In difficult markets, investors may want to look at idiosyncratic situations. After all, Warren Buffett is doing just that, playing merger arbitrage with Activision Blizzard, betting its merger goes through later this year.
Another type of idiosyncratic situation is activist investing. That happens when a large investor takes a big stake in an underperforming company, and then advocates for specific changes to unlock value.
Last week, activist hedge fund Elliott Management revealed it had invested $1 billion in storage maker Western Digital (WDC -2.64%), and then disclosed its letter to management, which proposes the company split its business in two.
Splitting its HDD and NAND business
Elliott believes Western Digital should essentially undo its 2016 acquisition of SanDisk. Western Digital was a hard disk drive (HDD) producer before that acquisition, and some investors feared HDDs would perpetually decline thanks to the rise of NAND flash. So Western Digital bought NAND producer SanDisk for $19 billion, which was a rather high price at the time.
Elliott's argument is that NAND flash and hard disks are different technologies, that there aren't material synergies from the transaction, and that hard disks aren't actually in a decline, thanks to growing demand from cloud computing giants. Since Western Digital has underperformed HDD pure play Seagate Technology, Elliott thinks a lot of value can be unlocked if Western Digital splits the two businesses, and that Western Digital could be worth $104 per share, up from $59 as of this writing.
Elliott appears to have a strong case.
Image source: Getty Images.
How Elliott gets there
The easy part of Western Digital's valuation is the HDD segment, which it does separate out in its financial statements. The HDD business operates in an oligopoly with Seagate, with 38% market share, while Seagate has 46%. Both companies have similar growth rates and gross margins.
Since Western Digital doesn't break out operating expenses by unit, but since it has similar HDD gross margins to Seagate, Elliott doesn't see why Western Digital's HDD business shouldn't trade at Seagate's enterprise value-to-sales ratio of 1.8. That would value Western Digital's HDD business at $17.3 billion -- nearly 80% of its enterprise value today.
That leaves just $4.1 billion of remaining value for the NAND flash business -- and remember, Western Digital bought this business for $19 billion all the way back in 2016.
The thing is, the NAND flash business may even be a better business than hard disks. Last quarter, Western Digital had slightly more NAND revenue than HDD revenue, and the NAND gross margin was actually higher.
Therefore, it's likely the NAND business would fetch an even higher valuation than the HDD business. Elliott estimates the likely value between $17 billion and $20 billion, which seems about right. There aren't any "pure-play" public companies that produce NAND -- most also produce DRAM memory and don't break each unit's profitability out individually -- so Elliott is using a multiple slightly below where NAND acquisitions have occurred in the past. Elliott said it would even contribute another $1 billion at that valuation into the NAND business to invest in technology.
It looks like a promising bet
Western Digital has been an unexciting stock for years, as other semiconductor and memory companies have fared much better amid strong industry growth. That's largely because the company took on too much debt to pay for SanDisk, and it had to cut its dividend in May 2020 to pay down debt.
However, new CEO David Goeckeler, who took over in 2020, has already split the two units up underneath Western Digital. Therefore, it's likely that he sees this as a possibility as well.
If you think the market is in for more trouble, Western Digital could be an interesting bet to outperform if the company announces a split or a sale of one of the units this year. That being said, many of what I'd consider better-quality semiconductor stocks have also sold off heavily this year despite booming demand. So if you think the entire sector is due for a bounce back higher, one could probably do fine in many names other than Western Digital.
