What This Acquisition Means for Competitors

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Western Digital's (NASDAQ: WDC) decision to purchase rival hard drive maker STEC (NASDAQ: STEC) did not come as much of a surprise to those familiar with the two companies. In light of a recent insider trading scandal and ongoing turmoil within the company's upper management ranks, many observers believed that it was only a matter of time before STEC accepted such an offer. Indeed, the company's largest institutional shareholder had aggressively pushed for a buyout for over a year.

Despite its troubles, STEC appears to offer significant value for Western Digital. The company's solid-state hard drives are crucial to the operations of data-hungry tech firms and larger conventional businesses, and its operations overlap with those of Western Digital in key areas. Arbitrageurs and short-term traders might find something to like in this transaction as well. On the other hand, Western Digital will have to work hard to integrate STEC's under-performing segments into its operations. Investors should keep a close eye on this situation.

Western Digital, STEC and Competitors

When it is compared to many of its competitors, STEC looks like a runt. Unfortunately, it must contend with a number of rather large, diversified firms that operate within its niche. In addition to Western Digital, the company directly competes with Seagate Technology (NASDAQ: STX).

Seagate and Western Digital are roughly equivalent in size. Whereas the former has a market capitalization of about $15.8 billion, the latter is valued at around $14.4 billion. By comparison, STEC has a market cap of barely $320 million. In 2012, the two larger companies enjoyed healthy revenues and profits. Western Digital finished the year with a gross take of $16.4 billion and a final profit of about $2 billion. With revenues of $15.4 billion and earnings of about $2.5 billion, Seagate had a slightly more robust profit margin. Meanwhile, STEC reported a crushing loss of $118 million on total revenues of $140 million. It should be noted that STEC's revenue fell by about 50 percent in the first quarter of 2013.

Although STEC lacks long-term debt, its cash reserve of about $130 million is shrinking at a rate of $44 million per year. Cash flows for Western Digital and Seagate are robustly positive, and neither company has significantly more debt than cash. However, Seagate is considerably more expensive than Western Digital: Its price-to-book ratio of 4.64 is nearly triple that of its California-based competitor. Meanwhile, STEC's price-to-book ratio of 1.56 is artificially inflated by Western Digital's offer.

How the Deal Is Structured

According to both parties to the deal, the merger will be structured as a cash-for-stock transaction. Western Digital will issue cash payments of $6.85 per share to STEC shareholders of record on a yet-to-be-determined date. Relative to STEC's current share price of about $6.75, this represents a premium of 1.5 percent. As such, there is a small but persistent arbitrage opportunity available to interested investors. All told, the deal is worth about $340 million and should close by the end of 2013. 

Potential Synergies and Benefits

Despite its lopsided nature, this deal is widely viewed as a near-necessity for Western Digital. With the rise of mobile technology and the shrinking of the consumer-driven PC and laptop markets, demand for traditional hard drives has cratered. Although they remain quite large by most standards, companies like Western Digital and Seagate must contend with stagnant or falling revenues and changing demand profiles. STEC manufactures the powerful solid-state drives that businesses and institutional clients will continue to require for the foreseeable future.

STEC's recent troubles have created a tremendous opportunity for Western Digital: A few years ago, the California-based drive-maker probably would have paid several times more for the property. It is likely that the larger company will use STEC's operational expertise to buff out its server businesses and create synergies that could create significant cost savings. Since Western Digital is already regarded as a leader in the solid-state industry, this acquisition could make things more difficult for big-name competitors like Seagate.

Legal Issues and Complications

Western Digital's planned acquisition still faces some hurdles. Despite offering to double STEC's pre-announcement market cap, the company has faced criticism from investors and market-watchers who believe that its offer undervalues its smaller rival. Several law firms have begun to investigate the terms of the deal and the maneuvers that preceded it. Although it is too early to tell for sure whether these investigations will affect the merger's outcome, investors should keep one eye on the proceedings and await the results of a shareholder-approval vote that will take place later this year.

Effects on the Competition and Potential Plays

Assuming that the deal goes through as planned, Western Digital's solid-state competitors will feel a renewed sense of urgency. Seagate and other firms like Fusion-io  have made it clear that they wish to grow by acquiring smaller drive-makers that operate in the space. Although Western Digital has removed a prime target from the marketplace, it is likely that the broader hard drive ecosystem will see additional mergers and acquisitions in the near future. For now, Western Digital will enjoy an attractive competitive advantage.

In sum, investors who recognize the changing realities of the hard drive market would do well to look at this acquisition. For short-term traders, STEC continues to offer a meaningful arbitrage premium. Long-term investors can find plenty of value in a post-deal Western Digital. Taken as a whole, this deal could be a win-win situation for all involved parties.

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Mike Thiessen has long position in Seagate. The Motley Fool owns shares of Western Digital.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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