Free NPV

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.

Zip Realty (ZIPR) is an online real estate broker company. They have a large site where prospective home buyers and sellers come to browse ZIPR’s database of homes posted in the MLS system. Buys are offered a 20% cut of any commission the site makes from being the agent. As well, ZIPR has their own agents who can assist buyers and sellers. These agents work on commission for ZIPR. 98% of ZIPR’s revenues come home sales transactions, so the main driver behind ZIPR’s revenue is average home selling price and number of homes sold.

This is a horrible business to be in right now. As you may be aware, there is a new mess that is just emerging in the foreclosure market. This mess, caused by fraudulent foreclosures, may result in a total freeze of the foreclosure market which could take years to fix. This would mean a greatly reduced supply of foreclosed homes on the market. As well, this mess means that buyers of previously foreclosed homes might now not have the true title to the homes. If the situation worsens, it seems very possible that title insurers will refuse to insure new home purchases. This would freeze the existing home sales market (ZIRP’s market).

For the past 2 years, many of the sales on ziprealty.com have been of foreclosed homes. The percentage of total sales that were of foreclosed homes has bounced around from 51% in Q1 2009, to 31% last quarter. Management has guided that they believe last quarter was artificially low due to the ending of the home buyer tax credit, and that they expect that foreclosed homes as a percentage of total sales will rise in the second half of the year.

As the number of foreclosed homes available for sale slows to a trickle in the coming months, ZIRP will have much lower sales. The buyers who are looking for foreclosed homes will not buy more expensive normal homes in their place. Many people who were planning on buying a new house will fear the uncertainty over who the true owner is and will choose to wait. This will hurt ZIRP greatly. Even as ZIPR has grown volume over the past 3 years, they have yet to be cash flow positive. Their valuation, at 70 million, is low but considering that they have yet to prove that they can make money, and the coming pain in the next year, they should be valued much lower (I realize this is lacking a complex valuation, but for a bad company in a market that is about to get alot worse you don’t really need one). Their business model is commission driven, yet there are large costs that aren’t flexible. Product development and G&A came in at 18.6 % of sales last year. Sales and marketing (and this does not include commissions paid to agents) came in at 35% of revenues. These costs are not that avoidable. As ZIPR has shrunken their operating losses in the past few years thanks to economies of scale from these items, it will also hurt them on the way down as their revenues shrink in the coming months.

I would have expected that this news would be priced in since it has been getting more and more attention lately in the media, but as anyone can see, ZIPR had a large run-up in September and October when this story was breaking. I shorted ZIPR this morning at 3.33. If it bounces back up in the near term I might short more.

Click here to download my excel file that I constructed to value Western Digital. You can play around with the inputs yourself (they are blue) to come up with your own valuations on the DCF page.

Some notes:

The tax rate is 8%. This is slightly misleading as WDC is incorporated in the islands where it pays extremely low levels of taxes. Should WDC one day want to repurchase shares or issue dividends, it will have to pay the difference between the 8% rate and the 30% US rate on dividend repatriation. So you may want to change the tax rate in the model to reflect this. I choose to leave it for now as WDC does not pay dividends and is still earning a high ROE, thus it makes sense for them to keep the capital and invest it profitably. Eventually they will need to return money to shareholders, but until then they are getting to keep it and reinvest it into their business tax free.

Risk free rate is 4%. The real risk free rate right now is 2.37%, however using this number in your DCF will lead to an extremely high stock valuation. Enter whichever input you wish but understand how much of a difference in valuation this number can make.

Other inputs which are important drivers are gross margin and sales growth, which you can change on the income statement page. Enjoy and let me know your thoughts on the assumptions.

ps. I should have a lot more updates in the next week or two as many of the companies I’ve written about here announce earnings. As well I should have a new write up out this week.