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Rising Star Buy: Double-Down on Western Digital

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This article is part of our Rising Star Portfolios series.

At the beginning of the month, I bought an initial 2% position in hard drive maker Western Digital (NYSE: WDC  ) for my Messed-Up Expectations portfolio. At the time, I believed that the market was underappreciating the continued need for inexpensive mass storage for digital content. After Tuesday's earnings release, I believe that's even more the case.

Not only that, but I believe the market's short-sighted concern with management's comments about over-supply of hard disk drives in the pipeline and how Western Digital is going to deal with that is continuing to hold the price down, giving us an opportunity to buy more shares.

The law of supply and demand
In the last earnings conference call, CFO Wolfgang Nikl and COO Tim Leyden gave an Economics 101 lesson to analysts and investors -- you know, the one on supply and demand. Nikl noted that over the last decade, PC shipments (with HDDs inside them) declined by 9% on average in the first calendar quarter, but HDD makers only cut back shipments by 4%. The law of supply and demand says that when there is an oversupply of drives, their selling prices will go down. This is exactly what's been happening to the industry. Leyden said, "The consequence of this mismatch ... has been to put pressure on March quarter pricing, contribute to an inventory overhang exiting [that] quarter, and consequently exert further pricing pressure in the June quarter."

By its estimates, there is still an excess of 6 million to 8 million drives in PC manufacturers' pipeline. Even though Western Digital expects them to go through about 160 million units in the quarter, it is predicting that new shipments will only be 155 million units, in order to reduce that excess. Simply put, Western Digital isn't going to take it anymore.

Yeah, so?
Analysts on the call weren't impressed. Sherri Scribner of Deutsche Bank said, "I think it is admirable to try to change the dynamics of the industry, but I am curious what you guys think you can do." Mark Moskowitz of JPMorgan Chase added, "I share Sherri's confusion over the guidance."

Scribner also asked, "Will you allow yourself to lose [market] share [to competitors] or will you still try to keep share?" CEO John Coyne replied, "The customers will decide that at the end of the day, but we are a for-profit business. We're not a charity."

Prisoner's dilemma
My take on what Western Digital is trying to do is to awaken competitors Seagate Technology (NYSE: STX  ) and Hitachi (NYSE: HIT  ) to the fact that none of them can survive on low margins driven by a glut of HDDs in the pipeline. This is not a "make it up on volume" type of business. That point was further driven home to Seagate when it reported its own second quarter earnings on Wednesday and had to show a drop of 11 percentage points in gross margin from a year ago -- from 30.5% to 19.5%. That drop contributed to a massive 72% drop in net income.

Western Digital's management is making the right move in trying to rebalance supply to demand. If Seagate and Hitachi are smart, they'll follow its lead. And everyone will live happily ever after... well, at least until next quarter.

My response
The price of Western Digital's stock continues to reflect very low expectations by the market. At Friday's close of $31.51, trailing free cash flow of $1 billion is expected to grow annually by 1% for the next five years, by 0.5% for the following five, and then never grow again (discounting at my 15% hurdle rate). I think that's an MUE.

Consider this not-very-aggressive scenario:

  • Management's prediction of 7.5% growth in total HDD shipments for this year is accurate and growth then slowly declines.
  • Western Digital retains its market share level of 32%.
  • It slowly increases gross margin from the trailing level of 21.3% to the high end of its margin-model range of 23%, thanks to better supply and demand alignment.
  • Operating expenses grow with revenue.
  • Effective tax rate, and all else, remains the same.

That results in average FCF growth of 6% for the next five years (well below its historical average) and then 2% from then on. And that gives an expected share price of $41, using my hurdle discount rate, which is 31% above Friday's close.

Therefore, tomorrow the MUE portfolio will double its exposure to the company by purchasing another 2% position.

I invite you to join me on my discussion board where I'll be happy to share the details of the above model, why I use 15% as a discount rate, and what exactly MUE means.

Fool analyst Jim Mueller doesn't own shares of any company mentioned. He works for the Stock Advisor newsletter service. The Fool owns shares of JPMorgan and Western Digital. 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 (2) | Recommend This Article (9)

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 January 24, 2011, at 2:43 PM, CMFSoloFool wrote:

    I tend to agree with most of your points, and see the value in WDC, which is why I am long WDC and looking to add to my position. The big question is whether STX and HIT got the message. I don't think STX is in a position to cut more margin to try and gain market share. HIT is not a big enough player in HDD to steal a lot of market share from either one, but they could stir things up a bit.

    However, my bigger concern is whether the analysts will continue to discount the HDD makers at these rates. Many are discounting just because of the threat from SSD and the tablet euphoria, so they have taken a very bleak outlook on PCs and the HDDs within them. What would change this outlook is stronger PC sales, and strong Cloud acceptance, which increases HDD demand. I do think PC sales will improve somewhat, but I don't really know if it will be enough to cause analysts to recommend the stock to their followers.

  • Report this Comment On January 24, 2011, at 4:27 PM, TMFTortoise wrote:

    All good points, FoolSolo. Weighing vs voting.



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