.
Hard drives are key components of computers, including desktop and notebook computers ("PCs"), data storage subsystems and many consumer electronic ("CE") devices. A hard drive is a device that uses one or more rotating magnetic disks ("magnetic media") to store and allow fast access to data. Hard drives provide non-volatile data storage, which means that the data remains present when power is no longer applied to the device. WDC hard drives currently include 2.5-inch and 3.5-inch form factor drives, having capacities ranging from 80 gigabytes ("GB") to 3 terabytes ("TB"), nominal rotation speeds up to 10,000 revolutions per minute ("RPM"), and offer interfaces including Enhanced Integrated Drive Electronics ("EIDE"), Serial Advanced Technology Attachment ("SATA") and Serial Attached SCSI (Small Computer System Interface) ("SAS"). The company also embeds their hard drives into WD®-branded external storage appliances using interfaces such as Universal Serial Bus ("USB") 2.0, USB 3.0, external SATA, FireWiretm and Ethernet network connections with capacities of 160 GB up to 8 TB. In addition, WDC offers a family of hard drives specifically designed to consume substantially less power than standard drives, utilizing our WD GreenPower Technologytm.
WDC also designs, develops, manufactures and sells solid-state drives and media players. A solid-state drive has no moving parts and is a storage device that uses semiconductor, non-volatile media, rather than magnetic media and magnetic heads, to store and allow fast access to data. The company sells their solid-state drives worldwide to OEMs and distributors for use in the embedded systems and client PC markets. A media player is a device that connects to a user's television, the Internet and/or home theater system and plays digital movies, music and photos from any of the WD®-branded external hard drives, other USB mass storage devices or content services accessed over the Internet.
The main markets the company targets are
Industry
The hard drive industry is intensely competitive and has experienced a great deal of growth,
entry and exit of firms, and technological change over the past several years. This industry is characterized by short product life cycles, dependence upon highly skilled engineering and other personnel, significant expenditures for product development and recurring periods of oversupply.
In calendar year 2000, there were fifteen vendors of hard drives. The industry has under gone a period of consolidation and now only five companies compete in the $30 billion-a-year (600 million units) hard drive market. The leading companies are Seagate, Western Digital, Hitachi, Samsung and Toshiba.
Industry Consolidation
· 2001: Maxtor acquired Quantum for about $1 billion to leapfrog Seagate to the number one position. Fujitsu exited the desktop hard drive market to focus on notebook and server markets.
· 2002: IBM sold its hard drive business to a joint venture controlled by Hitachi Data Systems.
· 2006: Seagate completed the acquisition of Maxtor Corporation which, at the time of the acquisition, was one of the hard drive industry's four largest suppliers. The transaction was worth $2 billion and valued at 14x EBITDA. Maxtor at the time of the acquisition was not profitable on an operating basis.
· 2009: Fujitsu sold its hard drive and SSD business to Toshiba for about $330 million.
· Refer to Wikipedia for a full list of defunct hard disk manufacturers (http://en.wikipedia.org/wiki/List_of_defunct_hard_disk_manufacturers)
2011
· In March 2011, WDC signed an agreement to acquire Hitachi Global for $4.3 billion in cash and stock. More on this later.
· In April 2011, Seagate signed an agreement to purchase the hard disk drive operations of Samsung Electronics Ltd for $1.5 billion in cash and stock.
· If both these transactions go through, then WDC would have 50% market share followed by Seagate at 40% market share. Toshiba would remain a small player with 10% market share.
Change in WDC Strategy
Late 90s to early 2000's: WDC was not vertically integrated in the late 1990s. The company sold its media manufacturing division in 1999 to Komag, Inc. After this sale, WDC was purchasing all of the standard mechanical components and micro controllers for its hard drives from external suppliers.
Vertical Integration strategy:
2003: Acquisition of Read-Rite - Western Digital's acquired Read-Rite out of bankruptcy for a price tag of $172 million. WDC's acquisition of the head manufacturing operations of Read-Rite represented a fundamental change in its operating structure. As a result of this acquisition, WDC manufactured heads for use in its hard disk drives. Previously, the Company purchased all of its recording head requirements from external suppliers, including Read-Rite.
2007: Acquisition of Komag -Western Digital Corp acquired Komag Inc in 2007 for $1 billion. Komag was one of the suppliers of thin film disks (media) for the disk drive industry. CEO John Coyne said about the acquisition "This acquisition will enable WD to optimize synergies through the integration of heads and media, secure our long-term supply of media, and sharpen our ability to deliver high quality, highly reliable and cost-effective products to our customers."
Manufacturing
WDC's hard drive manufacturing facilities are located in Thailand and Malaysia. Other complementary design and manufacturing facilities are located in California, Thailand Singapore and Malaysia.
The company follows a strategy of vertical integration. Heads and magnetic media are the two most important technology components of hard drives. Vertical integration has enabled WDC to achieve optimum design and help maintain its low-cost leadership position in the industry.
Research and Development
R&D is vital to technology firms that have to stay ahead of the competition by constantly innovating and introducing new product lines. R&D spending in FY 2001 was $113 million and increased to $611 million in FY 2010. This 20% CAGR in R&D spending has helped spur revenue growth from $1.9 billion in FY 2001 to $9.8 billion in FY 2010.
R&D spending averages about 6% of revenues.
Sales and Distribution
The Company sells its products globally to OEMs, ODMs, distributors and retailers. OEMs purchase their products, either directly or through a contract manufacturer such as an ODM, and assemble them into the computer or CE systems they build. Distributors typically sell their
products to non−direct customers such as small computer and CE manufacturers, dealers, systems integrators, online retailers and other resellers. Retailers typically sell their products directly to end−users through their storefront or online facilities.
Revenue by Channel
Competition
Seagate (STX, Financial) and Western Digital compete neck and neck and are the leaders in the data storage industry. Both companies have a 30% market share with Hitachi having the third largest market share with 18%. The other significant players are Samsung and Toshiba. While WDC recently overtook Seagate in number of units sold annually, Seagate has more revenue (STX $11.9 billion v/s WDC $9.8 billion in FY 2010) as it dominates the high-end enterprise market.
The company's competitors in the external hard drive market include companies such as EMC Corporation, Hitachi Global Storage Technologies, LaCie S.A., Melco Holdings Inc. and Seagate Technology.
The company's competitors in the solid-state drive market include Intel Corporation, Micron Technology, Inc., Samsung Electronics Co. Ltd., Smart Modular Technologies, Inc. and STEC, Inc.
The company's competitors in the media player retail market include companies such as Apple Inc., EMC Corporation, LaCie S.A., Roku, Inc. and Seagate Technology.
Revenue Sources
Revenue by Geography
Asia represents the most important growth market for WDC with 53% of revenue in FY 2010 compared to 39% in FY 2008.
Revenues by Product
WDC strategic goal is to diversify its revenue sources. The shift away from desktop market can be clearly seen as 64% of revenue came from non-desktop market in FY 2010 compared to 56% in FY 2008.
Profitability of the business
At the start of the 2000s, gross margins averaged 16%. As a result of its vertical integration strategy as well as industry consolidation, gross margins have improved significantly and averaged 27% in the last three years. Operating margins improved from low single digits to mid teens.
While margins move around quite a bit between years, WDC has remained consistently and solidly profitable and has generated excellent ROE north of 20%.
Brief history
2000: 3.5 inch drives for desktops. Capacity - 7.5 GB to 45 GB. 90% sold to desktop PC market.
2001: Capacity doubled to 100 GB.
2002: Capacity doubled to 200 GB.
2003: Capacity 250GB.
2004: September 2004, made entry in mobile PC market with new 2.5 inch form factor.
2005: 3.5 inch drive capacity 400 GB. 2.5 inch capacity 40GB – 80GB.
2006: Introduced 1 inch form factor for handheld devices with capacity 4GB – 6GB. 3.5 inch drive capacity 500 GB, 2.5 inch drive capacity 160 GB.
2007: 3.5 inch drive capacity 1 TB. 2.5 inch drive capacity 160 GB.
2009: 3.5 inch drive capacity 2 TB. 2.5 inch drive capacity 1 TB. Entered SSD market via acquisition with capacity 32 MB - 120 GB. Started selling media players.
Balance Sheet Analysis (as of April 2011)
· WDC has $3.2 billion in cash and short term investments.
· ST Debt is $125 million.
· LT Debt stood at $200 million.
· Net cash $2.9 billion
· Inventory is $574 million
· A/R is $1171 million.
· Payables is $1486 million.
Income Taxes
WDC enjoys a low effective tax rate due to tax holidays, incentive programs and tax credits. The effective tax rate in the last three years was 9%, 6% and 12%. A substantial portion of the Company's manufacturing operations in Malaysia and Thailand operate under various tax holidays and tax incentive programs which will expire in whole or in part at various dates through 2022. As of July 2, 2010, WDC had approximately $230 million of unrecognized tax benefits which, if recognized, would decrease the effective tax rate in subsequent years.
Foreign Exchange Contracts
Although the majority of the Company's transactions are in U.S. dollars, some transactions are based in various foreign currencies. The Company purchases short-term, foreign exchange contracts to hedge the impact of foreign currency exchange fluctuations. These contract maturity dates do not exceed 12 months. All foreign exchange contracts are for risk management purposes only. The Company does not purchase foreign exchange contracts for trading purposes.
Management quality:
Experienced and Long duration
Mr. John F. Coyne, 60, is President and CEO. He has been a director since October 2006 and joined WDC in 1983. From November 2002 until June 2005, Mr. Coyne served as Senior Vice President, Worldwide Operations, from June 2005 until November 2005, he served as Executive Vice President, Worldwide Operations, and from November 2005 until June 2006, he served as Executive Vice President and Chief Operations Officer. Effective June 2006, he was named President and Chief Operating Officer. In January 2007, he became President and Chief Executive Officer. Mr. Coyne is currently a director of Jacobs Engineering Group Inc.
Mr. Coyne's has nearly 30 years of experience in the industry, with valuable operations, manufacturing and international experience. He also has extensive experience overseeing and integrating merger and acquisition transactions.
Mr. Tim Leyden, 58 is the Chief Operating Officer. He re-joined the company in 2007 as executive VP finance and later that year became CFO. He had served in various roles at WDC from 1983 to 2000. In his earlier career at WDC, Mr. Leyden served in various worldwide finance, manufacturing, and information technology capacities in the company's storage controller, semiconductor and hard drive businesses, both in his native Ireland and in the U.S. He worked with Mr. Coyne on the acquisition and integration teams when WD entered the hard drive business in 1988.
Mr. Wolfgang Nickl is the senior vice president and Chief Financial Officer. He is responsible for Western Digital's financial planning and analysis, operations finance, accounting, treasury, credit, tax, investor relations and internal audit functions. He also leads the company's market analysis and competitive intelligence groups. Nickl has been with the company since 1995.
Insider Ownership
Ownership as of September 28, 2010
It is worth noting that the CEO owns $35 million worth shares in the company. That is a strong and positive sign.
What the bears are saying:
HDD industry is cyclical, ruthlessly competitive, has low profit margins and generally a bad business.
Some of the above concerns are indeed valid. The HDD industry is seasonal as well as cyclical. However, the hard drive industry has under gone several rounds of consolidation both in the manufacturers as well in the supply chain. The number of competitors is down in the single digits (and could be down to three). Even though the business is cyclical, it is not similar to pure commodity industries where profits and cash flows swing wildly. WDC has a much better business than investors understand. Sales have increased by CAGR of 22% in the five year period from FY 2005 to FY 2010. Operating Income, Net Income and FCF grew by 47%, 45% and 40% respectively. Return on equity has averaged 28% over the five year period. ROE dropped below 20% only in FY 2009. WDC has been profitable and generated positive FCF in every quarter since 2002. Margins have improved tremendously over the last decade with vertical integration.
HDDs are in freefall now due to weak PC trends, growth of tablet computers led by the iPad and heightened competition. Solid State Drives will replace need for HDDs, especially in notebooks / tablets.
While it is true that Apple has used Flash memory/Solid State Drive (SSD) in both its market leading tablet product the IPad (64GB) and the new MacBook Air laptop (256GB), Solid State Drives are not a viable threat to HDDs given sustained cost disadvantage and lower maximum capacity. Most consumer-grade SSDs from leading vendors now cost around $3 per gigabyte, while traditional hard drives cost about 20 to 30 cents per gigabyte for 2.5-in. laptop drives and 10 to 20 cents per gigabyte for 3.5-in. desktop drives, according storage market research firm Coughlin Associates Inc. On Dell.com, you can get a 1TB SSD for $3800 while you can get a 2TB WDC external hard drive for $180. So, SSDs are not only more costly per GB but are available in much lower capacity points than HDDs.
Sales of IPads and other tablets may eat into the sales of low-end netbooks and laptops causing sales of HDDs to drop in that segment of the market. However, on the flip side since the storage capacity of tablets is less, consumers will need to augment the storage by purchasing external hard drives or store data in the 'cloud'. WDC already sells several products in the retail market to address external storage and backup.
Advent of Cloud Computing will be disastrous for hard drive manufacturers.
Companies offering cloud infrastructure such as Amazon, Google, etc offer services where applications and data can be accessed from anywhere from any device. Cloud Computing makes use of shared computing power and storage to provide cost effective solutions for enterprises. I argue that cloud computing will infact be beneficial to the HDD manufacturers. As demand for cloud computing increases, storage needs will also increase. These data centers will require vast amount of storage at the lowest possible cost. HDD will be in the sweet spot here due to the advantages in lower cost and higher capacity over SSD.
With the explosion in digital content creation and consumption such as movies, music, photos as well as backup of personal data, there will be huge demand for cost effective storage solutions. HDD remains the best option at the moment.
What the bears seem to be missing about SSD manufacturing capacity and storage demand
Seagate has published some excellent papers on its website. One such paper from Jan 2011 titled "NAND Flash: Can It Meet the growing storage capacity demands of the Laptop PC market?
Key points are
· One Exabyte of storage = 1 million terabytes ( 1 billion gigabytes)
· Total market for laptop/PC hard disk drives in 2010 was 69 exabytes and is expected to grow to 95 exabytes in 2011.
· Entire NAND flash memory industry had installed capacity to produce to 11 exabytes of storage. (11/65)
· More than 10 exabytes of that went to consumer devices such as smartphones, tablets and SD cards. Just 7% of capacity was used in solid state drives.
· NAND flash memory production capacity is forecast to grow to 21 exabytes in 2011. Only 9% going to SSD ( rest going to smart phones and other devices)
· Cost to build a megafab capable of producing 3.8 exabytes of NAND flash is $10 billion.
· Spending $10 billion on such a megafab would serve 4% of the projected 2011 95 exabyte market.
· To serve the entire laptop/PC storage market, $170 billion investment in NAND Flash memory fabs would be required.
· $10 billion is just the cost of the fab. It does not include the NAND, operations and other costs.
Valuation
P/E: At the current price of $35.18 and TTM EPS of $3.54, WDC appears very cheap trading at a TTM P/E of 10. And if we back out the net cash balance of $2.9 billion ($12.3 per share), we arrive at a P/E multiple of 6.4. (We will ignore this measure as the cash will be used to fund the acquisition of Hitachi Global)
If I take the average EPS of WDC over the last 5 years of $3.22 and divide into the stock price, I arrive at a P/E of 10.9 which seems quite cheap.
EV/EBIT: Let us consider the EV / EBIT multiple. WDC has about $2.9 billion in cash on its balance sheet out of a market cap of $8.3 billion, giving an Enterprise Value of $5.4 billion. FY 2010 Operating Income was $1550 million and TTM number is $938 million. Using the TTM Op Income, I get a 5.75x multiple. Average Op. Income over last three years was $1076 million. WDC is trading at 5 times this average op. income.
EV/FCF: TTM FCF is $761 million. On an EV to FCF basis, WDC is trading at about 7x the TTM FCF. The average FCF over the last three years was $935 million, WDC is trading at about 5.8 times this average FCF which is extraordinarily cheap.
P/FCF: Assuming WDC's acquisition of Hitachi Global goes thru, it may not have this excess cash. It makes sense to look at P/FCF multiple as well. Using TTM FCF of $761 million and market cap of $8300 million, the P/FCF is 11x and using the three year average FCF of $925 million, the P/FCF is 9x.
Target Valuation
Assumptions: 236 million diluted shares, $3 billion net cash and $800 million FCF.
Historical: Using Morningstar to look at historical valuation of WDC, I find that from 2002 to 2010, the P/E range for WDC was 3.6 to 15.8. The average P/E over those years was 11.
Possible stock prices at different P/E could be
DCF valuation using low growth: Using DCF with 2% FCF growth rate, discount rate of 12% and starting FCF as $800 million, I arrive at an intrinsic value of $42.5 which is a 17% margin of safety. If I use the average FCF over the last three years of $935 million, I arrive at $47 intrinsic value (25% margin of safety)
DCF valuation using zero growth: I like to employ inverse DCF to see what expectations are priced in at current prices. To arrive at the current price of $35.18, I had to input $675 million as starting FCF (not seen in the last three years) and 0% FCF growth rate and 12% discount rate. This clearly shows at the current market price, there are 0 growth expectations priced into the stock price. I like to believe, this is a good indicator of downside protection.
Comps
While the valuation for both WDC and STX is cheap, I favor WDC due to the much stronger balance sheet and consistent profitability. WDC recently entered the traditional enterprise market and has potential to capture additional market share. WDC has been gaining market share over a decade now without buying any major competitors. Also, on an EV / FCF basis, WDC is quite cheap at 5.8x v/s 7x for STX and 9x for SNDK.
1Q 2011 Overview
2Q 2011 Overview (ending Dec 31, 2010)
3Q 2011 Overview (ending April 1, 2011)
Catalysts
Pending acquisition of Hitachi Global goes through
March 7, 2011: WDC announces acquisition of Hitachi Global Storage for $4.3 billion in cash and stock
Western Digital Corp. (NYSE: WDC) announced that it has agreed to acquire Hitachi Global Storage Technologies for $4.3 billion in cash and stock, increasing the company's market share in the hard disk drive space. Under the terms of the deal, Western Digital will pay $3.5 billion in cash for Hitachi Storage, plus 25 million of its common shares, which based on the Friday closing price of $30 was valued at $750 million. Following the closing of the deal, Hitachi Ltd. (NYSE: HIT), the parent company of Hitachi Global Storage, will own about 9.6% of Western Digital's outstanding shares (25 million out of 260 million), while two of Hitachi's executives will join the Board of Directors at Western Digital. Hitachi Global Storage CEO Steve Milligan will join Western Digital after the closing of the deal, which is expected in the third quarter of 2011.
Seagate (STX) and Western Digital compete neck and neck and are the leaders in the data storage industry. Both companies have a 30% market share with Hitachi having the third largest market share with 18%. The other significant players are Samsung and Toshiba. If the acquisition goes through, WDC would have almost have 50% of the market share in the industry. In 2002, IBM sold its hard drive business to a joint venture controlled by Hitachi Data Systems.
WDC should have 260 million shares outstanding after this acquisition. WDC had net cash of $2.9 billion on its balance sheet at the end of Q3 2011. In addition, they should also be able to issue debt at favorable interest rates in the prevailing conditions, given its strong free cash flow and strong balance sheet.
Valuation of WDC if acquisition of Hitachi Global goes through
Price: $35.18
Diluted Shares Out: 261 million (236 + 25 issued to Hitachi)
Market Cap: $9.2 billion
Net Cash: $(0.6) billion ($2.9 billion excess cash - $3.5 billion cash payment)
EV: $9.8 billion (estimated)
Hitachi GST (now called Viviti Technologies) had revenues of $6 billion as of Dec 31, 2010. It generated EBIT of $645 million and had assets of $3.66 billion. At the current stock price of WDC, Viviti is being purchased for $3500 million in cash + $879 million in stock for a total enterprise value of $4379 million.
Deal multiples:
EV/ Sales = 0.73x; EV/EBIT = 6.8x \
WDC after the merger should have sales of about $15-16 billion (50% market share of the $30 billion industry) with EBIT of $1600 million plus any benefits from synergies and margin improvements.
On an EV/ EBIT, WDC would be valued at 9.8 billion / 1.6 billion = 6.1x (without assuming any benefits)
The news indicates that as of May 31, The European Commission (EC) is entering a phase II review of the acquisition. The acquisition is pending antitrust approvals and is expected to close in the fourth calendar quarter of 2011.
Deal Benefits: The rationale behind the acquisition could be to continue the industry consolidation process that has been ongoing since the last decade. It is said that Hitachi followed a heavy discounting strategy in order to gain market share and this hurt all players. By taking out another large player, WDC would be able to set reasonable pricing and stabilize and even increase gross margins. Hitachi has a large presence in the high margin enterprise market and this could help WDC to compete more effectively with Seagate. Hitachi also has a joint venture with Intel to make solid state drives (SSD). In addition to Hitachi GST's presence in enterprise storage, Western Digital is also gaining the Japanese firm's manufacturing plants in China and the Philippines. "[This] will provide us with our first manufacturing facilities in these key markets," said Wolfgang Nickl, Western Digital's CFO, during the conference call.
Related to Financing: From 8-K
Western Digital entered into a commitment letter with Bank of America, N.A. and Merrill Lynch, Pierce, Fenner & Smith Incorporated, pursuant to which, subject to the conditions set forth therein, Bank of America, N.A. committed to provide to WDC new senior secured credit facilities (the "Senior Credit Facilities") up to $3.0 billion, consisting of a $500 million revolving credit facility and $2.5 billion in term loan facilities. The Senior Credit Facilities are contemplated to be used to finance a portion of the cash portion of the purchase price of the Transaction, to refinance WDT's existing credit facilities and to pay certain fees and expenses in connection with the Transaction and the Senior Credit Facilities. The revolving credit facility is contemplated to be used for working capital, capital expenditures and other corporate purposes.
Risks: When Seagate acquired Maxtor Corporation in 2006, it is said that they lost 30% of sales to WDC as clients wanted to diversify their suppliers. CEO Coyne vowed to minimize this possibility.
Risks
· Imbalance in supply / demand
Significant, unexpected production capacity additions at HDD competitors could disrupt the supply-demand balance and put downward pressure on pricing and margins.
· Constant need to increase areal density to upgrade capacity of drives and reducing costs.
· Faster than expected adoption of SSDs could adversely affect HDD demand.
· After vertical integration, WDC has a higher fixed cost structure, higher capex and great level of R&D. This increased level of operating leverage could cut the wrong way in time of low asset utilization.
Summary:
WDC is an innovative market leader that has caught up with one time leader Seagate. WDC has a solid balance sheet where cash makes up 35% of the market capitalization. WDC produces excellent free cash flows and has remained profitable every quarter since 2002. Valuation of WDC @7x TTM FCF and @6x 3 year average FCF is compelling. The reason Mr. Market is giving us such a deal is due to the perceived demise of hard disk drives and the perception that solid state drives and the advent of tablets will make the HDD extinct. While the price per GB for SDD has been dropping, the price differential between HDD and SDD has remained. With the huge storage demands in the era of modern computing days and heavy multimedia usage with photos, movies and music, the demand for storage will be huge. WDC has seasoned executive management and the company has been buying back stock to enhance shareholder value.
Disclaimer: Accounts managed by Motiwala Capital have long position in WDC at the time of writing this post.
Price: $35.18
Diluted Shares Out: 236 million
Market Cap: $8.3 billion
Net Cash: $2.9 billion (April 2011)
EV: $5.4 billion (estimated)
WDC SELECTED FINANCIALS 2001-2010
| Year | Sales | Op Inc | Net Inc | EPS | OCF | Cap-Ex | FCF | Shares |
| 2001 | $1,953 | $ (34) | $(120) | $(0.59) | $ (103) | $(51) | $(154) | 203 |
| 2002 | $2,151 | $51 | $ 65 | $0.34 | $83 | $(48) | $35 | 193 |
| 2003 | $2,719 | $187 | $ 182 | $0.89 | $281 | $(62) | $219 | 205 |
| 2004 | $3,047 | $155 | $ 151 | $0.70 | $190 | $(132) | $58 | 216 |
| 2005 | $3,639 | $197 | $ 198 | $0.91 | $461 | $(232) | $227 | 218 |
| 2006 | $4,341 | $366 | $ 395 | $1.76 | $402 | $(302) | $100 | 224 |
| 2007 | $5,468 | $415 | $ 564 | $2.50 | $618 | $(324) | $294 | 226 |
| 2008 | $8,074 | $1,055 | $ 867 | $3.84 | $1,399 | $(615) | $784 | 226 |
| 2009 | $7,453 | $627 | $ 470 | $2.08 | $1,305 | $(519) | $786 | 226 |
| 2010 | $9,850 | $1,525 | $1,382 | $5.93 | $1,942 | $(737) | $1,205 | 233 |
| TTM | $9,505 | $938 | $ 832 | $3.54 | $1,571 | $(810) | $761 | 236 |
Company Description:
Western Digital Corporation ("WDC") was founded in 1970 and is headquartered in Irvine, California. WDC primarily engages in the design, development, manufacture, and sale of hard drives worldwide. The company's hard drives are used in desktop computers, notebook computers, enterprise storage products, servers, workstations, video surveillance equipment, networking products, digital video recorders, satellite and cable set-top boxes, and external storage appliances. It also offers hard drives as stand-alone storage products for personal data backup, and portable or expanded storage of digital music, photographs, video, and other digital data. In addition, the company provides solid-state drives under the SiliconDrive and SiliconEdge brand names for use in the embedded systems and client PC markets; and media players under the WD TV brand name. It offers its products to original equipment manufacturers and original design manufacturers, as well as to distributors, resellers, and retailers.
Hard drives are key components of computers, including desktop and notebook computers ("PCs"), data storage subsystems and many consumer electronic ("CE") devices. A hard drive is a device that uses one or more rotating magnetic disks ("magnetic media") to store and allow fast access to data. Hard drives provide non-volatile data storage, which means that the data remains present when power is no longer applied to the device. WDC hard drives currently include 2.5-inch and 3.5-inch form factor drives, having capacities ranging from 80 gigabytes ("GB") to 3 terabytes ("TB"), nominal rotation speeds up to 10,000 revolutions per minute ("RPM"), and offer interfaces including Enhanced Integrated Drive Electronics ("EIDE"), Serial Advanced Technology Attachment ("SATA") and Serial Attached SCSI (Small Computer System Interface) ("SAS"). The company also embeds their hard drives into WD®-branded external storage appliances using interfaces such as Universal Serial Bus ("USB") 2.0, USB 3.0, external SATA, FireWiretm and Ethernet network connections with capacities of 160 GB up to 8 TB. In addition, WDC offers a family of hard drives specifically designed to consume substantially less power than standard drives, utilizing our WD GreenPower Technologytm.
WDC also designs, develops, manufactures and sells solid-state drives and media players. A solid-state drive has no moving parts and is a storage device that uses semiconductor, non-volatile media, rather than magnetic media and magnetic heads, to store and allow fast access to data. The company sells their solid-state drives worldwide to OEMs and distributors for use in the embedded systems and client PC markets. A media player is a device that connects to a user's television, the Internet and/or home theater system and plays digital movies, music and photos from any of the WD®-branded external hard drives, other USB mass storage devices or content services accessed over the Internet.
The main markets the company targets are
- Desktop PC Market
- Mobile PC Market
- Enterprise Market
- Consumer Electronics Market
- External Hard Drive Market
- Solid-State Drive Market
Industry
The hard drive industry is intensely competitive and has experienced a great deal of growth,
entry and exit of firms, and technological change over the past several years. This industry is characterized by short product life cycles, dependence upon highly skilled engineering and other personnel, significant expenditures for product development and recurring periods of oversupply.
In calendar year 2000, there were fifteen vendors of hard drives. The industry has under gone a period of consolidation and now only five companies compete in the $30 billion-a-year (600 million units) hard drive market. The leading companies are Seagate, Western Digital, Hitachi, Samsung and Toshiba.
Industry Consolidation
· 2001: Maxtor acquired Quantum for about $1 billion to leapfrog Seagate to the number one position. Fujitsu exited the desktop hard drive market to focus on notebook and server markets.
· 2002: IBM sold its hard drive business to a joint venture controlled by Hitachi Data Systems.
· 2006: Seagate completed the acquisition of Maxtor Corporation which, at the time of the acquisition, was one of the hard drive industry's four largest suppliers. The transaction was worth $2 billion and valued at 14x EBITDA. Maxtor at the time of the acquisition was not profitable on an operating basis.
· 2009: Fujitsu sold its hard drive and SSD business to Toshiba for about $330 million.
· Refer to Wikipedia for a full list of defunct hard disk manufacturers (http://en.wikipedia.org/wiki/List_of_defunct_hard_disk_manufacturers)
2011
· In March 2011, WDC signed an agreement to acquire Hitachi Global for $4.3 billion in cash and stock. More on this later.
· In April 2011, Seagate signed an agreement to purchase the hard disk drive operations of Samsung Electronics Ltd for $1.5 billion in cash and stock.
· If both these transactions go through, then WDC would have 50% market share followed by Seagate at 40% market share. Toshiba would remain a small player with 10% market share.
Change in WDC Strategy
Late 90s to early 2000's: WDC was not vertically integrated in the late 1990s. The company sold its media manufacturing division in 1999 to Komag, Inc. After this sale, WDC was purchasing all of the standard mechanical components and micro controllers for its hard drives from external suppliers.
Vertical Integration strategy:
2003: Acquisition of Read-Rite - Western Digital's acquired Read-Rite out of bankruptcy for a price tag of $172 million. WDC's acquisition of the head manufacturing operations of Read-Rite represented a fundamental change in its operating structure. As a result of this acquisition, WDC manufactured heads for use in its hard disk drives. Previously, the Company purchased all of its recording head requirements from external suppliers, including Read-Rite.
2007: Acquisition of Komag -Western Digital Corp acquired Komag Inc in 2007 for $1 billion. Komag was one of the suppliers of thin film disks (media) for the disk drive industry. CEO John Coyne said about the acquisition "This acquisition will enable WD to optimize synergies through the integration of heads and media, secure our long-term supply of media, and sharpen our ability to deliver high quality, highly reliable and cost-effective products to our customers."
| 2009: Acquisition of SiliconSystems -Western Digital Corp acquired SiliconSystems from a group of shareholders for $65 million in cash on March 27, 2009. This acquisition helped WDC enter the emerging Solid-State Storage business. 2010: Acquisition of Hoya Magnetics - Western Digital acquired the magnetic media sputtering operations of Hoya Corp. and Hoya Magnetics for approximately $236 million. The acquisition was made to support anticipated growth in hard drive demand. |
Manufacturing
WDC's hard drive manufacturing facilities are located in Thailand and Malaysia. Other complementary design and manufacturing facilities are located in California, Thailand Singapore and Malaysia.
The company follows a strategy of vertical integration. Heads and magnetic media are the two most important technology components of hard drives. Vertical integration has enabled WDC to achieve optimum design and help maintain its low-cost leadership position in the industry.
Research and Development
R&D is vital to technology firms that have to stay ahead of the competition by constantly innovating and introducing new product lines. R&D spending in FY 2001 was $113 million and increased to $611 million in FY 2010. This 20% CAGR in R&D spending has helped spur revenue growth from $1.9 billion in FY 2001 to $9.8 billion in FY 2010.
R&D spending averages about 6% of revenues.
Sales and Distribution
The Company sells its products globally to OEMs, ODMs, distributors and retailers. OEMs purchase their products, either directly or through a contract manufacturer such as an ODM, and assemble them into the computer or CE systems they build. Distributors typically sell their
products to non−direct customers such as small computer and CE manufacturers, dealers, systems integrators, online retailers and other resellers. Retailers typically sell their products directly to end−users through their storefront or online facilities.
Revenue by Channel
| Channel | FY 2010 | FY 2009 | FY 2008 |
| OEMs | 51% | 54% | 51% |
| Distributors | 31% | 26% | 31% |
| Retailers | 18% | 20% | 18% |
Competition
Seagate (STX, Financial) and Western Digital compete neck and neck and are the leaders in the data storage industry. Both companies have a 30% market share with Hitachi having the third largest market share with 18%. The other significant players are Samsung and Toshiba. While WDC recently overtook Seagate in number of units sold annually, Seagate has more revenue (STX $11.9 billion v/s WDC $9.8 billion in FY 2010) as it dominates the high-end enterprise market.
The company's competitors in the external hard drive market include companies such as EMC Corporation, Hitachi Global Storage Technologies, LaCie S.A., Melco Holdings Inc. and Seagate Technology.
The company's competitors in the solid-state drive market include Intel Corporation, Micron Technology, Inc., Samsung Electronics Co. Ltd., Smart Modular Technologies, Inc. and STEC, Inc.
The company's competitors in the media player retail market include companies such as Apple Inc., EMC Corporation, LaCie S.A., Roku, Inc. and Seagate Technology.
Revenue Sources
Revenue by Geography
Asia represents the most important growth market for WDC with 53% of revenue in FY 2010 compared to 39% in FY 2008.
| Region | FY2010 | FY 2009 | FY 2008 |
| Americas | 24% | 24% | 31% |
| Europe, Middle East and Africa | 23% | 20% | 30% |
| Asia | 53% | 49% | 39% |
Revenues by Product
WDC strategic goal is to diversify its revenue sources. The shift away from desktop market can be clearly seen as 64% of revenue came from non-desktop market in FY 2010 compared to 56% in FY 2008.
| Product | FY 2010 | FY 2009 | FY 2008 |
| Non-desktop | 64% | 62% | 56% |
| Desktop | 36% | 38% | 44% |
Profitability of the business
| FY 2010 | FY 2009 | FY 2008 | FY 2007 | |
| Revenue | 100% | 100% | 100% | 100% |
| COGS | 76% | 82% | 78% | 84% |
| Gross Margin | 24% | 18% | 22% | 16% |
| SGA | 2.7% | 2.7% | 2.7% | 3.3% |
| R&D | 6.2% | 6.8% | 5.8% | 5.6% |
| Op Margin | 15.5% | 7% | 12.5% | 7.6% |
| Net Margin | 14% | 6.3% | 10.7% | 10.3% |
| ROE | 35% | 16% | 39% | 39% |
At the start of the 2000s, gross margins averaged 16%. As a result of its vertical integration strategy as well as industry consolidation, gross margins have improved significantly and averaged 27% in the last three years. Operating margins improved from low single digits to mid teens.
While margins move around quite a bit between years, WDC has remained consistently and solidly profitable and has generated excellent ROE north of 20%.
Brief history
2000: 3.5 inch drives for desktops. Capacity - 7.5 GB to 45 GB. 90% sold to desktop PC market.
2001: Capacity doubled to 100 GB.
2002: Capacity doubled to 200 GB.
2003: Capacity 250GB.
2004: September 2004, made entry in mobile PC market with new 2.5 inch form factor.
2005: 3.5 inch drive capacity 400 GB. 2.5 inch capacity 40GB – 80GB.
2006: Introduced 1 inch form factor for handheld devices with capacity 4GB – 6GB. 3.5 inch drive capacity 500 GB, 2.5 inch drive capacity 160 GB.
2007: 3.5 inch drive capacity 1 TB. 2.5 inch drive capacity 160 GB.
2009: 3.5 inch drive capacity 2 TB. 2.5 inch drive capacity 1 TB. Entered SSD market via acquisition with capacity 32 MB - 120 GB. Started selling media players.
Balance Sheet Analysis (as of April 2011)
· WDC has $3.2 billion in cash and short term investments.
· ST Debt is $125 million.
· LT Debt stood at $200 million.
· Net cash $2.9 billion
· Inventory is $574 million
· A/R is $1171 million.
· Payables is $1486 million.
Income Taxes
WDC enjoys a low effective tax rate due to tax holidays, incentive programs and tax credits. The effective tax rate in the last three years was 9%, 6% and 12%. A substantial portion of the Company's manufacturing operations in Malaysia and Thailand operate under various tax holidays and tax incentive programs which will expire in whole or in part at various dates through 2022. As of July 2, 2010, WDC had approximately $230 million of unrecognized tax benefits which, if recognized, would decrease the effective tax rate in subsequent years.
Foreign Exchange Contracts
Although the majority of the Company's transactions are in U.S. dollars, some transactions are based in various foreign currencies. The Company purchases short-term, foreign exchange contracts to hedge the impact of foreign currency exchange fluctuations. These contract maturity dates do not exceed 12 months. All foreign exchange contracts are for risk management purposes only. The Company does not purchase foreign exchange contracts for trading purposes.
Management quality:
Experienced and Long duration
Mr. John F. Coyne, 60, is President and CEO. He has been a director since October 2006 and joined WDC in 1983. From November 2002 until June 2005, Mr. Coyne served as Senior Vice President, Worldwide Operations, from June 2005 until November 2005, he served as Executive Vice President, Worldwide Operations, and from November 2005 until June 2006, he served as Executive Vice President and Chief Operations Officer. Effective June 2006, he was named President and Chief Operating Officer. In January 2007, he became President and Chief Executive Officer. Mr. Coyne is currently a director of Jacobs Engineering Group Inc.
Mr. Coyne's has nearly 30 years of experience in the industry, with valuable operations, manufacturing and international experience. He also has extensive experience overseeing and integrating merger and acquisition transactions.
Mr. Tim Leyden, 58 is the Chief Operating Officer. He re-joined the company in 2007 as executive VP finance and later that year became CFO. He had served in various roles at WDC from 1983 to 2000. In his earlier career at WDC, Mr. Leyden served in various worldwide finance, manufacturing, and information technology capacities in the company's storage controller, semiconductor and hard drive businesses, both in his native Ireland and in the U.S. He worked with Mr. Coyne on the acquisition and integration teams when WD entered the hard drive business in 1988.
Mr. Wolfgang Nickl is the senior vice president and Chief Financial Officer. He is responsible for Western Digital's financial planning and analysis, operations finance, accounting, treasury, credit, tax, investor relations and internal audit functions. He also leads the company's market analysis and competitive intelligence groups. Nickl has been with the company since 1995.
Insider Ownership
| John Coyne – CEO | 1.16 million shares |
| Timothy Leyden – COO | 247k shares |
| All Directors and Executive Officers as a group | 1.1% |
It is worth noting that the CEO owns $35 million worth shares in the company. That is a strong and positive sign.
What the bears are saying:
HDD industry is cyclical, ruthlessly competitive, has low profit margins and generally a bad business.
Some of the above concerns are indeed valid. The HDD industry is seasonal as well as cyclical. However, the hard drive industry has under gone several rounds of consolidation both in the manufacturers as well in the supply chain. The number of competitors is down in the single digits (and could be down to three). Even though the business is cyclical, it is not similar to pure commodity industries where profits and cash flows swing wildly. WDC has a much better business than investors understand. Sales have increased by CAGR of 22% in the five year period from FY 2005 to FY 2010. Operating Income, Net Income and FCF grew by 47%, 45% and 40% respectively. Return on equity has averaged 28% over the five year period. ROE dropped below 20% only in FY 2009. WDC has been profitable and generated positive FCF in every quarter since 2002. Margins have improved tremendously over the last decade with vertical integration.
HDDs are in freefall now due to weak PC trends, growth of tablet computers led by the iPad and heightened competition. Solid State Drives will replace need for HDDs, especially in notebooks / tablets.
While it is true that Apple has used Flash memory/Solid State Drive (SSD) in both its market leading tablet product the IPad (64GB) and the new MacBook Air laptop (256GB), Solid State Drives are not a viable threat to HDDs given sustained cost disadvantage and lower maximum capacity. Most consumer-grade SSDs from leading vendors now cost around $3 per gigabyte, while traditional hard drives cost about 20 to 30 cents per gigabyte for 2.5-in. laptop drives and 10 to 20 cents per gigabyte for 3.5-in. desktop drives, according storage market research firm Coughlin Associates Inc. On Dell.com, you can get a 1TB SSD for $3800 while you can get a 2TB WDC external hard drive for $180. So, SSDs are not only more costly per GB but are available in much lower capacity points than HDDs.
Sales of IPads and other tablets may eat into the sales of low-end netbooks and laptops causing sales of HDDs to drop in that segment of the market. However, on the flip side since the storage capacity of tablets is less, consumers will need to augment the storage by purchasing external hard drives or store data in the 'cloud'. WDC already sells several products in the retail market to address external storage and backup.
Advent of Cloud Computing will be disastrous for hard drive manufacturers.
Companies offering cloud infrastructure such as Amazon, Google, etc offer services where applications and data can be accessed from anywhere from any device. Cloud Computing makes use of shared computing power and storage to provide cost effective solutions for enterprises. I argue that cloud computing will infact be beneficial to the HDD manufacturers. As demand for cloud computing increases, storage needs will also increase. These data centers will require vast amount of storage at the lowest possible cost. HDD will be in the sweet spot here due to the advantages in lower cost and higher capacity over SSD.
With the explosion in digital content creation and consumption such as movies, music, photos as well as backup of personal data, there will be huge demand for cost effective storage solutions. HDD remains the best option at the moment.
What the bears seem to be missing about SSD manufacturing capacity and storage demand
Seagate has published some excellent papers on its website. One such paper from Jan 2011 titled "NAND Flash: Can It Meet the growing storage capacity demands of the Laptop PC market?
Key points are
· One Exabyte of storage = 1 million terabytes ( 1 billion gigabytes)
· Total market for laptop/PC hard disk drives in 2010 was 69 exabytes and is expected to grow to 95 exabytes in 2011.
· Entire NAND flash memory industry had installed capacity to produce to 11 exabytes of storage. (11/65)
· More than 10 exabytes of that went to consumer devices such as smartphones, tablets and SD cards. Just 7% of capacity was used in solid state drives.
· NAND flash memory production capacity is forecast to grow to 21 exabytes in 2011. Only 9% going to SSD ( rest going to smart phones and other devices)
· Cost to build a megafab capable of producing 3.8 exabytes of NAND flash is $10 billion.
· Spending $10 billion on such a megafab would serve 4% of the projected 2011 95 exabyte market.
· To serve the entire laptop/PC storage market, $170 billion investment in NAND Flash memory fabs would be required.
· $10 billion is just the cost of the fab. It does not include the NAND, operations and other costs.
Valuation
P/E: At the current price of $35.18 and TTM EPS of $3.54, WDC appears very cheap trading at a TTM P/E of 10. And if we back out the net cash balance of $2.9 billion ($12.3 per share), we arrive at a P/E multiple of 6.4. (We will ignore this measure as the cash will be used to fund the acquisition of Hitachi Global)
If I take the average EPS of WDC over the last 5 years of $3.22 and divide into the stock price, I arrive at a P/E of 10.9 which seems quite cheap.
EV/EBIT: Let us consider the EV / EBIT multiple. WDC has about $2.9 billion in cash on its balance sheet out of a market cap of $8.3 billion, giving an Enterprise Value of $5.4 billion. FY 2010 Operating Income was $1550 million and TTM number is $938 million. Using the TTM Op Income, I get a 5.75x multiple. Average Op. Income over last three years was $1076 million. WDC is trading at 5 times this average op. income.
EV/FCF: TTM FCF is $761 million. On an EV to FCF basis, WDC is trading at about 7x the TTM FCF. The average FCF over the last three years was $935 million, WDC is trading at about 5.8 times this average FCF which is extraordinarily cheap.
P/FCF: Assuming WDC's acquisition of Hitachi Global goes thru, it may not have this excess cash. It makes sense to look at P/FCF multiple as well. Using TTM FCF of $761 million and market cap of $8300 million, the P/FCF is 11x and using the three year average FCF of $925 million, the P/FCF is 9x.
Target Valuation
| FCF multiple | 8x | 10x | 12x |
| Enterprise Value | $6.4 billion | $8 billion | $9.6 billion |
| Expected share price | $40 | $46 | $53 |
Historical: Using Morningstar to look at historical valuation of WDC, I find that from 2002 to 2010, the P/E range for WDC was 3.6 to 15.8. The average P/E over those years was 11.
Possible stock prices at different P/E could be
| P/E multiple | 7x | 11x | 15x |
| Using current EPS $3.5 | $25 | $38.5 | $52 |
DCF valuation using low growth: Using DCF with 2% FCF growth rate, discount rate of 12% and starting FCF as $800 million, I arrive at an intrinsic value of $42.5 which is a 17% margin of safety. If I use the average FCF over the last three years of $935 million, I arrive at $47 intrinsic value (25% margin of safety)
DCF valuation using zero growth: I like to employ inverse DCF to see what expectations are priced in at current prices. To arrive at the current price of $35.18, I had to input $675 million as starting FCF (not seen in the last three years) and 0% FCF growth rate and 12% discount rate. This clearly shows at the current market price, there are 0 growth expectations priced into the stock price. I like to believe, this is a good indicator of downside protection.
Comps
| Western Digital (WDC, Financial) | Seagate Tech. (STX) | Sandisk Corp. (SNDK, Financial) | STEC Inc. (STEC, Financial) | |
| Market Cap | $8,300 m | $6,600 m | $9,282 m | $892 m |
| Enterprise Value | $5,400 m | $7,000 m | $8,000 m | $700 m |
| Revenue (ttm) | $9,505 m | $10,769 m | $ 5,034 m | $336 m |
| P/E (ttm) | 9.9x | 9.5x | 7.3x | 18.6x |
| EV/ FCF (3 yr av) | 5.8x | 7x | 9x | 34x |
| EV/ Sales (ttm) | 0.6x | 0.7x | 1.6x | 2.1x |
| EV / EBIT (ttm) | 5.6x | 6.8x | 5.3x | 13.5x |
While the valuation for both WDC and STX is cheap, I favor WDC due to the much stronger balance sheet and consistent profitability. WDC recently entered the traditional enterprise market and has potential to capture additional market share. WDC has been gaining market share over a decade now without buying any major competitors. Also, on an EV / FCF basis, WDC is quite cheap at 5.8x v/s 7x for STX and 9x for SNDK.
1Q 2011 Overview
- Consolidated net revenue totaled $2.4 billion.
- Hard drive unit shipments increased by 15% over the prior-year period to 50.7 million units.
- Average selling price per unit decreased 6% from $49 to $46.
- Gross margin decreased to 18.2%, compared to 23.3% for the prior-year period.
- Operating income was $211 million, a decrease of $108 million compared to the prior-year period.
- Generated $390 million in cash flow from operations in the first quarter of 2011.
- Management was cautious in the outlook for the next quarter due to inventory build up by the OEMs. Some competitors indulged in aggressive pricing during the quarter to gain market share. The industry had experienced four sequential quarters (April 2009 to March 2010) where the demand outstripped the supply and competitors wanted to keep sales momentum and this impacted margins for everyone.
2Q 2011 Overview (ending Dec 31, 2010)
- Revenue totaled $2.48 billion v/s $2.62 billion in 2010
- Net Income of $225 million v/s $429 million
- EPS 0.96 (analyst expected $0.58) v/s 1.85 last year
- Hard drive unit shipments: 52.2 million units v/s 49.5 million units in year ago period. Shipments were also up sequentially from 50.7 million in Q1.
- Gross margin was 19% (analysts expected 16%) v/s 26% for the prior-year period.
- Operating income was $240 million, a decrease of $233 million compared to the prior-year period.
- FCF: Cash from operations $505 million. FCF was $255 million v/s $360 million in 2010.
- Balance sheet: Ending cash $3.1 billion. Net Cash was $2.75 billion, an increase of $250 million or $1 per share. Cash per share approximately $12.
- Share buyback: None.
3Q 2011 Overview (ending April 1, 2011)
- Revenue totaled $2.25 billion v/s $2.6 billion in 2010
- Net Income of $146 million v/s $400 million
- EPS 0.62 v/s 1.71 last year
- Hard drive unit shipments: 49.8 million units (decrease of 3%)
- Gross margin was 18.2% v/s 25.2% for the prior-year period.
- Operating income was $158 million, a decrease of $283 million compared to the prior-year period.
- FCF: Cash from operations $313 million. FCF was $138 million.
- Balance sheet: Ending cash $3.2 billion. Net Cash was $2.9 billion, Cash per share approximately $12.3.
- Share buyback: None.
Catalysts
Pending acquisition of Hitachi Global goes through
March 7, 2011: WDC announces acquisition of Hitachi Global Storage for $4.3 billion in cash and stock
Western Digital Corp. (NYSE: WDC) announced that it has agreed to acquire Hitachi Global Storage Technologies for $4.3 billion in cash and stock, increasing the company's market share in the hard disk drive space. Under the terms of the deal, Western Digital will pay $3.5 billion in cash for Hitachi Storage, plus 25 million of its common shares, which based on the Friday closing price of $30 was valued at $750 million. Following the closing of the deal, Hitachi Ltd. (NYSE: HIT), the parent company of Hitachi Global Storage, will own about 9.6% of Western Digital's outstanding shares (25 million out of 260 million), while two of Hitachi's executives will join the Board of Directors at Western Digital. Hitachi Global Storage CEO Steve Milligan will join Western Digital after the closing of the deal, which is expected in the third quarter of 2011.
Seagate (STX) and Western Digital compete neck and neck and are the leaders in the data storage industry. Both companies have a 30% market share with Hitachi having the third largest market share with 18%. The other significant players are Samsung and Toshiba. If the acquisition goes through, WDC would have almost have 50% of the market share in the industry. In 2002, IBM sold its hard drive business to a joint venture controlled by Hitachi Data Systems.
WDC should have 260 million shares outstanding after this acquisition. WDC had net cash of $2.9 billion on its balance sheet at the end of Q3 2011. In addition, they should also be able to issue debt at favorable interest rates in the prevailing conditions, given its strong free cash flow and strong balance sheet.
Valuation of WDC if acquisition of Hitachi Global goes through
Price: $35.18
Diluted Shares Out: 261 million (236 + 25 issued to Hitachi)
Market Cap: $9.2 billion
Net Cash: $(0.6) billion ($2.9 billion excess cash - $3.5 billion cash payment)
EV: $9.8 billion (estimated)
Hitachi GST (now called Viviti Technologies) had revenues of $6 billion as of Dec 31, 2010. It generated EBIT of $645 million and had assets of $3.66 billion. At the current stock price of WDC, Viviti is being purchased for $3500 million in cash + $879 million in stock for a total enterprise value of $4379 million.
Deal multiples:
EV/ Sales = 0.73x; EV/EBIT = 6.8x \
WDC after the merger should have sales of about $15-16 billion (50% market share of the $30 billion industry) with EBIT of $1600 million plus any benefits from synergies and margin improvements.
On an EV/ EBIT, WDC would be valued at 9.8 billion / 1.6 billion = 6.1x (without assuming any benefits)
The news indicates that as of May 31, The European Commission (EC) is entering a phase II review of the acquisition. The acquisition is pending antitrust approvals and is expected to close in the fourth calendar quarter of 2011.
Deal Benefits: The rationale behind the acquisition could be to continue the industry consolidation process that has been ongoing since the last decade. It is said that Hitachi followed a heavy discounting strategy in order to gain market share and this hurt all players. By taking out another large player, WDC would be able to set reasonable pricing and stabilize and even increase gross margins. Hitachi has a large presence in the high margin enterprise market and this could help WDC to compete more effectively with Seagate. Hitachi also has a joint venture with Intel to make solid state drives (SSD). In addition to Hitachi GST's presence in enterprise storage, Western Digital is also gaining the Japanese firm's manufacturing plants in China and the Philippines. "[This] will provide us with our first manufacturing facilities in these key markets," said Wolfgang Nickl, Western Digital's CFO, during the conference call.
Related to Financing: From 8-K
Western Digital entered into a commitment letter with Bank of America, N.A. and Merrill Lynch, Pierce, Fenner & Smith Incorporated, pursuant to which, subject to the conditions set forth therein, Bank of America, N.A. committed to provide to WDC new senior secured credit facilities (the "Senior Credit Facilities") up to $3.0 billion, consisting of a $500 million revolving credit facility and $2.5 billion in term loan facilities. The Senior Credit Facilities are contemplated to be used to finance a portion of the cash portion of the purchase price of the Transaction, to refinance WDT's existing credit facilities and to pay certain fees and expenses in connection with the Transaction and the Senior Credit Facilities. The revolving credit facility is contemplated to be used for working capital, capital expenditures and other corporate purposes.
Risks: When Seagate acquired Maxtor Corporation in 2006, it is said that they lost 30% of sales to WDC as clients wanted to diversify their suppliers. CEO Coyne vowed to minimize this possibility.
Risks
· Imbalance in supply / demand
Significant, unexpected production capacity additions at HDD competitors could disrupt the supply-demand balance and put downward pressure on pricing and margins.
· Constant need to increase areal density to upgrade capacity of drives and reducing costs.
· Faster than expected adoption of SSDs could adversely affect HDD demand.
· After vertical integration, WDC has a higher fixed cost structure, higher capex and great level of R&D. This increased level of operating leverage could cut the wrong way in time of low asset utilization.
Summary:
WDC is an innovative market leader that has caught up with one time leader Seagate. WDC has a solid balance sheet where cash makes up 35% of the market capitalization. WDC produces excellent free cash flows and has remained profitable every quarter since 2002. Valuation of WDC @7x TTM FCF and @6x 3 year average FCF is compelling. The reason Mr. Market is giving us such a deal is due to the perceived demise of hard disk drives and the perception that solid state drives and the advent of tablets will make the HDD extinct. While the price per GB for SDD has been dropping, the price differential between HDD and SDD has remained. With the huge storage demands in the era of modern computing days and heavy multimedia usage with photos, movies and music, the demand for storage will be huge. WDC has seasoned executive management and the company has been buying back stock to enhance shareholder value.
Disclaimer: Accounts managed by Motiwala Capital have long position in WDC at the time of writing this post.
