High sales, low margins:
Western Digital (WDC) reported quarterly earnings after the bell yesterday. They managed to beat lowered expectations by having a strong last week of sales, which management said were twice the average weekly level of the quarter. This resulted in a total of 50.7 million units shipped, higher than the year before number of 44.1 million. As well, WDC increased their market share y-o-y from 28.9% to 30.8%, although it was down from 31.8% in the previous quarter. However, pricing was much lower than the year before, coming in at $46 per unit compared to $49 per unit in the year ago period and $47 per unit in the previous period.
This means that the industry is still dealing with competitive pressures that have not worked themselves out. Coming off the huge inventory rebuild and demand strength that started last summer and was responsible for the record year, hard drive manufactures have forecasted too optimistically. They have spent too much on CapEx and now industry supply capacity is too great. WDC management estimated that there is about 5-10% excess capacity right now. While the large manufacturers such as WDC have ramped down CapEx as much as possible (WDC forecasted Q1 CapEx of $270 million, came in at $200 million), it will take some more demand growth to get the supply demand balance back in line. With excess supply, it is no surprise that gross margins are down. For the quarter, they came in at 18.2%, below the 19% I forecasted for the year and below the long term target of 20.3% I use in my model. Based on management EPS guidance (.50 to .60), it appears that margins will also be weak in the coming quarter. Therefore I have lowered my 2011 margin estimates to 18.5% and my EPS estimates to $3.74. As you can tell, I do expect a pickup in prices in the second half of WDC’s year.
It is unclear how long it will take to work off this excess supply or for demand to catch up to capacity but it is possible that it will be resolved after the next quarter. Normally the Christmas period is the strongest for hard drive manufacturers; however WDC has forecasted sales to be roughly the same as the fall quarter. This is due to that extra week of purchases squeezed into the end of the quarter as mentioned above. So while end user demand will probably be stronger, that will not be reflected in sales at the manufacturer level.
WDC still had strong cash flow generation in the quarter, earning $190 million after CapEx outflows. This caused net cash to grow to almost $2.5 billion. Management again expressed on the conference call their preference for saving the cash for strategic acquisitions but said they are also open to buy backs and dividends if that is the best use of cash. In the latest quarter WDC did buy back $60 million worth of shares. WDC still has $416 million remaining on their share repurchase allowance. I hope they decide to return cash to shareholders through this method, although it would require making up the tax difference between the 8% they paid on money earned overseas and the 30% they would be required to pay at home. Recently, however, there has been some noise of companies looking for a onetime tax holiday to repatriate overseas money to the U.S. without having to pay the tax differences. Should this happen, it would be a big plus to WDC as I imagine most of the cash on their balance sheet is held overseas (53% of revenue now comes from Asia).
Overall, not a great quarter, although management seems to be doing all they can given the competitive environment. It will definitely get worse before it gets better, but I expect the issues to be worked out in the next 3-6 months and for the industry to see a margin bottom at that time. I would look to pick up more shares in the coming months on news of a tax holiday materializing, or on news of better pricing in the industry.
Here is a link to the WDC pdf file that breaks down the important numbers and trends. Very helpful.