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Why Western Digital Shareholders Have Nothing to Worry About

Western Digital (NASDAQ: WDC) shareholders may be scratching their heads. The company just wrapped up a fiscal year in which it grew revenue 8%, operating income 38%, and earnings per share a whopping 60%. And yet the stock trades at less than 5x forward earnings. That means the good times may come to a screeching halt. But are the fears overblown?

Cyclical worries weigh

To understand the disconnect, one needs to understand the industry Western Digital operates in: nonvolatile memory, or "storage" to most. On that front, the company is diversified, making both NAND flash and the older (but cheaper) technology of hard disk drives (HDDs). It's a very unsexy business, made even worse by the fact that the company's products decline in price most years. Of course, technology advancements also allow memory producers to regularly lower their costs of goods sold and sell higher volumes, but the cost-versus-price dynamic can often cause large swings in profitability.

A man kneels to inspect an array of Western Digital storage drives
A man kneels to inspect an array of Western Digital storage drives

Image source: Western Digital.

Coming off an unusually strong fiscal 2018, prices for nonvolatile memory have been sliding, even more so than Western Digital management expected. Management attributed the declines to near-term soft demand in the mobile phone market.

On its recent conference call with analysts, management said it now expects NAND flash average selling prices to decline mid to high single digits per quarter through the end of this year. Those declines are currently outpacing Western Digital's roughly 20% annualized cost declines, which will hit gross margin. The company now forecasts gross margin between 38% and 39%, which is below the past year's mark of 42.5% and last quarter's 41%.

As usual, the market seems to be predicting current trends will last well into the future, but I think there are some reasons to believe this storm shall pass.

Raising long-term targets

While management guided down profitability for the next quarter, it actually raised the company's long-term gross margin range, from 33% to 38% to 35% to 40%. As you can see, management had already predicted gross margin would fall from last year's highs, so next quarter's decline shouldn't be too concerning in that light.

The reason for the long-term strength is an increasing mix of flash versus HDDs, as flash price declines allow flash to replace HDDs in many applications. Fortunately, NAND flash carries a higher margin profile than HDDs for Western Digital, though management doesn't disclose the exact breakdown for each product. The other reason for the increased gross margin is a larger mix shift to higher-margin "capacity enterprise" solid-state drives. To me, that reads as "cloud computing" -- a growth vertical that doesn't show signs of slowing down any time soon.

It's good to be flexible

Not only should Western Digital's gross margin stabilize at some point, but it should also get help on operating expenses. During the quarter, the company reported $820 million in operating expenses, below the company's guidance last quarter of $840 to $850 million. The lower figure is due to the company's variable compensation structure, which helps when gross margin declines. This is a very smart policy for companies with fluctuating revenue and margins and should help insulate the company's profits during volatile memory periods.

And unlike past periods when companies would fight for market share, Western Digital is prudently scaling back. The company is in the process of shutting its Kuala Lumpur hard disk factory this year, which should lead cost savings in that segment. Similarly, management said it was in talks with joint venture partner Toshiba Memory Corporation (now private) to scale back capital spending at its flash production factory in Japan.

The company's realistic and prudent focus on costs should help cushion the blow in down periods, helping it maintain its dividend and buyback. Speaking of which ...

$5 billion to shareholders

The company also announced a fresh $5 billion buyback program on the recent earnings call. For perspective, Western Digital now has a market capitalization just under $20 billion, so management could theoretically repurchase 25% of the company's shares at these prices.

Of course, those buybacks won't happen all at once. The company only generated $2.7 billion in free cash flow last year and plans to repurchase only $1.5 billion over the next 12 months. Still, that's a healthy return to shareholders at a time when the stock price is down.

Investors are clearly nervous about declining prices for flash memory after a stellar year, but a raised long-term outlook, variable compensation structure, and large buyback program should give longer-term Western Digital shareholders some comfort going forward.

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Billy Duberstein owns shares of Western Digital. His clients may own shares in some of the companies mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.