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Tuesday, 30 October 2012 17:42

Is Western Digital an Ideal Acquisition Target?

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*May The Lord rest the souls of those who have departed in the destruction caused by Hurricane Sandy, and console their loved ones.

 

MBAsOn October 22nd, 2012 Western Digital Corp. released their Q1 2013 financial results.  Here are a few key points that are worth noting:

 

Valuation Ratios:  The cheapest Company in America?

 

"Citigroup‘s Joe Yoo today cut his ratings on hard drive and storage technology developers Seagate Technology (STX) and Western Digital (WDC) to Sell from Buy, writing that there is a chance of 25% downside to current estimates for the companies this quarter given what may be drastically lower volume of drive shipments.  Yoo cut his Seagate target to $25 from $37, and cut his Western Digital target to $32 from $53. …For Western, his estimates go to $15.3 billion and $9.99 in EPS from a prior $15.84 billion and $10.68 per share."

STX, WDC Cut to Sell at Citi; Estimates Too High Amidst PC Slowdown (Tech Trader Daily, Oct. 12th, 2012)

After the company’s earnings release on Monday Oct. 22nd, 2012, several other analysts also downgraded the shares. On Tuesday Oct. 23rd in the pre-market, shares of WDC traded as low as $32 per share. 

 

Monday, October 22, 5:33 PM Western Digital (WDC) -3.6% AH after guiding on its FQ1 call (webcast) for FQ2 revenue of $3.55B-$3.7B and EPS of $1.65-$1.85, below a consensus of $4.13B and $2.43. Seagate (STX) -4.5%. Expectations for hard drive shipments have been deteriorating as PC sales dive, but it looks as it they need to fall further still.

 SeekingAlpha (Currents)

 

At $32 per share the company’s enterprise value was 6.46 B, while EBIDTA (TTM) was 3.46 B.  The result was that on Tuesday morning, October 23rd, 2012 the EV/EBIDTA ratio of the company was ~1.86.  In other words, based on EBIDTA earnings, the company could recover it’s entire enterprise value in only 1.86 years.  Or stated differently, an acquirer could recover their investment almost in full, in just under two years.  

 

These figures seem so low that it was worth filtering all equities traded on US markets to find out if any comparable bargains existed. 

 

Four basic criteria were used as follows:

 

1. P/B between .1 and 1.3       (WDC traded at ~  .97 on Oct. 23rd)

2. P/E at or below 4                (WDC traded at ~4.12 on Oct. 23rd)

3. EV/EBITDA at or below 3     (WDC traded at ~1.86 on Oct. 23rd)

4. Market Cap over 500 M       

 

The list produced only one result for all US listed companies: Western Digital Corp. (WDC)

 

Given these valuation ratios WDC may well be an acquisition target.  Seagate Technologies (STX) for instance, based on earnings, is also very cheap, however it can not be said that the shares have the same security underlying the issue. 

 

Earnings:  Calculating future Growth

 

Here are the one, five, and ten year growth rates for WDC (excluding the most recent quarter):

 

Fig. 1 - Historical Growth Rates for WDC

Symbol

Price

Rev. GR 1 Yr.

Rev. GR 5 Yr.

Rev. GR 10 Yr.

WDC

34.12

24.2

11.9

16.6

         
   

EBITDA GR 1 Yr.

EBITDA GR 5 Yr.

EBITDA GR 10 Yr.

   

77

21

31.9

         
   

EPS GR 1 Yr.

EPS GR 5 Yr.

EPS GR 10 Yr.

   

108.9

15.3

29.5

         
   

Book GR 1 Yr.

Book GR 5 Yr.

Book GR 10 Yr.

   

22.7

29.5

45.1

 

EBITDA, EPS and Book growth rates have far outpaced revenue growth rates (which are significant), that is to say the company is not only getting larger, but also far more profitable.

 

Here is what a graph of the EBITDA earnings per share and EV/EBITDA ratios look like for the last ten years (Q1 FY13 figures are not included in the showing, which would have the effect of increasing the EBITDA figure and lowering the EV/EBITDA number, thus increasing the spread illustrated below):

 

Fig. 2 - EBITDA and EV/EBITDA Graph

interactive chart WDC

 

"I mean, $10 is the target and remains the target. Our complete focus is on the items that we control or at least influence. We're focusing heavily on cost. We're focusing on OpEx and spending. We somewhat impact the share count as well and obviously try to optimize volume price mix decision. So we're focusing on what we control or influence. We have made an assumption when we originally stated the $10 target in July, I believe, yes, in July, that we assumed the TAM to increase by 5%. And if you do the math, that would be a TAM of 630 million units. And with the first 2 quarters at 139 and 140, respectively, we need a bit of an uptick in the second half of the fiscal year to continue to be able to do the target. I believe that we'll get in the 600 range. It's very doable. And like we said, we focus on the levels that we control. And it remains a target, and that's what we're shooting for."

Wolfgang U. Nickl - Chief Financial Officer (Q1 FY13 Earnings Call)

 

A review of the historical earnings record will show that Western Digital has been historically very conservative with earnings estimates. Therefore there is no reason to think that that the comments above are in any way "aggressive".  In fact, in the current instance, the estimates (despite lowered guidance for one quarter) have not changed. 

 

Here is what the remaining quarters in Fiscal 2013 look like (based on the company's guidance) in terms of both "Total Addressable Market" (TAM) and EPS:

 

 Fig. 3 - Projecting Forward - Q3 and Q4 Estimates

Item

Q1

Q2

Q3

Q4

Total

TAM

139

140

175.5

175.5

630

EPS

$     2.06

$   1.85

$   3.05

$   3.05

$   10.00

 

If this conservative CFO's figures are correct, than the TAM will grow in aggregate by ~20% in the last two quarters of FY 2013, while the EPS figure will grow in aggregate by ~35.7%.   Even if this growth did not occur, but rather sales were closer to analysts estimates (~$8 per share), the company would still be well ahead of it's own historical rate of growth (Fig. 1).  

 

A review (going back to Q2 FY2009) of Actual EPS figures to even high EPS guidance, puts the company's estimates almost always below actual.  It may also be worth noting that since the completion of the HGST acquisition (Q3 FY12), the company has lowered it's worldwide headcount by well over 10k (from 106,604 to 96,002), or by roughly 10%, despite formerly indicating that there would be no OpEx synergies from the deal until FY 2014.

 

Also, as pointed out in the Amvona article "Another look at the Low Cost Building Blocks of Storage", estimating revenue may not be as simple pegging to the "TAM" based on the company's own Q2 FY13 guidance.  Since unit volume excludes WD TV Media Players w/o hard drives, WD Livewire, SSD and media, it seems safe to reason that these non-HDD products, the most important of which may be SSD, are indeed growing.

 

Fig. 4 - TAM vs. Rev.

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

 

Revelations (on a per share basis)

 

"Tuesday, October 16, 10:02 AM A Minnesota district court has vacated a $630.4M arbitration award granted to Seagate (STX +1.4%) in a dispute with Western Digital (WDC +1.7%) over the alleged theft of trade secrets by a former Seagate employee."

SeekingAlpha (Currents)

 

"I mean, first of all, I think you're right, the 382 is probably a peak. I want to remind you that we report CapEx on a cash basis, so the 382 includes flood-related spending that was actually for capital that was received in Q4. With that, before that, in total, we expect for flood recovery about $400 million, for which approximately half will be in fiscal year '13."

Wolfgang U. Nickl - Chief Financial Officer (Q1 2013 Earnings Call)

 

Looking ahead, Western Digital  sees second-quarter adjusted EPS of $1.65 to $1.85 and revs of $3.55 billion to $3.70 billion. The Street sees EPS of $2.43 and revs of $4.13 billion.

StreetInsider (Oct. 22nd, 2012)

 

 Fig. 5 - Effect of recent events on EPS

Item

Event

Dollars

Per Share

A.

Benefit - Arbitration award

630 M

$2.56

B.

Cash from Ins. Proceeds (FY13)

200 M

$0.81

C.

Value of lowered guidance Q2 FY13

143 M

$0.58

       

D.

(A + B) - C

687 M

$2.79

 *Calculation based on 246 M shares outstanding.

 

What was learned in the October period is that the future earnings of WDC were augmented for FY13 by a net positive (from previous estimates) of about $2.79 per share.  If the company purchases a large number of shares during FY13 as they have indicated they may well do, the figures for points A and B above would increase, while the showing for point C would decrease, leading to a larger overall figure for point D.  This says nothing of the possibility of WDC beating estimates (for Q2 FY13), which they often do.

 

However, despite the net positive, the market focused on only the revised guidance for Q2 FY13, even though this revision did not result in an overall revision to the company's FY 2013 EPS forecast as indicated above.

 

"It's not how much money you make, it's how much you keep"

 

Those are the words of a brilliant Cretan business women who had not even finished primary school.  It begs the question how many Harvard MBA's it might take to arrive at the same simple conclusion.

 

Wednesday, October 24, 7:01 AM First come positive earnings, then come the upgrades. Already on a tear following its report last night, Facebook (FB) gets an additional push from upgrades at Citi and BAML. "What investors have for the first time since the IPO is fundamentals acceleration WITH a reasonable valuation," writes Citi's Mark Mahaney. Shares +12.9% premarket

SeekingAlpha (Currents)

 

The Amvona article On the value of Users, Hard Drives and Batteries, published on June 11th, 2012 paired Western Digital (WDC) and Facebook (FB) for the sake of analysis.  Two earnings seasons later it seems like a good time to pair the two again.

 

Tuesday, October 23, 9:14 AM Western Digital (WDC) -8.7% after issuing poor FQ2 guidance to go with its FQ1 report. CLSA is downgrading shares all the way to Underperform from Outperform, citing weak hard drive demand and a lack of catalysts. During its earnings call, WDC said it expected calendar Q4 industry hard drive shipments of 140M, in-line with a bleak Citi forecast and below a Seagate forecast of 150M-155M.

SeekingAlpha (Currents)

 

How does one define "guidance" by the quarter or by the year? 

 

In the day that followed WDC's Oct. 22nd earnings release which included quarterly net income figures of $594 M (an increase of more than 100% YoY) and subsequent analyst downgrades, the shares lost almost 10% in the pre-market trade (down over 9.5% at one point).  This decline followed a ~25% decline in the share price in the nine weeks leading up to the earnings release.  One day later Facebook (FB) would also announce their earnings, a net loss of $59 M, concluding the fourth consecutive decline in quarterly earnings or in the par lance of Wall Street "Negative Earnings Growth", which somehow manages to pair the word "growth" with "negative" - the shares, after broad analysts upgrades were up as much as 26% the following day.

 

According to Citi, WDC quarterly earnings at 100% YoY growth and more than half a billion dollars, which is set to accelerate dramatically (see above)  apparently could not justify a PT of more than $32 (see above), or basically book value.  FB on the other hand, with the fourth consecutive quarterly decline in earnings (which finally arrived at a negative figure), and basically flat revenue during the same period, not only has "fundamental acceleration" but boasts even a "reasonable valuation".  

 

Fig. 6 - FB "A Reasonable Valuation

As of Oct. 26th, 2012

Metric

Value

Market Cap

47.54B

P/E

113.69

Price/Book (mrq)

3.42

Enterprise Value/EBITDA

34.84

 

If FB were to continue on the current earnings trend, the P/E ratio would soon arrive at infinity, since it would be impossible to calculate the Price to Earnings ratio when there are no earnings.  That having been said, FB with it's ~48 B market cap. earned less in the last year (a time when earnings continue to decline), than WDC earned in the last 3 months, yet it is possible to buy nearly six whole Western Digital's for the price of just one Facebook.

 

 Fig. 7 - WDC "Cut... Ratings to Sell from Buy"

As of Oct. 26th, 2012

Mertic

Value

Market Cap

8.39B

P/E

4.49

Price/Book (mrq):

1.05

Enterprise Value/EBITDA

2.02

 

Such a definition of "Reasonable Valuation" seems like it should be criminal - but it's not.  It even seemed like it should be the reason why the Citi Analyst, who ascribed those words to FB was no longer working at Citi only days later -  it's not.

 

"Mark Mahaney, a star tech analyst at Citigroup, was just fired.  He got canned because one of Mahaney's junior associates leaked information about the bank's views on the Facebook IPO to TechCrunch writers Josh Constine and Kim-Mai Cutler, and that led to the state of Massachusetts fining his firm $2 million.   Mahaney also went outside required protocol interacting with a French journalist."

Citigroup's Star Tech Analyst Mark Mahaney Fired After Leaks To TechCrunch (Business Insider, Oct. 26th, 2012)

 

The timing of such a call may be at the very least "convenient".  Now that the company is running at a deficit, there is "fundamental acceleration" (whatever that means), and a "reasonable valuation" - perhaps it would have been helpful for the average retail investor to have been reminded in the same research note of the following:

 

"...Accordingly, we expect that a total of approximately 234 million shares held by employees who are employed by Facebook through October 15, 2012, will be eligible for sale in the public market as of market open on October 29, 2012."

Form 8-K for Facebook Inc. (Sept. 4th, 2012)

 

The relationship between analysts, and the timing of share price performance might just be coincidence, if there is such a thing as "coincidence".  The comments of analysts, whatever their motivations, work in tandem with the media to create extremes of price in both directions (both high and low).  Depending on how broad (or narrow) the horizon of the analyst is, even the most simple comments of a company executive can provide the buying (or selling) opportunity of a life time.

 

Q. Benjamin A. Reitzes - Barclays Capital, Research Division Okay. And just my follow-up's real quick on share repurchase. If you take your $10 guidance as literal, it means about $3 in earnings probably in the March and June quarters. I mean, is there any thought about accelerating share repurchase now...

 

A. Wolfgang U. Nickl - Chief Financial Officer,  It's certainly one of the levers available to us, and we're exploring that.

Western Digital Q1 FY 2013 Earnings Call 

 

For example WDC, by guiding lower for Q2 FY13, abides by all safe harbor provisions, and cannot later be accused of overstating earnings guidance or in anyway speculating. It is safe, fair and good for investors to be cautioned - everyone will agree.  No harm done.   This cautious guidance of course will be the sole item used by analysts (as above) to lower estimates and ratings.  These analysts ratings in turn results in an immediately lowered share price.  If the company is then able to repurchase its own shares back at a much more favorable price, almost nobody will notice.  The company will not be accused of any wrong doing, because they have stated the possibility openly, and the analysts (rather than the company itself) have acted to amplify the perception of bad news, though few will calculate the affects because it requires (only) slightly more math than a simple quarterly EPS estimate.

 

After the (WDC) shares were sold on August 13th, 2012, the following was written:

 

"The position in WDC owned for investors' account were sold on August 13th, 2012 at $44 per share... not because the shares were overpriced, or even at fair value (estimated at least at $68...), but rather because it was hard to recollect seeing a price performance chart which went up diagonally in perfectly straight line.
 
Hopefully WDC shares can be re-aquired..."

Buying glass and other problems with interventions (Amvona - Aug. 28th, 2012)

 

The largest potential buyer of the shares must be the company with ~2.6 B in outstanding authorization, which on the morning of Oct. 23rd, 2012 represented a full 33% of the company.

 

Perhaps the public market will not reward WDC for it's stellar performance afterall.  This does not mean however that somebody else won't. For this reason increasingly the opinion has formed that WDC itself may have become the ideal take-over target. 

 

Time will tell.

 

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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