Shares of Western Digital (NASDAQ:WDC) have tumbled more than 20% since the beginning of the year, extending its 12-month decline to 56%. However, that drop has reduced its trailing P/E to just 8, a big discount to the industry average of 15, while its dividend yield has hit a historic high of 4.2%. Do those figures now make Western Digital a compelling value stock? Or could 2016 be the storage device maker's worst year yet?
The good news
Western Digital and Seagate (NASDAQ:STX) control over 80% of the global market for platter-based hard disk drives (HDDs). But over the past decade, the HDD market has been cannibalized by flash-based solid state drives (SSDs). SSDs are more expensive than HDDs, but they run faster, use less power, don't have damage-prone platters, and fit better in ultrathin notebooks and tablets. Between the third quarters of 2011 and 2015, TrendFocus estimates that global HDD shipments fell from 175.3 million to 118.6 million.
To counter that decline, Western Digital expanded its core business away from HDDs and toward SSDs. It acquired Hitachi's hard drive business, SSD maker STec, enterprise storage firm Virident Systems, storage software maker Velobit, flash storage array maker Skyera, and flash storage giant SanDisk (UNKNOWN:SNDK.DL). WD will control 14% of the SSD market after the SanDisk deal closes, according to Kitguru. That will make it the second largest SSD maker in the world after Samsung, which controls nearly half the market.
There were also two positive developments for WD in China last year. First, state-backed Tsinghua's Unisplendour bought a 15% stake in the company to expand its data storage portfolio. Second, the Chinese government finally approved WD's integration of Hitachi's hard drive business after three years of antitrust-related delays. The combination of WD and Hitachi's manufacturing and supply operations should cut production costs of data storage devices for the Chinese market. To balance out the market, the Chinese government also approved Seagate's integration of Samsung's HDD operations, which had been stalled for similar reasons.
The bad news
The problem with Western Digital's SSD strategy is that it's a costly one that was arguably executed too late. WD will fund the $19 billion SanDisk acquisition by taking on $18.4 billion in debt and suspending its buyback program. By comparison, it finished last quarter with $2.1 billion in long-term debt and $5.9 billion in total liabilities. WD will keep paying dividends, but it's unclear if it can keep raising that payout annually. WD's buyout offer also valued SanDisk at 35 times earnings -- a steep premium considering that analysts expect SanDisk's earnings to decline 2% annually over the next five years.
DRAMeXchange recently noted that 2.5-inch SSDs cost 11 times more than HDDs on a dollar-per-GB basis in 2012, but they now cost just 6.5 times as much. The company also expects next-gen 3D NAND technology to narrow that gap to just 2.8 times by 2017. SanDisk notably lags behind Samsung in 3D NAND technology, which means that WD's HDD commoditization problems could play out again with SSDs.
To make matters worse, sales of PCs, which are crucial to HDD and SSD makers, continue to decline. IDC recently estimated that global PC shipments fell 10.6% annually in the fourth quarter of 2015. Although the market is expected to stabilize this year as more consumers replace their aging PCs, that growth might coincide with bigger price declines in HDDs and SSDs.
Lower demand and price declines will weigh down WD and Seagate's margins and bottom line growth. Last quarter, WD's gross margin fell from 29.1% in the prior year quarter to 28.4%. Seagate's fell from 28.1% to 24.2%. Looking ahead, growth looks weak -- analysts expect WD's annual earnings to grow just 2.3% annually over the next five years, and for Seagate's to rise 4%. That gives WD and Seagate respective 5-year PEG ratios of 3.2 and 2.7. Since a PEG ratio under 1 is considered undervalued, neither stock looks cheap based on its earnings growth potential.
Will it be Western Digital's worst year yet?
2016 probably won't be pretty for Western Digital, but it probably won't be the company's "worst" year yet. Its worst years in recent history were 2008, when the stock lost three-fourths of its value, and 2015, when it plunged nearly 50%. For now, WD's low P/E and 4.2% yield will probably limit its downside potential. However, its upside potential will also probably be limited because of ongoing concerns about sluggish PC sales and the commoditization of the HDD and SSD markets.