Shares of Western Digital (WDC -2.64%) rallied 8% on Jan. 25 after the disk drive maker followed up a second-quarter miss with updated guidance for the third quarter. WD's revenue dropped 21% annually to $4.23 billion during the second quarter and missed estimates by $30 million. Its non-GAAP net income plunged 65% to $424 million, and its EPS declined 63% to $1.45 per share, missing expectations by a nickel.
For the third quarter, WD expects its revenue to decline 24% to 28% annually and for its non-GAAP EPS to fall 83% to 89%, which indicates that the cyclical declines in disk drive sales and memory prices won't bottom out anytime soon. Nonetheless, WD's post-earnings rally indicates that some investors think that this hated stock -- which has been cut in half over the past 12 months -- could be bottoming out.
Image source: Getty Images.
WD's forward P/E of 6 and its forward dividend yield of 5% might look tempting to some bottom-fishing investors. But should we really consider WD a value play when its core business is stuck in a cyclical downturn?
A closer look at WD's problems
WD's growth in revenue, non-GAAP earnings, and free cash flow (FCF) all deteriorated over the past year. Its guidance for the third quarter indicates that this slowdown will continue:
|
Q2 2018 |
Q3 2018 |
Q4 2018 |
Q1 2019 |
Q2 2019 |
|
|---|---|---|---|---|---|
|
Revenue |
9% |
8% |
6% |
(3%) |
(21%) |
|
Non-GAAP EPS |
72% |
52% |
23% |
(15%) |
(63%) |
|
Free cash flow |
(37%) |
(17%) |
(16%) |
(46%) |
(96%) |
Year-over-year growth. Source: WD quarterly reports.
Two relentless headwinds are battering WD's business. First, soft demand for platter-based HDDs (hard disk drives) in the PC and enterprise markets caused its HDD revenues, which accounted for 49% of its second quarter revenue, to fall 24% annually.
Second, tumbling prices for NAND (flash) memory chips caused its revenue from SSDs (solid-state drives) and memory chips, which accounted for the remaining 51% of its revenue, to decline 18%. WD significantly increased its exposure to the flash market with its acquisition of SanDisk in 2016, which initially juiced up its sales but backfired when memory prices peaked last year.
Image source: Getty Images.
Those cyclical headwinds caused WD to lose its pricing power. As a result, the non-GAAP gross margins for its HDD and Flash units quickly deteriorated:
|
Q2 2018 |
Q3 2018 |
Q4 2018 |
Q1 2019 |
Q2 2019 |
|
|---|---|---|---|---|---|
|
HDD |
30% |
33% |
32% |
32% |
27% |
|
Flash |
57% |
55% |
51% |
34% |
35% |
|
Total |
43.2% |
43.4% |
41% |
38% |
31.3% |
Non-GAAP gross margins. Source: WD quarterly reports.
WD expects its gross margin to contract to about 28% for the third quarter, which is well below its long-term gross margin target of 35% to 40%. But during the conference call CEO Steve Milligan reaffirmed that target range, and stated that WD would "periodically operate below the range and periodically operate above the range" due to cyclical price changes.
For now, WD plans to reduce its operating expenses (which fell 15% annually during the second quarter) and continue paying out dividends. However, investors should note that WD generated just $24 million in FCF during the quarter, but paid out $144 million in dividends. Milligan declared that WD remained "absolutely" committed to its dividend, but that high payout ratio is clearly a red flag. WD also hasn't raised that dividend since 2015.
A light at the end of the tunnel
Analysts expect WD's revenue and earnings to decline 17% and 54%, respectively, this year. But in fiscal 2020, which starts at the end of June, they expect roughly flat sales growth and 2% earnings growth as WD hits a cyclical bottom.
Meanwhile, analysts expect WD's rival Seagate (STX), which is less exposed to the flash market, to post milder single-digit revenue and earnings declines this year. Seagate also pays a higher forward dividend yield of 6.2%, and trades at just 8 times forward earnings -- but it could be left behind as flash prices rebound and break WD out of its year-long rut.
But is WD an undervalued income play?
WD's low valuation and high yield could limit its downside potential, but its decelerating growth makes it a risky play, and its plummeting FCF levels could also eventually impact its dividend. Investors looking for undervalued income plays should probably stick with more bear-friendly consumer staples stocks in this wobbly market.
Check out the latest Western Digital earnings call transcript.
