Western Digital Corp. (NYSE: WDC). Although revenue slipped 3% below year-ago levels, non-GAAP EPS nearly doubled 1Q20 results, reflecting a solid demand environment led by client (PC) devices. Fiscal 2Q21 guidance at the midpoint was below pre-reporting consensus estimates, although the company has sharply exceeded its lowball guidance in recent quarters.
In September, Western Digital revamped its operating structure to carve out its non-volatile (flash) memory business from its HDD business. By delivering both Flash and HDD market-leading innovation through highly focused product development teams, Western believes it can leverage operational synergies and uniquely address customers’ broad storage needs from edge devices to cloud infrastructure.
The September announcement led to investor speculation that the reorganization could lead to a spin-off of one of the units. Our working assumption is that Western Digital will continue to serve both HDD and flash customers, most of whom use both technologies, with an integrated go-to-market strategy.
Western Digital under relatively new CEO Dave Goeckeler has suspended its dividend and announced a new operational structure. While WDC shares have underperformed in CY20 along with other memory companies, we believe WDC’s end markets are largely intact. Consumer spending on work & learn from home and ongoing home-centric lifestyles are driving very strong end-device (PC & smartphone) demand. That in turn should drive growth in data center markets targeted by Western’s HDD business.
In our view, underperformance of WDC shares offers an opportunity to initiate or increase positions in a premier memory player, which should begin to benefit from the developing 5G cycle as well as from the ongoing digital transformation of the economy. WDC is appropriate for risk-tolerant investors apprised of the volatility in memory-sensitive equities.
RECENT DEVELOPMENTS
WDC declined 53% in 2018, versus a 15% pullback for peers. WDC stock rose 17% in 2017, slightly behind the 18% gain for peers. WDC rose 13% in 2016, just above the 12% peer-group gain.
Western Digital under relatively new CEO Dave Goeckeler has suspended its dividend and announced a new operational structure. In recent years, Western Digital has gone to market serving customer categories of Client Devices, Client Solutions, and Data Center Devices & Solutions. Those categories were based on the reality that data center customers and PC makers were simultaneously using NAND Flash and DRAM-based memory solutions in their equipment.
Nonetheless, on 9/1/20 Western Digital announced it was aligning its product strategy with new Flash and HDD business units. Management called the realignment a significant step in the ongoing implementation of its diversified storage portfolio strategy. The Flash business and the HDD business will each be led by a general manager.
During the fiscal 1Q21 post-results-release conference call, CEO Goeckeler provided additional color on the new business unit structure. Western has a strong conviction in the market opportunity from rapid global adoption of technology architecture built with cloud infrastructure tied to intelligent endpoints and connected by high performance networks.
To capture this opportunity at every stage, the CEO emphasized the ‘criticality’ of having a broad portfolio of both flash and HDD products. Unless that’s a head fake, it would seem to signal that Western is not separating the two businesses in advance of selling or spinning one off. The CEO called Western’s portfolio the best and most comprehensive in the industry. He also called out the ‘significant operational and to market synergies between integrated flash and HDD portfolios, calling this an important competitive differentiator for WDC.
Following the SanDisk acquisition, WD was able to transition its PC clients toward solid state drives, resulting in a strong and leading client SSD business. Western now is taking aim at the enterprise SSD business. Western now supplies both flash and HDD products to all of its top 20 customers, and this should help with the enterprise SSD ramp in the coming years.
The CEO also noted that there are very different technical dynamics between flash and HDD. With each new business operating under a dedicated general manager, WD expects to accelerate growth and drive agility, sharpen focus, and increase accountability throughout the organization.
Western generated $16.7 billion in fiscal 2020 revenue, which was somewhat evenly divided between its flash and HDD businesses. For all of the FY20 year, HDD revenue of $8.9 billion (53% of total) edged up 2% year-over-year; and Non-Volatile Memory (NVM, or Flash) revenue of $7.8 billion was flat year-over-year. In fiscal 2019, both HDD and flash revenue declined in mid-teen percentages, which first caused Wall Street to question the wisdom of the SanDisk acquisition.
Western announced the appointment of Robert Soderbery as EVP and general manager of the flash business unit. GM Soderbery is a 30-year industry veteran who has worked at Cisco, where he ran the enterprise business, and at Symantec/Veritas, where his work focused on mission-critical enterprise systems.
On 10/29/20, Western announced the appointment of Ashley Gorakhpurwalla as EVP and GM of the HDD business. The new GM has spent most of his 30-year career at Dell Technologies in a range of technology and leadership roles. His main focus has been on data center infrastructure, servers and infrastructure systems.
The September announcement led to investor speculation that the reorganization could lead to a spin-off of one of the units. Based on the CEO’s comments about criticality of an integrated solution with both businesses, along with the hiring of the new GM, we believe that Western Digital will continue to serve both the HDD market, which is moving from client (PC) to data center, and the flash market going forward.
For 1Q21, WDC’s nonvolatile memory (NVM) revenue of $2.08 billion (53% of total) rose 25% year-over-year and was down 7% sequentially. Non-HDD revenue consists mainly of nonvolatile memory in various applications, including embedded (for smartphones) and removable (memory cards), as well as client and enterprise SSDs. NAND flash Exabyte shipments rose 1% sequentially, marking a fifth straight quarter of sequential momentum and pointing to accelerating demand for NAND memory.
Given the competitive nature of the data center market, WD continuing its momentum in enterprise SSDs by advancing the qualification process for its second-generation NVMe SSDs. The lag in the enterprise SSD market, in our view, was a key driver of the decision to hire an outside expert to run the flash business.
HDD revenue of $1.84 billion (47% of total) fell 22% year-over-year and 9% sequentially. HDD unit shipments of 23.0 million decreased 21% year-over-year and less than 1% sequentially. HDD exabytes sold declined 7% sequentially.
HDD ASP of $79 per drive was down 9% sequentially and 2% annually, breaking a string of double-digit percentage annual growth in ASPs. We believe the sequential decline in HDD ASP reflects a more PC-driven product mix. Consistent with the ASP unit trend, HDD shipments in 1Q21 fell 1% sequentially in client compute HDDs but declined 19% sequentially in data center HDDs.
WDC continues to benefit from demand for high-capacity drives for large commercial client markets (servers and desktop PCs), capacity enterprise, and cloud service providers. The sequential unit trend for data center aligns with commentary from other companies, which have spoken of a digestion phase among cloud service providers.
In terms of HDDs for the data center market, WD’s main products are 14 Tb, 16 Tb and 18 Tb drives; WD sees 18 Tb as the ‘sweet spot’ for data center going forward. WD has completed over 100 qualifications for its energy-assisted drives, with another 125 qualifications in the pipeline. WD has also completed qualifications and begun shipping its 20 Tb platform for revenue.
In terms of customer categories served across both HDDs, SSDs, and other product categories, revenue from client devices & solutions (a combined 72% of total) was up 11% annually, led by client devices. Revenue from data center devices & solutions (29% of total) was down 26% year-over-year, reinforcing perceptions of an inventory digestion phase among data center customers.
In our view, the recent underperformance of WDC shares offers an opportunity to initiate or increase positions in a premier memory player, which should begin to benefit from the developing 5G cycle as well as from the ongoing digital transformation of the economy.
EARNINGS & GROWTH ANALYSIS
Western Digital which was down 3% year-over-year and 9% sequentially. Revenue came in above the $3.80 billion midpoint of management’s $3.7-$3.9 billion guidance range; revenue also edged past the consensus forecast of $3.83 billion.
Non-GAAP earnings came to $0.65 per diluted share, up 90% from $0.34 in the year-earlier quarter (though down from peak EPS of $1.23 in fiscal 4Q20). Adjusted EPS exceeded the $0.55 midpoint of management’s $0.45-$0.65 guidance. The Street had been modeling $0.54 for 1Q21.
For fiscal 2Q21, Western forecast revenue of $3.75-$3.95 billion. Non-GAAP EPS would be down 20% from a year earlier. We note, however, that WDC in recent quarters has topped its own guidance.
Given the margin impact of the skew in business toward client and away from data center, we are cutting our fiscal 2021 non-GAAP diluted EPS forecast to $3.33 from $3.58. We are trimming our FY22 non-GAAP EPS forecast to $6.07.
FINANCIAL STRENGTH & DIVIDEND
In fiscal 2017, WDC paid in full its $3 billon bridge loan related to the SanDisk acquisition, reducing both cash and indebtedness by $3 billion. WDC also repaid its euro term loan B in full.
MANAGEMENT & RISKS
On 3/5/20, Western Digital appointed David Goeckeler as its new CEO, effective 3/9/20. Michael Cordano is the COO and Bob Eulau is CFO. In September 2020, WDC appointed Robert Soderbery as EVP and general manager of the flash business unit. In October, Western announced the appointment of Ashley Gorakhpurwalla as EVP and GM of the HDD business.
CEO Goeckeler most recently served as EVP and GM of Cisco’s Networking and Security business. We believe his deep engineering and business development strategy in these areas aligns with Western’s swing away from the client (PC) market and to memory and mass storage markets in cloud, large enterprise, data center and carrier infrastructure.
Splitting off Flash from HDD risks creating duplicative sales efforts toward the company’s many customers who use both technologies. It will be up to the sales & marketing organization to prevent duplicative efforts in addressing customers that use both memory technologies in their own infrastructures and products.
Cutting the dividend usually sends a message that a company has a strained cash situation or a fast-deteriorating operational outlook; WDC has neither. We believe the company eliminated its dividend so it could invest in its two main businesses of NVM and DRAM memory, and better compete with Micron. WDC also looks to reduce earnings volatility by reducing its interest payments on its debt.
Other risks for Western Digital are largely related to conditions in the hard disk drive (HDD) market, which is highly volatile. Unexpected changes in end-user markets (PCs, servers, storage and consumer electronics) can hurt manufacturers’ pricing and margin structures. Competition is fierce, not only from U.S.-based participants, but also from Asian providers. Going forward, we expect WDC to use cash generated from the structurally declining HDD market to fund its expansion into solid-state memory.
COMPANY DESCRIPTION
In May 2016, WDC acquired NAND flash leader SanDisk, expanding into the solid state drive (SSD) market, hybrid HDD-SSD solutions, and the storage systems business.
VALUATION
The average FY21-FY22 multiple of 9.0 is below the historical five-year average multiple of 9.9.
Discounted free cash flow valuation signals value around $130, in a stabilizing trend.
We continue to regard any weakness in WDC shares as a chance to build or initiate positions in a premier memory player. WDC is appropriate for risk-tolerant investors apprised of the volatility in memory-sensitive equities.
