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Western Digital (WDC):

Western Digital (WD) is the largest (by units shipped) maker of hard drives (HDD ) in the world. They make hard drives used in desktops, laptops, and net books as well as portable hard drives (last year desktops 38% of sales, all others 62%). They are known as one of the lowest cost producers in the business. Even though they shipped more units than their largest competitor, Seagate (STX), last quarter, WD had lower revenues as they have a lower average sell cost per unit. The industry as a whole is experiencing a cyclical high in margins and extremely strained capacity thanks to larger than expected demand in the past year which is expected to continue throughout 2010 resulting in very tight inventory (2 weeks for WD). The reason I believe WD is undervalued is due to the fact that most investors are expecting margins to fall back to normal levels. Yet as I show later, even if this happens due to changes in the industry, WD would still be considered a buy.

Industry considerations:
The HHD industry has become much more consolidated in recent years going from 8 major players 10 years ago to only 5 today. Based on last quarters shipment numbers the breakdown is as follows

And for those who care, the HHFI is 2451, indicating a strongly concentrated industry. What this chart leads me to believe is that:
1. WD is gaining market share as this is the first quarter that they have been the leader in units shipped
2. Industry margins have undergone a shift and will no longer be fluctuating on the old cycle but on a new higher cycle.
In the past whenever the industry margins grew too ft, the many HDD manufacturers would ramp up CapEx too far, causing margins to become depressed over the next few years. Now however this will no longer happen as severely. The industry is more concentrated and the industry players are more open with respect to total CapEX. Here is an except from the CFO of WD during the latest conference call when asked about industry margins

“Okay, yes, we were encouraged by Hitachi’s results and we think it’s the level of transparency they are providing is a positive for the industry. And we also think that level of transparency will also be beneficial to the investment community as the behavior of the people now hold somewhere close to around 80% of the total market. And so everybody has got the information available to them in order to make their decisions relative to capacity additions and then once they have the capacity additions in place, they have the information available to them relative to capacity utilization.”
I believe a main reason WD is undervalued has to do with the expectations that WD margins will some come crashing down like they have in the past, and I believe this is false. Another threat to WD seen by many analysts is the shift to solid state drives.

HDD vs SSD
A lot of people and industry analysts seem to be under the impression that solid state drives (SSD) will soon kill Hard disk drives (HDD). They point out that SSD is so much faster than HDD, which is true. Yet SSD is also much much more expensive. For example a quick google search shows a random 32g SSD sells for $110 whereas a quick check shows you can get about 2 terabytes of HDD storage space for the same cost. I have read that this is only temporary and cost effective SSD is right around the corner yet that is also what I have been hearing since first following this industry is 2007 and nothing so far has led me to believe that we are any closer than before. In fact, since that time, WD and Seagate have both come out with hybrid HDD that are mostly solid state yet possess a certain amount of SSD for when you need to access data very quickly.
As well, companies that might eventually pose a threat to WD from the SSD world such as Sandisk have drastically cut down CapEx from 260 million in 2007 to 60 million in 2009. This gives less credence to the argument that they are getting ready to push into basic computers and basic external drives, WD’s bread and butter.

Finally, when SSD takes over in the future (it may be a long time off, but it will happen), WD will not be sitting still. Spending over 450 million in each of the past 3 years on R&D (464 million in 2008, 509 million in 2009, and 456 million through the first 9 months of 2010), as well as currently sitting on over 2.8 billion in cash, they have the resources and the expertise to quickly develop their own SSD technology. They just won’t bother until SSD becomes a cost efficient technology.

Management:

The current CEO is John F. Coyne. He has been with the company since 1983 working his way up through different divisions within WD. Management has a good reputation for being conservative with their estimates and doing deals that make sense for shareholders. Looking over their last large deal, the 1 billion acquisition of Komag, we can see that they were able to complete the integration with lower costs than expected. In that conference call, management warned of lower margins for the next few quarters as a result of the deal. As you can see by looking at the excel file and the numbers for 2008, this never materialized. As well management warned of increased R&D cost of 20 million a quarter for the year, yet 2008 R&D spending came in at only 50 million higher than the previous year. Management also promised long term improvements from the deal of 250 bps to gross margin. Again from the excel file we can see that 2008, 2009 and the first 3 quarters of YE 2010 have experienced higher gross margins than 2007.

WD also has a good track record of not taking one time charges every quarter like their rival Seagate. I used to own shares in STX but became disconcerted with the constant restructuring and one time charges that appeared every single quarter. Eventually I gave up and sold my shares and bought WD instead because they didn’t seem to experience this problem. After following the company for several quarters and listening to the conference calls I also began to appreciate the conservativeness of management and their frankness (see above quote about industry CapEx). Only 1 year in the past decade has restructuring charges (2009, everyone restructured).

WD has strong corporate governance practices. The board is composed of 10 directors, 7 of whom are independent. The 3 remaining directors are 2 former CEOs of WD and the current CEO, John F. Coyne. The role of chairman and CEO is always separate and all the committees (audit, compensation, governance) are composed of independent directors. The entire board is up for election annually. All of these are consistent with best practices.

The one place for concern is insider sales. In the last 6 months insiders have sold half of the shares they held, although this is only .0025 of all shares held. This could be due to the fact that management is often rewarded with stock grants rather than options. As well the shares have recently traded at their all time high of 45. It would be nice to see some buying soon though around the 31, 32 level.

Valuation:

To make the valuation model I assumed that the past 5 years (9 months for the past year) represent normalized earnings. Based on my comments above about the change in the competitive landscape of the industry I believe this is more accurate than a 10 year model. Examining the past 5 years we see that the gross margin has been about 20% with a high of 25% this year and a low of 16.46% in 2007. So I used this as a base to get gross profit.

Sales were estimated extremely conservatively. They have been growing at a CAGR of 20% over the past 9 years. Instead of using this I used total industry HDD shipment expectations of 5.4% yearly growth over the next 4 years. I don’t believe that WD will experience sales growth this low as Asia makes up a larger and larger share of their customers (asia contributed 33% of total sales in YE 2007 vs 50% in YE 2009) and they should continue to experience rapid capital growth, I figure I will be conservative.

I kept R&D at a constant % of sales.

I estimated SG&A would be 235 million this year. I regressed the relation between sales and SG&A which resulted in a slope coefficient of .011. I also calculated SG&A as a % of sales in each year and it has been slowly declining but it makes more sense to use the slope rather than the trend of sg&a as a % of sales in my opinion since you can only cut so low before economies of scale taper out. With this I took forecasted SG&A for year 2010 and added [marginal sales each year x the slope] to come up with incremental sg&a spending for the forecast.
Interest expense is expected to be minimal since the giant surplus of cash and taxes are estimated to continue at the current rate of 9%

Terminal growth is expected to be 4% a year, in line with world growth. If I were modeling a mostly North American company I would use lower long term growth forecasts, but WD is increasingly a global player and now Asia accounts for half of revenues. Since this region is expected to grow much more quickly for the foreseeable future than Europe and North America, I think 4% long term growth is a fair assumption. I expect to reach the terminal level of growth after 3 years. This may be quick ands the company may still be growing rapidly 3 years from now, but id rather be caution and not estimate too far out. The discount rate is a standard 10%, the minimum return I would expect from my investments. As a note, I am not crazy about using betas and WACC all that much as stock price vol doesnt necessarily equate real risk. In any case the beta is 1.5 and the capital structure is almost all cash so the cost of equity using a 5% market risk premium and the 10 year as the rfr is about 10.8% which is lower than the 12% higher end I will use in my calculations (next paragraph).
Using these numbers we get a value of 16.4 billion. Changing the terminal growth rate to 2% we get 13.1 billion. Changing the discount rate to 12% and the growth rate to 2% we still get a value of 12 billion. Changing all those numbers and putting the margin at the cyclical low of 15% going forward we still get a value of 7.16 billion, substantially higher than the current market value – cash.

I also constructed a FCFE model. Under this I assumed ROE would be 15% going forward for 3 years and then drop to my long term growth rate of 4%. ROE for the last 5 years has averaged 43% so I do not think 15% going forward is a crazy estimate. I think 15% is low enough under the average that I have accounted for the low ROE next year due to the giant cash position.

Given that assumption and the fact that they retain almost 100% of their income, the growth rate should match ROE. Using this year’s FCFE (9 months actual and 3 months forecast by management) of 1188 and my assumptions, along with a 10% discount rate, FCFE comes in at 18.1 billion. Using the average FCFE rate of 715 million over the past 5 years and the growth assumptions we get a valuation of 10.84 billion.

Considering the market cap less cash is only 4.84 billion WD seems like a screaming buy. Under the most stringent assumptions it is still selling for much less than what it appears to be worth.

Uses of cash:
Since the cash on the balance sheet is such a large part of market cap it is worth talking about what management intends to use it for. One option would be to begin issuing dividends but because of their tax rate it would be disadvantageous to do that. The dividend would be taxed at a much higher rate than the 9% WD pays. Another option is to buy back shares. Management has shown a small willingness to do this in the past and has 466 million remaining on a repurchase authorization. I expect they will use this up shortly. The final option is to acquire competitors and new technologies. Last spring they spent 65 million to acquire SiliconSystems, a maker of SSD. It is due to acquisitions like this that I am not worried about WD falling behind the technology curve. 2 years ago they acquired a large player in the same HDD industry, Komag for 1 billion. This acquisition went smoothly with all synergies realized. I would find it hard for WD to duplicate this move however, as the industry is already quite concentrated and any further moves might bring on the scrutiny of regulators. Therefore I predict that the main use of cash will be for CapEx when needed (about 600-700 million a year) with the rest being returned to shareholders via share repurchases.

Final thoughts:
It seems to me that WD is a clearly undervalued company. The market cap of 7.66 billion includes more than 2.8 billion of cash and the company is still gaining market share in a growing industry. Even though the HDD market can be considered slightly commoditized at this point, the recent consolidation and clarity with regards to CapEx will lead to continual high margins over the next few years. I believe the true value is close to 15 billion, or close to double what it is currently trading at.

here is a copy of the excel I used for the valuations

Excel File

A value investor friend of mine recently told me he liked PennantPark (pnnt) and asked me to take a look. I did and decided its a pass, but I figure ill share some of my thoughts here.

Pennantpark is an investment company that borrows money from its banks and reinvests in high yield bonds to small cap companies and private companies that couldn’t get financing in conventional means. The CEO and guy who makes the majority of the decisions, Arthur Penn, is the cofounder of Apollo investment co. which basically does the exact same thing. A few years ago he left to do his own thing. He has a lot of experience in this field and seems decent at his job, shown by their lower than average default rate on investments. Pennantpark is a regulated investment company, which basically means they pay little or no taxes but have to give the majority of their income out as dividends. This makes it hard to grow from internally generated funds.

So my friend believed they were undervalued for two reasons. The first is their borrowing terms. They locked in a rate of libor+ 100bps for 5 years in jan 2007. This gives them a competitive advantage over rivals who have to pay libor +300 to 500 bps. This should lead to much higher roe.

The second advantage is that they are trading slightly below NAV when all their competitors trade 1.1 to 1.5 times NAV. For investment companies NAV is an extremely important benchmark to trade around since you are essentially buying a piece of all their investments.

Their average loanable funds rate is 13.3%. Libor +100bps is about 1.3% right now, so they are making a net interest margin (NIM) of 12%. Since most of these companies use leverage you would expect a pretty good roe (roe = roa * d/e). However, they are currently at 245 million borrowed on their 300 million credit facility. So while they can make a lot of NIM right now, they wont be able to scale this at all until they renew their credit facility at a higher rate of interest 1.75 years from now which will bring down their NIM to a normal rate of maybe 9.5-10.5%. This competitive advantage of theirs is unscalable and not lasting so I put very little value in it.

The other problem is their actual equity. You look at 300 mil equity and 1.75 debt ratio and think, 12% return on that is 63 million, market cap is 288 mil, that’s a pretty amazing return. A few problems. First is normal default rates. Historically on high yield bonds these are about 5.5%. Lets assume that management has great skill in making investments and they can get this number down to 3%. This brings NIM down to 9% and income down to 47.25 million. Next is that management charges 2 and 20, or 2% of all assets managed every year plus 20% of profits. That adds up a lot over the years. For the 2 years reporting those totaled 13.4 million 2009, and 11 million 2008. A big part of profits. SG&A came to about 4.4 million each year. So right away that take income down to about 29.5 million, or about 10% yield. Not looking as good since such a huge chunk went to pay those high management fees, but still pretty good return for a company that trades at 288 million market cap. However in less than 2 years net interest marking will drop off to about 7 % after defaults. Lowering the variable part of their fee structure to account for this it works out to about 21 million in profits a year, much lower.

Now the other main problem. They discount their own credit facility borrowing to fair value and count the difference as equity. That is really really ridiculous for a public company to do. They are basically saying there is a good chance we will not pay what we owe (go bankrupt) and thus it makes sense to use fair market accounting on the balance sheet. No other company in their industry does this (for good reason). To me it seems like a bs (albeit GAAP conforming) way to increase stated equity. The amount of this overstated equity is about 45 million according to their latest Q-10. This amounted to about 45 million of extra equity that shouldn’t be on their balance sheet which pushes down their NAV to 260 million and gives them a market cap/ nav ratio right among their peers. So no more discount.

So I didn’t do a huge cash flow analysis but basically it seems to me the best they can do is make about 30 million a year on about 288 mil market cap which works out to a yield of 10.4%. This is pretty good except there is very little chance for growth in the near term (without diluting equity, which they recently voted to do) given that they are close to maxing out their credit facility and cant reinvest earnings, and when they have to go back to normal borrowing costs (in 1.75 years) they will only make about 21 mil a year or 7.3% yield. As well, since all the income they generate is given out as dividends, you will still have to pay taxes on that.

So basically its an ok investment for the fixed income part of your portfolio but by no means anything special at all, and I definitely wouldn’t consider it for a value investor. Also I don’t like it when I see management do something really aggressive like the way they increased their stated equity.

So hope this is interesting to some. Its obviously not a super deep analysis but was enough to let me pass.

This site intends to be a place where I publish my findings and analyses of various publicly traded companies. My goal is to share my thoughts with you and hopefully start some discussions and receive feedback on my write-ups. All good write-ups need their assumptions tested and critiqued. It’s the only way to learn and get closer to the truth.