Western Digital (NASDAQ:WDC) recently received a dose of good news when the Chinese government finally approved its integration of Hitachi's hard-drive business, HGST. Western Digital acquired HGST three years ago, but the integration of its manufacturing and supply operations was delayed by Chinese regulators due to antitrust concerns.
The approval still comes with some strings attached. HGST and Western Digital must sell products under both the HGST and Western Digital brands while maintaining separate sales teams for the next two years. However, R&D, corporate leaders, engineering, manufacturing, and media operations have been cleared for integration. Let's take a closer look at the WD/HGST deal, and whether or not it can strengthen Western Digital's position against Seagate (NASDAQ:STX) and other rivals.
Understanding Western Digital's woes
To understand where the HGST acquisition fits into Western Digital's business strategy, we should first discuss the business of hard drives. Western Digital and Seagate are the two largest manufacturers of platter-based hard disk drives (HDDs) in the world. Western Digital controlled 43% of the HDD market last year, while Seagate controlled 41%. But during the past few years, HDDs have been steadily displaced by smaller flash-based solid-state drives (SSDs), which don't contain damage-prone platters or moving parts. SSDs are pricier than HDDs but are ideal for lightweight notebooks and tablets.
Western Digital was unprepared for that shift as SSD sales only accounted for 3% of its revenue in 2013. Meanwhile, flash memory manufacturers like Samsung and SanDisk -- which WD recently agreed to acquire for $19 billion -- emerged as the go-to brands for data storage. To remain relevant, Western Digital expanded its SSD portfolio with a series of acquisitions, including SSD manufacturer sTec, enterprise flash storage company Virident Systems, storage optimization software developer Velobit, and flash storage array maker Skyera.
Thanks to those investments, WD's enterprise SSD (data center) revenue more than doubled annually to $244 million, which puts it on track to become a $1 billion to $2 billion business in 2016. Once the acquisition of SanDisk closes, that number will rise even more -- SanDisk generated $1.9 billion in SSD revenues and controlled 12% of the overall market last year.
Why would WD strengthen its HDD business?
That's why WD's acquisition of HGST might seem odd. If HDDs are being displaced by SSDs, why would Western Digital increase its exposure to the HDD market by boosting its market share? The answer is economies of scale. By acquiring HGST, Western Digital can expand its manufacturing capacity and cut costs. By producing more HDDs, it can lower the production cost of each unit and apply pricing pressure on Seagate.
Although the popularity of HDDs has waned among consumers, sales remain steady among data centers that are meeting the demands of cloud-based services. HDDs are still a much more economical way to store massive amounts of data than SSDs. For $50 today, a customer can either buy 128GB of storage on an SSD or 1TB of storage on an HDD. In bulk purchases, that difference is even greater. HGST also manufactures helium-filled drives, which are notably cooler, lighter, and more power efficient than traditional HDDs -- which are ideal for power-hungry data centers.
By selling HDDs at a lower price than Seagate, WD's market share will likely increase. That's likely the issue which caused Chinese regulators to stall the deal for three years.
A murky outlook
Looking ahead, Western Digital will likely try to keep growing its SSD revenues while undercutting competitors on HDDs. Both strategies will inevitably weigh down its bottom line. The slumping PC market, which isn't expected to recover until next year, will also throttle sales of both HDDs and SSDs to computer manufacturers. That's why analysts expect Western Digital's earnings to decline 12.5% annually this year.
The long overdue approval of the HGST deal doesn't really make the stock a compelling buy. The stock is fundamentally cheap at 12 times earnings versus the industry average P/E of 15 for data storage devices, but I'm not confident that it can balance growth in SSDs and HDDs effectively as average costs decline in both product categories.
Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of Western Digital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.