This incident was in some ways, convenient, because we had just finished a cursory analysis of Western Digital (WDC), and it closest competitor, Seagate (STX) in early August. Often in the main stream financial media these two top-tier firms are grouped together, indeed enjoying analyst upgrades and downgrades in tandem (the number three concern being “Hitachi”). However, upon closer examination we find two very different companies financially.
Here are a few key measures as of September 10th 2010
|Current Assets||$ 4,720,000,000||$ 5,418,000,000|
|Current Liabilities||$ 2,023,000,000||$ 2,997,000,000|
|Current Ratio||2.33||$ 1.81|
|LT Debt / Equity||0.13||$ 0.93|
|Total Assets||$ 7,328,000,000||$ 8,247,000,000|
|Total Debt||$ 2,619,000,000||$ 5,523,000,000|
|Net Current Assets||$ 2,101,000,000||$ (105,000,000)|
STX is about 15% larger than WDC by current asset size and about 12.5% larger by Total asset size. However, STX current liabilities are about 48% greater than that of WDC while the Total liabilities of STX exceed those of WDC by a full 110%. The result is the current ratio of STX is roughly 22% less than that of WDC while debt to equity is roughly 7 x’s that of WDC.
Looking at the firms “Net working Capital” (or current assets minus all liabilities), we find that while WDC maintains roughly 2.1 bln in NWC (about 38% of its share price), STX actually runs a deficit of roughly 105 mln ($-.22 per share, or -2% of its share price).
|EPS (ttm)||$ 5.93||$ 3.35|
|EPS as % of current share price||23.0%||31.1%|
|MRQ||$ 265,000,000||$ 386,000,000|
|MRQ annualized (avail. to common)||$ 1,060,000,000||$ 1,544,000,000|
|% of current market cap||17.9%||29.4%|
|MRQ EPS||$ 1.13||$ 0.77|
|MRQ EPS (annualized)||$ 4.52||$ 3.08|
The earnings picture is where things appear to get reversed. Here STX is producing net earnings that amount to about 31% of its share price over the last twelve months, while WDC turned out about 23% of its share price in net earnings. The disparity is even greater when the most recent QTR is consider alone ( ~ 29% and 18% respectively), placing STX’s recent earnings power at 61% over that of WDC in its most recent QTR, and up from a 35% average over the last twelve months. While this lends credence to the market premium placed on STX, it should be tempered by the loss STX reported in Q2 and Q3 of FY 2009, and an overall loss of $3.30 per share in FY 2009 (a loss of about 31% of its quoted price).
During the same period WDC reported solid earnings of $2.53 per share (or about 10% of its share price), with no reported deficit in the last four years, and a significant increase in earnings over the 4 year average of $2.67 per share likely for FY 2010 (already $5.93 per share).
|Current Price||$ 25.74||$ 10.77|
|Net Working Capital per Share||$ 9.13||$ (0.22)|
|NWC as % of Share Price||35.5%||-2.0%|
|Market Cap||$ 5,920,200,000||$ 5,244,990,000|
|Shareholder Equity||$ 4,709,000,000||$ 2,724,000,000|
|Book Value Per Share||$ 20.47||$ 5.59|
|Current Price to Book||1.26||1.93|
Without questions the market favor STX over WDC, at least for the time being. By volume, they are the number one concern, and the market appears willing to pay a premium for this title, placing, as of September 10th, 2010 a premium on the stock of roughly twice the tangible assets. This equates to a market cap of about 85% of that of WDC, despite the fact the owner’s equity is only about half that of WDC.
A great deal of optimism about the future prospects of STX is assumed in the share price. This optimism is all the more questionable as the owner’s equity is eroding. Conversely the price of WDC, it could be said, reflects little more than a conservative estimate of “good will” (discussed further below) and pays no materials premium for future prospects, despite stellar growth in owner’s equity.
The exercise of understanding a company’s capital, and how it has increased over time, can provide a basic framework for estimating its future worth.
|2006||$ 1,157,000,000||$ 5,212,000,000|
|2007||$ 1,716,000,000||48%||$ 4,737,000,000||-9%|
|2008||$ 2,696,000,000||57%||$ 4,586,000,000||-3%|
|2009||$ 3,192,000,000||18%||$ 1,554,000,000||-66%|
|2010||$ 4,709,000,000||48%||$ 2,724,000,000||75%|
|2011 forecast||$ 6,726,180,822||$ 2,702,712,341|
|Avg. w/ dividend:||43%||-1%|
|forecast book value per share (1 yr. est)||$ 29.24||$ 5.55|
|1 yr. price at today's premium over book||$ 36.77||$ 10.69|
In the case above the average annual growth in owner’s equity for WDC is 43%, while STX has reported an aggregate loss of about 1% over the same period. Multiplying the most recent year owner’s equity balance by the average 5 year increase provides some guidance on what the balance sheet is likely to look like in a year. By this calculation the actual owner’s equity in STX will be a mere $5.55 per share, while WDC would be $29.24. At today’s premium that would mean STX would continue to trade about two times net asset values, while WDC would actually be trading below book value – placing less than zero value on the entire company as a going concern and valuing the entire enterprise for less than its net asset value ( as if liquidation were a consideration).
It should be noted here that both companies handle intangibles in a very conservative way. STX is the more conservative here with only ½ % of their total assets recorded to “intangibles”, and goodwill depleted to zero as of their most recent QTR. WDC on the other hand has 1.2% of total assets booked to “intangibles” with a further 1.9% of total assets booked to the “Goodwill” account.
On the one hand, it is a benefit that a company does not inflate its balance sheet through the use of liberal entries to the “intangibles” account. Yet on the other hand, realities such as “brand strength” are very real intangibles that rather than being impaired grow with time. Unfortunately GAAP is formulated in such a way as to allow the impairment of this account for tax purposes vs. recognizing their value in any way that resembles reality on the balance sheet. The result can be a balance sheet that dramatically understates the true value of the enterprise.
However the numbers become more interesting if we apply the estimated future book value of the companies by the modest premiums the market is willing to place on them today. This is done by multiplying the estimated future book value of the assets times the “price to book” ratio on September 10th, 2010. It should be noted that during the frame of reference, the general sentiment about the storage industry was poor and a number of analyst downgrades were announced for both companies shortly after the date the prices were quoted for this article. If we assume that sentiment is no better or worse than it is today, then we see that the potential future market value of the shares of WDC would be about $37 (an increase in share price of about 43%) while STX would remain about where it is today. This assumes the continued disregard for the true value of “intangibles”. In and of itself, this information is not particularly enlightening, given its parallel to information and sentiment available on September 10th, 2010, that is to say, other than to point out that a dramatic rise in the price of WDC over the next twelve months would still allow for a modest valuation in relation to its nearest competitor. However, the point becomes more interesting If we consider the possibility of sentiment worsening. If sentiment were such that both companies were to trade for just their net assets values in one year’s time, WDC would still gain about 13.5% while STX would lose 51.5% of its value based on the share prices as of September 10th, 2010 and their average historical increase in owners equity. If preservation of principle is in anyway important, this type of scenario cannot be over-looked.
Investing in Technology is difficult. It is highly speculative, and hard to create enduring advantages over competitors. The price of technology goes down constantly, and “breakthroughs” are quickly eclipsed; storage and memory are no different. Another setback for technology is the cost of R & D, taken out of operating income, it reduces owner profits. As technology goes, if there is a “commodity” in the business that benefits from brand strength, and steady, growing demand, it is storage.
Storage however, in the technology world, may be a bit unique in this area. Gains are made over a span of many years in quantity, and not necessarily quality, or major scientific breakthroughs in the way data is stored. Those costs are often shared amongst many commercial concerns and academic institutions, freeing commercial storage companies to focus on operational efficiency during long periods of regenerating and improving existing storage technologies. Investments in “promise”, although still “technology” related, are all the more difficult to understand given this realty. History is replete with examples of the clear delineation between innovation and profit. If innovation is not always commensurate with consistent profits, then is the balance sheet not one of the best place to look for value?
The general idea behind investing (not to be confused with speculation) is to attempt to determine, in approximate terms, both the real value today as well as the likely value in the future of an asset. If approached in a systemic, rational and calculating way, this exercise should provide a fair degree of accuracy over time. It can produce better than average investing results if these figures can be arrived at before too many others, for it allows for the investment of capital at prices that can be confidently discerned as favorable. If securities are purchased under these conditions, then there should be little worry over the “how” or “when” of selling.
WDC and STX provide a great example of two companies in the same industry with financial qualities that are as different as the sentiment that surrounds them. It would be interesting to check in on the price of these securities in one year.
**The above is not an endorsement to either buy or sell an interest in either security, but is intended rather, as a review of the quantitative factors of the concerns. The approach is “value” oriented and intended for readers with intermediate to advanced experience with securities analysis. Qualitative factors are undoubtedly important in any consideration of value, but are beyond the scope of this article, that having been said, the financial statements of a company should reflect quality within the organization.