On the morning of Sept. 30, Western Digital Corporation(NASDAQ:WDC) and China-based Unisplendour Corporation announced that a Unisplendour subsidiary will purchase $3.775 billion in newly issued Western Digital common stock at $92.50 per share. That represents a whopping 33% premium to its prior-day closing price of $69.37 and gives Unisplendour a 15% stake in the storage company.
Western Digital plans to use the funds to strengthen its balance sheet, gain financial flexibility, and pursue long-term strategic growth initiatives. What exactly does that mean?
The company has suffered two unusual financial hits in the past few years. First, its manufacturing facilities suffered severe damage in 2011 as a result of the tragic flooding in Thailand. Second, the company paid out $773 million in damages related to a lawsuit in October 2014. That explains the balance sheet and financial flexibility comments -- I will get to strategic growth initiatives shortly.
Death of hard disk drives may have been greatly exaggerated
Western Digital is known for its increasingly outdated hard disk drives, or HDDs, used in PCs which are themselves experiencing shrinking unit sales. HDDs are giving way to faster, albeit more expensive, solid state (semiconductor) drives, or SSDs.
But SSDs haven't entirely replaced HDDs and don't appear to be on track to do so over the intermediate term -- that has a lot to do with price. As PC Magazine observed in February, "For the same capacity and form factor 1TB internal 2.5-inch drive, you'll pay about $60 to $75 for an HDD, but as of this writing, an SSD doubles that to $130 to $150." Last year, Enterprise Storage Forum suggested that this roughly 2-to-1 price gap could persist, stating:
Even if it is assumed that SSDs continue to fall at their historical rates and HDDs fall at their historical rates, SSDs will still be about $0.15/GB in 2020 ($0.06 more than HDDs are today), while the HDDs vendors are promising maybe as low as $0.03/GB.
When did you last clean out your digital closet?
It's a time-tested principle in the computer storage business: People prefer supersized digital closets, which HDDs provide, to the smaller but quicker-access closets that SSDs provide. Has that changed? A bit. Digital closets have gotten so large that:
- HDDs are being replaced by SSDs for frequently accessed data.
- HDDs are often being used in place of tape for infrequently accessed data that is put into "cold storage." None other than Facebook is on record as preferring HDDs to tape.
You might say that tape giveth and SSDs taketh away.
What's more, the amount of digital data is exploding. Just because your photos and other data are stored in the cloud doesn't mean they aren't stored on a hard drive as well. What it really means is that your data have been moved from a relatively inexpensive, low-margin HDD in a PC to a relatively expensive, high-margin enterprise HDD in a system made by the likes of EMC, IBM, Hewlett-Packard, or NetApp. That's good for Western Digital, which has seen non-PC revenue grow from less than 40% of its mix in fiscal year 2012 to about 60% in fiscal 2015.
A recent history of the disk drive business
Once upon a time, there were hundreds of independent hard drive suppliers. From 2011 through 2012, the industry consolidated from six to three players, with Western Digital and Seagate(NASDAQ:STX)accounting for a majority of the market and Toshiba a distant third.
At the same time the industry was consolidating down to three vendors, floods in Thailand significantly reduced their manufacturing capabilities. Severe HDD shortages persisted for roughly a year and drove prices to more than three times pre-flood levels. Though prices have since come back down, the combination of consolidation and shortages changed the balance of power between HDD vendors and their customers. That shift in the vendors' favor has had legs that translate into pricing and profit power. One reason Unisplendour may want an ownership stake in Western Digital is to secure a supply of drives for its technology products.
Back to strategic growth initiatives
So the HDD business is a mixed bag: Unit sales are declining, but the product mix is shifting to higher-margin products.
The HDD makers aren't content with a mixed bag, however. Remember, these guys are survivors looking to move up the value chain. They have also entered the SSD business. Additionally, large Internet companies such as Facebook, Google, and Amazon have bypassed server vendors with DIY technology in their data centers and are working on a similar move in storage. You can bet Western Digital and Seagate are eagerly helping them figure out how to bypass the expensive, high-margin enterprise storage vendors, too. Indeed, Unisplendour may be investing in Western Digital to ensure the latter company's help in product development.
The bull case
Industry consolidation and supply shortages in 2011 and 2012 have given hard disk drive makers more power over their customers, which has translated into pricing power, wider margins, and stronger cash flow. On top of that, Western Digital shares trade at a very modest 11.6 times trailing earnings and offer a dividend yield of 2.5%, even after a 14.5% pop in the stock on the Unisplendour announcement.
Western Digital is a leading provider of a must-have product that is underappreciated on Wall Street. It just received a $3.8 billion investment at a significant premium from a company that may be looking to lock in supplies and/or ensure Western Digital's help in product development. It would be easy to write the company off as a declining old-tech player, but at its current valuation, the stock is worth a closer look.