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FPA Capital Comments on Western Digital

- By Holly LaFon

Western Digital (WDC) was the Fund's worst performing holding in the last fiscal year (it detracted 2.93% from performance), but rallied 31% in 1Q 2019. The Fund's Western Digital investment contributed 1.44% of the Fund's Q1'2019 returns. As the stock price went lower in 2018, we increased the Fund's share count by 33% into the weakness. We thought now would be a good opportunity to review our investment thesis, talk about what we got wrong, and why it is our biggest position today.

Investment Thesis

Western Digital is a market leader in non-volatile memory offering both Hard Disc Drives (HDDs) and Solid-state Drives (SSDs). We believe that the memory market is benefitting from multiple mega-trends (e.g. Internet of Things, Artificial Intelligence, Big Data, cloud, autonomous vehicles, etc.) that will continue to drive overall demand higher for years to come. Furthermore, in our view, the industry structure for both HDDs and SSDs are such that we can expect rational actions from the major players to help rebalance supply and demand. We believe this presents a ripe situation for the major players to earn good returns over the cycle as the market normalizes. Furthermore, with the stock trading at $48.06 (closing price on 03/31/19), we think this presents a compelling opportunity to own a company that we believe can compound earnings at a cheap valuation, a rare combination.

What We Got Wrong Last Year

While we understood that Western Digital's business is inherently cyclical, we underestimated the magnitude of this current cycle. In particular, we had not expected two of the biggest end-markets for NAND flash (the memory chip used in SSDs), mobile and cloud, to correct simultaneously. As that demand disappointed relative to expectations, supply was just starting to ramp up and exceeded estimates. The mismatch of supply and demand sent prices tumbling and investors adopted a shoot first, ask questions later approach to their selling in the memory space. We reflected on what we could have done differently: cyclical companies' sizing needs to be adjusted to the current point in the cycle rather than the cycle average. We have incorporated this learning across the rest of the book.

Why It is Still One of the Fund's Biggest Positions Today

In our view, the underlying thesis behind the Western Digital investment has not changed. What has changed in the last fiscal year is the price of the stock (cheaper) and the point in the cycle (closer to trough). While Western Digital stock price has rallied 31% in the first quarter of 2019, we believe there is substantial upside opportunity as we expect the street to begin to look through the down cycle as we approach the trough and begin to value the firm on its meaningfully higher normalized earnings potential.

From FPA Capital's first-quarter 2019 shareholder letter.

This article first appeared on GuruFocus.