Too Much Love Is Killing This Stock Today

"No, there's no making sense of it
Every way I go I'm bound to lose
Too much love will kill you
Just as sure as none at all"
-- "Too Much Love Will Kill You" by Brian May, 1992

This tribute to the rapidly waning National Poetry Month seems like a perfect fit for Western Digital (NYSE: WDC  ) today.

The maker of hard drives for enterprise and consumer systems just reported third-quarter results, and it was a blowout. Non-GAAP earnings jumped 281% year over year to $2.52 per share on $3.0 billion in sales -- a 30% boost. Analysts would have settled for something like $1.55 per share on the bottom line and a 7% revenue boost.

Moreover, Western Digital is so over the flooding disaster in Thailand. "The recovery activities related to both WD operations and those of our supply chain partners affected by the Thailand floods have reached a point where we now have the capability to adequately meet anticipated customer demand in the current quarter and beyond," said CEO John Coyne.

And therein lies the rub. WD's quick recovery is killing the stock, which dropped as much as 15% on the news. Not exactly the kind of reaction you'd expect from earnings like that, right? In all fairness, archnemesis Seagate Technology (Nasdaq: STX  ) shareholders are feeling the pain, too: Seagate plunged 10% at worst.

So why is a full recovery so bad for hard-drive stocks? In very simplistic terms, the disaster hamstrung hard-drive production and drove up prices significantly. With supply and demand in balance once again, investors fear that drive prices might plummet -- taking revenue and profit boosts with them. Just look at this pricing trend and tell me what happens when average unit prices snap back to normal levels:

Quarter

Q2 2011

Q3 2011

Q4 2011

Q1 2012

Q2 2012

Q3 2012

Average Selling Price $47 $45 $44 $46 $69 $68
Unit Volume (Millions) 52.2 49.8 53.8 57.8 28.5 44.2

Data taken from Western Digital's earnings calls as presented by S&P Capital IQ.

Put your Foolish thinking cap on
How should we Fools think about Western Digital's update? For one thing, these comments run counter to Seagate's more muted recovery outlook. In Seagate's view, it will take another year or so to repair the capacity gap across the computing industry's food chains. System builders, distributors, and other customers still need to rebuild their depleted inventories even after manufacturing plants get back to full speed.

And I think Western Digital agrees with that thinking. The outlook for the second quarter points to sales in the $4.3 billion range and earnings close to $2.45 per share. The year-ago quarter -- pre-flooding -- stopped at $2.4 billion and $0.81 per share, respectively. That surge comes even as the expected unit volume fell somewhat year over year.

Coyne underscores that conclusion: "There's still a little bit of catch up to do." My math also agrees as the stable revenue and earnings guidance figures imply that pricing should stay pretty flat at last through the summer. If you picture unit prices plunging while volumes ramp up, you might still see similar top-line sales, but profits would suffer.

Concrete examples
It's like the difference between Apple (Nasdaq: AAPL  ) and Wal-Mart (NYSE: WMT  ) : Apple collects huge revenue from a relatively small number of pricey transactions, while Wal-Mart turns over untold billions of transactions at much lower prices and sliver-thin profit margins. That's why Wal-Mart handles triple the revenue of Apple but Cupertino walks home with the larger profits and cash flows.

If Apple's margins ever start looking like the retailing giant's, profits would plunge. That's what investors imagine happening to Western Digital and Seagate very soon. But even a fully functional supply chain will need to run red-hot to plug the lingering unfilled demand -- and don't forget the holiday and back-to-school seasons boosting demand in the back half of the calendar year. I still see strong pricing lasting at least until the holidays, maybe even into 2013.

But wait -- there's still more! Some technology trends work in favor of the big and cheap magnetic disk drives that are Western Digital's bread and butter. In a special report penned by the Fool's finest analysts, you'll find the only stock you need to profit from the new technology revolution in Big Data and business intelligence. The report is totally free, but it won't be available much longer, so get your copy right away.

Fool contributor Anders Bylund holds no position in any of the companies mentioned. Check out Anders' holdings and bio, or follow him on Twitter and Google+. The Motley Fool owns shares of Western Digital and Apple. Motley Fool newsletter services have recommended buying shares of Apple, creating a diagonal call position in Wal-Mart and creating a bull call spread position in Apple. The Motley Fool has a disclosure policy.

We Fools don't all hold the same opinion, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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 April 27, 2012, at 5:52 PM, Mega wrote:

    Today's reaction was way overdone. Everyone knows the hard drive industry is cyclical and current profits are massive. There's nothing to indicate that this cycle is nearing an end. Furthermore WDC has consistently been the most disciplined company in the industry, which is why they have outperformed all the others over the last 10 years.

  • Report this Comment On April 27, 2012, at 8:31 PM, hin25 wrote:

    I think they forgot that there is only 2 player in the market now.... For a hdd to be price @60+ is resonable

  • Report this Comment On April 29, 2012, at 5:39 PM, kdsudac wrote:

    The table showing ASP vs. quarter is very helfpul information.

    I'm long both STX and WDC. While I do think it is likely that prices decline from their post-flood peak, I don't think it's a given that the prices return to their pre-flood levels.

    As hin25 points out, consolidation has resulted in their being 2 major players in the HDD industry. The consolidation was the result of Samsung and Hitachi selling their hard drive divisions to Seagate and Western Digital.

    I think even more important than the number of major players is the fact that the major players are exclusively HDD companies. Going forward there will definitely be strong pressure from shrewd OEM customers to lower prices. However, now the OEMs don't control a significant percentage of HDD capacity (Samsung and Hitachi HDD units). This means more pricing power in WDC's and STX's hands.

    The billion dollar question is: "what are the medium-term ASPs?" If you take the midpoint, and model a $55 ASP, then the cash flow is extremely attractive. Even with a conservative $45 ASP there is still healthy cash flow. The current valuations and cash flow potential of WDC and STX indicate a great value.

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