Revisiting WDC

I wrote about WDC earlier this year and appraised it at $85-$115. At that time it was trading around $80, but by mid-March, it had breached its 52-wk high of $105+.

In the 4 months since, it crashed over 35% to its current trading range of ~$65. What changed? And is it worth taking a stake in now?

The TTM revenue has increased to $20.6B (from $19.5B), debt outstanding has dropped to $11.2B (from $13.1B), and has been refinanced at rates below 4%. Consequently, interest expense has dropped from $800m/yr (~$2.75/share) to about $600m/yr (~$2/share), and is expected to decline further to about $450m over the next year. The FCFF/sales held firm at its long term average of 13-14%.

If I use the same valuation methodology, (Sales * (1 + growth) * FCFF/Sales – interest) / shares), I get a FCFE of $8+/sh. Using a conservative multiple easily gets me over $100.

The Subtext

The financial position of the company is secure. Data storage has strong long term tailwinds. The company authorized a $5B buyback announcement (could buy back a fourth of outstanding shares at current prices).

Strategically, WDC is well positioned for the long term. So what gives?

Well, its the consensus view, which is decidedly bearish.

Memory is a cyclical business. WDC made hay while the sun was shining, and now winter is approaching. The SSD/NAND business which has many producers is “normalizing”: it will likely suffer from oversupply issues, and hence lower margins. The other part of WDC’s business (HDDs), while a virtual duopoly with Seagate – and hence insulated from irrational behavior – is in terminal decline.

All of these claims are either partially or completely true!

Bear Thesis

Let’s say this bear thesis plays out. In the previous down cycle revenues declined about 15% over 3 years (2013-2016). Assume FCFF margins hold steady; this would imply FCFF of (revenue $20.6B * decline 85% * FCF margin 0.13)/(300m shares)~ $7.50/sh; subtracting $1 in interest payments, we are looking at FCFE = $6.50/share. Slap a 12x multiple, and we are looking at $80/share, or a 6%+ CAGR.

Not great, but not devastating either. Yes, things could and probably will get worse, but this calculation, doesn’t include the residual earnings of $10-$15 that the company will generate between now and then – so let’s call that even.

I am not saying things can’t get scary in the interim. I can imagine dire scenarios where the stock plummets to $30-40/sh (recession, China tariffs, etc.), but I don’t think survival is an issue for WDC.

Variant Perception

As perverse as it sounds a severe downturn might actually help WDC in the long run. How? Well, the SSD/NAND market might consolidate. WDC stands to benefit directly and indirectly from consolidation. Its rival in the HDD business (Seagate) is highly levered, which might help WDC squeeze out more juice. WDC’s stock price will probably languish as a result, which is great news given the massive $5B buyback.

So while I believe that the bear case is reasonable, the current price more than fully accounts for it.

However, if any part of the bear thesis turns out to be overly pessimistic, then the upside can be fantastic. Perhaps, as many argue convincingly, the decline in HDDs may plateau given new technology and price benefits (10x) over SSDs.

Given the number of gadgets requiring flash memory, the NAND market might prove more elastic than suspected – new demand may arise from unseen places to exploit declining prices. The short term pain, if any, may be much more muted, while the persistent long term tailwinds eventually come roaring back.

 

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