Why We Revised Our Price Estimate For Western Digital To $75

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Western Digital

Hard-drive and flash storage provider Western Digital (NASDAQ:WDC) has seen a few strong quarters after the addition of SanDisk’s flash storage products to its business. Since the $19 billion acquisition went through, Western Digital has reported a significant improvement in its gross margins, which was expected given the high-margin flash storage product portfolio. Moreover, the merger was expected to bring sizable improvement in operating profit margins from realized cost synergies. Over the last 2-3 quarters, Western Digital has reported almost $300 million in cost synergies on an annualized basis. [1]

Given the strength in Western Digital’s recent quarterly results, higher-than-anticipated cost synergies and a robust outlook for future quarters, we’ve revised our price estimate for Western Digital’s stock to $75. Western Digital’s stock price has surged from $35 in May last year to over $90 earlier this month. It’s stock is currently trading at around $85. Below we take a look at revisions we’ve made in our forecasts and how that impacts Western Digital’s price estimate.

See our complete analysis for Western Digital

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Key Financial Metrics

SanDisk’s flash storage business comprised of solid state drives (SSDs) for enterprise and well as client segments, embedded storage for smartphones and portable devices, removable flash storage such as USB flash drives and memory cards and other flash storage wafers and components. Western Digital has integrated enterprise-grade SSDs to its existing enterprise hard disk drive (HDD) business, which is now called Data Center Solutions.

SanDisk’s Client SSDs, embedded storage and wafers & components are integrated with its hard drive segment for PCs, notebooks and consumer electronics under the Client Devices segment. The removable flash storage sold via the retail channel is integrated to Western Digital’s existing retail products or branded HDD products under the Client Solutions category. The direct addition of SanDisk’s product portfolio has helped Western Digital increase net revenues by 40-65% on a y-o-y basis in each of the last three quarters. As a result, we forecast 2017 revenues to be around 15% higher on a y-o-y basis to $18.3 billion for the year. Note: the inorganic growth factor will not be applicable to the September and December quarters of 2017. Our previous estimate for revenues was similar to our current revenue forecast for Western Digital.

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The key change in our previous estimate for WD and our current estimate lies in the adjusted gross margin. We initially forecast its company-wide gross margin (adjusted for depreciation, amortization and share-based compensation expenses) to improve by around a percentage point to 36.5%. However, a higher revenue mix of SanDisk’s products has led to a significant improvement in gross margins over the last few quarters. As a result, we now forecast Western Digital’s adjusted gross margin to be over 4 percentage points higher than 2016 levels at 39.5%, as shown above. Note that SanDisk’s company-wide adjusted gross margins stood at around 45% when its acquisition was announced in late 2015.

Moreover, with expense synergies, we have revised our forecasts for Western Digital’s operating expenses. As shown below, we forecast adjusted SG&A expenses to be around $1.47 billion for 2017 (or under 21% of gross profit), compared to $1.51 billion previously. Similarly, R&D expenses could stand at around $1.72 billion (or 24% of gross profit) as compared to our previous forecast of $1.75 billion.

With gross margins improving and operating expenses increasing at lower-than-anticipated rates, Western Digital’s adjusted EBITDA margin could be lower by only around a percentage point at 21.7% as compared to our previous estimate of 19.3%.

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Healthier Balance Sheet

At the time Western Digital announced the SanDisk acquisition, the company was expected to enter into new debt facilities of over $18 billion, with a revolving credit facility of around $1 billion. [2] At the end of its fiscal 2016 in June last year, Western Digital’s net debt stood at around $17 billion. Over the past few quarters, the company has paid off its bridge loan, reduced the net debt to around $13 billion and improved its net cash as shown below. The company’s debt, net of cash, has gone down from over $8 billion in mid-2016 to $6.9 billion at the end of March.

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Unit Shipments Remain A Challenge

Western Digital’s core HDD business has continued to suffer, with unit shipments across all divisions declining on a y-o-y basis as shown in the table below. In the most recent quarter, the company’s management announced that it will no longer provide data for unit shipments across categories and will only report data shipped in terms of exabytes on a quarterly basis. Sustained weakness in the compute (or client devices) segment, coupled with low demand in the consumer hard drive market, has led to decline in units sales in 2016. While this trend is expected to continue in the coming quarters, a strong demand for flash storage should help drive top line growth and improve gross profit margins.

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You can modify the interactive charts in this note to observe the impact a change in individual drivers can have on our price estimate for Western Digital. We have a revised $75 price estimate for Western Digital, implying a market cap of $22.5 billion. Our price estimate is around 10-15% lower than the current market price.

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Notes:
  1. Western Digital Q2 2017 Earnings Call Transcript, Seeking Alpha, January 2017 []
  2. Western Digital Announces Acquisition of SanDisk, SanDisk Press Release, October 2015 []