Is Western Digital’s Stock Undervalued After The SanDisk Announcement?

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Hard drive manufacturer Western Digital (NASDAQ:WDC) has endured soft product sales in recent quarters, with a slow PC market weighing on the consumer IT market. For the first nine months of the year, Western Digital has faced a 26% decline in the number of desktop and notebook hard drives shipped, to about 87 million units. Similarly, its retail sales have also fallen in the same period, with the combined consumer electronics and branded product shipments declining by over 4% over the prior year period to 68 million units. Comparatively, enterprise hard drive unit shipments have stayed flat on a y-o-y basis at about 22 million units through the first three quarters of the calendar year.

The company’s recent $19 billion acquisition of flash storage provider SanDisk Corporation (NASDAQ:SNDK) indicates a firm decision to solidify its presence in the enterprise storage segment. [1] The announcement was made in what has been a slow year for Western Digital in terms of both revenues and profits. The company reported a 13% year-on-year decline in net revenues to just under $3.2 billion in the most recent quarter, while revenues through the three quarters of the calendar year have fallen by about 10% to just under $10 billion. Similarly, its net income fell by over 20% to just under $900 million for the three quarters of 2015 thus far.

We have an $83 price estimate for Western Digital’s stock, which is significantly higher than the current market price. Western Digital’s stock price fell from about $110 at the beginning of the year to about $70 by the end of September, after three quarters of subdued results. Subsequently, it’s stock price rallied to $85 in October after Chinese state-backed Unisplendour Corporation invested $3.8 billion in the company for a 15% equity stake at $92.50 a share. Following the announcement of the SanDisk acquisition, Western Digital’s stock price plummeted to under $60 in the month, with reports suggesting that Western Digital may have overpaid for SanDisk. [2]

See Our Full Analysis For Western Digital’s stock

Western Digital’s Presence In Enterprise Storage

Western Digital’s enterprise storage segment was a fast-growing division within the company, with the number of hard disk drive shipments rising from under 9 million in 2011 to over 30 million in 2013. Subsequently, the company witnessed a slowdown in product sales, with unit shipments staying flat at 30 million units sold in 2014. The trend has continued in 2015 thus far, with the number of enterprise-grade hard drives sold by Western Digital staying at previous year levels at 22 million units sold through the first three quarters of 2015. Subdued product sales are partially attributable to SSD and flash-based storage gaining traction in the market.

Since the introduction of flash-based memory chips, there have been constant talks about how long it will be before hard disk drives eventually become obsolete. NAND-flash based storage – or solid state drives (SSD) – have numerous advantages over rotating-disk drives, ranging from the sheer speed of read/write operations, low latency in data access, relatively low power consumption, as well as lighter and more durable drives with a greater resistance to mechanical shock. Western Digital’s presence in the SSD market is currently limited to only enterprise customers. Moreover, much of Western Digital’s SSD consumption in the retail segment is via solid state hybrid drives (SSHDs), which use a regular hard disk drive for core storage operations while a smaller built in SSD storage is added for cache memory purposes. [3]

What SanDisk Brings To The Table

SanDisk has been a leading flash-storage provider over the years, with expertise across various product categories that include enterprise-grade solid state drives (SSDs), embedded flash storage in computing devices and removable storage such as USB flash drives and external SSDs. According to a Gartner report, enterprise SSD has been a fast-growing space over last few years, with global revenues rising by over 30% in 2014 to $5.8 billion. [4] SanDisk had a strong presence in the market, with the combined SanDisk-Fusion-io entity grabbing a nearly 15% share in 2014. Combined enterprise and client SSD sales were a key contributor to SanDisk’s growth through the year, with its SSD revenues rising by over 60% on a y-o-y basis to $1.9 billion in 2014. As a result of massive growth in the SSD segment SanDisk’s stock price surged by over 50% through 2014. The company subsequently endured a difficult period of low product sales through the first three quarters this year, with its SSD revenues declining by about 30% over the comparable prior year period to just under $1 billion.

Western Digital has been betting on hard drives for a long time, and has often been reluctant to switch over to flash storage completely. SanDisk could fill that void perfectly, and the resulting vertical integration with its flash-assets and capabilities could give Western Digital an edge over rival Seagate (NASDAQ:STX) when its comes to flash storage. Moreover, the timing of the acquisition made sense for Western Digital, since the company took on $18 billion debt to finance the deal. Delaying the acquisition would have meant that the debt would likely have higher interest rates, which would translate to hundreds of millions in additional interest payments after the expected hike in rates. Moreover, Fusion-io’s earnings beginning to contribute to SanDisk’s results in the most recent quarter meant that the longer Western Digital waited, the more it might have to pay later on. [2]

Can Falling SSD Prices Limit Growth?

SSD prices have been falling consistently over the last few years owing to economies of scale. According to data compiled by DRAMeXchange, the global prices of SSDs on a price per GB basis were about 11 times more expensive than regular hard disk drives back in 2012. [5] The gap has narrowed in 2015, with SSDs costing $0.39 per GB as compared to $0.06 per GB for HDDs, or only about 6-7 times more expensive. The gap is likely to continue to narrow in the coming years. Moreover, SanDisk’s management mentioned that the NAND flash market faced an oversupply issue through the first half of the year, leading to a decline in selling prices. [6] Moreover, with the price of SSD storage falling at higher rates than production costs, it is likely that it hinders near-term growth for flash-based storage providers. However, with volumes expected to pick up in the long run, flash storage is expected to remain more profitable than traditional disk-based storage. DRAMeXchange estimates that by 2017, the 2.5″ form factor SSD will cost about 17 cents per gigabyte while the price of a regular hard disk drive will hover around the 6-cents-a-gigabyte mark.

Competing hard drive manufacturer Seagate signed an agreement with chip maker Micron Technology (NASDAQ:MU) earlier this year to collaborate on enterprise-grade flash-storage offerings. However, the cost synergies, product capabilities and vertical integration of the Western Digital-SanDisk entity in the long run could give it a formidable presence in the storage industry. According to Western Digital’s estimates, its total addressable market (TAM) for enterprise SSDs stands at about $7 billion for 2015. With SanDisk’s enterprise and client SSD business integrated with its core HDD business, Western Digital expects its TAM in the enterprise SSD market to grow at a CAGR of over 36% in the enterprise SSD space to $13 billion by 2017. Moreover, from currently having no presence in the client SSD, embedded storage and removable flash storage market, the combined entity could have a TAM of about $30 billion by 2017. [7]

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Notes:
  1. Western Digital to buy SanDisk in $19 billion deal, Reuters, October 2015 []
  2. Did Western Digital Corp. Overpay for SanDisk Corporation?, Motely Fool, October 2015 [] []
  3. SSD vs SSHD: which is the best hard drive to buy?, PC Advisor, May 2014 []
  4. Gartner: Dell nowhere to be seen as storage SSD sales go flat, The Register, May 2015 []
  5. Consumer SSDs and hard drive prices are nearing parity, Computer World, December 2015 []
  6. SanDisk Q1 Earnings Call Transcript, Seeking Alpha, April 2015 []
  7. Western Digital SEC Filings, SEC, November 2015 []
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