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Friday, February
13, 1998
Western Digital Corp.
<% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WDC)") else Response.Write("(NYSE: WDC)") end if %>
Phone: 714-932-5000
Website: http://www.wdc.com
Price (2/12/98): $19 3/16
HOW DID IT FIND TROUBLE?
When irrational price-cutting hits a largely commodity business, look out
below! Disk drive maker Western Digital had been a Wall Street darling,
delivering an eight-bagger in just 2 1/2 years. But since hitting an August
high of $54 3/4, the company's stock has been pummeled as inventory troubles
at competitors and then widespread dumping following the Asian economic crisis
has destroyed profitability for all industry players.
Trouble began on September 30 when Western Dig
said
first quarter profits would come in between $0.63 to $0.66 a share, well
below estimates of $0.80 due to "greater than anticipated competitive pressure."
Seagate <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SEG)") else Response.Write("(NYSE: SEG)") end if %> had gotten stuck with too many 1.2 gigabyte drives
and had to cut prices to clear away inventory. That news gave Western Digital
a 20% haircut to $40 a share.
Shortly after Wall Street's October panic crunched the shares down to $30,
the company
announced
that second quarter profits would also miss earnings estimates, falling to
the $0.20 to $0.30 a share range, way below the $0.83 estimate. That sent
the stock for another little free fall to $23 a share. A subsequent conference
call painted a bleak picture of a market gone mad. CEO Charles Haggerty suggested
that some of the company's overseas competitors were actually selling drives
well below cost.
The news got worse. On December 2, the stock fell below $20 on
word
that Western Dig was tripling its projected second quarter charge to $85
to $95 million, as pricing pressures continued. In addition to more inventory
write-downs, the company announced a more extensive restructuring, including
scrapping the 3-inch portable drives it had rolled out earlier in the year.
The firm said second quarter profits would be flat and the company would
be only "modestly profitable" in FY98.
The pain at Western Dig was being shared throughout the industry, as Singapore
Technologies opted in mid-November to shut down its Micropolis disk drive
unit, and Seagate followed with the decision to close its plant in Ireland.
With tax-loss selling season underway and competitors Seagate and
Quantum <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: QNTM)") else Response.Write("(Nasdaq: QNTM)") end if %> also being crushed, the sun set on Western
Digital's year with the stock near a low of $14 1/2 -- 74% off its high!
BUSINESS DESCRIPTION
Western Digital is one of the top three independent manufacturers of
hard disk storage drives for personal computers (around 90% of sales) and
high-end enterprise systems such as network servers. About 72% of revenues
come from sales to original equipment manufacturers (OEMs) such as IBM, Gateway
2000, Apple, Compaq, and Dell. The rest come from sales of drives through
resellers such as your local computer store.
As of the second quarter, about 59% of sales came from drives of 2.5 gigabytes
or less, 37% from drives in the 3-5 gigabyte range, and just 4% from drives
in the 5 gigabyte and higher range. The firm is now continuing the rollout
of its 9.1 gigabyte drive for the fast-growing enterprise market still dominated
by Seagate. It's also working on an offering for the under $1,000 PC.
The recent industry troubles have accelerated the company's transition to
magnetoresistive (MR) head technology, which allows for much higher storage
capacity than current thin film head technology. While Western Dig trails
its competitors in this move, it expects its transition to be far smoother
since it can take advantage of the industry's MR learning curve. By the June
quarter, over 80% of its products will use MR heads versus just 40% in March
and 20% in the December quarter.
The company has two plants in Singapore and one in Malaysia where the drives
are manufactured. It also makes about 40% of the media it uses at its own
California plant. Unlike its competitors, particularly the vertically integrated
Seagate, Western Dig attains nearly all of it component parts from third-party
suppliers, giving it added flexibility.
FINANCIAL FACTS
Income Statement
12-month sales: $4235.9 million
12-month income: $235.6 million*
12-month EPS: $2.51*
Profit Margin: 5.6%*
Market cap:: $1782.5 million
(*Excludes second quarter special charge of $148 million)
Balance Sheet
Cash: $119.3 million
Current Assets: $923.7 million
Current Liabilities: $696 million
Long-term Debt: None
Ratios
Price-to-earnings: 7.6
Price-to-sales: 0.42
HOW COULD YOU HAVE SEEN IT COMING?
The disk drive industry is notoriously cyclical, with some investors banking
on a three-year boom/bust cycle. In the past, the busts were initiated by
players cutting prices in order to grab market share. The current downturn
is different in that it's driven by price cuts caused by excess inventory
and by completely irrational pricing from frantic Asian drive makers looking
to lock up whatever revenues they could as quickly as possible.
But as Gertrude Stein might have said, price pressure is price pressure is
price pressure. Having earlier dismissed fears raised by Seagate's price
cuts, by December, Fool Randy Befumo
came
around to the view that the investment thesis on Western Dig absolutely
depended on price stability. Investors playing the cycle thesis seemed to
have sensed this in September.
Investors who bought on the third dip, though, came up feeling like dipsticks.
The early November conference call when CEO Haggerty described the utter
price irrationality in the marketplace should have left few sanguine. With
absolutely no price visibility and the company making wholesale changes,
the stock still appeared headed for a rough ride even after being sliced
in half.
WHERE TO FROM HERE?
Despite a recent rally, Western Dig still trades so far off its highs that
it's tempting just to take the contrarian perspective and figure: the time
to buy a cyclical is when it's in the trench, and here the drive makers are
neck deep in mud.
The key questions, though, involve the timing of a recovery and the extent
of one. On the positive side, Haggerty said in the January 29
conference
call that "while it's too early to declare the bottom of the current
cycle, we have seen constructive steps taken by some of the major industry
players in terms of production cutbacks and restructuring programs, all of
which will hasten the industry's recovery."
Also, Western Dig's entry into the potentially lucrative enterprise market
is going according to plan, making up more than 10% of revenue for the first
time. Seven OEMs have already qualified the 9.1 gig drive with others waiting
in the wings. Haggerty said this market offers "perhaps the most significant
upside in our recovery."
Then there's the 2.1 gig drive for the desktop introduced in September. The
company shipped 1.1 million of these drives in the second quarter and expects
it to become the firm's dominant product by June. The accelerated move to
MR technology also seems to be on track.
On the downside, gross margins fell to 9% from 14.8% in the first quarter.
Given the price environment, the company cut back on production, shipping
just 5.8 million units in the second quarter versus original analyst estimates
for 7.5 million units. Even so, Western Dig still has 1.1 million drives
in inventory, up from a million at the end of September. Inventory in the
channel is still around 8 weeks versus the typical 4-5 weeks. Inventory turns
have fallen to 14 from the target 18-20 range.
The company sees unit sales dropping sequentially in the third quarter before
recovering a bit in the fourth quarter. In the conference call, management
said the third quarter loss should be worse than the then $0.38 per share
high side estimate. (Analysts are now looking for a loss of $0.40 to $0.48
a share for the quarter.) The company also said the fourth quarter loss would
approach the then worst-case estimates of $0.32 (the consensus had been for
a $0.17 per share loss.)
Though the company doesn't expect to record any additional charges, it will
use $73 million of its cash in the next two quarters as part of the charge
already announced. While a more attractive $250 million financing deal will
allow it to build for the future despite a short-term cash crunch, this overall
picture doesn't yet look that appealing.
After all, the industry must regain its senses before Western Dig can return
to healthy profitability. But major players such as Seagate reportedly still
have even more excess inventory than Western Dig does. Plus, there's certainly
deep suspicion among the analysts about how the widespread popularity of
the under $1,000 PC will affect long-term average prices and profitability.
Western Digital's lean and efficient operations leave it well positioned
to weather this storm and restructure its operations. But the end of the
recent troubles is not yet in sight.
-- Louis Corrigan
([email protected])
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