How Will HGST Integration Impact Western Digital?

Western Digital Corporation (NASDAQ:WDC) acquired Hitachi Global Storage Technologies (HGST), Hitachi’s hard drive business, for $4.5 billion back in 2012. According to regulations laid down by the Chinese Ministry of Commerce (MOFCOM), Western Digital was required to wait 24 months before completing the merger between the two companies. In the meantime, HGST would continue to operate as an isolated entity within Western Digital. However, after waiting for 33 months and resolving certain non-compliance issues, Western Digital is still waiting for approval from the Chinese authorities. Below we take a look at the company’s HGST subsidiary and how the completion of the merger will benefit the company.

We have a $100 price estimate for Western Digital’s stock. Our price estimate is slightly lower than the current market price, which has risen by almost 15% since the company released its Q1 FY 2014 earnings in late October.

See our full analysis of Western Digital here

$4.5 Billion Acquisition

Western Digital acquired Hitachi’s hard drive business (HGST) for $4.5 billion in 2012, in an attempt to dominate the hard drive market. ^[1] Hitachi retained its storage systems business, Hitachi Data Systems, at the time. The company announced the HGST acquisition just months after competing hard drive maker Seagate Technology (NASDAQ:STX) acquired the hard drive division of Samsung Electronics (PINK:SSNLF) for $1.4 billion in December 2011. ^[2] As a result, both Western Digital and Seagate now enjoy a near duopoly in the hard drive market, with each commanding a nearly 45% share.

HGST is a crucial business within Western Digital, with the company making new technology-based acquisitions under the HGST banner. Western Digital recently announced that HGST will acquire flash storage array maker Skyera in an all cash transaction estimated to cost in the range of $200 million and $500 million. ^[3] Additionally, HGST acquired SSD manufacturer sTec in June 2013 for $340 million, which helped the company to bring the faster PCIe SSD product line to the table, to add to its existing portfolio of SAS and Fibre Channel SSD drives which HGST manufactured. Western Digital also acquired enterprise flash and SSD storage manufacturer Virident Systems for $685 million in September 2013 through HGST.

Fully Merged HGST And Cost Synergies

When Western Digital acquired HGST in 2012, MOFCOM asked Western Digital’s management to submit a detailed document containing an operating plan that would ensure that HGST will continue to maintain R&D, marketing and production at pre-acquisition levels, manufacture products in existing production facilities and keep the existing sales and marketing team for a period of 24 months after the acquisition. In addition, Western Digital was required to report production capacity and output to a trustee on a monthly basis and place firewalls within the development segments of the two companies so that no information is exchanged between the two. ^[4] MOFCOM had placed similar restrictions on Seagate’s Samsung acquisition for a period of 12 months to safeguard interests of the Chinese workforce under the employ of Samsung/Hitachi at the time. So it effectively meant that for a limited period of time, Western Digital would realize revenues generated by sales of HGST products, but for all practical purposes and research, HGST would be a separate entity.

As of December 2014 (33 months since the acquisition), HGST still hasn’t completely merged with Western Digital. According to MOFCOM, there were two non-compliance issues with the prior agreement which included the ownership of HGST as a subsidiary of Western Digital and the organizational structure within a certain department that included a few former HGST employees. If Western Digital intends to integrate the two companies, it will have to incur a fine of 600,000 RMB or about $100,000, restructure the said department and make changes to the subsidiary ownership structure. ^[5]

A recent statement by Western Digital management mentioned that it will incur the fine and make the required modifications to enable the merger. However, the company is unsure about when the authorities will lift restrictions for the integration to go through. The company has already lost nine months of cost synergies with HGST thus far. According to the company’s estimates, if the merger does go through successfully, it could help the company save almost $400 million in operating expenses due to cost synergies in research and development and other expenses. ^[6] There could also potentially be savings of around $200 million in cost of goods sold. If the merger goes through early next year, implying a combined $600 million in savings, it could lead to a definite upside to our price estimate for the company. $200 million saved on cost of goods in 2015 and subsequent years with all other forecast drivers remaining the same could imply a 4% upside to our $100 price estimate. Similarly, a $400 million reduction in combined operating expenses (R&D and sales, general and administrative expenses) for 2015 and subsequently through the end of our forecast period could imply a nearly 10% upside to our price estimate for the company. You can modify the interactive charts below to gauge the effect a change in gross margin or operating costs (R&D and SG&A) will have on our price estimate.

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1. WD® Completes Acquisition of Hitachi Global Storage Technologies, Western Digital Press Release, March 2012 [↩]
2. Seagate Completes Acquisition of Samsung’s Hard Disk Drive Business, Seagate Press Release, December 2011 [↩]
3. Drive-making kingpin WD gobbles Skyera..to give to HGST, The Register, December 2014 [↩]
4. Western Digital gets China’s nod to gobble Hitachi GST, The Register, March 2012 [↩]
5. Western Digital Corporation Statement Regarding MOFCOM, PR Newswire, December 2014 [↩]
6. WD and HGST: We tried to merge our two drive makers, MOFCOM said NO, NO, NO, The Register, December 2014 [↩]