A Quick Look at Western Digital

Western Digital (WDC) does storage; it designs, makes, and sells hard disk and flash drives. These are used from PCs/notebooks, consumer electronic products, all the way to enterprise servers.

The company’s 2016 investor presentation, and this 2017 update provide a good overview of the business and opportunities.

WD has a history of bolstering its storage offerings by arguably decent acquisitions. It has morphed from a pure HDD play to a more general storage play over the past 10 years.


The company’s presentation also lays out positive and negative factors.



  • secular decline in PC and notebook industries; but the company expects the storage portion of this market to work out better
  • HDD industry is essentially a duopoly (with Seagate); but overall storage industry (particularly HDD) is cyclical
  • commodity product; no durable competitive advantages


  • in the near term, HDD to remain dominant fraction of total stored data
  • decent management, good acquisition and capital allocation record
  • increased demand due to “big data”, more digitalization
  • datacenters, cloud computing


The company lays out numbers to anchor a valuation.


  • TTM revenues are ~$19.5B (up from $8B in 2008); EBIT is $2.6B (up from $1B in 2008). EPS numbers are noisy, but FCF is indicative of a cash generating business.
  • Share count has increased from 226M to 301M over the past 10 years.
  • Historical tax rate has been 7-12%, in line with future expectations. Probably should not expect tax bill to help much.
  • Total debt is $13.1B (about 2.75x EBITDA), peaked at $17B in 2016. WDC is develering. Interest expenses are currently ~$800M (compared with EBIT of $2.6B). Debt looks manageable, especially when compared to competition like Seagate, which has a much more levered balance sheet.

The adjusted FCF/sales has been 13-14% (in line with target). Sales growth is expected to be low single digits.

If we use FCF/sales = 13%, sales growth = 3%, then FCFF/share = $9.05. Subtracting the $2.75 of interest payments/share, we get FCFE for the next year of $6.30. Using the Gordon growth model with a hurdle rate of 10%, we get a target price of $85.

If we use less conservative numbers (FCF/sales = 13.5%; sales growth = 3.5%, and interest payments of $2.50 from continued delevering), we get a target a target price of $115.

Thus, the range of values is probably between $85-$115. Currently, it is trading below the lower end of this range.





A Pile of MCK?

McKesson Corporation (MCK), founded 1833, is the largest distributor of drugs, medical products, and supplies in the US.

Distributors like MCK connect pharmaceutical manufacturers like Pfizer, Merk, and Bristol-Meyer-Squibb to outlets like Walmart, Albertsons, and hospital pharmacies.

Industry Landscape

McKesson’s fingerprints can be found somewhere on nearly a third of all prescriptions in the US. MCK is a supplier to more than 75% of US hospitals with more than 200 beds. The breadth of their products and services, combined with their geographical scale allows them to offer attractive package deals to their customers.

The US distributor market has characteristics of a mature oligopoly. 90% of the market is dominated by three relatively equisized players.

McKesson  (MCK): ~$30B market cap, ~$200B revenue
Cardinal Health (CAH): $17B market cap, $130B revenue
AmerisourceBergen (ABC): $19B mcap, $150B revenue

As a result, pricing in the US is mostly rational.

While US retail is a $400B opportunity, Europe is a ~$200B market.

MCK has recently been growing its presence in Europe, Canada, Brazil etc., where the distributor landscape is much more fragmented, and opportunities from consolidation abound.

In 2016-17, MCK merged its legacy technology solutions business with Blackstone owned Change Healthcare to form a new IT company. MCK owns 70% of the new firm. This allows McKesson to focus on its core drug distribution business. The end-game is to spin it off as an independent company.

Financial Overview

As of 09/2017, TTM revenues were $202B. However, the margins in this business are brutal. Despite the huge topline number, only $4.5B flowed to the bottomline.

Operating margins are generally in the 1.5-2% range, with net margins slightly over 1%.

It is hard for me not contrast these terrible margins with the fat 15-20% EBIT margins for industrial distributors like Fastenal (FAST) or MSC Industrial Direct (MSM). It is no surprise that FAST or MSM boast impressive returns on capital and equity. The ROIC and ROE for both these industrial distributors is in the 15-25% range.

It might therefore come as a surprise that McKesson also has racked up impressive ROIC (10-12%) and ROE (15-20%) numbers, despite terrible margins.

How in the world is it able to do that?

The short answer is that it plays the Costco game.

If you sell a lot of stuff without using much capital, then you can generate high returns on capital. The sales/capital ratio for industrial distributors (FAST and MSM) is in the 1.5-2.0 range.

For MCK, sales/capital is in the 7-10 range!

ROIC = NOPAT/IC = (Sales/Capital) * (EBIT Margin) * (1-tax rate)
ROE  = NI/Equity = ROIC * (1 - interest/EBIT) * (1 + debt/equity)

If we use normalized numbers for sales/capital (8.5), EBIT margin (1.75%), tax rate (30%), interest/EBIT (10%), and debt/equity (0.75), one can easily see how MCK hits ROIC in the 10-12% range, and ROE in the mid-high teens.

Unlike FAST or MSM, the healthcare market, and MCK by extension, is more recession resistant. It can afford the luxury of running a more leveraged operation to lower its cost of capital and turbo-charge returns to equity (and it does!).

Nevertheless, debt levels remain manageable; the entire debt can be paid off in 2 years from operating cash flows. Indeed, the company is delevering (a little).

MCK has grown topline at a steady 7-10% rate for nearly 10 years now. The business survived the 2008-09 crash relatively unscathed. The share count has declined almost 30% from 290M in 2008 to 214M in the most recent quarter. The company also pays a small dividend (~1%).


  • Although brand Rx drugs constitute a large fraction of the revenue (~60%), generic drugs constitute most of the gross profit (~65%). After a blockbuster 2015 in which the price of Gx increased, subsequent deflation has pressured profits.
  • 2016 was an election year, and drug prices were in the spotlight. These temporary unfavorable pricing dynamics should eventually normalize.
  • There is continued uncertainty regarding the future of healthcare reform, and any regulatory risk that may entail.
  • Customer consolidation (Target/CVS, RiteAid/Walgreens) affects contracts. Their resulting heft implies a weaker negotiating position for distributors.
  • Just recently (11/20/2017), the stock fell more than 3% on a report that Amazon would slice away a significant portion of MCK’s revenue. I think this fear is overblown. Just look at the low margins in the business. They provide a basis to mount a strong defense against Amazon.


If there are no major disruptions, we should anchor expectations close to the return on equity (~15%).

Terminal Model

Let’s use a simple terminal model. TTM revenues were $202B. Since CapEx is modest, we can assume FCF ~ NI (FCF margins 1%), and growth rate of 5% for the next decade or so, and a cost of capital of 9%, we get a TV of $52.7B.

Subtracting the net debt ($5.8B), and dividing by the number of shares, we get an IV/share of $220.

Relative Valuation

Historically, MCK has traded in P/E band of 11x-24x, with a midpoint around 17. For 2018 and 2019, S&P estimates EPS to be $12.14 and $12.98, respectively. At a P/E of 17, this implies a target price of 17*$12.14 = $207.

At current prices of $130-150, shares are attractively priced.

Portfolio Moves: Sold Apple

After 4.5 years, I finally closed my Apple position last week.

I started buying in early 2013 in the low $60s (accounting for the 7 for 1 split). In 2016, I added to the position in the low-mid $90s. For quite some time it was my largest or second-largest position.


No matter how conservative I got, I couldn’t come up with a value below $120. Last fall, I wrote:

The narrative is either “its going gangbusters” or “its going down the toilet”. Right now, we seem to be closer to the latter.

The narrative shifted over the past year, as Apple racked up an impressive 80% run.

As usual, I began selling way too early ($120), and finally exited my last sliver on November 10 at $175. Overall, my cost basis was $71, and my average exit price was $130 and change.

Counting dividends, Apple returned between 18-20% CAGR. Not spectacular, but considering the size of the position, and its relative safety (in my opinion), it is my kind of long-term trade.

At current prices of $175/share, AAPL doesn’t seem to be as great a value.


Last year, Apple earned about $9/share. It has about $31/share of excess cash. Using a conservative 12x multiple on the earnings, and a 20% repatriation haircut on the excess cash, I get a valuation of about $135. If you use a 15x earnings multiple, you can justify paying up $160.

I don’t know what the right multiple is. I hesitate using a high multiple because (i) Apple relies heavily on the iPhone, which regardless of how the winds are blowing currently is subject to disruption/erosion, and (ii) earnings are starting to saturate/grow more slowly.

I don’t think AAPL is grossly overvalued. However, I prefer to sit this one out.

Apple might quite possibly march onward to become the first trillion dollar company. I’ll be happy to watch the fireworks, and cheer on from the sidelines.

Under Dog

Over the past three years, Under Armour’s (UA) market cap has fallen by nearly 80%. Just over the past year, shares have lost 2/3 of their market value.

The most recent quarterly (Q3 2017) earnings report was brutal. Everything that matters was revised downwards. A series of external pressures (North American weakness, price war etc.), and internally inflicted wounds (ERP integration mismanagement etc.) have conspired to make 2017 a year UA would like to forget.

This is what happens when a growth story goes wrong. The sentiment against the company is overwhelmingly negative. The short ratio is around 10-12%, and the days to cover based on normal volumes is now about 15.

Is UA broken for good? Or are its troubles temporary? Will the company plough through this bad patch, and return to “normal”? Is the rational behavior at this time, to fold and cut our losses, or to hold our noses and double down?

Back Story

Previously, I thought UA was worth somewhere in the high teens. That was earlier this year, when the stock was trading near $20.


Since I was learning a new put-writing option strategy, I thought UA – with its high volatility – might be a good candidate to experiment with. I began writing $20 strike puts in Feb 2017, and kept rolling them until August. After Q2 results, the stock dropped to the $15-16 range, and I got assigned my first set (400) of UA shares.

At that time, I revalued UA, and thought the long-term thesis remained mostly intact, and began writing more puts. This time at $16.50 strike. I kept doing this, until Q3 earnings were declared on 10/31. The stock subsequently dropped further, and now hovers between $10-11. The puts are deep in the money, and will likely get assigned when they expire on 11/24/2017 (500 more shares).

All said and done, I now have 900 shares at an average price of $15.50 (~$14k). My total maximum target allocation for UA is $25k (for a 5% position), which means I could more than double my ownership at current prices.


After I factor in the disastrous Q3, and modest improvements over the next three years, followed by a return to industry averages by year 10, I get a DCF value of $15-16.I think this is a conservative estimate.

At current prices of $10-$11, the stock may be undervalued by nearly a third.


Any improvement beyond the currently depressed valuations, any unexpected return to 10-20% growth rates in the near/medium term, and resulting multiple expansion could easily double the target price.

Five years from now, we might look back at this period as a good buying opportunity.

Just Do What?

Nike is a monster. It is the largest athletic apparel and footwear manufacturer in the world.

It sports mouth-watering returns on invested capital (25-30%), and has been consistently growing revenues and EBIT in the 6-9%/year range for well over 10 years now.

It is a growing, profitable, wide-moat business with an iconic brand.

Its has sales of over $34B, net-income of $4.2B, which towers over Adidas ($20B sales) and Under Armour ($5.5B) sales. Footwear and apparel account for 65% and 30% of revenues, respectively; the remaining sliver comes from equipment sales.

International sales now account for over half of Nike’s sales (~55%). About 30% of its revenues are DTC (website and company owned stores). In the medium-term both these slices are likely to continue growing.

Unlike Under Armour, Nike is a shoe company gate-crashing into the apparel market. The total addressable apparel market is $135B, almost 2x that of footwear. The size of the market and the popularity of athleisure provides a tailwind, and a new market for Nike to grow into.

It has stellar management (interview with CEO), and high insider ownership.

Essentially it is a great business. Usually such businesses are not cheap.

However, a glance at its chart reveals that it currently sits close to its 2-year low.

Screenshot from 2017-10-08 16-49-46

Might this be a good time to ease into NKE? Before we look at valuation, it might be useful to understand what the bear case might be.

Amazon. Of course.

It is killing retailers (Footlocker etc.) which still account for a majority of Nike’s sales. It is also jumping into Amazon branded apparel.

While I respect Bezos too much to dismiss Amazon, I think the actual threat posed by Amazon to Nike is far weaker than perceived.

Nike is a powerful identity brand. Like Ferrari, Harvard University, and Rayban. Unlike Gillette, Tide, or Hanes underwear, whose brands were protected through the premise of lowering search costs. Amazon (or Dollar Shave Club or Kirkland) could kill such categories with their store branded products. And they probably will.

Perhaps a bigger threat is that the apparel industry is subject to fashion trends. Nike knows how to engineer performance shoes that are sought after. The transition to a casual fashion brand may be not be easy.

The game is different. Just because someone has a black belt in karate, doesn’t mean they will do well in the boxing ring.

Currently, the North American market environment is overly promotional. This will eat into margins. However, over a few years, one would expect this latest catfight for market-share to have play out, and settle. So while this does present short-term headwinds, perhaps we should be thankful to it for allowing us to buy a great company at a reasonable price.

Which finally brings us to valuation.

Graham’s formula for growth companies, suggests a fair P/E ratio of (8.5 + 2g). In NKE’s case growth is approximately 7% for quite a few years to come. So that would suggest a reasonable P/E of 22. For FY2018, EPS is expected to be around $2.40.

This would imply a fair value of 22*$2.40 = $53, which is close to today’s share price.

One could also use a terminal value formula to come up with an alternative fair P/E, and isolate the drivers of value.

P/E = Value/NOPAT(t+1) = (1 - growth/ROC)/(COC - ROC)

If we assume Nike is a truly great company capable of growing profitably for quite some time, we might assume growth = 7%, COC = 10%, and ROC = 25%. This yields a fair P/E of 24, which after subtracting the $2.50 debt/share brings us to a fair value of $55.

If we treat Nike like a solid (but not extraordinary) company, with growth ~ 4%, and ROC = 20%, we get estimates of value between $35-40.

Thus, despite the fall in stock price Nike is not really cheap. For $50-$55, we are, at best, buying a wonderful company for a fair price. It will probably turn out to be a fine investment. However, this is not a back-up-the-truck price, just yet.

In my opinion the $35 estimate provides a lower bound. It implies a P/E less than 15 for a company like Nike!

Given the liquidity of the stock and share price, NKE might be an ideal candidate for selling cash secured puts. I would like to try to build a sizeable long-term position in NKE, especially if I can reduce the cost basis to the lower of mid $40s.



Valuation Updates

Here are some updates on companies I valued earlier this year

First Solar: I came up with a fair value of ~$31/share in January, and suggested huge uncertainty around that estimate. I even embarked on a put campaign when it dipped to my target buy price near $25, before it roared back to nearly $50.

Under Armour: I estimated UA to be worth about $17.50. Since then, it has simply hovered in the $15-$20 range. I’ve been trying to build a position in UA by writing puts. In August 2017, I bought 40% of my target allocation for $16.15. The recent swoon in prices has me eyeing a second slug.

VF Corp: I thought VFC was worth about $65, when it was selling in the low $50s. Since then, it has bounced back to $63 and change. I have no position in the stock currently, although I did make a decent return writing puts.

Hanesbrand: I came up with a conservative $20-25 range for HBI, when it was trading at the lower end of that range. Currently, it is trading at the higher end of that range.

Compounding Insurers: In April, I updated by valuation of BRK ($200), MKL ($1080) and Fairfax ($580). Since FFH was cheap for a large part of the year, I doubled my position. Just today, the price breached $500 on the back of a stellar Fairfax Asia deal.

ALJ Regional Holdings: A depressed fair value estimate for the company is about $3.40. But buying ALJJ is a bet on the jockey. It could be worth more than $5 shortly. I have been buying ALJJ since June.

Others: I thought Charles Schwab was an excellent company worth somewhere between $30 and $40, and that GameStop was a struggling retailer that might still be worth about $25-30. Finally, I estimated the value of Disney to be $120.

MSC Industrial Direct

MSC Industrial Direct (MSM) is an 75-year old industrial distributor with a focus on metalworking and maintenance, repair, and operations (MRO)-related products and services.

It is primarily a US based company (>95% revenue), where it has 5 large distribution centers and 80 branch offices.

Since its IPO in 1995, it has grown top and bottom lines at 12%. Here is its fundamental performance since 2007.

Screenshot from 2017-08-26 16-45-19

Here is the performance of its stock price, annotated with some plausible narrative:

Screenshot from 2017-08-26 16-47-44.png

In 2017, it fell from a high of $105 to its current price in the $65-$70 range.

Alan Mecham had this to say about industrial distributors (emphasis mine):

… an industrial distributor, like MSM, has very low cap ex requirements but large working capital needs. What I have an affinity for are companies with staying power that I feel I understand well.

I like the hourglass model, where a distributor stands in the middle of fragmented markets. That model allows a well-managed distributor to enjoy strong bargaining power in both buying and selling while occupying a niche that’s valuable to customers and difficult for competitors to dislodge. I also like when there’s a high-touch service component that’s valued, which further fosters sticky customers.

So here we have a $4B market cap company with $2.9B in TTM sales, and $382M in EBIT, whose price has fallen ~40% from recent highs. It is probably worth a look.

The rest of the post follows a Q&A format. I raise questions that seem relevant, and try to address or counter them, as best as I can.

EBIT and sales have grown at 13% for 20 years. Is this extraordinary growth sustainable?

The MRO business in the US is fragmented. Not just the suppliers and the customers, but also the distributors.

The top 50 distributors account for less than 30% of the market. MSM is in the top 10. Currently, there are 145K companies like MSM in the US; most of them operate at a much smaller scale.

Management estimates that the total addressable market for MSM is $160B. With revenues of $2.9B, MSM has a market share of under 2%. There is plenty of room for consolidation. MSM could acquire or displace smaller companies. It is also small enough to get acquired itself.

If MSM continues to grow at 13% for another 20 years, its revenue would be ~33B. Over the time period, it is possible that the TAM would have increased further, making this scenario (brisk and steady growth) completely within the realm of possibility.

Industrial distributors like MSM have high gross margins near 45-50%. Are these sustainable?

MSM has boasted gross margins in the neighborhood of 45% since inception. That said, product cost is a tiny sliver of the total operating expenditure, which is instead dominated by the procurement and inventory operating costs. Thus, focusing on gross margins might be somewhat misleading.

Screenshot from 2017-08-26 17-17-36

If this is a big market with juicy margins, won’t Amazon Supply step in to defragment the market and eat their lunch?

Bezos is famous for saying, “your margin is my opportunity”, and even during these time of “peak Amazon”, I wouldn’t willingly compete against Bezos or Amazon.

But AMZN is not infallible. That I am willing to bet on.

Amazon’s entry into a large market with juicy margins, doesn’t mean incumbents are toast. Amazon tried to compete with Priceline in the online travel business before giving up. The Fire smartphone was a debacle – it couldn’t hold its own against the iPhone or Samsung. In these markets, it was Amazon that had to retreat.

In other domains, including groceries I suspect, AMZN will be a player – perhaps, even an important one – but it won’t suck the oxygen out of the room. 15 years ago people worried that Walmart would displace all the local and regional grocers, yet stores like Publix and Wegmans have continued to thrive.

You don’t want to fight Amazon (or yesteryear Walmart) only on price. When outmatched, like David against Goliath, the key is to play the game by different rules. For example, I happily go to my neighborhood Publix, even though there is a Walmart offering better prices at the same distance, because of three reasons: (i) The staff is familiar, and I feel my presence is acknowledged (low churn unlike Walmart), (ii) shopping is more pleasurable; the lighting, the produce; if I don’t find something I need there is someone close by happy to help, and (iii) I absolutely love their store branded (Greenwise) cereal.

There are some lessons here for industrial distributors like MSM, which runs a well-oiled call-center that fields customer queries. They might not be able to compete with AMZN in logistics, but so long as they play in a field where customer relationships are important, they will be resistant to AMZN attacks. Even if AMZN somehow makes deep inroads, MRO is not necessarily a winner-take-all business.

Also, who knows, at a $4B market cap, AMZN might even see MSM as an acquisition target. Of course, the Jacobson family who owns most of the voting power would have to bless any such merger.

ROIC has decreased from 20% in 2012 to 13% TTM. Operating margins have declined from 15-17% to 13%. EBIT has stagnated. Earnings have declined. Is the best behind?

MSM operates in a cyclical industry. Currently demand and pricing are soft, and yet MSM spews off cash throughout the cycle.

CEO Erik Gerstner once remarked:

Economic slowdowns are the times when MSC makes its greatest strides. These are the times when the local and regional distributors that make up 70% of our market suffer disproportionately. History tells us what will happen to local distributors if this downturn prolongs. Reducing their inventory leaves customer service vulnerable. Clamping down on receivables disrupts long-standing customer relationships. Laying off people creates hiring opportunities to acquire industry talent not typically available.

We are just starting to see the very early signs of these things occur in the marketplace. The pace will accelerate the longer these conditions hold. We are pleased with our share gain performance to date and would anticipate it to continue or even accelerate the longer these conditions last, and that will lead to disproportionate top-line growth when the environment does improve.

At some point, the cycle will turn. Perhaps, the infrastructure bill will be the first domino to fall. It might be something else. Whatever it is, it will cause the earnings numbers to explode. If tax-reform happens around that time (currently MSM pays 35% in taxes), any savings will flow to the bottomline, and lace the upside.

The company’s debt has increased significantly over the past few years. Isn’t that a cause for worry?

Debt is still only 1/3 of the total capital, and less than 2x EBIT. So debt-levels are very manageable. From a tax perspective taking on some more debt might be the smart thing to do.

By and large, management allocates capital well. Recently, they borrowed $365 million at 1.29% after tax to retire shares which yielded nearly 2.5% in dividends each year [S/O have declined by 10% over the past 10 years]. This would be smart, even if shares were fairly valued. However, if MSM is undervalued, this is even smarter.

So what is it worth?

It is always difficult to value a cyclical company at the bottom of the cycle. Especially, one that gains strength during a down cycle.

Based on history, assuming long enough holding periods, one would expect returns to mimic ROE: mid teens, say 15%.

A DCF with reasonable inputs yields $65-$75 as fair price for the equity. At its current price, it is in the lower range of my estimate.

figure_1However, my DCF anchors too much on the recent past and suppressed earnings, even when it tries not to. It doesn’t factor in the likely levered upswing, when the cycle turns. Both Credit Suisse and Morningstar have target prices in the low $90s. Those analysts probably know how to account for cyclicality better than me.

Over the past 5 years, MSM has traded between $55 and $105. The EV/EBITDA and P/E have ranged between 8.3-15, and 15-27, respectively. The current EV/EBITDA and P/E at 9.7 and 16.8, are at the lower end of the historic range. Unless you believe that the recent stagnation is a secular trend, and not a cyclical low, it would be prudent to bet on some reversion to the recent mean.