In my last post, I outlined at a high level an investment case for Western Digital Corporation (WDC). I continue to believe that it remains undervalued despite a 69% rally in its share price over the last 12 months, as both the business itself and the industry in which it operates is misunderstood by investors generally. I believe a conservative estimate of the intrinsic value of the business is between $21 billion – $25 billion, compared to its present market capitalisation of approx. $16.9 billion, representing upside of between 23% – 52%. In this post, I set out a detailed fundamental business and valuation analysis for WDC which I believe justifies my estimate of intrinsic value.
1. Executive Summary
Western Digital Corporation (“WDC” or the “Company”) is currently priced at approx. $71 per share in the market, giving a total equity value for the business of approx. $16.9 billion.
I conservatively estimate intrinsic value for the entire Company to be in the range of $21 billion – $25 billion, or $86 – $106 per share, based on a detailed fundamental analysis of the business, its industry, management and future prospects.
My investment approach for equities is to acquire fractional ownership in businesses at a price that affords me a satisfactory margin of safety to mitigate against error, imprecision, bad luck or the vicissitudes of the stock market. I therefore look to pay prices that approximate no more than two-thirds of a conservative estimate of intrinsic value for an entire business or company.
On this basis, my analysis leads me to conclude that WDC is a Buy at $63 or less per share, being a 33% discount to the mid-point of my estimated range for intrinsic value, of $23 billion. I believe that buying into the business at this price level should afford me a satisfactory margin of safety.
2. Investment Thesis & Catalysts
Despite the significant rise in its share price over the last 12 months, WDC remains undervalued in the market versus a conservative estimate of its intrinsic value. This undervaluation is attributable to a misunderstanding of both the Company and the data storage industry by investors. Essentially, WDC has suffered from a double-fear of obsolescence:
- Firstly, it suffers from the perception that it is primarily a PC-related business, having historically been a major manufacturer of hard disk drives (“HDDs”) for the PC market, and so is part of the “Death of the PC” narrative that has gained traction with the rise of smartphones, tablets and cloud computing
- Secondly, HDDs themselves have come to be viewed as a storage medium destined for obsolescence with the increased adoption of Solid State Drives (“SSDs”) that use NAND flash memory and which offer improved performance over HDDs
This perception of both WDC and data storage technology is in fact overly simplistic, flawed, and constitutes a clear misunderstanding of both the Company and the data storage market itself, for the following reasons:
- Non-PC related business now accounts for approx. 50% of WDC’s revenues, and following the intelligent strategic acquisition of Hitachi Global Storage Technologies (“HGST”), it has significant exposure to the higher margin enterprise storage segment of the market
- Secondly, WDC has and continues to develop a growing SSD presence, with 5 SSD-related acquisitions (SiliconSystems, HGST, STEC, VeloBit and Virident) since 2009, as well as having a strategic investment in a pure-play, high-growth SSD business, Skyera
- These acquisitions are evidence that management are transitioning the business from being a traditional HDD manufacturer to a HDD/SSD solutions business, recognising that both storage mediums have a role in the continued growth of digital content and consequent storage requirements
- Therefore WDC is not simply a HDD business, and indicates intelligent capital allocation by management to enhance its data storage offering, gain exposure to the high-growth SSD/tablet computing market and thereby combat any potential obsolescence risk facing traditional HDD storage.
- Additionally, the threat of obsolescence facing HDD is overstated, as not all data needs to be stored in SSD form and not every device requires the rapid access times that SSDs permit. While ultrabooks, smartphones and tablets now use SSD storage, the majority of data continues to be stored on HDD (70% of all exabytes in 2013 according to WDC), rather than SSD, flash memory and other storage mediums. This is likely to remain the case, due to two factors – continued data growth and the cost-benefit of HDD versus other mediums. At present, SSDs remain 8x – 10x more expensive than HDDs, and the continued rapid growth in digital content means that HDD remains the most economic and appropriate medium to meet storage requirements arising from continuous data growth
- Digital content continues to growth at an exponential rate, and is perhaps one of the great secular growth stories of our time – digital content growth and the corresponding growth in storage requirements are forecast to have a CAGR of between 30% – 50% over the next 5 – 7 years according to various industry and market reports. The data storage business is therefore one with favourable long term prospects, which bodes well for WDC
- The above facts appear to have been lost within the clamour for all things smart/tablet-computing related in recent times however, leading to a flawed assessment of WDC and hence its undervaluation in the market
- WDC is a fundamentally strong business with excellent management and an excellent performance track record – over the last 10 years it has achieved consistent growth in revenues and free cash flow using minimal debt, and generated consistently high returns on capital in an intensively competitive and commoditised industry, to the point where it has now has the leading market share in the HDD segment
- All of this creates an attractive investment opportunity; the catalyst for the full value of WDC’s business to be realised is the market’s eventual recognition of two key factors: (1) at the broader industry level, digital content will continue to grow at an exponential rate, which will require storage, which will be met by HDD, SSD and other storage mediums that will complement each other and the nature of data to be stored, and (2) WDC has proven itself to be the best in class operator, with an excellent business that now offers multiple storage solutions catering to all major areas of storage demand
3. Company Overview & History
WDC is a developer and manufacturer of data storage devices, networking equipment and home entertainment products serving all primary data storage markets— enterprise and cloud data centres, client (PC) market, consumer electronics, data backup, internet and other emerging markets such as automotive and home and small office networking.
Historically, WDC’s principal products have been hard disk drives, but in recent years, WDC has expanded into other storage products including solid-state drives, home entertainment and networking products and software applications for smart phones and tablets.
WDC was originally founded in 1970 as a specialized semiconductor manufacturer, and entered the storage industry in 1988. In that time it has grown by both innovation and acquisition to become the leading HDD manufacturer in terms of market share and sales today. In 2012, WDC acquired Hitachi Global Storage Technologies (“HGST”), allowing it to surpass competitor Seagate (“STX”) as the leading HDD manufacturer, and crucially expanding its enterprise storage offering. HGST develops advanced hard drives for enterprise, cloud, personal computing, consumer electronics, enterprise-class solid state drives and external storage solutions. WDC is headquartered in Irvine, California, with additional offices and facilities in the US, Europe, Asia and Brazil.
In 2013, WDC made two further significant acquisitions, with the purchases of sTec, Inc. (“sTec”), an established provider of enterprise storage class and solid-state drives (SSDs) in June, and of Virident Systems Inc. (“Virident”) in September. Virident is a provider of “flash” storage solutions for the enterprise storage market segment. Both acquisitions are intended to boost WDC’s presence in enterprise and SSD, key growth segments within the data storage market.
For the most recent financial year to 30 June 2013, WDC reported sales of $15.4 billion, net income of $1.7 billion and free cash flow of $2.2 billion. WDC is a constituent company of the S&P 500 and the NASDAQ 100, and is listed on the NASDAQ.
Its share price has increased approx. 69% in the last 12 months (S&P 500: 24%), and 526% over the last 5 years (S&P: 96%).
The company has grown revenues, net income and free cash flow at CAGR’s of 19.7%, 22.3% and 32.6% over the last 10 years respectively, while delivering average returns on invested capital in excess of 40% over the same period. Over the same time horizon, the Company’s market cap has increased at a CAGR of approximately 27.5%, or 8.9x, from $1.9 billion to $16.9 billion.
4. Data Storage Industry Overview
In broad terms, the data storage industry comprises three main categories of businesses: (1) information infrastructure businesses, (2) hard disk drive (HDD) manufacturers and (3) solid-state drive (SSD) and flash technology memory manufacturers. Major players in each category at present include:
|EMC||Western Digital Corporation||Samsung|
The information infrastructure companies provide data storage solutions primarily to large-scale, enterprise class customers including businesses, government agencies and data centres. Information infrastructure companies provide both hardware and software products, including storage array systems, back-up, recovery and archiving solutions, security and encryption applications, data management systems, big data applications, cloud storage services and platforms and consulting services. Products such as storage arrays use both HDD and SSD drives as components.
HDD companies have traditionally produced hard drives for consumers and businesses, supplying PC Original Equipment Manufacturers (OEMs) such as Dell and Hewlett Packard with internal disk drives for desktop and notebook computers, external hard drives for consumers and storage solutions for businesses and enterprise-class customers.
SSD manufacturers develop and supply hard drives using SSD/flash storage technology. SSDs use flash technology and have numerous performance advantages over HDDs, including faster data recovery, greater energy efficiency, no noise, are light-weight and use less moving parts. SSDs have replaced HDDs in certain applications, such as in mission-critical enterprise applications and smart/mobile computer devices, including smartphones, tablets and ultrabooks.
However over the last 5 years, the HDD industry has consolidated significantly, and with the two remaining independent HDD manufacturers WDC and STX transitioning into SSD manufacturers as well.
Data Storage Technology – HDDs vs. SSDs
HDD companies such as WDC have traditionally manufactured hard disk drives (HDDs) that use rotating magnetic disks to store and allow fast access to data. A HDD consists of one or more rigid, rapidly rotating discs or platters with magnetic heads. The storage capacity of a hard drive is determined by the number of disks and each disk’s areal density (that is, the amount of data that can be stored on a given area of surface on a storage medium). Since their introduction by IBM in 1956, HDDs have been the dominant secondary storage medium in computing (as opposed to primary storage, being the CPU), and have maintained this position into the present with continued technological improvements. Despite the introduction of solid state drives (SSDs) using newer flash memory technology, HDD’s remain the primary storage medium for digital content today, with the total addressable market (TAM) for HDD’s in 2012 estimated to be approx. 592 million units shipped, compared with approx. 39 million SSD units shipped, according to IHS, the analytics firm. SSD shipments are now forecast to increase to 83 million units in 2013, and to 239 million units by 2016.
In recent years, SSDs have become primary competing technology to HDDs. SSDs use non-volatile, semiconductor technology known as NAND flash memory, rather than magnetic discs, to store and allow fast access to data without any moving parts. With SSDs, data is stored on NAND memory chips which do not require power to retain data. Compared to HDDs, SSDs offer greater performance, being faster in terms of access time, are less susceptible to physical shock, produce no noise, and are more energy efficient. While SSDs offer greater performance, HDDs offer greater capacity at present, due to the higher cost and limited supply of NAND.
A recent innovation is the hybrid drive, which is seen as a cost-efficient compromise between HDD and SSD. Hybrid drives combine the higher performance of NAND flash memory as used in SSDs with the greater storage capacity of a magnetic HDD. This combination allows better pricing and so provides a more cost-effective solution than a pure SSD, while providing sufficient capacity to meet storage needs.
At present, HDDs remain the dominant medium however, primarily due to lower cost, wider availability and higher capacity compared with SSD/flash-based storage devices. At present, SSDs are approximately 8x – 10x the cost of HDDs on a per-gigabyte of storage basis. The higher cost is attributable to both the higher cost of development and production of flash chips versus magnetic discs, and to frequent supply constraints for NAND flash memory. Flash memory is used exclusively in smartphones and tablet computer devices, meaning a significant and continuously growing demand for NAND chips as these devices have gained in popularity. Moreover, demand for NAND flash memory for SSD storage at the enterprise end of the market (i.e. servers and other data centre equipment) has also increased dramatically, leading to a limited supply of NAND. Within the SSD segment, major competitors to WDC such as Micron, Samsung, Toshiba and SanDisk manufacture their own NAND chips for their SSDs, giving them an advantage over WDC (and STX) which currently has to purchase NAND from third parties. However, WDC and SanDisk announced in May 2013 that both companies were collaborating to manufacture hybrid drives, which will benefit WDC by giving it access to a steady NAND supply via this partnership with SanDisk.
In time, the cost of SSD storage is predicted to decline and converge with that of HDDs, due to expected technological improvements and increased. It has been predicted that SSDs will eventually replace HDDs to the point of near or even total obsolescence (similar to CD’s replacing cassettes tapes for example), once cost declines sufficiently. Therefore the advent of mobile computing (including smartphone and tablets), SSD technology is perceived as the data storage medium of the future, as such devices use SSDs due to their greater speed and lighter, more compact and non-volatile form factor.
However, it is important to consider that given the continued growth in digital content in areas such as Big Data and cloud and mobile computing in the context of supply constraints and higher relative cost for SSD production, it is likely that HDDs will continue to be the dominant data storage medium for the foreseeable future. Another consideration that is often overlooked in the excitement generated in relation to all things smartphone and tablet-related, is the fact that not all data actually requires SSD storage, as not every device requires rapid access to data. For example, while a tablet computer will use an SSD drive, the data which is consumed on it will be stored in the cloud, i.e. on an enterprise server in a data centre, which will most likely use HDDs for their capacity and lower cost. Therefore it is far from certain that SSDs will fully replace HDDs. At present, the price of SSDs is declining, but not at a rate sufficient enough to totally replace HDD from an economic perspective, particularly given the on-going rate of data content creation.
Data Storage Demand Trends
The shift to mobile computing and the emergence of Big Data are the two major demand trends impacting the data storage industry and are secular in nature. With mobile computing, more and more data is being consumed via mobile devices, as evidenced by the declines in PC shipments (10.9% YoY in Q2 2013 according to Gartner). All data consumed and produced via mobile devices is invariably accessed and stored via cloud computing, which means that data is ultimately stored on enterprise-class HDDs or SSDs in a data centre.
Similarly, given its scale and complexity, Big Data has enormous enterprise-class storage requirements. Big Data covers huge volumes of complex structured and unstructured data across the entire data spectrum including videos uploaded to YouTube, digital movies on HD-TVs, banking data processed at ATMs, security footage at airports, subatomic collisions recorded by the Large Hadron Collider at CERN, voice-calls made over digital phone line, medical records and numerous other kinds of other digital content.
Both of these trends have created a huge and ever-growing demand for enterprise-class storage solutions which will continue to be the biggest driver of demand for data storage devices. As such, data storage, and the enterprise-class segment in particular is a secular, high-growth story for the foreseeable future.
Consolidation and Transition
The hard drive manufacturing end of the storage industry (i.e. HDD and SSD) is intensely competitive with HDD and SSD suppliers competing for sales to a small number of major customers. As a product hard drives are highly substitutable, and therefore there are limited barriers to prevent existing competitors from offering similar products. As per WDC’s 2012 annual report, “Hard drive manufacturers compete on the basis of product quality and reliability, storage capacity, unit price, product performance, production volume capabilities, delivery capability, leadership in time-to-market, time-to-volume and time-to-quality, service and support and ease of doing business.” The commoditised nature of the industry has led to significant consolidation within the industry to a point where only three strong manufacturers now remain.
While the SSD industry segment remains somewhat fragmented with a number of private and mid-cap manufacturers competing with the three dominant players in Samsung (31% market share), SanDisk (17%) and Toshiba (9%), the HDD industry is effectively a now a duopoly between WDC and Seagate. Since 2007, the HDD industry has consolidated from 8 major manufacturers to just three major manufacturers today. The most significant phase of this consolidation wave occurred in 2012 when WDC acquired HGST (which in turn was formerly part of IBM), while Seagate acquired Samsung’s HDD business, reducing the industry to the current duopoly between WDC (44.5% market share) and Seagate (41.5%), with Toshiba trailing in third place (~13%). WDC’s acquisition of HGST was notable in that it gave WDC, traditionally a PC OEM supplier, greater exposure to the high margin enterprise storage market segment, and thereby to cloud and large-scale enterprise storage customers, the highest growth segment within the industry. Prior to this, Seagate had a stronger enterprise-class presence.
The consolidation within the HDD industry has also meant that margins have improved. The HDD industry, along with many supply chain companies to the computing and data storage industries were impacted by severe flooding in Thailand in October 2011, where many industry manufacturing facilities are located. The floods resulted in temporary suspension of operations and a drop in margins to sub-20%. Prior to these floods, HDD gross margins averaged 20% over the period from 2003 to 2010. The post-flood recovery in the industry combined with the consolidation to an effective duopoly has meant that gross margins have increased and been maintained by both WDC and Seagate to a 28% – 30% range in 2012 and 2013, with both companies targeting a 27% – 32% gross margin range going forward.
By contrast, SSD margins have tended to be significantly higher than HDD historically, with pure-play SSD companies such as sTec, SanDisk, Fusion-io and OCZ achieving gross margins in the 30% – 50% range over the last 5 years. Additionally, enterprise storage drive gross margins tend to be approx. double those for desktop and laptop PCs.
Given the increased adoption of SSD technology in recent times, the big three HDD manufacturers have moved to transition from traditional HDD businesses into both HDD and SSD manufacturers, developing SSD solutions internally through R&D, development of hybrid drives combining both technologies, and by strategically acquiring SSD businesses to augment their data storage offering.
5. Data Storage Business Prospects
Despite historically being a commoditised industry, the trend of consolidation has resulted in the survival of only the strongest companies in this industry. Coupling this with the ongoing secular growth in data creation, analysis and consumption, the data storage business is one with very favourable business prospects.
At a high level, particular “megatrends” expected to drive increasing storage requirements for the foreseeable future include the storing of human genome data for the worlds approx. 7 billion people, all social media content, personal consumer data and Big Data. More specifically, the following factors are expected to be key growth drivers for the industry in the future:
- Rapid growth in creation, sharing and distribution of digital content via social networking platforms, email, high resolution images, high definition video content, movie/tv/music streaming services, electronic data from businesses, and large data files
- Continued advances in online/network infrastructure and accessibility, including wireless/broadband access, cloud computing, local networking, smart/internet television, increased bandwidth, facilitating improved data access, hosting and distribution
- Rapid growth in consumption of digital content due to mobile and tablet computing devices, smartphones, DVRs, gaming consoles, set-top boxes and media equipment, motor vehicles
- Continued need for data protection and digital content back-up
- Advances and tailoring in storage technology due to technological improvements in terms of capacity, performance, power requirements/efficiency
- Adoption of different storage architectures and solutions to meet specific storage requirements
Each of the above factors will drive continually increasing demand for data storage devices as the ever-growing body of digital content globally will require increased capacity to store, manage, access, back-up and distribute this content.
Unabated data growth outlook
The standard metric for measuring data storage in the industry is the exabyte, which is 1 billion gigabytes. To put this in context, according to an IDC paper sponsored by EMC, 161 exabytes of data were created in 2006, which approximated “3 million times the amount of information contained in all the books ever written.” IDC published a study in December 2012, The Digital Universe in 2020: Big Data, Bigger Data Shadows, and the Biggest Growth in the Far East, which reported that from 2005 to 2020, the digital universe will grow by a factor of 300, from 130 exabytes to 40,000 exabytes, or 40 trillion gigabytes (more than 5,200 gigabytes for every man, woman, and child in 2020). From now until 2020, the digital universe will about double every two years. Furthermore, IDC found that the proliferation of devices such as PCs and smartphones worldwide, increased Internet access within emerging markets and the boost in data from machines such as surveillance cameras or smart meters has contributed to the doubling of the digital universe within the past two years alone. In April 2013, IDC produced a further report, stating that Big Data is fuelling enterprise demand for increased data storage, a market that IDC forecasts to increase at a 53 per cent compound annual growth rate (CAGR) through to 2016.
These findings also square with WDC and Seagate’s own business outlooks – WDC stated in their conference call for the March 2013 quarter that “We believe digital data growth will continue unabated for the foreseeable future with total exabyte shift growing from 600 exabytes in 2012 to at least 5,900 exabytes by 2020, representing a 33% compounded annual growth rate.” Similarly, Seagate management stated on their March 2013 conference call that “the growth trajectory of data-driven in part by cloud of mobile applications has our industry on pace to close to 500 exabytes of storage and is advancing at a rate which is more than two times greater than expected areal density growth rate,” meaning in simple terms that the data is growing at more than two times the expected HDD capacity growth rate. Finally, Toshiba, the third major HDD player indicated in January 2013 that the volume of data generated globally has been increasing by over 40% annually, while Cisco estimated that worldwide cloud traffic will grow at an annual rate of 45%. By 2017, 48% of the global population will be online, up from 32% at present according to Cisco’s Visual Networking Index forecast from May 2013, meaning that the number of devices and connections can only grow. All of this suggests that evermore creation and consumption of digital content.
At this point then, based on the views of both the manufacturers themselves and independent industry research, it is reasonable to conclude that data storage is a growth industry with positive business prospects. Perhaps it could be argued on the basis of the above that only three things are certain in life now – death, taxes and continued data growth; data growth is a simple function of time and technology – digital content will only ever grow, and not diminish with the passage of time, as more and more people use devices to create and consume countless types of digital content that will require storage, while data itself is never “uncreated”. Data storage must therefore be considered a secular growth story.
HDD and SSD segment growth
Within the general data storage industry outlook, what of the growth prospects for the competing technologies of HDDs and SSDs themselves?
With regard to HDDs, WDC’s Investor Presentation for June 2013 projects that over 75% of exabytes in 2020 (or 4,425 exabytes) will be stored on HDDs. This expectation is based on the relative supply, capacity and cost advantages relative to SSDs, enabling HDD to dominate as the most cost effective mass storage medium, primarily in the enterprise storage segment. Referring again to WDC’s March 2013 quarter conference call, CEO Stephen Milligan stated that management expected a longer-term unit growth for HDDs of 3%. How does this compare to independent industry forecasts though? In Q1 of 2013, Gartner forecast HDD unit CAGR of 2.4% to 2017, while a May 2013 report from IHS forecasts a HDD CAGR of -2.9% to 2017. However, other industry reports outline a more robust outlook. TechNavio’s report, Global Hard Disk Drive Market 2011-2015 forecasts that the global HDD market will grow at a CAGR of 8.1% from to 2015, primarily driven by demand from the enterprise segment. In addition, IDC published a report in April 2012, Worldwide Hard Disk Drive 2012-2016 Forecast: The Industry Hits the Reset Button, forecasting a HDD unit CAGR of 9.6% to 2016. On balance then WDC management forecasts would appear conservative.
While the outlook for HDDs is decidedly modest, the outlook for SSDs by contrast is universally bullish. IHS forecast SSD unit shipments to grow at a CAGR of 63% to 2016, with PC’s alone to grow at a CAGR of 48% to 2017. Similarly, IDC in January 2012 forecast SSD to grow at a CAGR of 51.5% to 2015, attributable to lower prices per gigabyte, increased use of hybrid drives and increased enterprise adoption of SSD storage to complement HDD solutions. In terms of market share, SSDs are forecast to increase market share from 6% to 36% in the PC storage market alone by 2017 according to IHS, with HDD market share for PC storage declining to 64% from 94%. More recently, a study by IDC indicates that revenues from SSDs are expected to reach $7 billion in 2017 from the approximately $2.5 billion estimated for 2012, implying a CAGR of 23%.
Overall then, despite the bleak outlook for PCs, digital content growth is expected to drive continued data storage demand, primarily in the enterprise storage segment. On balance the outlook for HDDs is low to modest growth, with very strong growth forecast for SSDs. As the dominant HDD manufacturer in the PC segment, with a growing enterprise storage presence and a nascent SSD business line, WDC would appear to have favourable prospects itself, operating in this high-growth industry.
6. Business Model
WDC operates a global business through two independent subsidiaries due to regulatory requirements—Western Digital (“WD”) and HGST. Within these subsidiaries, WDC has three brands – WD (WDC), HGST and G-Technology (both HGST)
WDC has four distinct business segments, as follows:
- Client Compute
- Consumer Electronics
- Branded Products
1. Enterprise – Enterprise storage devices require the greatest capabilities and reliability, and consist of high performance and capacity hard drives and solid-state drives. These are used in multiple types of enterprise data-centres, and provide storage solutions for a range of cloud and corporate applications. Within data-centres, these drives are typically used in workstations, computer servers and storage systems. This class of drives is the most highly engineered product line in the storage industry.
The Enterprise segment also consists of solid-state drives for use in embedded applications, such as network communications and industrial, medical, military and aerospace applications, all of which require high durability and long life cycles.
2. Client Compute (Desktop & Notebook PCs) – Client storage devices consist of internal hard drives and solid-state drives for desktop and mobile (Notebook) PCs.
3. Consumer Electronics (“CE”) – CE devices include hard drives used in digital video recorders (“DVRs”), game consoles and security video recording systems.
4. Branded Products – include external storage devices for PCs and home and small office networks, USB drives, and media players for television/home theatre systems.
Revenue % by business segment for last 5 years by number of hard drive units shipped is as follows:
Historically, the majority of revenues have been generated by the Client Compute (PC) segment, with CE and Branded Products segments remaining relatively stable.
Per the company’s recently filed 10-K for the financial year to June 2013, 50% of revenue was derived from non-Compute (PC) markets, including enterprise drives, solid-state drives, CE products and branded products, up from 36% in FY12. This is significant and indicates that with half of all revenues now generated from the non-PC segments, WDC is becoming less a PC-oriented business, and transitioning to an enterprise, cloud and SSD-oriented data storage business. As such, WDC has significant exposure to, and is participating in the higher-growth data-storage markets of the future. This is something that to date has not been fully understood by investors. This transition is something that has been actively managed by management over the last 8 years as the overall revenue mix has shifted significantly away from traditional PC HDDs to non-PC related segments:
The Enterprise segment has been the fastest growing segment for WDC, with units shipped growing at a CAGR of 45% over the period shown. WDC’s acquisition of HGST allowed them to gain a stronger foothold in the enterprise market, with IDC ranking HGST as one of the Top 5 external data storage providers in the world in 2011 behind, EMC, IBM, HP and NetApp. Furthermore, the recently announced acquisition of sTec in June 2013 increases WDC’s exposure to the high growth enterprise and SSD storage market segments. sTec is an enterprise-class SSD storage business, whose customers include IBM and EMC. WDC’s acquisition (for $340 million in cash) of STEC therefore further leverages WDC to the high growth end of the data storage market. Similarly, the post-2013 year-end acquisition of Virident in September 2013 enhances WDC’s enterprise-SSD offering, with Virident being a leading flash storage provider to the enterprise segment. Virident’s customers include EMC, Linkedin and Micron. Prior to the acquisition, Virident stated that it expected 2013 revenues to increase 140% from 2012 levels, and expects to triple its customer base by 2014. Finally, WDC announced a strategic collaboration with competitor SanDisk to manufacture hybrid drives in May 2013. This is a significant development, and indicates that hybrid drives represent a significant revenue opportunity for WDC, given that SanDisk, a leading SSD/flash storage manufacturer, has sought to enter the nascent hybrid space.
[Note the analysis above and below excludes any results for recent acquisitions sTec and Virident].
WDC’s customers include personal computer (“PC”) and Mac providers, storage subsystem suppliers, and Internet and social media infrastructure players. WDC sell products to original equipment manufacturers (“OEMs”), distributors, resellers and consumers. The chart below breaks down revenue by customer type over the period:
OEM’s have traditionally been the largest customer segment. These include companies such as Dell, HP and Lenovo. The Distributor segment includes technology wholesalers including Avnet, Ingram Micro and numerous others. Retailers include major retailers include computer superstores, online retailers and electronic stores. Retail sales are also made via the WDC website.
Historically, Dell and HP have been the largest customers of WDC, however no individual customer has generally accounted for more than 10%-11% of revenues. During the last three financial years (FY11 – FY13) sales to WDC’s top 10 customers accounted for approx. 48% on average. [Note the above analysis excludes any results for recent acquisitions sTec and Virident].
In terms of geographical spread, the majority of WDC’s customers have been in Asia, followed by a generally even distribution between the Americas and EMEA regions historically, as shown below:
The concentration of customers in Asia is attributable to the fact that both WDC’s manufacturing facilities and those of its larger customers (e.g. OEMs such as Dell) are located in Asia. For this reason, a large proportion of revenues are generated in this region.
Manufacturing operations are based in California and in Asia, in particular China, Malaysia and Thailand.
Gross margins for HDDs are currently in the 28-32% range, but historically have averaged approx. 20% prior to 2011. In late 2011, severe flooding in Thailand resulted in the temporary closing of approx. 45% of the HDD industry’s assembly capacity and a significant part of the associated supply chain. This caused component shortages, leading to a significant undersupply for HDDs. This resulted in higher HDD prices in the first half of 2012, boosting margins for WDC and Seagate to approx. 30%. In addition, WDC’s acquisition of HGST and major competitor Seagate’s acquisition of Samsung’s HDD business consolidated the HDD market from 5 companies to 3 (Toshiba being the only other HDD manufacturer) in 2012. The resultant duopoly between WDC and Seagate has allowed both companies to maintain gross margins at post-flood levels to date (28% – 30%), with both companies targeting a 27% – 32% gross margin range going forward.
SSD margins for the pure-play SSD companies such as STEC, SanDisk, Fusion-io and OCZ have historically been in the 30% – 50% range over the last 5 years, while enterprise storage drive gross margins tend to be double or more those of desktop and laptop PCs (approx. 40% based on pre-flood PC HDD margins).
7. Financial Overview
Summary financial performance for WDC for the preceding 10 year period is as follows:
8. Competitive Advantage
WDC’s business exhibits a number of characteristics that indicate it has built up a competitive advantage within its industry:
Lowest cost operator in commoditised industry
In a commoditised industry, the strongest company is usually the lowest cost producer. Looking at the HDD industry over the last 10 years, WDC has managed to maintain a lower cost basis as measured by operating expenses as a % of revenue (excluding R&D, impairment charges, restructuring costs and other exceptional items), as shown below:
Comparing WDC to its most directly comparable competitor Seagate (“STX”), WDC has maintained an average 1.2% better OpEx cost differential over the 10 year period. Including R&D within this measure, the relative performance is even stronger in WDC’s favour, with WDC averaging 10.4% over the 10 year period, compared with Seagate’s 13.9%.
In terms of gross margin, having historically lagged Seagate by approx. 4% on average, WDC overtook STX in in FY13, the year in which it gained the largest market share, indicating a change in competitive dynamics within the industry and helped by the HGST acquisition improving the revenue mix with increased exposure to the higher margin enterprise drive segment. (FY13 is the first year to include a full year of HGST results within WDC reported results):
Over the last 10 years, WDC’s gross margin has trended consistently upwards as it became the dominant player in the HDD industry, to the point where it is now the stronger half of the duopoly with STX and should benefit from pricing power to sustain its target margins of 28-32%. Furthermore, its transition to a higher margin enterprise and SSD business should also help support its margins, where pure play SSD businesses have historically achieved margins in the 30% – 50% range.
Dominant HDD manufacturer
WDC has consistently grown its market share to the point where it has become the dominant player in a consolidated industry with the largest market share:
As of July 2013, WDC has approx. a 45% market share, gaining 10.9% at the expense of Seagate and Toshiba YoY. This gain in market share is primarily attributable to the HGST acquisition, with FY13 including full year results for HGST for the first time after the acquisition closed in 2012. Given that it is the lowest cost producer with the largest market share in a fully consolidated industry it is unlikely that a competitor would be able to step in and undermine WDC going forward, providing a barrier to entry to the industry that should protect WDC’s position.
Cash Generating Ability
WDC has consistently been the most cash generative hard drive manufacturer historically, as measure by both cash conversion cycle (CCC) and free-cash flow (FCF) margin:
In terms of CCC, WDC has historically converted sales to cash at a faster rate than STX, with a modestly negative cycle on average, compared with STX which has had a modestly positive cycle. Both companies’ CCC’s increased over the prior year, attributable to more timely repayments to creditors on average. However, the longer-term track record indicates that WDC has demonstrated superior management of its CCC.
In terms of assessing free-cash flow margin (being free cash flow/revenue %), WDC again has the superior record:
The consistent upward trend in FCF margin also indicates that WDC has a built a competitive advantage in being able to generate true, cash earnings. While in FY13 STX has a slightly higher margin, WDC has delivered a less volatile, steadily rising FCF margin over a 10 year time frame, with an average FCF margin of 9%, compared with STX’s 8%. Generally, any business that can achieve a 5% margin with consistency is a cash cow-type business, and while both WDC and STX qualify in this regard, WDC’s record is that bit superior in generating true cash earnings. Since the last major round of consolidation within the HDD industry occurred in 2011, on average 14% of every dollar in sales made by WDC has translated into FCF, compared with 12.4% for STX over the same period.
Historically, WDC has maintained the strongest balance sheet in the industry, as measured by debt-to-total-capital:
In each of the last 10 years, WDC has maintained a net cash position, with a modest amount of debt, while STX has been moderately to significantly leveraged, with a net debt position in 6 of the last 7 years, again indicating WDC possesses a competitive advantage within the industry. WDC has been able to grow and generate cash earnings without the use of significant leverage.
Return on Capital
Warren Buffett has espoused that companies generating consistent returns on equity (with little-to-no debt) of greater than 15% typically have a sustainable competitive advantage. Given the differing capital structures between WDC and STX, it is more meaningful to compare return on capital between WDC and STX, rather than simple ROE to assess any sustainable competitive advantage.
I consider return on capital from two perspectives, and my preferred measures are Buffett’s Return on Unleveraged Net Tangible Assets (ROUNTA), which excludes goodwill and Return on Invested Capital (ROIC), inclusive of goodwill. As Buffett stated, “What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractiveness of the operation,” (1983 Shareholder Letter). On this basis, ROUNTA is perhaps the best indicator of a company’s true return on capital invested in operations, as it reflects both debt and equity capital, and excludes goodwill and other intangible assets, which may reflect arbitrary historic decisions (such as acquisition premiums paid) that may not reflect the economic reality of a business. Additionally, I look at ROIC, which again includes debt and equity capital, but I include goodwill to assess management’s capital allocation decisions in the past, as it reflects prices paid for acquired entities or assets, which is relevant in the context of the acquisitions by WDC in the context of a consolidated industry. My ROIC also excludes cash, unlike ROUNTA, on the basis, that WDC as a highly cash generative business with a very short CCC and historically a neutral to negative working capital cycle, has a significant amount of cash on hand and so one could argue is not “invested” in operational assets which generate its FCF. Finally, I must qualify here however that I use FCF as proxy for owner earnings, or true, cash earnings to the owner of a business for the “return” measure, rather than accounting earnings, which do not always reflect economic reality.
Both measures indicate the persistence of a competitive advantage or economic moat in Buffett parlance, despite the commoditised nature of the industry in which WDC operates, as ROUNTA for most recent full financial year is 30% (vs. 10 year average of 25%) and ROIC is 33% (10 Year average is 44%):
Both measures demonstrate that the Company has consistently delivered rates of return on capital significantly in excess of average market rates of return. Compared to STX however, WDC returns, while high, have lagged STX on average (using ROUNTA):
STX’s higher returns have been attributable to STX historically having greater exposure to the higher margin enterprise segment. However, WDC’s return profile has been significantly less volatile and unpredictable compared with STX. Additionally, the acquisitions of HGST, sTec and Virident, all higher margin enterprise and SSD focused businesses, should help WDC maintain and improve its returns on capital going forward.
Commoditised industry and investment proposition
While WDC operates in a commoditised industry, I do not believe this disqualifies WDC from being a good investment. Commodity-type businesses are usually characterised by all or some of the following:
- Low gross margins
- Low returns on capital
- Absence of brand loyalty
- Presence of multiple competitors/operators
- Excess production capacity versus demand
- Erratic profits
I believe WDC counters each of the above characteristics as follows:
|Commodity business characteristic||WDC position|
|Low gross margins||Current margin of 28.5%, above its 5 and 10 year average margins; gross margin has steadily risen over time|
|Low returns on equity||Consistently high (and above average) ROUNTA and ROIC over a 10 year time frame|
|Absence of brand loyalty||While WDC produces commoditised storage products, the duopoly within the HDD industry means a lack of alternative options for storage demand; additionally, WDC has track record of producing reliable, high quality products with positive reviews|
|Presence of multiple competitors/operators||HDD industry duopoly with Seagate; SSD/flash industry has small number large players, with fragmented smaller players now seeing consolidation; WDC financial position has already allowed it to take advantage and gain foothold via acquisition|
|Excess production capacity versus demand||Duopoly in HDD, relatively small number of major competitors in SSD mean production can be regulated to match demand; also robust demand outlook due to rapid growth in digital content mean that capacity may not meet demand|
|Erratic profits||Consistent 10 year track record of rising revenues, gross margins, net margins and free cash flow, while delivering high returns on capital with no debt|
On the basis of the above, WDC demonstrates that it is an attractive investment proposition with favourable prospects, despite the commoditised nature of its industry.
Competitive Advantage – Overall Assessment using SWOT analysis
On balance, it appears that the strengths and opportunities for WDC’s business outweight the weaknesses and threats facing it.
9. Management ability and integrity:
In assessing management performance, I examine 4 areas:
- Returns on capital
- Capital allocation
- Insider holdings
Returns on capital: as Buffett stated in his 1979 shareholders letter, “the primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry etc). The ROUNTA and ROIC analysis provided above clearly demonstrates that WDC’s management have acted as effective stewards of the business for its owners, the shareholders. Consistently high returns on capital, in excess of average market rates of return, without any meaningful leverage, indicate that management have and continue to be highly capable managers of the business.
Capital allocation: there are three primary areas in which an assessment of WDC management’s allocation of capital should concern itself in my view: (1) M&A, (2) share repurchases and dividend policy, and (3) retention of earnings compared to increase in market value.
Firstly, I believe management have intelligently allocated capital historically by the businesses they have acquired or invested in. As outlined above, the enterprise and cloud segments are the high growth segments within the data storage industry, while SSD-oriented technology is the higher growth technology trend going forward. WDC management have clearly understood these aspects of their business, and continue to transition the business in this regard away from the traditional PC-reliant HDD model, without a decline in profitability or employing excessive leverage. The most notable capital allocation decision from management over the previous 10 years has been the acquisition of HGST. HGST was acquired for $4.3 billion, or approx. 5x EBITDA, a relatively modest multiple, and resulted in WDC becoming the dominant HDD manufacturer with the greatest market share, surpassing STX, while also giving it significantly increased exposure to the high margin enterprise and SSD ends of the market. To finance the acquisition, WDC assumed $2.3 billion of debt, but still remained in a net cash position given its significant cash generation at the time. The rationale for assuming the additional debt was to lower its cost of capital as interest rates were declining at the time, and to avoid tax that would have arisen should it have used its own cash reserves – approx. 65% of the Company’s cash is held overseas, and would have subject to tax were it to have been repatriated to the US parent company to fund the transaction. Further evidence of intelligent capital allocation has been WDC’s acquisition of STEC for $340 million in cash in June 2013 (not included in 2013 financial results). STEC is primarily an enterprise-oriented SSD manufacturer, and has been a top 10 SSD manufacturer for the last 5-6 years, although it has suffered from poor management, particularly in relation to sales and marketing, both areas of strength for WDC. WDC have effectively paid a relatively low price of $340 million (versus its own FCF of $2 billion+) for STEC’s strategically valuable enterprise-SSD technology and IP, again indicating an intelligent allocation of capital. So this again demonstrates management’s intention to continue to transition the business towards the higher growth (and margin) data storage segments. WDC has also made a number of other smaller, strategically significant investments this year, including investing $51 million in Skyera, which develops energy-efficient storage systems with SSDs, and the acquisition of Velobit, which develops SSD optimization software, for an undisclosed amount. Most recently, WDC announced the acquisition of Virident Inc, for $685 million in September 2013, a provider of server-side flash storage solutions, one of the fastest growing segments in enterprise and cloud computing. While this transaction is estimated to valued Virident 6x sales, and therefore ostensibly not cheap, this was a strategically important and complementary acquisition which should enhance WDC’s offering to the higher margin enterprise/SSD segment, and it must also be noted that Virident is on course for YoY sales growth of 140% in 2013, and is estimated to be growing at twice the rate of growth for the $4 billion server-side flash storage market segment. In my view, these acquisitions all constitute intelligent capital allocation decisions, with management employing relatively modest amounts of capital to acquire strategically important assets that increase the company’s exposure to the high growth, high margin market segments.
Secondly, in 2012 WDC announced two significant programmes to return cash to shareholders during FY13, as part of a plan to return 50% of its FCF to shareholders, via a share repurchase programme and initiating a dividend. The Company repurchased 19 million shares at an average price of approx. $44 per share during FY13, significantly below my conservative estimate of intrinsic value for the business, thereby constituting an intelligent capital allocation decision by management. The share repurchase programme also has capacity to buyback a further $1.9 billion worth of shares through to 2017, and so will continue to create shareholder value at current prices. WDC also initiated a dividend during FY13, with a $240 million dividend declared for FY13 (and $181 million of this paid at year-end), representing a dividend yield of 1.6% based on the year-end market cap.
While some may argue the institution of a dividend indicates that the Company has run out of ideas in terms of internal re-investment opportunities, I would argue this is not the case – WDC simply does not require all the cash it now generates to maintain and to continue to grow operations, and so the decision to return some cash to shareholders via a dividend indicates a clear recognition of shareholders’ interests. Overtime, I would expect the dividend to continue to grow at a sustainable level, given the Company’s cash generating ability.
My final assessment of management capability is again best articulated by Buffett, who in his 1984 shareholders letter, stated “that that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.” So how does WDC perform with under this criteria? Quite well, based on a 5 year track record as espoused by Buffett himself. The table below summarises this track record:
As the analysis above shows, retained earnings of $4.9 billion over the 5 year period from 2009 to 2013 produced a $5.9 billion increase in market value (with minimal leverage). Furthermore, the result is even better if one were to assess the above using year-end market capitalisation figures, as WDC’s market cap at 31 July 2013 was approx. $15.4 billion, meaning the same $4.9 billion in earnings retained over the period produced an increase of $9.8 billion in market value.
In each regard, WDC management has demonstrated a consistent track record of prudently allocating capital, having delivered consistently high returns on capital, intelligently selecting strategic acquisitions without paying excessively for them, and delivering at least a $1.20 increase in market value for every dollar retained in the business.
Management remuneration: given that WDC has historically been a highly cash generative business that has reached a dominant position as part of an industry duopoly, it is worthwhile examining how management have paid themselves. Have management steadily paid themselves more and more as the business has grown to its current position? Are there any indications of overly generous insider remuneration levels at the expense of the owners of the business? It does not appear so. The analysis below sets out the total remuneration for “named executive officers” of the company, that is the CEO, CFO, President, and various divisional head officers for 5 year period from 2008 to 2012 (2013 not filed as of writing):
Total compensation amounts outlined above comprise salary, bonus, stock awards, options awards, non-equity incentive plan compensation and other compensation disclosed. As the analysis shows, remuneration levels have remained broadly stable, averaging at 0.24% of revenues over the 5 year period. In 2012 remuneration levels were significantly higher than prior years due to the retirement of John F. Coyne as CEO, which triggered automatic vesting of stock options previously awarded to him, amounting to $6.3 million. Excluding this, total remuneration would have represented 0.26% of revenues. On this basis, it does not appear that WDC management have been drawing excessive remuneration from the company at the expense of shareholders.
I have appraised WDC using two primary valuation methodologies:
- EV/FCF multiple
Companies in the data storage industry tend to exhibit strong cash generation, with shorter cash conversion cycles than businesses operating in other industries. On this basis, free cash flow based methodologies are the most appropriate for valuing WDC. Both methods involve the conservative estimation of future FCF for WDC, which I outline below:
- Revenue split between Compute and Non-Compute in 2013 was 50%/50%; Compute revenues assumed to decline by 12% YoY from FY14 – FY17 – Gartner reported in June 2013 that worldwide PC shipments decline 11% YoY to June 2013, therefore analysis assumes this negative trend for PCs and consequently PC HDD units will continue. I believe this is extremely prudent given that IHS forecast that HDD storage will remain the prevailing medium in terms of market share for PC storage by 2017, at 64%, while WDC management projects that over 75% of exabytes in 2020 (or 4,425 exabytes) will be stored on HDDs.
- Compute gross margin assumed to revert to pre-Thailand flood level of approximately 18% (note 2012 and 2013 margins were approx. 28%, so prudently assume decline in HDD margins given increased expected adoption of SSD, despite likely pricing power for WDC given duopoly with STX)
- Non-Compute revenues (comprising non-PC related revenue streams of enterprise HDD, SSD, CE and Branded Products) leveraged to cloud computing, big data and consumers are assumed to increase by 15% per annum from FY14 through to FY17; I believe this projected growth rate is very reasonable, being below projected CAGR for general exabyte storage from 2012 to 2020 of 33% according to WDC as well as below the projected growth in SSD, ranging between 23% and 63% CAGR according to various industry analyst reports from IHS and IDC
- Non-Compute gross margins are assumed to be maintained at 33%, based on current margin range achieved by both WDC and STX and in line 5 year average margins achieved by enterprise and SSD storage providers such as SanDisk STEC and Fusion-io.
- Overall I assume revenues are projected to grow at 5.9% CAGR over the next 5 years in my model, which I believe is extremely conservative in the context of the growth outlook for data storage and WDC’s track record (10 year CAGR of 19.7%)
- Opex assumed to represent 15% of revenues going forward, in line with 2013 and 2012 levels, but above pre-2013 5 year average of 10.9%, to reflect likely increased R&D spend requirement going forward given advances in SSD technology and WDC’s increased exposure to this segment
- Depreciation & Amortisation is assumed to be 7.6% of revenues, based on 2013 and 2012 levels, reflecting steady rate post-HGST acquisition
- No incremental working capital requirement is assumed based on 2011-2013 trend
- Capex is assumed at 6.9% based on 2011-2013 trend, and approximates depreciation. This is also in line with capex rates for other storage businesses, including pure enterprise and SSD providers; therefore no incremental capex is assumed to be required for WDC as it furthers transition from traditional HDD manufacturer to HDD and enterprise and SSD- business
- Resulting free cash flow margin from these projections ranges from 12% – 15%, in line with WDC’s 5 year historic range of 9.2% – 18.8%; therefore I conclude these projections to be reasonable
- As a sense check, my projected CAGR for revenues and free cash flow appear reasonable at 5.8% and 12.1% respectively, versus WDC’s historic 10 year track record of 19.7% and 32.6% respectively
I believe the above analysis presents a conservative estimate of WDC’s sustainable free cash flow or earning power for valuing the business.
The above DCF valuation analysis assumes the following:
- Discounting using mid-year convention at a rate of 15%, being my required after-tax rate of return on my investments; terminal growth rate assumed to be 2%
- Deduction of total debt per most recent 10-Q filing for the quarter ended 30 September 2013
- Deduction of pension-underfunded balance, operating lease obligations and Seagate litigation settlement as disclosed per 31 July 2013 year-end 10-K and most recent 10-Q filing
- Add back of $4. 5 billion, being my estimate of excess cash (vs. gross cash balance of $4.8 billion per 10-Q at 30 September 2013)
- Implied valuation of $22 billion, or $93 per share on a fully diluted basis (242 million shares per 10-Q at 30 September 2013)
The above EV/FCF valuation analysis assumes the following:
- Sustainable FCF of $2.4 billion as per projections outlined above
- Multiple range of 8x – 10x used, given quality of cash earnings and growth prospects, with WDC having a dominant HDD position and strong growth outlook for its nascent SSD business
- Additionally, upper range of 10x multiple is further supported by market valuations for relevant comparable businesses in the data storage industry at present:
- Excluding outliers highlighted, an 8.0x – 10x EV/FCF multiple appears reasonable for a business of WDC’s quality and prospects. This implies a valuation for WDC’s equity of $21 billion – $26 billion or $86 – $106 per share on a fully diluted basis (242 million shares per 10-Q at 30 September 2013)
I believe the following represent the primary risks to my appraisal of WDC:
|Decline in HDD usage/faster SSD adoption than expected||While HDD usage may decline over time, it should remain the dominant storage medium over the next 10 years, due to cost and capacity advantages over SSD; additionally NAND supply constraints will mean that SSDs cannot be produced at a sufficient rate to keep pace with continued data growth to fully replace HDDs; furthermore, WDC’s nascent SSD business should benefit from any increase rate of SSD adoption|
|Margin erosion – falling Average Selling Prices, increased input costs (particularly NAND prices)||HDD revenues may be impacted by further price and/or volume declines given increase in expected SSD usage and declining PC sales reducing demand. However, WDC’s position as market leader within HDD duopoly with STX should enable it to maintain pricing. With regarding to SSD revenues, margins may be impacted by NAND prices, which are susceptible to sudden increases due to supply constraints; WDC’s partnership with SanDisk to produce hybrid drives should enable it to source sufficient NAND supply for SSD lines|
|Further PC declines in PC shipments||50% of WDC’s revenues are from PC market, which is expected to weaken further due to proliferation of smartphones and tablet computing; while PC sales may decline further, it is unlikely that PCs will be replaced completely by non-PC or “smart” devices. Additionally, my intrinsic valuation analysis reflects an assumed 12% YoY decline in PC client sales, which is worse than current expectations|
|WDC’s SSD business fails to grow as expected||WDC offers SSD products via its HGST, STEC and Virident acquisitions, and via its strategic investment in Skyera. There is a risk that the SSD offering fails to reach potential due to post-acquisition integration issues. However, WDC management has a history of successfully integrating bolt-on and strategic acquisitions and financial performance over the last 10 years clearly demonstrates this. Furthermore, the SSD offering has real potential, with STEC, Virident and Skyera are each ranked in the top 10 SSD companies for the first half of 2013 (www.storagesearch.com).|