Western Digital analysis and valuation – Is it time for a comeback? ($WDC)

Western Digital is one of the companies that had terrible share price performance over the last 5 years, down over 40%.

This post is an attempt to understand the company's historical performance, how the company operates today, what's ahead of it, and finally, how much it is worth today.

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What is Western Digital?

In one sentence, this is a company that develops, manufactures, and provides data storage devices and solutions.

If there's one thing we know about data, it is that it keeps increasing, hence there's increased demand for solutions around it. These solutions are not only in personal computers and smart video systems, but in the last decade also in automotive, IoT, and various home applications.

So, we have a growing industry, yet, Western Digital's share price has declined from $80 to $50.

Attractive industries always attract more competitors. The higher the supply of products, the lower the price. Western Digital's sales experienced a huge drop during 2019 to $16.5b (compared to $20.6b the year before). The reason is oversupply and competition for flash-based products. 

It is worth mentioning that the innovation in this industry is very aggressive, so the value of the products is decreasing significantly when a new and better product is introduced. When faced with high competition and an oversupply of products, there's no option to defer the sale to a later point in time, as if that option is chosen, those products are likely to be sold at a loss.

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Historical financial performance

The operating margin declined from 17.5% in 2018 to only 0.5% in 2019, all due to the drop in sales price and gross margin. Since then, the company started recovering. The operating margin increased to 2% in 2020, to 7.2% in 2021, and is up to 13.2% for the last twelve months.

If we measure the sales activities of the company through the cost of goods sold, it is quite clear that their activities didn't decline. The number of goods sold remained stable. The R&D as % of revenue remained stable and during the last 5 years, the company even reduced the SG&A from 25% to 20% of the total revenue.

However, one bad year was enough to cause fear among investors and question the ability of the company to innovate and stay on the top of its game. Although the company has been around for over 50 years, the innovation of new products is as important as it was on day 1.

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Financial position

During the last 5 years, there are a few points to be noted related to the financial position:

1. The cash position decreased from $5b to $2.5b. Not because they were losing money, but because of the following two points.
2. The debt decreased from $11b to $7b (excluding leases). This roughly means, they generated an additional $1.5b to pay down debt from their regular operations. (not to mention, up until 2020, they were paying dividends)
3. A slight increase in PPE – is always a good sign which means their capacities have increased.

So, if we compare the balance sheet 5 years ago and today, it is clear that the company is in a better position than it was. Yet, the share price is much lower.

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What's next?

If we take a look at the company's priorities, based on the investor presentation, they've noted three:

1. Reinvestment in the company – mainly through R&D – no doubt that this is the most important use of funds. If this is not done, there will be no profitable company to run in a few years.
2. Reduced debt – Although it is at an acceptable level, one of their priorities is to further reduce it.
3. Shareholder return (through Dividends/share repurchases) – The company was a dividend-paying company between 2013 and 2020. I would not be surprised if they start paying dividends again within 2 years.

The market size (both for flash-based products and HDD) is expected to grow at around 4-5% year over year and analysts are projecting double-digit revenue growth. This is in line with management's expectations for the next year.

However, taking the fact that the company is operating in a highly competitive industry, I do not feel comfortable forecasting double-digit growth after the next 12 months. 

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Valuation – Key assumptions

As the valuation is based on certain assumptions, here are mine:

Revenue growth – 10% in the next 12 months, followed by 2.5% growth afterward (equal to the current risk-free rate)

Operating margin – 13% for the next year, followed by 14%. Although the margin was over 17% in the past, and there's a chance the company will get back there, there's also a chance to encounter another bad year, such as 2019.

Discount rate – 9% (Based on WACC)

Outcome – The company's fair value is $22.5b ($72.18/share) – slightly undervalued at the moment based on my assumptions

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What if my assumptions are wrong?

Based on my assumption, the company's revenue will grow by 37% in 10 years. However, I could be wrong.

So here are a couple of different scenarios related to the revenue and operating margin 10 years from now.

In all of these scenarios, the company seems undervalued, in some more than others and it is quite clear that maintaining a high operating margin is more important than growing the revenue. If I am to invest in the company, I'll be more focused on the margins.

I hope you enjoyed the post, feel free to add your take on the company and provide feedback.