Western Digital (WDC 1.30%) dramatically expanded over the past decade. It acquired Hitachi Global Storage Technologies (HGST) to become the world's top hard drive maker, launched new video surveillance HDDs (hard disk drives), and acquired flash memory maker SanDisk, cloud storage firm Upthere, and flash memory storage array maker Tegile Systems.
But over the past five years, WD's stock lost more than 40% of its value on concerns about slowing demand for HDDs, declining prices for flash-based SSDs (solid state drives), and slowdowns in the enterprise and consumer electronics sectors. This sell-off reduced WD's forward P/E to 8 and boosted its forward dividend yield to nearly 5%.
Patient investors might find that low P/E valuation and high yield tempting. But before they take the plunge, they should be asking: Will Western Digital rebound over the next five years? Or will it keep disappointing investors with dismal returns?
Check out the latest Western Digital earnings call transcript.
Looking back at Western Digital's past five years
WD's revenue growth over the past five years was significantly inflated by its acquisition of SanDisk, which closed in 2016.
That merger also significantly boosted its free cash flow (FCF). Its net income declined after the acquisition, but gradually recovered over the following two years.
But here's the problem: The cyclical decline in NAND prices and slower sales of storage products to OEMs and enterprise customers caused its revenue, earnings, and FCF growth to drop off a cliff over the past year.
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%) |
What will happen in the next five years?
These declines are expected to continue for the foreseeable future. Analysts expect WD's revenue and earnings to fall 19% and 61%, respectively, this year. In fiscal 2020, they expect its revenue to dip 1% and for its earnings to drop 2%.
Those milder declines look encouraging, but the longer-term forecast still looks tepid. Analysts expect WD's annual earnings to decline at an average rate of 10% over the next five years, versus an average growth rate of 13% over the past five years.
By comparison, WD's rival Seagate (STX) only grew its earnings at an average rate of 2% over the past five years because it wasn't heavily exposed to the flash memory and SSD markets. But over the next five years, analysts expect its earnings to rise an average of 6% per year -- which arguably makes it a safer play than WD.
Investors should take analysts' long-term forecasts with a grain of salt, since cyclical headwinds and broader economic downturns are notoriously tough to predict. Moreover, Seagate's dedication to platter-based HDDs -- which are bigger, slower, and more prone to damage than SSDs -- could backfire as the price gap between SSDs and HDDs narrows.
Meanwhile, WD is stuck in a cyclical slump, but its big investments in SSDs and flash memory (which generate over half of its revenue) could pay off once NAND prices start rising again. NAND prices will likely keep sliding in 2019 and 2020, but they'll probably recover within five years. Until that happens, WD plans to cut operating expenses, reduce its wafer output (by up to 15% in 2019), and keep paying out its dividend.
However, WD hasn't raised its dividend since 2015, and there are concerns that its plunging earnings, FCF levels, and high long-term debt could eventually lead to a dividend cut. That probably won't happen this year, since its FCF payout ratio remains below 100% (on a trailing 12-month basis), but it could occur within the next five years.
So is Western Digital a poor long-term investment?
Western Digital is cheap for a simple reason -- no one wants to buy a cyclical stock before it bottoms out. Half of WD's revenue comes from HDDs, which are struggling with both soft demand across multiple markets and macro challenges. The other half comes from flash memory devices, which are being crushed by a global supply glut.
WD's core business should survive this downturn, but its stock could either flatten out or decline over the next five years as its growth continues to decelerate. As for its dividend, investors should stick with safer income stocks instead.