luxxtek/iStock Unreleased via Getty Images

luxxtek/iStock Unreleased via Getty Images

Western Digital Corporation (NASDAQ:NASDAQ:WDC ) is a global leader in hard drives and flash memory. Its stock price has been butchered by ~67% from its all-time highs in 2018, but now is showing signs of value. The business has strong partnerships with "hyperscale" cloud providers and is in prime position to benefit from the growth in the cloud industry. In this post, I'm going to break down its business model, financials and valuation. Let's dive in.

Western Digital manufactures, distributes and sells hard drive and flash memory products. The business has one of the strongest brands in the hard drive industry and is known as a category leader. A quick check on review websites, shows Western Digital products are usually in the number one or number two spots. Its competition includes Seagate, Samsung, Dell and many more.

On the Flash memory side, Western Digital acquired SanDisk in 2016, which is a category leader in flash memory cards and USB drives. SanDisk is pretty dominant in this market with memory cards provided for cell phones and professional cameras. A headwind against this part of the business has been the smartphone transition to in-built memory as we first saw with the iPhone, but even most Samsungs now come with substantial in-built memory.

All Sandisk (Canon Memory card search)

All Sandisk (Canon Memory card search)

Western Digital currently makes 46% of revenue from hard drives, 54% from flash memory, which is a pretty even split.

The company also has a leading position in gaming with its WD_BLACK brand, which is certified for Song PS5 Consoles. Total exabyte shipments for its SSD [Solid state drives] increased by 70% year over year.

Western Digital generated steady financials for the fiscal fourth quarter of 2022. Revenue was $4.53 billion, which increased by 3% sequentially but declined by 8% year over year. This decline may seem terrible at first glance, but when we take a step back we see total revenue for the fiscal year 2022 was $18.8 billion, up 11% from the $16.9 billion generated in the prior year.

By end market, Cloud revenue was $2.1 billion, which showed solid growth as it increased by 18% sequentially and 5% year over year. This increase in Cloud revenue is no surprise, as the freight train that is digital transformation shows no sign of slowing down, even as we enter a potential recession. This is because ultimately, when a business moves their on-premises IT to a data center or the "Cloud", it can give them greater flexibility and result in cost savings long term. Thus, it's no surprise the Cloud Computing market was worth approximately $430 billion in 2021 and is forecasted to reach over $1 trillion in value by 2028.

With regards to Western Digital specifically, enterprise solid state drives [SSD] revenue doubled sequentially and increased by 38% year over year for cloud customers. The company also continued to ramp up its 18TB and 20TB energy-assisted hard drives, which increased nearline HDD revenue by 7% year over year. The industry is also transforming to Shingled magnetic recording [SMR] hard drives, these enable greater storage density and thus are a popular offering by Western Digital to cloud customers.

In FQ4, Client revenue was $1.6 billion, which declined by 5% sequentially and 14% YoY. This decline was mainly driven by 10% decline in PC shipments, as OEM aggressively adjust their inventory down to meet the tepid consumer demand. The PC market is going through a transition from HDD [Hard Disk Drives] to flash technology. Therefore, it is not a surprise to see HDD revenue declining rapidly. However, this decline has occurred at a slightly faster rate than expected, thus Western Digital is having to think on its feet and downsize its manufacturing setup for HDD.

Client Revenue (FQ4 Earnings Report)

Client Revenue (FQ4 Earnings Report)

Reduced smartphone demand in China, has also been a headwind against the company. However, they are well positioned to supply flash memory from the new fleet of 5G smartphones, which are expected to come online. 5G smartphone penetration is expected to reach 21% globally by 2025, with approximately 51% of devices in North America having a 5G connection by the end of the period.

Western Digital has a popular consumer brand, with its products sold direct to the consumer from its own website. In addition, through popular retailers such as Best Buy (BBY), Target (TGT), and JD.com (JD) in China. Despite the brand popularity, its consumer segment makes up just 17% of its total revenue. For FQ4, the business generated $0.8 billion in consumer revenue, which declined by 9% sequentially and 23% year over year. This was mainly driven by tepid consumer demand, which is a macroeconomic issue, and thus I don't deem this to be a major worry long term.

If we analyze the business by technology, Hard Drive Revenue was $2.1 billion in FQ4, down 15% year over year. This decline was driven by 10% lower total shipments, due to lower consumer demand as mentioned prior. The HDD gross margin increased to 28.2%, up 50 basis points sequentially due to higher selling prices, but this was still down year over year due to inflation headwinds.

Hard Drive Revenue and Margin (FQ4 Earnings Report)

Hard Drive Revenue and Margin (FQ4 Earnings Report)

Flash memory revenue was $2.4 billion in FQ4, which increased by 7% sequentially but was down 1% year over year. These results were driven by a 6% increase in bit shipments and 2% higher selling prices.

Flash gross margin also showed steady improvement by 40 basis points year over year to 35.9%. This was driven by growth in the enterprise data center segment as mentioned prior.

Flash Memory (FQ4 Earnings Presentation)

Flash Memory (FQ4 Earnings Presentation)

Moving onto earnings, Western Digital generated normalized earnings per share of $1.78, which beat analysts' expectations by $0.06. This profitability was helped by operating expenses of $760 million, which came in below management guidance.

Western Digital has been focusing heavily on "right-sizing" its manufacturing and inventory while reducing debt by $1.7 billion. In the "cash flow walk" below, you can see the business generated $295 million in operating cash flow, then had $392 million in Cash CapEx. Then after debt repayments, the business was left with a robust cash position of $2.3 billion. However, it should be noted the business still has approximately $7 billion in long-term debt, which is substantial, but just $91 million of this is current, due within the next two years.

Cash Flow Walk (created by author Ben at Motivation 2 Invest)

Cash Flow Walk (created by author Ben at Motivation 2 Invest)

In order to value Western Digital, I have plugged the latest financials into my advanced valuation model, which uses the discounted cash flow method of valuation. I have forecasted revenue to continue to decline by 20% for next year, which is very extreme, although I believe it's best to be conservative due to the macroeconomic challenges. In addition, I have forecasted steady growth of approximately 5% over the next 2 to 5 years.

Western Digital stock valuation 1 (created by author Ben at Motivation 2 Invest)

Western Digital stock valuation 1 (created by author Ben at Motivation 2 Invest)

I have also forecasted the business operating margin to increase slightly to 13% over the next three years, as inflation subdues and supply chain constraints untangle. This margin also includes an adjustment for R&D investments, which I have capitalized. I have also taken into the account the business's expected higher tax rate of 28%, which is driven by R&D tax changes.

Western Digital stock valuation (created by author Ben at Motivation 2 Invest)

Western Digital stock valuation (created by author Ben at Motivation 2 Invest)

Given these factors I get a fair value of $54.67 per share, the price at the time of writing is ~$32 and thus the stock is ~40% undervalued, which offers a substantial margin of safety.

As an extra data point, Western Digital trades at a forward Price to Earnings [P/E] ratio = 13.42. This is ~18% higher than its 5-year average of 11.29. However, the price-to-sales ratio = 0.67, which is 31% cheaper than its 5-year average. Relative to other industry players, Western Digital is at the cheap end of the spectrum, with a P/E Ratio [TTM] of 6.9.

The high inflation and rising interest rate environment has caused many analysts to forecast a recession. I personally believe the fear-driven news cycle doesn't help, as this can strike fear into the consumer and cause them to delay spending they would have otherwise done. The good news for Western Digital is you could say the product is partly essential as, if your hard drive breaks and you need another one for storage, you will likely buy it no matter what the economic outlook.

As mentioned prior, there is plenty of competition in the hard drive industry. In addition, the number of consumers using cloud storage such as G-Drive, iCloud etc. is only set to increase and thus the need to buy physical hardware is not essential as previously. Thus, I believe Western Digital is doing the right thing in leaning into its cloud offering although in the short term I do expect a decline in consumer segments. In terms of semiconductor stocks, I personally prefer Micron (MU), which produces DRAM and NAND [ Flash Memory]. Although not as well known as Western Digital, I believe they have more of a moat, as DRAM requires more advanced capabilities to manufacture. I have written a full analysis on Micron, you can read here.

A bet on Western Digital is really a bet on the future of hard drives and flash memory. Given the thirst for data and information we are seeing globally, I forecast the secular trend to be positive. The stock is currently undervalued intrinsically, and although I suspect some volatility within the next year, long term this looks like a solid investment assuming management can execute at the Data Center level.

This article was written by

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.