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Be Careful with the Post-Earnings Rally in WDC Stock

Vince Martin

The long nightmare for Western Digital (NASDAQ:WDC) seems like it might be over. WDC stock briefly traded over $100 in March, after months trading around $90. By December, Western Digital stock was below $35, trading at its lowest levels (save for a brief 2016 dip) in almost six years.

WDC Stock May Be a Steal


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Source: Shutterstock The news looks a bit brighter at the moment, however. WDC stock has rallied 39% from those lows. Sure Q2 earnings disappointed, but guidance for the fiscal third quarter suggested a bottom is approaching. And with Western Digital stock still cheap  and still yielding a healthy 4.3%; that’s been enough to drive some optimism.

But I’d be worried that there’s a bit of a “dead cat bounce” here. WDC stock looked cheap in September, too, but I didn’t think it was a buy then and I’m not convinced yet. Josh Enomoto detailed the skeptical case after earnings and I’m inclined to agree.

Western Digital stock might look cheap, but with the cycle still working against the company, $47 may not look that cheap a few quarters from now. HDD still faces long-term pressure. NAND pricing appears to have peaked.

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Meanwhile, there are two similar (and potentially more attractive) plays for investors betting memory has bottomed. I’m not sure WDC stock is the best choice, particularly with the gains after earnings.

WDC Stock Gains After Earnings

Western Digital earnings hardly looked impressive. Not only did the company miss on both revenue and earnings but the absolute performance looked concerning. Sales fell 21% in the quarter, and adjusted EPS was just $1.45 against $3.95 the year before, a 63% decline.

The key culprit, beyond revenue pressure, was gross margin. The figure on a non-GAAP basis was 31.3% in the quarter against 43%+ the year before.

But investors are looking forward, not backward. That’s a bit ironic given that chip stocks, including WDC, have suffered from the same attitude in recent months. Western Digital fiscal Q4 earnings in July, for instance, beat analyst expectations, yet Western Digital stock kept falling.

This time around, investors again focused on guidance – which truthfully isn’t that good. The company is expecting adjusted EPS of just $0.40-$0.60 – on gross margin of just 28%. That compares to $3.63 and 43%, respectively, in the year-prior quarter. Clearly, business isn’t expected to get better just yet.

That said, commentary on the Q2 conference call was optimistic looking toward the second half of this year. And it appears investors are starting to believe that the worst is over in terms of pricing in NAND flash and hard disk drives (HDDs). As such, those investors have bid Western Digital stock higher.

Reasons for Caution with Western Digital Stock

All that said, it’s awfully early to believe that Western Digital is out of the woods just yet. HDD and NAND weakness are tied in part to the same data center slowdown that’s hit Intel (NASDAQ:INTC) and Nvidia (NASDAQ:NVDA), among others.

Western Digital management believes that demand will return a few quarters from now, with CEO Steve Milligan predicting on the call that “growth [will] resume for us on both sides of the business in the second half of the [calendar] year”.

Elsewhere, though, investors aren’t so confident. NVDA, for instance, is bouncing off a 22-month low (though admittedly there are other factors at play there).

In NAND, meanwhile, Western Digital is cutting capacity in an effort to support pricing. But investors in memory stocks have heard that strategy before and it doesn’t always work.

Micron (NASDAQ:MU) has rallied so far this year on similar hopes. But memory is a viciously cyclical business and betting that the cycle is going to turn in the next couple of quarters creates a near- to mid-term risk in WDC stock.

Can Investors Do Better?

Particularly with Western Digital stock now up 27% YTD, there’s another factor to consider. The tailwinds that are needed to keep WDC moving higher will help other chip stocks as well. If Milligan is right in seeing just a short-term pause in data center demand, NVDA stock might be a stronger rebound candidate.

In memory, Micron stock is facing the same cyclical concerns yet remains cheaper to both near-term and (likely) mid-cycle earnings. It also has a much stronger balance sheet. Seagate Technology (NASDAQ:STX) has rallied itself, but has a similar valuation and a higher dividend yield.

Across the board, the case for WDC stock applies at least in part to other chip stocks some of which look more attractive. And it’s not as if WDC stock is that cheap anymore. Even though 8x+ forward earnings sounds cheap, it’s not exactly a screaming buy for a leveraged cyclical business.

If analysts are too optimistic toward FY20 EPS, as they’ve been across the chip space of late, either the 8x+ multiple expands to a less attractive double-digit figure, or Western Digital stock declines.

More broadly, the case for WDC stock here is that the worst is over. For a number of reasons, including the pressure the company itself sees in fiscal Q3, it seems too early to make that case, and dive into Western Digital stock.

Meanwhile, if the worst truly is over in memory and storage, there seem like better ways to make money than WDC.

As of this writing, Vince Martin has no positions in any securities mentioned.

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