Amvona

Monday, 22 October 2012 02:08

Another look at the Low Cost Building Blocks of Storage

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Shares of Western Digital (WDC) were sold for investors accounts on August 13th, 2012 at $44.  As of close of market on Friday Oct. 19th, the shares were being traded for a mere 34.88.  A decline of a full $9.12 or almost 21% in barely 9 weeks.  Is the value of the company really less than it was, when the shares recently traded at $44?

 

wdc chart 10-22-2012

On August 28th, 2010 Amvona published the article “Buying glass and other problems with interventions”.   The inspiration to write the article, as with so many Amvona articles, stemmed from questions received from a reader who was considering selling a stake in Corning (GLW).  The reader was a fund manager who oversees about 100 M for investors, in an email dated July 30th, 2012 the following was written as a follow up to a phone conversation on the topic:

 

From: Emmanuel Gregory Lemelson [mailto: This email address is being protected from spambots. You need JavaScript enabled to view it. ]

Sent: Monday, July 30, 2012 6:17 PM

To: [Name Omitted]

Subject: GLW

 

Dear [Name Omitted],

 

It was nice speaking with you by phone today…

 

...per our conversation sold GLW on April 25th at $14.30 per article here: The Prime Minister" One Dollar Bets"  however, not b/c didn’t think it was a good value – only wanted to allocate the capital to a better value… (WDC)

 

May write more soon on GLW – you might want to “hang in there” – it hasn't been too long (less than a year) and easy to get discouraged when the price of an issues stays low for a while… but it can change quickly (perhaps next QTR) –

 

…if possible try to forget about the price for a while – consider focusing on calc. for future value…  (e.g. DCF model = ~21 per share) – the real question is has this figure changed or is it likely to change….?

 

For e.g. you may want to also consider the following:

 

- The co. is selling at a huge discount (.8 book)

- Does a good job at retaining owners earnings

-  Increases per share book value at a high rate (see last 5 years)

- Healthy Op. margin.

- Enterprise Value/EBITDA (ttm) is only 5.51

- Pays a decent dividend - 2x cash to debt

 

Hope this helps… feel free to stay in touch…

 

 

Warm Regards,

 

G.M. Lemelson

 

The response was as follows:

 

From: [Name Omitted] [mailto: This email address is being protected from spambots. You need JavaScript enabled to view it. ]

Sent: Tuesday, July 31, 2012 3:18 PM

To: Emmanuel Gregory Lemelson

Subject: RE: GLW

 

Thanks very much for the insight and follow up!

 

I’m a bit concerned about cap ex, although management stated on the call that it will be less next year (subject to “process technologies” investments; I believe it could be higher than estimates but still not as much as the past year).  Throw in the impact of the BD Lab purchase, and the numbers are tough to pencil out over the next couple of quarters.  Hopefully, things stabilize after that, and ultimately a larger dividend or share buyback.

 

Given those issues, I have a tough time getting to a $21 on a DCF calculation (at least in the near term).  Perhaps heading into 2013, cash flow will be clearer.  Also,  I think there are some valuation “gray areas” with regard to the JVs.

 

I’ll hold on.  My hope is that the macro picture stabilizes, but I’m not sure what to expect.  Perhaps GLW is more of a consumer play than I thought.

 

I look forward to your next idea – I am very impressed with the work you put out.  I was playing around with some WDC numbers post-announcement, and it appears to be cheap even after the earnings pop (using what I believe are conservative numbers, the stock could still double and be - at worst - fairly valued).  It’s on my radar.

 

Please keep in touch, and feel free to email or call at any time to talk stocks or keep me posted...

 

Regards,

 

[Name Omitted]

 

And:

 

From: Emmanuel Gregory Lemelson [mailto: This email address is being protected from spambots. You need JavaScript enabled to view it. ]

Sent: Tuesday, July 31, 2012 1:03 PM

To: [Name Omitted]

Subject: RE: GLW

 

Dear [Name Omitted],

 

Thank you for the email.    You raise good points… definitely worth digging deeper… if / when look at GLW again (may do soon) would be happy to share the research with you.

 

The JV’s definitely add a layer of complexity… 

 

Re; consumer play – may depend on growth rate of other (non-consumer) businesses…

 

Agree fully on WDC – hard to explain the discount (other than  it’s just not popular right now) – may help that their main competition (which has been much more popular recently) appears to be stumbling… (see STX CC yesterday)

 

Not sure if you saw this article – but the assumptions for a DCF approach to WDC FV is included at the top of the article… agree fully that even if it were to double… still wouldn’t really be “expensive”…

 

Thank You very much for your kind remarks on the work…  the positive feedback is sincerely appreciated… 

 

…it would be great to keep in touch on stock …been blessed with consistently high returns… (as outlined in the Amvona articles)…

 

Warm Regards,

 

G.M. Lemelson

 

 In the following email dated September 7th, 2012 the article and research were sent:

 

From: Emmanuel Gregory Lemelson [mailto: This email address is being protected from spambots. You need JavaScript enabled to view it. ]

Sent: Friday, September 07, 2012 3:40 PM

To: [Name Omitted]

Subject: Hopefully not too late. but as promised.

 

Dear [Name Omitted],

 

…hope you have been well and business is good…

 

Hopefully not too late…  but as promised…    Buying glass and other problems with interventions

 

 

… let’s stay in touch.

 

Warm Regards,

 

G.M. Lemelson

 

the response that followed was simply:

 

From: [Name Omitted] [mailto: This email address is being protected from spambots. You need JavaScript enabled to view it. ]

Sent: Friday, September 7, 2012 6:50 PM

To: Emmanuel Gregory Lemelson

Subject: RE: GLW

 

Wow – looks great.  It’s never too late to read one of your reports!

 

I’ll take a look as soon as possible.  I definitely held on and I continue to hold out hope of future success....

 

More to follow after my read, and I’m very appreciative of your follow-up...

 

Have a great weekend!

 

Regards,

 

[Name Omitted]

 

 

In the article it was pointed out that shares of Western Digital (WDC) were sold on August 13th at $44 per share saying in part:

 

"Hopefully WDC shares can be re-aquired, but in the interim, there was suddenly much more cash available for investment after the WDC trade returned over 179% (annualized)...”

 

And further:

 

"On August 28th, a large stake in GLW was re-acquired at $11.64, using in part the cash which had been freed up from the WDC sale.”

 

“Perhaps Next Quarter” Those three words appeared in the July 30th email above.   The shares of GLW were sold on October 8th 2012 (the next quarter), although again not because they had reached fair value, but rather to free up capital for another larger investment.   Here is how the investment performed (the second time the shares were owned in 2012):

 

Issue Purchase Date Price Date Value Performance. Months Annualized
GLW 8/28/2012 $ 11.64 10/8/2012 $               13.29 14.2% 1.3 126.2%
S & P 500 8/28/2012 1409.3 10/8/2012 1455.69 3.3% 1.3 29.3%

 

 

IMG 1327-copyHowever before executing the above trade, the opportunity to go traveling again presented itself, and couldn't be passed up.  This time, the trip would include Switzerland and Italy.  For a change the cell phone camera was left behind in favor of a new Canon (CAJ) T4i.  A remarkable company that produces remarkable products and that incidentally is also on sale.   There was a sense of guilt splurging on a new camera, but after returning triple digits to investors for some time, perhaps it could be forgiven (especially since no fee or commission had ever been charged, although the profits for this handful of individual investors had already climbed into the millions). 

 

Human nature can be curious.  When amvona was building it’s photo equipment and online business, great care was taken to keep everything confidential – despite this the ideas were often copied - the strategies that Amvona pioneered in those days can still be found in other businesses large and small to this day.  

 

When Amvona was resurrected as a site that publishes (amongst other things) securities analysis as a means to discern sound investments virtually all of the ideas (that time permitted) were published and made freely available to the public. More than two years later, and despite consistent triple digit returns, hardly anyone seemed to notice or care.  Even intelligent businessmen, with under-performing portfolios, but who are otherwise successful have turned down help (offered entirely for free), and although an abundance of evidence exists, cast doubt on the entire operation.  From this a great lesson regarding human nature (and parenthetically) the markets has been learned – that is, you can show people to the truth (supported by all the data and evidence in the world), and often it will be rejected, particularly if it threatens an existing world view. 

 

IMG 2017-copyGetting back to the the T4i - it's a whole new camera, the 18 Megapixel CMOS sensor is incredible, and has the ability to shoot multiple images at great speed – when this is paired to the radically faster i/o speeds of the latest flash cards a new meaning arises from the term “data storage”. 

 

Upon returning home it seemed there must be over a thousand (high res.) images on that tiny card.  When the images were transferred to the hard drive on the desktop there were actually over 2200 (representing 12 days of travel).

 

Is there a misunderstanding?

 

Generally it seems the market feels that somehow SSD’s will replace HDD’s.  This is not correct, at least for the time being.  They are at the very least complimentary – indeed the more high capacity, high speed SSD’s which come into existence, the greater the need for HDD’s.  SSD’s are temporal storage for data that is intended to remain in perpetuity, but if this media is to be truly “stored”, it will be for the foreseeable future on mechanical hard drives.  However it is not enough to recognize the complimentary nature of SSD’s and HDD’s, but also to understand the long term changing dynamics of data storage and retrieval, particularly as it relates to three concepts:

 

1. The creation and growth of Cold Storage (e.g. Amazon Glacier)

2. The long tail of data storage (mathematical eventualities)

3. The potential in data which is not yet stored.

 

One type of media storage is dying, it is called “Tape”, and it will be widely replaced for archival storage purposes, but not by SSD’s which are altogether unnecessary for such an application.   HDD’s have a much lower cost per GB than tape, yet much faster access times.   Therefore, drives specifically designed for this purpose, needless to say, have the potential to capture “Exabytes” of existing market share from tape.

 

Jay Parikh, VP of infrastructure engineering at Facebook recently made comments which appear to support the HDD over Tape thesis, although his comments were subtle, and difficult to interpret given how he delicately circumvents the issue, nonetheless they appear to mean that HDD’s might well be preferable in the next compute challenge – to quote:

 

“… Facebook is rethinking the infrastructure for how it stores huge repositories or photos and videos in a way that’s accessible and convenient but also cost-effective. Unlike a business that might store records on tape, Facebook can’t afford to let users wait that long to access something, nor can it afford to build data centers that keep photos in caches next to the servers (those Fusion-io machines aren't cheap!).

 

‘The current data center and hardware design is actually very sub-optimal for that problem,” Parikh says. “People say to us we should just use tape, but I’d rather poke my eyes out with chopsticks.’ ”

"Facebook's next compute challenge is cold storage" (Gigaom Oct. 3rd, 2012)

 

Even if the message is not clear, one thing is certain, in order to avoid a potential medical emergency Jay ought to avoid Chinese food at all costs.

 

IMG 2378-copyPeople scoff.  The hard disk as we know it is “old school”, and it’s death has been predicted for a long time.  SSD’s are cool, small, fast, etc., companies that make them even have cool names like “SanDisk” (SNDK), companies that don’t have boring names like “Western Digital” which sounds like it’s from the transistor era (It is).  However, the market may be misunderstanding the relationship of the two.  

 

For example many types of engines have emerged since the dawn of powered flight, the progress is astonishing.  However, the basic shape of an airfoil (the very thing which produces lift) has not changed nearly as much, nor the idea of how to control the air which flows over it’s surface (what the Wright brothers initially called “wing warping” and later became “ailerons”).  The basic function of lift and control some hundred years later, is still intact.  The hard drive is somewhat newer, and although greatly improved, the basic concept is still intact because it works.

 

For this reason, even exciting new company’s, with far greater premiums on their market price, are endeavoring to find new ways to work with the HDD – for example, Prinevill Oregon (amongst other towns) will soon have close to one million sq. feet of cold storage space dedicated to the HDD as indicated in the following:

 

“The plan is to use the building to house a brand-new type of low-power deep-storage device that Facebook engineers will cook up over the next six to nine months. They’re designing a hard-disk storage server that powers off when it’s not in use, says Tom Furlong, vice president of site operations at Facebook. 'It’s going to sit in a dedicated building that is optimized to support this device that we don’t need to access very often.' ”

Facebook Will Ice Backup Data in 'Sub-Zero' Building (Wired Magazine August 18th, 2012)

 

To be clear the reference is to a “hard-disk storage server”, not an SSD storage server.

 

Facebook (FB) even after it’s epic stock price decline still trades at a P/E ratio of 65 and a P/B ratio of 3.05.  With the above article it is evident that at least part of the billions raised from the victims of the FB IPO will be used to build large storage facilities for Hard Drives – and even though the storage may be in a way “free” to the end user, the drives are not free to FB or any other operator endeavoring to build such a facility – of which there are many.

 

There was one other part of the article that seemed to have at least minor importance, namely:

 

“Facebook doesn’t use tape backups — they’re too kludgy and expensive for the social media company. But it does save two backup copies of all of its data: one that is there to be used whenever there’s a problem on the live server, and a second copy for emergency use only.”

Facebook Will Ice Backup Data in 'Sub-Zero' Building (Wired Magazine August 18th, 2012)

 

It is interesting to consider what might happen if an article or two was published that spoke of millions of square feet of storage space being built to house SSD’s, and that companies building these facilities were going to require two back-up copies of everything (on SSD’s of course) – and in fact that whole new types of servers would be built specifically for these SSD’s – what would happen to company's such as SanDisk (SNDK) stock price (which is already trading at roughly 3x the forward P/E of WDC, although WDC is more profitable)?

 

The market appears to like what is “technologically exciting” much more than what is “financially exciting” (WDC has better margins that SNDK for instance), even though few probably appreciate just how sophisticated these devices are.  According to Pantelis Alexopoulos, executive the director of Singapore's Data Storage Institute:

 

“The customer doesn’t know it’s a marvel of engineering.” A drive, he says, “is more sophisticated than a Boeing 747.”

Pantelis Alexopoulos's Push for Slimmer Disk Drives (Businessweek September 27th, 2012)

 

Boeing 747's are still being produced with hundred year old technology (see above).  That having been said, even modern jets have more than two primary suppliers – the same cannot be said of HDD’s.

 

Although it might at first seem a bit of a revelation, apparently there is over 4 times more content created than is actually stored on digital media.  According to WDC, capturing only 5% of this “unstored data” would equal all of the Exabytes shipped on enterprise disk and tape combined (See Driving Datacenter Change: Storage Opportunities in the Cloud [Mike Cordano September 13th, 2012] )  

 

IMG 2436-copyIt is worth contemplating if perhaps the greatest market opportunities (not to be confused with rate of growth) in storage are not in the smallest and fastest (e.g. PCIe solutions – High performance SSD / NVM, etc.), but rather these so called “Cold Storage” Solutions with their commensurate low cost per TB and TCO  advantages.  That having been said, it seems also more than likely that WDC will pursue both ends of the spectrum aggressively although they are not equal.

 

It does not take much calculus to understand that the faster a high performance memory card functions, the greater the number of low end drives are ultimately needed.  The relationship is hardly adversarial, in fact it is more than complimentary, it could even be said that the high performance SSD card “needs” the HDD for it’s very existence.  In other words, there would be limits on it’s speed, if there were nowhere to store all of the media over the long term at a very low cost.  This is a significant and fundamental paradigm shift in the very nature of how data is stored and utilized.

 

Even if images from a family trip to Europe are just of average quality, they will still be viewed many times on Facebook or other photo sharing sites – but not for very long.  After a matter of days, they will be all but forgotten in the online world that has become our collective consciousness.   That is to say, content on social media sites is characterized by high media access when it is at first new, then dramatically lower accesses as it ages even slightly.  This is the very nature of the new world we live in,  content may have great breadth and even depth, but at once is met by the short attention span of a changing society.  However, the HDD’s the media is ultimately stored on (unlike the SSD it is created on) will never be completely idle, because the content remains, and must be available at any time for access.

 

It is good if a technology company makes its first priority financial performance.  Many technology companies with brilliant ideas have failed because there is a certain romance, even seduction to pure technology, it burns in the mind of the true technologist - like true innovators, these folks struggle to build successful enterprises.   However, WDC is not run by true technologist (although they employ thousands), they are run by guys interested first and foremost in sound management and superior capital allocation – and to that end, there is no management team greater in technology or otherwise.

 

IMG 3056-copyConsider for a moment the fact that both FCF and GM% over the last ten years have increased in tandem, despite intermittent declines (as the current instance) in the price of the shares.  In fact, prior to the HGST acquisition WDC's gross margins averaged 18-23%, however the company now projects margins in the range of 27-32%, an increase of about 50%.  The earrings announcements and guides provided since March (when the transaction closed), seem to prove the new altered, and higher margin business model.  Given that OPEX, CAPEX and the Tax Rate are set to remain about the same, it seems WDC has entered a new phase of profitability.

 

How does he know?

 

• Friday, October 12, 12:58 PM More on Citi's downgrade of Seagate (STX -0.7%) and Western Digital (WDC -2.4%): Analyst Joe Yoo thinks Q4 hard drive sales could total just 140M units, below Seagate's lowered guidance of 150M-155M. Moreover, he think Windows 8 will "largely be a non-event for traditional PCs;" and that high-margin enterprise drive sales (Seagate has more exposure here) may have fallen 27% Q/Q in Q3. But he's still bullish on the industry long-term, viewing it as a play on general data storage growth.

http://seekingalpha.com/currents/post/584271

 

WDC indicated at their September 13, 2012 investor conference that the company expected the TAM to be 140 M units – so it is not correct to say that this is what “Analyst Joe Yoo thinks” but more correctly, this is what “Analyst Joe Yoo learned”.  And it is not that they “could” but rather, that they “will” ship ~140 M units.

 

With the formalities out of the way, it is curious how Joe Yoo could possibly know that “Windows 8 will ‘largely be a non-event…’ ”

 

If he is correct, than it can be inferred that Mr. Yoo is in fact more insightful and perhaps intelligent than a plenitude of CEO’s who have invested heavily in the success of Windows 8.  It’s possible he is.  However if one often changes opinions, engages in sudden upgrades and downgrades, and generally appears to go with the prevailing “spirit of the times” there are possibilities other than intelligence and the gift of foresight. 

 

It is always possible that one fears moving against the crowd, and prefers the comfort found in numbers – in the multitude.  However, is it not always the crowd who lose on wall street?  When in the history of the stock exchanges did the majority win?  Wealth could not be created for the few if this were to occur.  It is easy to say “the PC is dead” or “Windows 8 is no good” – after all who is not doing that?  It is hard to actually critically analyze companies and historical performance – and to ask the opposite question in the later instance – who is doing that?

 

Microsoft has never enjoyed the popularity in the minds of consumers that say Apple (AAPL) or Krispy Kreme Donuts (KKD) has.   Despite this by every financial metric, it is a force to be reckoned with.   

 

A few questions were raised about the opinion of analysts in the Amvona Article Silver Platters, Annie Oakley and “The Sidelines” published on May 1st, 2012.  It is hard to find websites that accurately track the wisdom of analysts opinions - this must be by design, so going back and reading the above article was enlightening, because it kept the temporal nature of these sort of comments in a historical perspective.

 

At the time the article was published back in May the concern was over the future of HDD pricing and it’s supposed erosion – which did not materialize.  Now the thesis seems more difficult to prophesy – the outcome of Windows 8, even before it launches. 

 

As late as May 9th, Citi had a “buy” rating on the shares of WDC.  In the five months that followed the delta in Price Target issues by the firm have equated to around 10 B in value – or more (by about 20%) than the market cap. of the whole company as of the writing of this article.

 

Wednesday, May 9, 6:26 PM Western Digital (WDC +2.1%) finished higher on the day after filing its FQ4 10-Q. Citi (Buy) points out WDC disclosed it has repurchased 7.8M shares in FQ1 as of May 8. Moreover, given the company was in a quiet period until April 26, Citi believes all of the buybacks, which cost the company $305M, occurred over the last 2 weeks. Comment! [Tech, On the Move]

http://seekingalpha.com/symbol/wdc/currents/3

 

The Amvona earnings FQ1 13 estimate for the record is between $2.85 and $2.95 per share (unlike previous articles, it’s a rough back of the envelope estimate) - while acknowledging the possibility that the company could miss even on consensus ($2.45-2.55) – it is not acknowledged or accepted that the company should thus be rated a sell. Also if forced to bet, it seems reasonable that Windows 8 will do just fine. 

 

If speculating on the success or failure of Win8 is not enough, hiding in plain sight is this fact:

 

TAM Δ
157  
-140  
17 10.8%
   
Rev. Δ
4.2  
-4  
0.2 4.8%

 

According to the company the Total Addressable Market (TAM) is set to decline by roughly 10.8% in the current quarter but the related revenue only by about half as much.

 

Wolfgang Nickl, CFO Western Digital:

 

“We now expect the total available market for hard disk drives in the September quarter to be 140 million units. That is down from 157 that we guided to in the July earnings call. As a result, our revenue will be lower assuming flat share. And our new revenue range is $3.9 billion to $4.0 billion. However, and, here’s the important part, we expect that our gross margin on a non-GAAP basis will continue to be at 30% like we guided to in the July call.”

 Western Digital Corp. - Analyst/Investor Day (Sept. 13th, 2012)

 

The word "assume" is interesting in the context of market share.  It is used often throughout the investor presentation when references are made to "market share".  The question is what prevents the company from taking further market share?  Visits to retailers have affirmed three incredibly important points regarding WDC's consumer business:

 

1. The Company has more shelf-space than the competition.

2. The Company's products have a superior look and feel (presentation)

3. The Company appears to have far greater pricing power.

 

Further with regards to the share repo: 

 

"You might recall last quarter, we finished with an ending authorization of $1.3 billion. I can tell you we spent about $150 million quarter-to-date. And with the additional $1.5 billion, we have around about $2.7 billion left, which is 25% of the market capitalization today."

Western Digital Corp. - Analyst/Investor Day (Sept. 13th, 2012)

 

mypassport edgeThese guys are smart.  In the prior quarter (Q4 F12) they spent about 600 M on share repurchases, that is to say when the shares were often in the low 30’s.  However in the current quarter, when the shares were often above 40, they spent a mere 150 M.    Now the shares are back in the early 30’s, and one has to wonder how busy the company’s broker is.  The company claims the share repurchases are “linear”, if so, this is the finest “linear” repurchasing ever, because it synchronizes beautifully with the company’s stock price performance (which has been anything but linear) – and unlike so many other public company’s with share repo’s, the company is actually buying at highly favorable prices, which is extremely beneficial to ongoing owners, who benefit every time the share price goes down.

 

And on the Dividend:

 

"We do see the value of the dividend and therefore, we have decided to initiate a dividend, $0.25 per share on a quarterly basis. The 8-K will say that it will go to shareholders of record that’s of September 28, and that's the last day..."

Western Digital Corp. - Analyst/Investor Day (Sept. 13th, 2012)

 

The fact that WDC presently has the ability / authorization to take back 25% of the entire concern should be startling to sellers of the stock because it could mean the company might be taken private or be acquired. 

 

If neither of the above happened, the dividend will attract dividend investors and funds focused only on companies that pay a dividend (i.e. the stock is now attractive to both value-oriented and income / dividend investors)  These facts, along with the realization that the HDD is already decoupled from the traditional PC food chain, may well be the catalyst that releases the share price to more normal valuation ratios.

 

The Amvona EPS estimate could be wrong, the market may continue it’s recent trend down – but if the market comes to understand the error of its ways, the price of WDC may well go up, for even a doubling of the share price would leave the stock cheap by all measures including the company’s own historical values.

 

Consider the valuation ratios in historical context: 

 

WDC Valuation Ratios 10 Yr. Avg. FYE 2012
     
PE Ratio (ttm) 10.3 4.5
     
Price to Tangible Book 3.2 1.6
     
Price-to-Free-Cash-Flow ratio 16.0 3.2
     
Price to Book 3.1 1.0
     
Free Cashflow per Share 2.3 9.3
     
Gross Margin % 18.4 29.2

 

Another way to look at it is to say if the company just earns consensus of $2.55 per share, at Sept. 30th, 2012 the company would have had approximately $33.72 in book value (or a P/B ratio of just 1.03).  A P/B book of ~1 means the company as a going concerns is, well, worthless or worth no more than the sum of it’s equity, the vast majority of which is tangible.  However, since more than three weeks will have passed by the time investors learn of the company’s FQ1 performance, it is almost certain that the actual P/B ratio on Oct. 22nd will be something below 1. 

 

That would mean the company is selling at just 33% of it’s historical 10 year avg. P/B value 3.11.

 

Taking another look at a DCF model, if EPS is $10 (per the company) and the Growth rate is 16.6% (the historical average), with a Terminal Growth rate of just 4% (10 yrs.) and a standard discount rate of 12%, it is possible to reach a DCF fair value of  ~$227.   It seems high.  However, in 2009 when AAPL's was trading at $92 per share it also seemed expensive. 

 

The price at Friday October 19th was 34.88 per share or 15.3% of the above DCF value.  Meaning there may be an 85% margin of safety at the Friday Oct. 19th, 2012 closing price.

 

The PC is dead

 

It’s hard to say, but isn’t it just as reasonable to think (and contrary to Citi's report) that Windows 8 may well be “a big event”?  Apple (AAPL) for instance is a great company, they’ve fought like a golden gloves champ, but virtually every other hardware and software vendor in the known universe is in the other corner, and they don’t look happy.  If handicapping the odds that all other giants (many of whom are collaborating) will stumble, at least consider the math, if not the fact AAPL is down one team member,  who everyone seems to agree was of utmost importance – with the last product he worked on just recently being launched (the iPhone 5).

 

Is the PC dead as Barron’s seemd to recently proclaim?

 

A title to the article claiming “Steve Jobs is Dead” (God rest his Soul) would not have been popular, although much more accurate and easier to verify, and perhaps also impactful to the dynamics at hand.   After all he was a brilliant visionary, for which there is no adequate substitute.

 

Consider the excellent point made by “the science of hitting”:

 

“At the end of October, Microsoft (MSFT)'s Windows 8 operating system will hit the market – and in some ways, this has been a more fiercely fought battle than the presidential election. Everybody has an opinion on the functionality of the new OS, its potential uptake in the PC market, its potential impact on PC sales, etc. – and the debate goes on and on. I think I might be looking at this launch a bit different than some people and would like to run you through my thought process. To start, let's look at what Apple (AAPL) had to say in their most recently 10-K about PC sales:

 

“Mac net sales were $21.8 billion in 2011, representing an increase of $4.3 billion or 25% compared to 2010. Mac unit sales increased by 3.1 million or 22% in 2011 compared to 2010. The year-over-year growth in Mac net sales and unit sales was due primarily to higher demand in all of the company’s operating segments for MacBook Air and MacBook Pro, which were updated in July 2011 and February 2011, respectively. The year-over-year revenue growth for portables and desktops was 36% and 4%, respectively. Net sales of the company’s Macs accounted for 20% of the company’s total net sales for 2011.”

 

Some quick math shows that unit sales for 2011 of 17 million (roughly 5% of the global total of about 350 million) were preceded by 2010 unit sales of roughly 14.1 million; for the sake of comparison, let’s assume that every single Mac was sold in the back half of 2010, bringing the 18-month total to 31.1 million units. With that as our back drop, what would be considered a failure for Microsoft with the Windows 8 release? We don’t have to go too far back in history to find what many consider to be an unmitigated disaster by Microsoft: the hated Windows Vista. The OS was released in January 2007 and caught some backlash in a big way – in fact, CNET would end up rating it the “Worst Tech Product of 2007.” Fast forward 18 months, and we get an idea of what a disaster looks like: When the company reported their fiscal 2008 full-year results in July, Microsoft announced that more than 180 million licenses had been sold since the launch.

 

Thinking about these numbers is instructive – over a similar time period, Vista outsold Mac’s (which naturally come with OS X) at a pace of six-to-one. And remember, when Microsoft was dealing with Vista, they weren’t losing share (at least not in a huge way); they were simply maintaining their current hold on the marketplace among consumers (like myself) who decided to stick with XP. While Steve Ballmer rarely says anything worth quoting, here’s something that he noted in a recent interview worth considering:

 

“People talk about: ‘How healthy is the PC market?’ There's going to be close to 400 million PCs sold in the next year, which makes it a big market. And whether it's 405 (million) or 395 (million), it's a big market, and Windows 8 will propel that volume.”

 

I think this alone is the most overlooked point with this product launch: that vast majority of consumers will end up with a Windows 8 laptop, for the simple fact that most people don’t see the rationale in paying two-to-three times as much for a Mac when it has comparable utility.”

What Would Make Windows 8 a Success? (GuruFocus, October 4th, 2012) 

 

 The combined effect is about 1.3 Billion

 

"Now we have a development on an ongoing arbitration between the two companies, according to an SEC filing this morning. At issue is a $630 million award being vacated where Seagate had alleged misappropriation of eight alleged trade secrets by Western Digital and a former employee."

$630 Million Award Vacated in Seagate/Western Digital Arbitration (Daily Finance, October 15th, 2012)

 

On March 23rd of this year, the following was written in the article “Wait! That was our price target and other musings on Memory and storage

 

‘On February 24th we wrote in a note to investors the following:

 

"WDC will (contrary to media / analyst reports):

 

-Jump on announcement of finalization of Hitachi merger (may be accretive in Q1)

- Announce return to full production before Q3

- Despite returning to 100% capacity, ASP’s will remain drastically elevated for remainder of 2012

- Announce huge insurance payment in Q2 CC

- Jump on release of Windows 8 (probably Q3) – desktop resets

- STX mediation award for 650 mln. will be thrown out" '

 

Most of points made in the February 24th, 2012 investor letter and published in the related article on March 23rd, 2012 have come to pass.  The insurance payments were not received in Q2 as anticipated, but it seems likely they will be in Q3.  It will be known shortly if the price reacts to the launch of Windows 8 above, but the impact of the mediation award being thrown out cannot be overstated.   The effect is not merely 650 M, but rather 1.3 B  – it is the 650 M WDC did not lose, and the 650 M STX did not gain.  1.3 B is roughly 17% of WDC’s enterprise value as of the writing of this article.  The news of the judges decision, unlike the updated Citi rating, was late to make it to the media, in fact it hardly appeared anywhere, much like Deutsche banks upgrade to a $60 Price Target on the shares just weeks before Citi’s downgrade to $32. 

 

Thoughts on the earnings record

 

Earnings consistency: It’s huge.   WDC has it.  STX not as much.  The average earnings coefficient over past time is irrelevant if the company’s performance is inconsistent: True Religion Apparel (TRLG) is a great example of consistent earnings over time.  Here is a chart illustrating the point.

 

TRLG chart

 

Although the company did not and still does not have the characteristics of a traditional value investment, the remarkable consistency in the earnings reports warranted careful evaluation, particularly in light of the “relative” value, by which standard TRLG was by far the cheapest in it’s group.  For this reason, the shares were acquired on September 4th, 2012 at $22.79 per share and again on October 2nd and 3rd at $20.74 per share and $20.68 per share respectively.

 

On October 10th, only seven days after the last shares were acquired, they were sold in the pre-market at $26.16 per share.  The results outperformed the S & P 500 just slightly as can be seen below:

 

Issue Purchase Date Price Date Value Perf. Months Annualized
TRLG 9/4/2012 $ 22.79 10/10/2012 $               26.16 14.8% 1.2 149.9%
S & P 500 9/4/2012 1404.94 10/10/2012 1432.56 2.0% 1.2 19.9%
               
TRLG 10/2/2012 $ 20.74 10/10/2012 $               26.16 26.1% 0.3 1192.3%
S & P 500 10/2/2012 1445.75 10/10/2012 1432.56 -0.9% 0.3 -41.6%
               
TRLG 10/3/2012 $ 20.68 10/10/2012 $               26.16 26.5% 0.2 1381.7%
S & P 500 10/3/2012 1450.99 10/10/2012 1432.56 -1.3% 0.2 -66.2%

 

Company’s with such characteristics are good “buy out” candidates, as is the case with TRLG - the company recently announced the possibility of just such an event. 

 

TRLG was the fourth company invested in (with three out of the four discussed at length in Amvona articles), to be either bought out or taken private in the last few years (the other three being (AM), (WINN), and (FRPT) ).

 

The WDC investor presentation features 10 full yrs. of operating history – the equivalent STX presentation only 5 – STX investors might find it worthwhile to investigate why.   Further the recent earnings record appears more substantial for STX, b/c the company was not as impaired as WDC after Thai floods – a temporary condition.   As these impaired quarters move out of the TTM figures, the P/E ratio on a TTM basis will decline (assuming the share price remains low).

 

Consider, at the investor conference in late September WDC basically knew their Q1 FY13 numbers – when they affirmed a high guidance ($10 per share), they must have felt confident – if FQ1 was already looking hairy, they would not have felt confident, they could have alternatively withdrew or lowered  their guidance as many companies do.  Because the company has been conservative historically, this should say everything.  The analysts, the investors, they didn’t and don’t know the figures for FQ1, but the company itself had barely two weeks of operations left before closing the books – and they guided at $10 a share, a conviction so high, the company moved forward with additional share repurchases and initiated a divided.

 

Decoupling – WDC may finally break free of the market perception about what exactly the PC food chain is – if this happens, and the old way of thinking changes, than the stock may emerge at more normal ratios comparable with other well run, established technology company’s – this could easily mean a doubling or tripling of the stock price.

 

However the forward P/E, even at the current level is deceptive – the present showing of 4.1 is based on analysts earnings estimates of about $8.50 per share, but if the company’s estimates of $10 per share are to be believed (which the company affirmed in September), the forward P/E ratio would not be 4.1 but rather 3.48.

 

If enterprise value is used (instead of “Market Cap.) as would be the perspective of a potential acquirer, than the ratio of enterprise value (~$31.71) to earnings at $10 per share (call it EV/E) is a mere 3.17 – this of course is based on a share count of 245 M outstanding as of the end of FY 12.   However, it is already known that the company is buying shares back aggressively, so feel free to round the EV/E down to a nice even 3.

 

Of course FCF might be even more important to a prospective acquirer, and in the TTM that figure was about $9.33 a share.  However in that $9.33 per share there exists (in addition to the impaired quarters) a mere 4.5 months of HGST cash flow in the total, when 4.5 months becomes a full 12 months, it’s not hard to see where the FCF figure on a per share basis would be much higher.  Surely a prospective acquirer, just as an enterprising value-oriented investor would be most interested in this “EV/FCF” ratio – after all it’s where the “meat and potatoes” is at. If FCF on a full year basis with HGST's earnings power is considered it not hard to see $12 per share or a EV/FCF ratio of only ~2.6. That means the company could potentially generate enough cash to effectively pay for itself (EV being the actual company price tag) in only 2.6 years. 

 

To recap, an argument could be made that more data is stored on WDC drives than any other form of media in existence and the data to be stored in the future is growing exponentially.   WDC is a forty year old company that is extremely well run and hugely profitable. 

 

Even Advanced Micro Devices (AMD), which presently appears to be a good candidate for bankruptcy sells at a significant premium to WDC.  After looking high and low it’s hard to find a cheaper listing, if even basic criteria are used (like not operating at a deficit).

 

open compute logoIn the end it doesn't matter whose EPS figures are right, or if Win8 succeeds or fails – what matters is that sooner or later the market will realize that the entire hardware ecosystem has changed.  The Open Compute Project for instance effects servers, storage and the datacenter, and at the heart of this movement is the Boeing 747 of the hardware universe – the HDD as low cost building block storage.

 

 

Lemelson Capital Management

Lemelson Capital Management, LLC is a private investment manager focused on deep value and special situation investments.

For regulatory reasons, information about products and services cannot be provided to the general public.

 

Website: www.lemelsoncapital.com

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