Western Digital

Western Digital (WDC) ($29.05)

by Scott Schoen

Introduction

Western Digital (WDC) is the world's second largest hard drive manufacturer, behind Seagate (STX). Owning about 22% of the overall disk market, WDC has a "half-spectrum" of data storage products which spans the market from small consumer devices up to corporate products, but not yet in the largest enterprise market (they are exploring entry). They are currently working to increase margins and expand product sets as they work to outperform their competitors Seagate and Hitachi.

WDC is a member of the S&P 400 MidCap & S&P 1500 Super Comp. Indices.

They are currently gaining against STX in the notebook market share.

Trends

The company has announced 60% year-on-year growth in storage size demands, and 15% year-on-year growth per in units shipped. In Q1 WDC has improved their gross margins by 500 basis points.

They have announced a Stock buyback of $500MM over 5 years, and this year have bought back 1.5MM shares for $44MM in '08 (avg. price. 29.33) In April 2008 WDC introduced the new VelociRaptor, the fastest SATA drive available on the market.

Right now they are facing pricing pressure, and entering a seasonal decline, hence the price drop after the earnings call on 4/24. They took a 10% hit immediately after and have since recovered, and the pricing concerns have now been priced into the stock after the earnings call. Adjusted EPS for Q2 are estimate earnings per share of between $0.77 and $0.83 for the June quarter.

Strategy

In Q307 WDC made a strategic vertical integration play with the purchase of the upstream manufacturer Komag, one of the leading maker of the internal drive platter components. Komag serves #2 WDC, #1 Seagate and #3 Hitachi as clients. Komag’s short-term inability to meet supplies drove the price down 29.4% and allowed Western Digital to acquire the company for a bargain price and even at the sale; Komag had a P/E around 7. So far the company addition has generated a 120 Basis Pt improvement in gross margin, and the company is targeting a 300 Basis Pt improvement due to this acquisition by year end.

Ratios

WDC’s Debt/Equity Ratio is 0.213 vs. 0.435 D/E for STX and 1.17 for HIT.

There was minor insider selling at Q407, and not much in Q108.

WDC’s Trailing P/E is 7.58 and with an even better forward P/E of 7.10. This is compared to STX’s similar P/Es (6.45 ttm and f 7.53) and HIT’s ttm 53.54 and F P/E of a potential loss.

The Market

Many new media devices use their products. I own at least 5 WDC hard drives w-no failures (so it passes my Peter Lynch test). They are using new technologies (flash, etc) in their products, so there is innovation at that front. WDC has come out with an external Tivo-add on to increase drive storage space, and other DVR players (as well as Tivos), MP3 players, portable devices, laptops, all use their products.

It has a strong patent portfolio and is not at risk right now from an intellectual property standpoint the Seagate is pursuing with other drive makers.

The drive market is a good renewable product market. Typically, in the PC market a new computer is required every 3 years which means a new drive. Drives do have an implied built-in obsolescence. MTTF (mean time to fail) can be 1MM hours. And although a very low-end grey/used market exists, it is not a market threat since it is generally considered poor professional practice to reuse old drives for reliability and data security reasons. It is actually more common to reuse old servers, but replace the drives.

In addition, new disk formats such as RAID (mirrored backups) and connection protocols (iSCSI, eSATA) generally trend to make older technologies (IDE) obsolete which drives up the replacement market. A permanently growing disk storage need market (demand for permanent storage always grows) old disks, which have smaller sizes, become obsolete anyway.

Margins are decently protected on new sales because although smaller, older sizes are worth less, they make it up my selling the newer larger sizes for the same price as the old one, and manufacturing costs per gigabyte continue to drop.

Demand will continue to grow as more mp3 players, pdas, smartphones, portable notebooks, enter the market, including in developing countries.

Disaster Recovery is another big industry. A company takes a big email outage (such as drive failure) and they buy new replacements – which is sale #1 and this time they will buy a DR backup server – for sale #2. Another terrorist attack in a civilized country, or worse, the USA will drive up sales as well.

I personally own shares in the WDC company based upon the results of this research report.

I think buying WDC buys us a quality company in a seasonal consumer down market, allowing us to get this for value. It diversifies the current holdings of the 360 Huntington fund by adding a strong tech sector stock that will be a good long-term to own.