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Western Digital: Cash Cow

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May 02, 2013 – Comments (0) | RELATED TICKERS: WDC

Board: Special Ops: Stocks to Watch

Author: turb0kat

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If you are looking for a cash cow, Western Digital is a gusher and one of the S&P 500's 3 cheapest stocks. Western Digital throws off about $2 billion a year in cash after capital expenses and has proven themselves to be a really amazing allocator of capital while delivering exceptional growth to top line, bottom-line and every line in-between.

Western Digital has had a phenomenal 10 year track record, growing earnings from 182m to 1.61b, shareholder equity from 327m to 7.67b, and operating cash flows from 281m to 3.07b while creating 1000% returns for investors. This has been done while expanding operating margins from 9% to 21%.

In the past 12 months Western Digital has bought back hundreds of millions in stock, proving that they are focused on delivering great returns to shareholders. At an average purchase price of 5x cashflow this would seem a phenomenal allocation of capital.

A recent acquisition brought their former CFO back into the fold as the new CEO. Much of the past 10 year's results correlate with his tenure. Given the fact that he left to run a smaller competitor and quickly raised its market value by a couple billion dollars and was bought out by his former employer, I believe him to be a great jockey to lead WDC forward.

Over the past 10 years margins have improved from 9% to 21% as the industry has rolled up into a two-player system, with WDC holding approximately 45% market share and Seagate holding a 42% share. As a result capital requirements are significant but low as a percentage of earnings. Western digital has consistently provided better returns on cash than Seagate year after year for at least a decade. Nothing gets me salivating like a nice duopoly.

We can imagine a number of scenarios for WDC going forward from the dire to the phenomenal.

The Death of Hard Drives:

The "Death of the PC" brings about an age where all storage is cloud based and competitors beat WDC entirely for cloud-based storage products. WDC sees demand for its products shrink to 0 linearly over a 10-year cycle. Management does the right thing for shareholders, returning capital on the way down through buybacks. This allows us to recoup a significant slug of our initial investment in spite of terrible business results ($20/share).

Meh:

WDC maintains market share in traditional hard drives and makes minimal inroads into burgeoning SSD (solid-state, where they are already a strong competitor) and ODD (optical) markets. Enterprise server growth balances out the reduction in demand for PCs and other consumer hard-drives. Management continues buying back, top-line growth is achieved through acquisition, cap-ex rises. ($75/share)

To the Clouds!:

Enterprise server growth continues to drive the 10% annualized growth of this market (matching current predictions for 2014). WDC maintains market share and margin while continuing to pursue buybacks or acquisitions of cheap properties. 30% of shares repurchased over the 10 year period while cashflow grows to $5.2 billion. Valuation multiple to cashflow expands from 6 to 10. ($310/share).

Thus we achieve a ratio of 10:1 (600% upside, 60% downside). The downside assumption seems relatively conservative as it only requires a return of capital (dividends, buybacks, liquidation) worth 2 years of cash generating capability - and also roughly equivalent to the cash on their books. The upside assumption is built against smart capital allocation combined with 10% annual increases in cash-flow - 1/3 the rate that they have achieved over the past decade.

Prognosticators like to talk about how no one buys PCs and therefore hard drive manufacturers will soon go bankrupt. The reality of the situation is that while global PC sales have slumped 7% year over year, hard drive manufacturers have seen top-line growth of 15% and cashflow increasing by 20-30% for each of the past two years. How can this be? Hard drive manufacturers make their margin in enterprise so the shrinking PC market is a small hit while the enterprise market is exploding upward with corporate demands for data. "Data Scientists" were just named THE SEXIEST JOB OF THE 21st CENTURY by McKinsey and global demands for data storage have only just begun.

With smart capital allocation and ridiculous cashflows, trading at 6x cashflow, Western Digital is well positioned to reward investors over the coming decade.


-tk 

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