Take Advantage Of Pessimism With This Bargain Stock

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It amazes me that anyone listens to analysts. In what other field does a group which is wrong a majority of the time carry so much influence? According to this article from Reuters, on average companies beat analyst earnings estimates a staggering 62% of the time. I think that number says more about the ability of analysts than the strength or weakness of earnings season. So when a stock gets downgraded, often accompanied by vague, strictly qualitative reasoning, why the market cares at all is beyond me. Western Digital (NASDAQ: WDC) was recently downgraded by an analyst at Citibank, citing a weak PC market. What the analyst ignores is how undervalued shares of Western Digital actually are.   

Company Profile

Western Digital is the world's largest manufacturer of hard disk drives. Their products are used in personal computers, consumer electronics, and servers. More than half of total revenue comes from Asia, with 23% coming from the Americas, and 19% from Europe in fiscal year 2012. The company's products can be split into five categories:

<table> <tbody> <tr> <td><strong>Division</strong></td> <td><strong>2012 Unit Volume (millions)</strong></td> <td><strong>% of Total Unit Volume</strong></td> </tr> <tr> <td><em><strong>Notebook</strong></em></td> <td>32.773</td> <td>46.1%</td> </tr> <tr> <td><em><strong>Desktop</strong></em></td> <td>21.211</td> <td>29.9%</td> </tr> <tr> <td><em><strong>Consumer Electronics</strong></em></td> <td>4.155</td> <td>5.8%</td> </tr> <tr> <td><em><strong>Branded</strong></em></td> <td>4.986</td> <td>7.0%</td> </tr> <tr> <td><em><strong>Enterprise</strong></em></td> <td>7.913</td> <td>11.1%</td> </tr> </tbody> </table>

Financial Performance

Let's take a look at the revenue and cash flows for the last five years. Fiscal 2012 values are significantly higher due to the purchase of Hitachi.

<table> <tbody> <tr> <td> </td> <td><strong>2008</strong></td> <td><strong>2009</strong></td> <td><strong>2010</strong></td> <td><strong>2011</strong></td> <td><strong>2012</strong></td> </tr> <tr> <td><strong>Revenue</strong></td> <td>$8,074</td> <td>$7,453</td> <td>$9,850</td> <td>$9,526</td> <td>$12,478</td> </tr> <tr> <td><strong>Operating Cash Flow</strong></td> <td>$1,399</td> <td>$1,305</td> <td>$1,942</td> <td>$1,655</td> <td>$3,067</td> </tr> <tr> <td><strong>Capital Expenditure</strong></td> <td>$615</td> <td>$519</td> <td>$737 </td> <td>$778 </td> <td>$717 </td> </tr> <tr> <td><strong>Free Cash Flow</strong></td> <td>$784 </td> <td>$786 </td> <td>$1,205 </td> <td>$877 </td> <td>$2,350 </td> </tr> </tbody> </table>

The floods in Thailand in 2011 caused production shortages which hurt Western Digital's top and bottom lines. At this point production has largely recovered. Revenue jumped to $12.5 billion in fiscal 2012, which ended in June, while free cash flow reached $2.35 billion. 

For valuation purposes I like to look at owner earnings instead of free cash flow. I define owner earnings as the net income plus depreciation plus certain non-cash charges, excluding changes in working capital. I then add to that interest payments adjusted for taxes and subtract the average capital expenditure. My calculation is below.

<table> <tbody> <tr> <td> </td> <td><strong>2008</strong></td> <td><strong>2009</strong></td> <td><strong>2010</strong></td> <td><strong>2011</strong></td> <td><strong>2012</strong></td> </tr> <tr> <td><strong>Net Income</strong></td> <td> $867</td> <td>$470</td> <td>$1,382 </td> <td>$726 </td> <td>$1,612 </td> </tr> <tr> <td><strong>Depreciation & amortization</strong></td> <td> $413</td> <td>$479 </td> <td>$510 </td> <td> $602</td> <td>$825 </td> </tr> <tr> <td><strong>Investment/asset impairment</strong></td> <td> -</td> <td>- </td> <td>- </td> <td>- </td> <td>$61 </td> </tr> <tr> <td><strong>Stock based compensation</strong></td> <td> -</td> <td>$47 </td> <td>$60 </td> <td>$69 </td> <td>$92 </td> </tr> <tr> <td><strong>Other non-cash item</strong></td> <td> $99</td> <td>$87 </td> <td>- </td> <td>- </td> <td>$119 </td> </tr> <tr> <td><strong>Interest payments</strong></td> <td> $52</td> <td>$27 </td> <td>$9 </td> <td>$10 </td> <td>$26 </td> </tr> <tr> <td><strong>Avg capital expenditures</strong></td> <td> $673</td> <td>$673 </td> <td>$673 </td> <td>$673 </td> <td>$673 </td> </tr> <tr> <td><em><strong>Owner Earnings </strong></em></td> <td> $752</td> <td> $435</td> <td> $1,287</td> <td> $714</td> <td> $1,920</td> </tr> </tbody> </table>

The owner earnings for fiscal 2012 were just short of $2 billion. The last financial item that we need to look at is the balance sheet. Here is the most recent balance sheet, as of June 2012.

<table> <tbody> <tr> <td><strong>Cash</strong></td> <td>$3,208</td> </tr> <tr> <td><strong>Total debt</strong></td> <td>$2,185</td> </tr> <tr> <td><strong>Net cash</strong></td> <td>$1,023</td> </tr> <tr> <td><strong>Diluted float</strong></td> <td>260</td> </tr> <tr> <td><strong>Net cash/diluted share</strong></td> <td>$3.93</td> </tr> </tbody> </table>

The company has about $1 billion in net cash, which comes out to $3.93 per share. Recently Western Digital announced the start of a dividend, with the first dividend payment of 25 cents per share being paid for the quarter ending September 28th. In addition, a $1.5 billion share repurchase plan was announced, with the company planning to return 50% of the free cash flow to shareholders in the future. The balance sheet is solid and can certainly support these plans.


Since the analyst downgrade is based on the assumption that demand for hard drives will fall and hard drive companies will be less profitable, I'll do a sort of reverse discounted cash flow valuation. Instead of estimating the fair value based on current earnings and future growth, I'll determine what the earnings need to be to justify the current share price. To further drive home my point I'll assume that the owner earnings will grow at 3% per year, or no real growth after inflation. For a discount rate I'll use both 12% and 15% and calculate a range of values for owner earnings.

The calculation is this: Next years owner earnings are $xxx.xx. I assume that owner earnings grow at 3% from that value. Find $xxx.xx such that the discounted cash flow calculation yields the current share price.

The results are a little bit stunning. My calculation shows that the range of owner earnings given by my two discount rates is $750 - $1,000. In other words, even if Western Digital was half as profitable next year as it was this year the stock is fairly valued.


Western Digital's main competitor is Seagate Technology (NASDAQ: STX). Western Digital's acquisition of Hitachi allowed the company to surpass Seagate in size in the second quarter of 2012. Although the profitability of both companies are closely tied to PC demand, Western Digital is a bit more efficient. In fiscal 2012 Western Digital enjoyed a free cash flow yield of 18.8% compared to 17.6% for Seagate. And since the Hitachi deal closed well into fiscal 2012 the full effect of the acquisition isn't reflected in those results.

Although both companies appear undervalued, Western Digital is by far the cheaper of the two. In fiscal 2012 Seagate recorded a free cash flow of $5.95 per share while Western Digital recorded a free cash flow of $9.59 per share. This means that Seagate currently trades at a P/FCF of 4.7 while Western Digital trades at a P/FCF of 3.7. In addition, Western Digital has a little less than $4 per share of excess cash on the balance sheet, while Seagate has none. So while both companies are trading cheaply, Western Digital is the better value.      

The Stock

<img src="http://media.ycharts.com/charts/6b861c9b63716b11d635ab677fa9f0be.png" />

WDC data by YCharts

Both Western Digital and Seagate have outperformed the S&P 500 over the past five years. With this outperformance comes much greater volatility, as Western Digital stock has seen large fluctuations during this time. Western Digital currently trades at about $35.50 per share.

The Bottom Line

I agree that the PC market is facing a decline in demand. At the same time, as more and more people store data in the cloud more and more hard drives will be needed. But regardless of these details, the stock market seems to be extremely pessimistic about Western Digital, valuing it at a price befitting of a far less profitable company. What you get with Western Digital is $1 billion in cash and $2 billion in annual owner earnings, all for a market cap of $8.7 billion. Seems like a good deal to me! 

TheBargainBin has no positions in the stocks mentioned above, but may open a position in Western Digital in the next month. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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