Western Digital (WDC 1.05%) recently agreed to acquire SanDisk (NASDAQ: SNDK) for $19 billion, or $86.50 per share. WD controlled 43% of the market for traditional hard disk drives (HDDs) last year. However, WD only has a small market share in solid-state drives (SSDs), which are smaller, faster, and don't have damage-prone moving parts. Despite their higher cost, SSDs have displaced HDDs in higher-end tablets and PCs over the past few years.
That's why WD bought SanDisk, which controls 11% of the SSD market. Combined with Hitachi's hard drive unit, which it acquired three years ago, WD will control nearly 14% of the SSD market. That makes it the second largest SSD manufacturer in the world after Samsung (NASDAQOTH: SSNLF), which controls nearly 45% of the market. While the logic behind the deal is sound, some WD investors might be wondering if the company overpaid.
The key numbers
Western Digital's proposed $86.50 purchase price will consist of $85.10 in cash and the rest in stock. But if a planned 15% investment in WD by Tsinghua Unigroup subsidiary Unisplendour goes through, the cash portion of the deal will drop to $67.50 per share.
Western Digital finished last quarter with just $5.3 billion in cash and $2.6 billion in debt. To finance the deal, WD plans to take on $18.4 billion in new debt. It will also suspend its buyback program, which was used to buy back $758 million in shares over the past 12 months. However, WD will keep paying dividends, which took $396 million out of its free cash flow of $1.6 billion over the past 12 months.
Western Digital expects cost synergies to reach a $500 million per year run rate within 18 months. The company expects the deal to become earnings accretive within 12 months after closing.
Do two losers make a winner?
By buying SanDisk's portfolio of NAND chips, controllers, and SSDs, WD has greatly reduced the threat of SSDs disrupting its core HDD business. But SanDisk also struggled over the past year due to lower prices, product delays, and a loss of top customers like Apple and Samsung. Apple previously accounted for nearly a fifth of SanDisk's business, according to Bloomberg estimates.
As a result, analysts expect SanDisk's revenue to tumble 17% annually this year, to $5.5 billion, and earnings per share to plunge 43%. By comparison, Western Digital is expected to post a 7.4% decline in sales to $13.5 billion with an earnings drop of 13%.
Buying SanDisk gives WD a strong presence in SSDs and flash memory, but it also inherits the company's problems. Samsung could keep stealing business away, while a projected NAND oversupply could keep driving down prices. Earlier this year, SanDisk admitted prices were declining faster than costs, and that it remained behind the technological curve in next-gen 3D NAND technology. While SanDisk's SSD sales rose 60% annually to $1.9 billion last year, or 29% of its revenue, sales of embedded and removable storage both declined.
Did Western Digital pay too much?
WD's offer of $86.50 per share values SanDisk at nearly 35 times trailing earnings, compared to the industry average P/E of 15 for the data storage industry. Therefore, investors might be wondering why WD didn't wait for SanDisk's price to drop further.
There are three explanations for WD's timing. First, it wanted to take on $18.4 billion in debt when interest rates were low. A potential hike later this year could cost WD hundreds of millions in extra interest payments. Second, SanDisk shares have been rebounding since September, thanks to several analyst upgrades that championed SanDisk's growth potential in the enterprise SSD market. Lastly, SanDisk's $1.1 billion acquisition of Fusion-io just started to become earnings accretive. If Western Digital waited longer, it could end up paying higher interest rates on an even higher total price tag.
How this fits into everything else
By merging its manufacturing operations with SanDisk, WD can take advantage of economies of scale and manufacture more SSDs and memory chips at lower prices. This would help it compete more effectively against Samsung. This strategy also complements WD's acquisition of Hitachi GST, which boosted its HDD market share against industry rival Seagate (STX).
It might take a while for Western Digital to fully integrate SanDisk's business, but after that integration concludes, Seagate could be in trouble. Seagate bought Samsung's HDD unit four years ago to counter WD's purchase of HGST, but its only defense against WD's acquisition of SanDisk is a multi-year NAND supply alliance with Micron.
The key takeaway
WD needed to buy SanDisk to boost its lead over Seagate and improve the balance between SSDs and HDDs in its portfolio. The price tag might seem high, but considering the favorable interest rate environment and SanDisk's potential rebound, I believe Western Digital made the right move.