Western Digital: undervalued on data center tailwinds

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Western Digital Society (NASDAQ:NASDAQ: WDC) is a world leader in hard drives and flash memory. Its share price has been slaughtered by around 67% from its all-time highs in 2018, but is now showing signs of value. The the company has strong partnerships with “hyperscale” cloud providers and is in privileged position to benefit from the growth of the cloud industry. In this article, I’ll break down its business model, financials, and valuation. Let’s dive into it.

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Data by Y-Charts

business model

Western Digital manufactures, distributes and sells hard drives and flash memory products. The company has one of the strongest brands in the hard drive industry and is known as a leader in its category. A quick check on review websites shows that Western Digital products are usually in the number a or number of them tasks. Its competition includes Seagate, Samsung, Dell and many more.

On the flash memory side, Western Digital acquired SanDisk in 2016, which is a category leader in flash memory cards and USB drives. SanDisk is quite dominant in this market with memory cards supplied for mobile phones and professional cameras. A headwind against this part of the business has been the smartphone’s transition to on-board memory as we first saw with the iPhone, but even most Samsungs now come with substantial on-board memory. .

Sandisk

All Sandisk (Canon Memory Card Search)

Western Digital currently makes 46% of hard drive revenue, 54% of flash memory, which is a pretty even split.

The company also holds a leading position in gaming with its WD_BLACK brand, which is certified for Song PS5 consoles. Total exabyte shipments for its SSD [Solid state drives] increased by 70% year on year.

Stable finances

Western Digital delivered stable financial results for the year Fourth quarter of 2022. Revenue was $4.53 billion, which increase down 3% sequentially, but was down 8% year-over-year. This decline may seem terrible at first glance, but when we step back, we see that total revenue for fiscal year 2022 was $18.8 billion, up 11% from $16.9 billion. generated the previous year.

By end market, Cloud revenue was $2.1 billion, which showed solid growth as it grew 18% sequentially and 5% year-over-year other. This surge in cloud revenue comes as no surprise, as the freight train that is digital transformation shows no signs of slowing down, even as we head into a potential recession. Indeed, when a company moves its on-premises IT to a data center or the “Cloud”, it can give it greater flexibility and lead to long-term cost savings. It is therefore not surprising that the Cloud Computing market was worth approximately $430 billion in 2021 and is expected to reach over $1 trillion in value by 2028.

Cloud revenue

Cloud revenue (Presentation FQ4)

With regard to Western Digital in particular, enterprise SSDs [SSD] revenue doubled sequentially and grew 38% year over year for cloud customers. The company also continued to expand its 18TB and 20TB power-assisted hard drives, which increased near-line hard drive revenue by 7% year-over-year. The industry is also transforming into magnetic recording Shingled [SMR] hard drives, these allow for greater storage density and are therefore a popular offering from Western Digital for cloud customers.

In the fourth quarter, customer revenue was $1.6 billion, down 5% sequentially and 14% year-on-year. The decline was primarily due to a 10% decline in PC shipments, as OEMs aggressively adjust inventory to meet tepid consumer demand. The PC market is going through a hard drive transition [Hard Disk Drives] to flash technology. Therefore, it is not surprising to see HDD revenues declining rapidly. However, this drop happened at a slightly faster rate than expected, which is why Western Digital needs to think things through and reduce its manufacturing setup for hard drives.

Customer revenue

Customer revenue (Revenue Report FQ4)

Reduced demand for smartphones in China has also been a headwind for the company. However, they are well positioned to provide flash memory from the new fleet of 5G smartphones, which are expected to come online. The penetration of 5G smartphones is expected reach 21% globally by 2025, with approximately 51% of devices in North America having a 5G connection by the end of the period.

Western Digital has a popular consumer brand, with its products sold directly to the consumer from its own website. Also, through popular retailers such as Best Buy (BBY), Target (TGT) and JD.com (JD) in China. Despite the brand’s popularity, its consumer segment accounts for only 17% of its total revenue. For FQ4, the company generated $0.8 billion in consumer revenue, which was down 9% sequentially and 23% year-over-year. This was primarily driven by weak consumer demand, which is a macroeconomic issue, so I don’t see it as a major long-term concern.

Consumer

Consumer (FQ4.22)

If we break down the business by technology, HDD revenue was $2.1 billion in the fourth quarter, down 15% year over year. This decline is due to a 10% drop in total shipments, due to lower consumer demand, as mentioned earlier. HDD gross margin increased to 28.2%, up 50 basis points sequentially due to higher selling prices, but was still down year-over-year due to winds opposites of inflation.

HDD revenue and margin

HDD revenue and margin (Revenue Report FQ4)

Flash memory revenue was $2.4 billion in the fourth quarter, up 7% sequentially but down 1% year-over-year. These results are due to a 6% increase in drill bit shipments and a 2% increase in selling prices.

Flash gross margin also showed a steady 40bps year-over-year improvement to 35.9%. This was driven by the growth of the enterprise data center segment, as mentioned earlier.

Flash memory

Flash memory (Presentation of FQ4 results)

Turning to earnings, Western Digital generated normalized earnings per share of $1.78, which beat analysts’ expectations by $0.06. This profitability was favored by operating expenses of $760 million, lower than management forecasts.

Western Digital has focused heavily on “adjustment” to manufacturing and inventory while reducing debt by $1.7 billion. In the “cash flow walk” below, you can see that the company generated $295 million in operating cash flow and then $392 million in Cash CapEx. Then, after paying off the debt, the company was left with a strong cash position of $2.3 billion. However, it should be noted that the company still has about $7 billion in long-term debt, which is substantial, but only $91 million is short-term and needs to be paid off within the next two years.

Cash flow market

Cash flow market (created by author Ben at Motivation 2 Invest)

Advanced Assessment

In order to value Western Digital, I incorporated the latest financial data into my advanced valuation model, which uses the discounted cash flow valuation method. I have projected revenue to continue down 20% for next year, which is very extreme, although I think it’s best to be cautious due to macroeconomic challenges. Additionally, I forecast steady growth of around 5% over the next 2-5 years.

Western Digital stock valuation 1

Western Digital stock valuation 1 (created by author Ben at Motivation 2 Invest)

I also forecast the business operating margin to increase slightly to 13% over the next three years as inflation subsides and supply chain constraints unravel. This margin also includes an adjustment for R&D investments, which I capitalized. I also factored in the higher expected corporate tax rate of 28%, which is driven by R&D tax changes.

Western Digital Stock Valuation

Western Digital Stock Valuation (created by author Ben at Motivation 2 Invest)

Given these factors I get a fair value of $54.67 per share, the price at the time of writing is around $32 and therefore the stock is undervalued by around 40% which provides a substantial margin of safety.

As an additional data point, Western Digital is trading at a futures price versus earnings [P/E] report = 13.42. That’s about 18% higher than its 5-year average of 11.29. However, the price-to-sales ratio = 0.67, or 31% cheaper than its 5-year average. Compared to other players in the industry, Western Digital is at the cheap end of the spectrum, with a P/E ratio [TTM] of 6.9.

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Data by Y-Charts

Risks

Recession/reduction in IT spending

The high inflation and rising interest rate environment has led many analysts to provide a recession. Personally, I believe the fear-driven news cycle does not help, as it can instill fear in the consumer and cause them to delay spending they would otherwise have made. The good news for Western Digital is that you could say the product is partly essential because if your hard drive fails and you need another one for storage, you’ll probably buy it no matter what. economic outlook.

hard drive contest

As mentioned earlier, there is a lot of competition in the hard drive industry. Additionally, the number of consumers using cloud storage such as G-Drive, iCloud, etc. will only increase and therefore the need to buy physical hardware is no longer essential as before. So, I think Western Digital is making the right choice by focusing on its cloud offering, even if in the short term I expect the consumer segments to decline. In terms of semiconductor stocks, I personally prefer Micron (MU), which produces DRAMs and NANDs [ Flash Memory]. Although not as well known as Western Digital, I think they have more moat because DRAM requires more advanced manufacturing capabilities. I wrote a full analysis on Micron, you can read here.

Final Thoughts

A bet on Western Digital is really a bet on the future of hard drives and flash memory. Given the thirst for data and information we are seeing globally, I predict the secular trend will be positive. The stock is currently inherently undervalued, and while I suspect some volatility over the next year, over the long term it looks like a solid investment assuming management can execute at the data center level.