My Fool.com colleague Tim Green recently argued that computer storage specialist Western Digital's (NASDAQ:WDC) dividend might not be as safe as it might seem. Tim makes a number of excellent points, observing that prices of NAND flash -- the storage medium that underlies the company's solid-state drive products -- have been in free fall. This, Tim observes, means that the company's recent free cash flow performance "is not sustainable."
He also argues that it's "impossible to predict how bad things will get" in the world of NAND flash, something that poses further risk to the company's free cash flow generation and, ultimately, its dividend.
All of those points are valid. Nevertheless, here's why, if I were a Western Digital shareholder, I wouldn't be worried about a dividend cut anytime soon.
Things would have to get really bad
Over the last 12 months, Western Digital generated about $9.10 per share in free cash flow. Given the current NAND flash pricing environment, that number is undoubtedly set to come under near-term pressure. However, considering that the company's current dividend per share on an annualized basis is $2, the company's free cash flow would need to drop by an eye-popping 78% from where they were over the last 12 months for the company to potentially be forced to cut its dividend.
I'm not convinced that things will get that bad. (Although, as Tim points out, analysts with Evercore see Western Digital's free cash flow per share dropping to $2.35, so at least someone out there thinks it could get that bad.)
Although analysts are certainly no strangers to getting things wrong, it's at least worth pointing out that current analyst consensus calls for the company to generate non-GAAP earnings per share (EPS) of $6.92 in 2019 followed by $7.31 in 2020. Those numbers are certainly significantly down from the $14.73 in EPS that the company generated in its fiscal 2018, but assuming that the company's free cash flow generation mostly follows non-GAAP EPS, and assuming that analysts aren't, in aggregate, wildly underestimating the magnitude of the profit deterioration, Western Digital's current dividend should be sustainable.
What if the dividend does get cut?
While I'm not particularly worried about Western Digital slashing its dividend, there's always the possibility that it could happen. In that case, however, I'd say that investors have bigger problems than the dividend being cut. If Western Digital can't generate enough free cash flow per share to comfortably cover the dividend -- say, at least $2.75 per share -- then not only would the dividend be at risk, but the share price could move substantially lower from here, since a business that generates lower free cash flow isn't worth as much.
For some perspective, even if Western Digital were to command a price-to-free-cash-flow multiple of around 12 -- which is close to where that metric peaked for the computer storage specialist over the last few years -- then free cash flow per share of $2.75 per share in that case would imply a share price of $33, or a 12% decline from current levels. However, there's no guarantee that investors would be willing to pay such a lavish multiple if a significant recovery in the company's free cash flow per share weren't in sight.
Ultimately, a dividend cut would be a bummer for shareholders, but the business would have to be in pretty awful shape for it to be forced to slash its dividend -- so bad that even the most ardent of income investors may have already exited.