Western Digital's (NASDAQ:WDC) stock recently dipped after the data storage solutions provider suspended its near-5% dividend. The move wasn't entirely unexpected since its dividend payments overwhelmed its free cash flow and earnings over the past year, but it was surprising since the company was still generating more than enough cash to cover its dividend.

I recently claimed Western Digital's dividend looked "stable" and its payout ratios could improve as cyclical demand for its traditional hard disk drives (HDDs), flash memory chips, and solid-state drives (SSDs) accelerated again. I was clearly wrong since the company opted to suspend its dividend to prioritize a "reinvestment in growth and innovation" amid "ongoing deleveraging efforts" instead. Is this strategic shift a sign of weakness, or did the market overreact to WD's decision?

Four overturned and open HDDs placed on other covered HDDs.

Image source: Getty Images.

Riding a cyclical rebound

Western Digital's revenue and earnings plummeted in fiscal 2019 as lower orders from PC makers and data centers hurt its HDD business, and a supply glut hammered its flash memory and SSD business. However, WD's revenue growth stabilized in the second quarter as rising demand for flash memory chips buoyed market prices again. That acceleration continued into the third quarter as sales of HDDs and SSDs to PC makers and data centers improved.

Growth (YOY)

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Q3 2020

Revenue

(27%)

(29%)

(20%)

0%

14%

Non-GAAP EPS

(95%)

(95%)

(89%)

(57%)

400%

YOY = Year-over-year. Source: WD quarterly reports.

The COVID-19 crisis is lighting fires under the PC and data center industries: Stay-at-home directives are prompting more people to upgrade their aging PCs, and the rising use of cloud storage and streaming services is straining the storage capacities of data centers.

The clarity of those markets enabled Western Digital to offer clear guidance for the fourth quarter: It expects its revenue to rise 18%-24% annually, with a six-to-eight fold jump in its non-GAAP EPS. That acceleration indicates WD's core business is riding a cyclical rebound.

So why did Western Digital suspend its dividend?

WD generated a free cash flow of $176 million during the third quarter, which adequately covered its dividend payments for the third straight quarter:

Millions USD

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Q3 2020

Free cash flow

($110)

($179)

$294

$377

$176

Dividends paid

($146)

($146)

($147)

($149)

($149)

YOY = Year-over-year. Source: WD quarterly reports.

But that gap is narrowing, and Western Digital already suspended buybacks for more than a year to conserve its cash. For now, extinguishing its long-term debt -- much of which was accumulated from its $16 billion takeover of SanDisk in 2016 -- remains a bigger priority.

Western Digital's cash and equivalents fell 20% annually to $2.94 billion during the third quarter. It spent $212 million on debt payments, and reduced its long-term debt 9% annually to $9.77 billion, with $35 million in convertible debt maturing this year. WD can easily cover its current maturities with its cash position, but the suspension of its dividend -- which it hadn't raised since 2015 -- would save nearly $600 million a year.

During the conference call, CFO Robert Eulau said Western Digital's goal is to reduce its debt-to-EBITDA ratio from 5.0 in the third quarter to between 1.0 and 3.5. CEO David Goeckeler, who took the helm earlier this year, admitted the macro headwinds amplified WD's "desire to deleverage a little faster," but noted that its core business remained "really well-positioned" to ride the aforementioned tailwinds in the cloud and enterprise markets.

Goeckeler also emphasized a need to continue investing fresh cash into higher-density drives, which would widen the company's moat against primary rival Seagate (NASDAQ:STX). However, Seagate -- which focuses more on the traditional HDD market than the SSD market -- didn't cut or suspend its 5% dividend yield last quarter.

Wall Street wasn't impressed

A few analysts cut their price targets after the dividend suspension. Wedbush, which lowered its per-share price target on Western Digital from $86 to $49, claimed the suspension "invariably creates concerns around WDC's ability to meet its capital needs." RBC, which cut its price target from $85 to $70, called the suspension "a surprise given the healthy profitability" of WD's core business.

Investors should always take analysts' comments with a grain of salt, but Western Digital's dividend suspension was certainly surprising. Management claims it was a prudent move instead of a desperate one, but it also arguably makes WD a less appealing investment than Seagate, which exposes investors to the rebounding HDD market while paying a generous dividend.