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Throughout the year, the Technology sector has led the market in terms of performance; as measured by the S&P Technology Select Sector ETF (XLK), the sector is up almost 12.5% year-to-date, with many analysts predicting even more growth ahead. One of the trends they like to point to is the growth of cloud-based services; after the market close yesterday, for example, Microsoft (MSFT) reported that revenue for its Azure cloud service jumped 89 percent to nearly $7 billion. As an investor, targeting cloud services specifically can be a little tough, since the market leaders are diversified businesses like Amazon (AMZN), MSFT, and Alphabet’s Google (GOOGL). Perhaps another way to look at it is to focus on companies that build some of the components used in cloud servers. Western Digital Corp (WDC) is a good example.
WDC has bucked the sector’s trend for the year, since it is down almost 5.5% for the year. More interestingly, the stock is nearly 28% below the high it found in mid-March at around $107 per share. WDC’s underperformance year-to-date, along with the fact that the stock is hovering near to its 52-week low point right now, raise some intriguing possibilities for a value-oriented investor. The hard disk drive market has seen declining trends over the last few years, since it has historically been closely tied to PC shipments. That doesn’t mean companies like WDC or its nearest competitor, Seagate Technology Plc (STX) are operating in a dying market space; it does mean that growth for stocks in this space has been closely tied to consolidation and diversification, since emerging storage technology such as solid state drives (SSD) makes standard hard disk drive (HDD) storage less and less compelling.
In late 2016, for example, WDC completed a $67 billion-plus acquisition of SanDisk, the maker of the NAND flash memory used in SSD’s. That positions the company to navigate what most think is an inevitable, and permanent transition away from HDD storage. In the meantime, another trend that also plays into WDC’s favor is the growth in storage demand from enterprise customers like cloud service providers. That growth is expected to largely offset declining consumer demand while the SSD market is expected to mark the best path to continued growth. WDC is positioned better than STX in this respect, since STX has so far been content to rely on the increase in enterprise demand for HDD storage capacity to this point. Don’t ignore the fact, however that other players, like Intel (INTC) and Samsung Electronics are pushing hard into the SSD space, which means that competition and pricing pressures are likely to remain pretty high.
Fundamental and Value Profile
Western Digital Corporation (WDC) is a developer, manufacturer and provider of data storage devices and solutions that address the needs of the information technology (IT) industry and the infrastructure that enables the proliferation of data in virtually every industry. The Company’s portfolio of offerings addresses three categories: Datacenter Devices and Solutions (capacity and performance enterprise hard disk drives (HDDs), enterprise solid state drives (SSDs), datacenter software and system solutions); Client Devices (mobile, desktop, gaming and digital video hard drives, client SSDs, embedded products and wafers), and Client Solutions (removable products, hard drive content solutions and flash content solutions). The Company develops and manufactures a portion of the recording heads and magnetic media used in its hard drive products. WDC’s current market cap is $23 billion.
- Earnings and Sales Growth: Over the last twelve months, earnings grew more than 62% while revenue growth was modest, posting an increase of almost 8%. WDC operates with a narrow margin profile of about 1%. By comparison, STX’s margins are around 10%. I believe the difference is a reflection of the company’s differing approach to growth; STX focuses almost exclusively on the higher margin aspect of increasing enterprise demand, while WDC is meeting enterprise demand while also pushing hard on innovation and evolution with SSD storage.
- Free Cash Flow: WDC’s free cash flow is very healthy, at more than $3.5 billion. That translates to a free cash flow yield of more than 15%, which is much higher than I would normally expect given the company’s narrow operating margins.
- Debt to Equity: WDC has a debt/equity ratio of .98. That number declined from a little above 1 over the last quarter, as long-term debt dropped by more than $1 billion. Their balance sheet indicates their operating profits are more than adequate to repay their debt, and with almost $5 billion in cash and liquid reserves, the company has excellent financial flexibility, which they plan to use to pay down debt, repurchase their shares and consider other strategic acquisitions.
- Dividend: WDC pays an annual dividend of $2.00 per share, which translates to a yield of about 2.6% at the stock’s current price.
- Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for WDC is $37.97 and translates to a Price/Book ratio of 2.02 at the stock’s current price. Their historical average Price/Book ratio is 2.12, which is less than 5% above its current level. That implies limited upside based on the way the market has historically priced the stock; however the industry average is 4.6, suggesting the stock could be significantly undervalued right now. Using a long-term target price above $140 is probably over-optimistic since the stock’s highest price was reached in late 2014 around $110; however if the company’s evolution strategy is correct, as I expect it to be, makes that historical high useful.
Here’s a look at the stock’s latest technical chart.
- Current Price Action/Trends and Pivots: The red diagonal line measures the length of the stock’s intermediate downward trend, and also informs the Fibonacci trend retracement lines shown on the right side of the chart. The stock is sitting very near to strong support from repeated low pivots since late last year. That support marks an important inflection point for the stock right now; if the stock breaks below it by dropping below $75, it could drop to as low as around $64 before finding a new, strong support level. On the other hand, a new pivot higher off of the $75 level, with strong buying volume could see the stock push near to the resistance line offered by the 38.2% retracement line around $88 in fairly short order. The stock would have to break above that resistance level to confirm a new upward trend and validate a longer-term push into the $107 to $110 level.
- Near-term Keys: If the stocks breaks below its current support at around $75, a smart short-term trade could be to short the stock or work with put options to take advantage of the stock’s current downward trend. If the reverse is true, and the stock uses that support to bounce higher, a short-term trader should look for a push to $80 as a signal to buy the stock or start working with call options. If you’re willing to tolerate some volatility in either direction right now, and you like the long-term prospects for WDC more than any current downside, this could be a good time to take a new long-term position. A strict value-oriented investor would probably prefer to wait to see the stock test support around the $64 level, where the stock’s Price/Book ratio would also be low enough to offer a significant discount.