Is Western Digital on Firm Footing?

A winning screen can save investors a lot of time, and that's exactly what Joseph Piotroski did when he created the Piotroski Score. By buying stocks with a high score and shorting those with a low score, Piotroski found that an investor would have had 23% annual profits from 1976 to 1996, soundly beating the market. Let's see how the score works and whether it shows a buy, sell, or ignore signal for Western Digital  (NYSE: WDC  ) .

How it works
Piotroski was looking for a way to separate the wheat from the chaff with low price-to-book stocks, so he defined the score's applicable universe to only include those in the bottom 20% of P/B-ranked stocks. The score then breaks down into nine criteria:

  • Positive return on assets. This should be obvious. A healthy company has positive net income.
  • Positive cash flow from operations. We want to make sure a company's earnings are actually available to shareholders and aren't going out the window with inventory buildup and other cash flows.
  • Positive change in ROA. A company can't improve profitability forever, but it gets another point if the return on assets, measured by net income divided by total assets, is higher this year than last year.
  • Higher cash flow from operations than net income. It's easier to use accounting shenanigans to make earnings look better than it is with cash flows, so a healthy company has higher operating cash flows than gimmick-prone earnings.
  • Decreasing leverage ratio. Another obvious one. Give the company a point if its long-term-debt-to-total-assets ratio is lower this year than last.
  • Increasing current ratio. Same deal here. A high current ratio is an indicator of stability, so the company gets a point if it increased this year over last year.
  • No new share issues. A healthy company doesn't need to fund itself by issuing new shares, and certainly not when they're selling below book value. You won't usually ding a company for slight dilution from things like option grants though.
  • Gross margin improvement. A company with rising margins is better able to control costs and generate demand for its products.
  • Increasing turnover ratio. A high asset turnover ratio indicates business efficiency and strong demand. Give the company a point if sales divided by assets was higher this year than last.

With a P/B of 1.04, Western Digital falls into the bottom 20% of P/B-ranked stocks. Let's see whether it meets the other criteria.

Criteria

Result

Pass or Fail?

Net income $768 million Pass
Cash flow from operations $1,617 million Pass
Change in ROA 10.03% versus 22.07% Fail
Cash flows > net income $1,617 million versus $768 million Pass
Decreasing leverage ratio 0.01 versus 0.03 Pass
Increasing current ratio 2.52 versus 2.29 Pass
New share issues No new issues Pass
Change in margins 7.82% versus 12.86% Fail
Change in turnovers 1.28 versus 1.71 Fail
     
  Total 6


Western Digital gets a medium-range score of six, suggesting that there isn't a compelling reason to buy shares now, nor sell any if you own them.

The company is healthy, but each of the tests it fails indicates that business is slowing. This isn't specific to Western Digital -- competitors such as Seagate (Nasdaq: STX  ) and SanDisk (Nasdaq: SNDK  ) fail the same tests. Much of this has to do with a weak market for PCs, especially as more consumers opt for tablets and smartphones, which tend to use solid-state drives for storage, rather than traditional PCs, which use hard-disk drives, the source of most storage manufacturers' sales.

At the same time, more consumers are moving much of their data into the cloud, which means even fewer hard drives sold. A thousand people don't have to store their downloaded movies on their own computers anymore, for example, but can instead stream from a central repository like Netflix.

This helps to explain why companies such as Rackspace (NYSE: RAX  ) and EMC (NYSE: EMC  ) , which are more geared toward cloud storage, have been outperforming their desktop-oriented peers, with better earnings growth, higher margins, and a rising return on assets. Neither company has a low enough P/B to qualify for the Piotroski Score, but if they did, they would only miss the current ratio test and score an eight, a clear buying signal.

It's important to note, however, that the numbers for all of these companies could change soon. Flooding in Thailand, where 40% of all hard drives are manufactured, has crippled the industry. Even Apple CEO Tim Cook recently predicted a shortage of hard drives for the foreseeable future. Western Digital may be healthy now, but this situation could deeply affect its prospects over the next year or so.

Stay updated by adding these companies to My Watchlist.

Fool contributor Jacob Roche holds no position in any of the stocks mentioned. Check out his Motley Fool CAPS profile, read some of his other articles, or follow him on Twitter. The Motley Fool owns shares of EMC, Western Digital, and Apple. Motley Fool newsletter services have recommended buying shares of Rackspace Hosting, Netflix, and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 03, 2011, at 2:09 PM, willypt wrote:

    Amazing, Piotroski should have added current news to his formula. WD's slider plant is under four feet of water, all equipment is destroyed. All notebook production equipment is also underwater. They will take nearly a year to recover if ever. Not time to watch now, maybe in six months if the other drive company doesn't take a lot of market share on long term contracts. Read the news before you post this inane useless information, you are scareing away potential clients, it worked on me!

  • Report this Comment On November 03, 2011, at 3:55 PM, TMFTheDoctor wrote:

    I noted the current situation at the end of the article. WDC is a perfect example of why the Piotroski formula is useful to ascertain the current health of a company but also can't be blindly followed. Based purely on financials, WDC has a solid balance sheet and is earning money. It remains to be seen what the full effect of the situation in Thailand will be, and if WDC were coming into this crisis in a less stable position, it would probably be a killing blow for the company. But they're coming in in a relatively decent position, and all of their competitors are being affected as well, so it's difficult to say what the long-term effects will be a few years from now after this crisis has passed.

  • Report this Comment On November 04, 2011, at 12:28 PM, nhawleysc wrote:

    "At the same time, more consumers are moving much of their data into the cloud, which means even fewer hard drives sold." Curious thing to say, last I checked the only thing a Cloud could store is water. The fact is when data move from the PC to the Cloud, the industry effect of a user moving data from their PC to the cloud, ends up being a net gain for HD makers. That's because the data is being moved from a low margin Personal Compute drive to a High Margin Mission Critical/Business Critical drive. Given Datacenter Architectures, data tends to be duplicated (in RAID Arrays, Mirrors, and Backups) which means that 1 GB stored on a PC may end up becoming 3-6 GB "in the cloud".

    So in the end "Moving Data to the Cloud" is a double or triple win for the industry.

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