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Hard drive manufacturer Western Digital (NYSE: WDC ) made its books light up with a fantastic jump in both revenue and profits for the quarter ending in March. Unfortunately, the fear of higher operating expenses, and softer demand that might result in weaker hard drive pricing in the current quarter, sent the company's stock price plummeting by 14% on April 27. Western Digital wasn't alone. Fear surrounding future prices of hard drives also had a negative effect on Seagate's (Nasdaq: STX ) stock price that day.
Last year, the Thailand floods disrupted the supply of hard drives, which gave both Western Digital and Seagate the opportunity to hike prices significantly. Now that supply in the industry is returning to normal, there are concerns about downward pricing pressures and the consequent impact on earnings.
In my opinion, the apprehension is exaggerated. Let's go over Western Digital's numbers.
Western clocked a cool 35% year-on-year jump in revenue in the first quarter of 2012, to $3.03 billion (including $614 million from newly acquired HGST). But even more impressive was the huge jump in the company's gross margins from just 18.2% to a lofty 32.2%. This means that the company was not only able to grow revenue significantly, in part thanks to higher hard drive prices, but it has also been able to control costs.
So it's not surprising to see Western's net income getting an astounding threefold boost from the previous year's figure to $483 million. The company also lifted its next-quarter guidance of $4.2 billion to $4.4 billion, which was above Street expectations.
Turning to the balance sheet, the company has about $3.4 billion in cash. So we have a solid cash-rich company that can pursue rapid inorganic growth through acquisitions or increase dividend payments. Either way, it's a win-win situation for investors.
So what will happen to hard drive prices and earnings?
Well, prices are likely to go down. It is plain and simple economics. In any case, the super-high prices need to be treated as windfall gains as they are not sustainable in the normal course of business. But fundamentally, the industry remains strong with significant demand to support reasonable prices (which allows for reasonable profit).
With increasing demand from storage-intensive data centers and cloud service providers such as Amazon's Web Services, demand for high-performance or hybrid hard drives will surely remain robust. According to Global Industry Analytics Inc., the storage of information is growing at a rate of 65% every year, and that's likely to generate a mind-boggling 3 million petabytes by 2020 worldwide. One petabyte is equivalent to 1 million gigabytes.
Besides that, new areas such as cloud computing, and traditional areas such as personal computers, are also expected to do well. Research firm Gartner predicts that personal computer shipments will rise by 4.4% to 368 million units this year. That should generate more demand for hard drives from OEM customers.
Apart from that, Microsoft is due to release the Windows 8 operating system this year, which could create demand for new computers as users replace or upgrade older machines to take advantage of the new operating system.
A solid future
Western's recent acquisition of Hitachi's hard drive business finally got an approval from the Chinese government. Hitachi is a renowned player with deep roots in the enterprise storage market -- a higher-margin segment and an area where Western is barely present.
The deal will also grant access to Hitachi's solid-state drive offerings, something commonly used in high-end PCs, servers, and ultrabooks. Western Digital is sweetly positioned, given that the enterprise SSD space is supposed to be a relatively high-margin business. To make things sweeter, Hitachi also has an agreement with Intel that allows Western access to its NAND flash technology. That is a sure advantage given the capital-intensive nature of the business.
All in all, there is a lot to look forward to from the deal: an expanded market opportunity and improved long-term profitability.
The Foolish bottom line
Western Digital will see margins dip below their supernormal highs, given that industrywide supply side issues have been resolved. However, the recent correction makes the stock lucrative at these levels. The company certainly looks like a value pick with limited downside risk.
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Also, don't forget to add Western Digital to your free Watchlist.