Shares of Western Digital (NASDAQ: WDC) fell 5% on Jan. 14 after Evercore analyst C.J. Muse downgraded the stock to Underperform and expressed concerns about its competitive threats and dividend.
In a note to investors, Muse warned that WD's competitive position was "not ideal," and claimed that its share of the enterprise SSD (solid state drive) market had "roughly halved in the last few years" to about 12%. Muse also pointed out that low market prices would reduce the average prices of its memory chips.
Image source: Getty Images.
Muse reduced his price target on the stock from $35 to $30, and warned that WD would be "hard pressed" to support its dividend with its free cash flow (FCF) this year. Investors should always take analysts' comments with a grain of salt, but is Muse right about WD's dividend?
A closer look at Western Digital's dividend
WD currently pays a forward yield of 5%, which hovers near a multi-year high due to the stock's 50% decline over the past 12 months. WD started paying a dividend in 2012, but it hasn't raised that payout since 2015.
Over the past four quarters, WD's dividend payments eclipsed its earnings per share by nearly 120%, but only used up 21% of its FCF. This indicates that WD's dividend should stay safe if its business doesn't deteriorate too quickly. During last quarter's conference call, CEO Stephen Milligan declared that WD was "not looking at cutting the dividend."
However, Muse claims that WD's FCF levels will plummet and cause its FCF per share to drop from $9.10 (on a trailing 12 month basis) to $2.35 for the full year -- thus boosting its FCF payout ratio to 85%. That cash payout ratio would represent a historic high for WD, but it's still well below 100%.
Muse notably doesn't mention stock buybacks, which WD restarted in 2018 after a two-year break. WD generated $2.8 billion in FCF over the past four quarters, and it plans to spend $1.5 billion on buybacks in fiscal 2019. If WD's FCF dramatically declines this year, the company would likely reduce or suspend its buybacks before cutting its dividend.
Muse also claims that WD's $10.9 billion in long-term debt represents a threat to its FCF and dividend. But roughly 98% of that debt isn't due until 2023, so it seems premature to claim that WD's debt could kill its dividend.
Identifying the real problems with WD
Based on those facts, I don't think WD will cut its dividend this year. However, investors should still recognize the biggest challenges: Its revenue growth is decelerating, its earnings growth is turning negative, and its FCF is drying up.
Free cash flow
Year-over-year growth. Source: WD quarterly reports.
Those declines can be attributed to two main headwinds. First, WD's total HDD (hard disk drive) shipments are dropping on softer demand from the data center, client computing, and non-computing markets. Second, declining memory chip prices are throttling its growth in NAND (flash) memory devices like SSDs and memory cards, which accounted for about half of its sales during the first quarter of 2019.
During that quarter, WD's gross margin fell 430 basis points annually to 38%. Softer enterprise spending could persist over the next few quarters, and DRAMeXchange expects DRAM and NAND prices to decline another 20% this year.
Image source: Getty Images.
Analysts expect those cyclical headwinds to cause WD's revenue and earnings to decline 16% and 53%, respectively, this year. WD's rival Seagate (NASDAQ: STX), which isn't as heavily exposed to the NAND market, is expected to post milder revenue and earnings declines of 5% and 6%, respectively. Seagate also pays a higher forward dividend yield of 6.2%, which might make it a safer storage play than WD.
The problem isn't the dividend... it's the stock
Muse's warnings about WD's competitive threats and the cyclical price declines in the memory market make sense. However, his claim that WD will cut its dividend doesn't properly factor in buybacks and the maturity dates of its long-term debt.
Therefore, the real problem with WD isn't its dividend -- it's the stock itself. WD's stock was already cut in half and it now trades at just five times forward earnings, but its earnings could continue declining and cause investors to shun the stock. WD's 5% yield simply isn't worth that drama, especially when there are safer stocks that offer comparable yields.
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