western digital initiating coverage report

INITIATINGCOVERAGEREPORT

WilliamC.DunkelbergOwlFundSeptember18,2016

Sector Outperform Recommendation: BUY

Key Statistics: values in mm except per share Price $54.94 52 Week Low $34.99

Return 25.4% 52 Week High $86.39

Shares O/S 239 Yield 3.64%

Market Cap $15,618 Enterprise Value $24,234

One-Year Price Graph

Earnings/Revenue Surprise History:

Quarters EPS Revenue Price

1Q16 (0.32%) 2.45% (4.57%)

2Q16 3.49% (1.02%) 5.01%

3Q16 (4.20%) (1.52%) (11.28%)

4Q16 9.72% 1.03% (11.53%)

Earnings Projections:

Fiscal Year Q1 Q2 Q3 Q4 Total

2015 $2.11 $2.26 $1.87 $1.52 $7.76

2016 $1.56 $1.60 $1.21 $0.79 $5.09

2017e $1.03 $1.22 $1.05 $1.18 $4.45

2018e $1.53 $1.77 $1.51 $1.61 $6.20

All prices current at end of previous trading sessions from date of report. Data is sourced from local exchanges via FactSet, Bloomberg and other vendors. The William C. Dunkelberg Owl fund does and seeks to do business with companies covered in its research reports.

Lead Analyst Anthony Merola [email protected]

Associate Analysts Daniel Wimer [email protected] Noah Herman [email protected] Flo Benhayoun [email protected]

COMPANY OVERVIEW

Western Digital Corp. is an American computer data storage company that designs and manufactures internal and external hard disk drives (HDD) and solid state drives (SSD) and provides storage solutions for consumers and businesses. It is globally recognized as a leading provider of storage solutions. The company provides drives for desktop, laptop, enterprise, and consumer electronics markets. Hard disk drives and solid state drives are responsible for all the storage on a given device including programs, applications and the device's operating system. Western Digital’s products include external storage, internal hard drives, personal cloud services, network attached storage, home entertainment storage and surveillance storage. Western Digital’s revenue breakdown by geography is as follows: Asia-Pacific (31.2%), Europe, Middle East, and Africa (21.8%), United States (21.0%), China (18.7%), and other (7.3%). The company releases Q1 2017 earnings on October 26, 2016.

INVESTMENT THESIS

Western Digital is currently trading at a 4.5% discount to its 3-year forward P/E spread against its main competitor Seagate. Investors began devaluing both Western Digital and Seagate due to secular declines in its core HDD business caused by the emergence of SSDs. Western Digital sold off even further after investors reacted negatively to the company’s $19 billion acquisition of SanDisk, which led to shares falling over 50% in the three month period after the acquisition was announced. This was due to fears that the company would not be able to smoothly integrate SanDisk. However, the company has since proved that it is on track to successfully integrate SanDisk, and will produce $500 million in synergies by the end of FY 2017, while also providing key positioning for WDC in the growing SSD market. The company is also set to benefit from shifting fundamentals in the NAND memory market that will provide short-term tailwinds as the industry shifts from 2D to 3D NAND. Western Digital is also set to see its core business outperform beaten down analyst expectations due to improved utilization rates and a product refresh that will regain market share. The efficiency improvements and entry into SSDs will drive multiple expansion due to its new unique position in the memory industry. Using the DCF Perpetuity methodology, we calculated a fair value of $64.94, providing 25.4% upside to current share prices after factoring in the company’s dividend.

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Western Digital Corp. Exchange:NASDAQTicker:WDCTargetPrice:$66.94

Fall 2016

T h e W i l l i a m C D u n k e l b e r g O w l F u n d Page2

INDUSTRY OVERVIEW

NAND Market One of the largest trends within the Technology Sector involves the transition from 2D NAND to 3D NAND as memory chipmakers are quickly adapting to the new technology for SSD storage. The ever-increasing demand for SSDs in smaller form with increasing memory space for devices like smartphones, tablets, and laptops has lead to the increasing demand for 3D NAND. 3D NAND essentially takes a parking lot of memory and turns it into a parking garage by stacking layers of memory on top of each other to create additional storage. The need for cost-efficient, secure and reliable data storage solutions by technologies like 3D NAND is expected to continue to drive the global semiconductor market. It is also expected to yield high adoption rates by consumer technology product vendors over the next 3 years as these companies transition from 2D to 3D for their products. Most vendors are promising to ship 64-layer 3D NAND by the end of CY 2016, which provides more storage than the 24-layer and 48-layer NAND currently available on the market. However, there have been continued setbacks on the market as NAND producers have struggled to contain costs of 3D NAND, which should continue to push back the release of 64-layer chips. Overall, the migration to the production of 3D parts for semiconductors has not been smooth. As vendors are racing to produce 3D NAND, they are allocating a majority of CAPEX spending towards the new technology and failing to ramp up their 2D NAND flash chips which is leading to a shortage in NAND flash memory. The NAND market is expected to fall into a period of undersupply by the end of CY 2016. Another cause for the expected undersupply is that although there has been flattening demand for systems, there has been an increase in the incorporation of NAND content per system as demand for more storage increases. This undersupply will benefit manufacturers as the price of chips is expected to increase due to traditional supply-demand factors. The undersupply is expected to last as long as it takes vendors to produce viable 3D NAND storage and should help drive NAND prices higher through 1h 2017.

Hard Disk Drive & Solid State Drive Market

Much like in the case of 2D NAND to 3D NAND, another large trend within the Technology Sector is the industry-wide move from HDDs to SSDs. SSDs are a much faster and stronger form of storage that is quickly taking over market share as companies are continuing to incorporate them into their PC’s. They offer quicker boot ups, faster file transfers and a better overall experience than that of a traditional HDD. In Q1 2016 the industry sold 30.8 million SSD’s, which was a YoY increase of 32.1% from Q1 2015. During the same period the industry sold 99.8 million HDD’s, which was a YoY decrease of 20%. The steady decline of HDD sales is not solely due to the switch towards SDDs, but also due to declining PC sales. In the same period the industry sold 60.6mm PC’s, which was a YoY decrease of 11.5%. Declining PC sales over the last few years are due to the consumer transition to tablets and smartphones. After the introduction of SSDs into the market, HDD supply far outweighed demand and the industry's largest suppliers, Western Digital and Seagate, were left with overstocked shelves of inventory. This forced the two companies to increase efficiency within their supply chains in order to decrease inventory levels that let to the oversupply of HDD. According to numbers from Q1 2016, WDC controlled 43% of the HDD market while Seagate controlled 39%. The only other substantial player is Toshiba who controlled an estimated 17% of the market. While SDDs are clearly the technology companies are turning to for performance, HDDs remain the best option for memory capacity and are more inexpensive than SSDs. Therefore, while technology companies race to produce the most advanced SSDs, HDDs will remain an important revenue driver as the need for high capacity memory continues across the market, particularly in data centers where HDD demand is projected to grow at a 10% CAGR through 2020.

Fall 2016


SEGMENT OVERVIEW

Western Digital reports in one reportable operating segment, the Hard Drive business. However, with the company’s recent acquisition of SanDisk, WDC is transforming into a storage solutions giant with global scale and an extensive product line in both the HDD and SDD realms. With this transition still materializing, WDC has yet to report on multiple segments. While the company currently only has one reportable segment, it can be broken down into three product segments: Data Center Devices and Solutions, PC Hard Disk Drives, and Solid State Drives.

Data Center Devices and Solutions

For data centers with high workload applications and massive storage demands for data warehousing and mining, capacity is the most important feature customers are looking for in their hard drives. WDC provides large-capacity HDD technology highlighted by their newly released WD GOLD product that provides 10TB of storage; a 25% increase in capacity over their second highest capacity product. As the PC market continues to decline along with their use of HDD, WDC is leveraging the market of growing storage demands by providing industry-leading data center HDDs.

PC Hard Disk Drives

WDC shipped 99 million units of PC HDDs in FY 2016, down-37.4% from the 136 million units shipped in FY 2015. All PC’s require a storage drive to store data and run applications, and until the recent trend favoring SSDs, all PC’s used HDD technology. However, because of the declining market for PC’s as well as PC producers switching to SSDs, the demand for PC HDDs continues to decline. This segment is one that is forecasted to continue to decline in sales unless the market for PC’s improves or WDC can gain market share. However given the conservative guidance in this segment, WDC should not have an issue hitting estimates.

Solid State Drives

Solid State Drives are transforming the data storage market across the globe with their advanced technology and dynamic performance. WDC recognized this trend and proceeded to acquire SanDisk - the third largest manufacturer of flash memory in the world. This acquisition positioned them to take full advantage of the growing market for SSDs. WDC now offers SSDs and systems as well as flash storage solutions for the PC, mobile, enterprise, and data storage markets. With the transition from 2D NAND to 3D NAND across the entire industry on the horizon, and WDC positioning itself as a front-runner in this new market, this product segment is expected to drive the value of WDC moving forward.

MOATS

Economies of Scale:

Western Digital is the leader in the HDD market allowing the company to avoid price wars since it is able to dictate the price in the market. The company holds intangible assets that contribute to its cost advantage in HDD manufacturing, which has allowed it to generate excess returns on capital. WDC is able to gain cost production efficiencies due to its dominant position in the HDD market (44% market share). The company is able to dictate the market while having a cost-advantage over competitors.

RISKS

Transition to 3D NAND:

The transition from 2D NAND to 3D NAND poses a risk for WDC due to its acquisition of SanDisk in May 2016. SanDisk has historically been able to benefit from its bit density, which has given the company a cost/bit advantage in 2D NAND. There is uncertainty whether companies in this sector will be able to maintain and improve a cost/bit advantage as the transition to 3D NAND unfolds. The 3D NAND market is seeing high capital expenditures in order to produce new chips, which can potentially create an oversupply of 3D NAND and create losses for manufacturers.

Declining PC Market:

Western Digital has a portion of their HDD revenue exposed to the PC market, which has seen shipments decline over the past two years. WDC is the largest U.S. manufacturer of HDDs holding about 44% of market share. Worldwide PC shipments decreased 5.2% from Q2 2015 - Q2 2016 and shipments have been declining for the past 7 consecutive quarters. SSDs have also threatened the HDD market within PCs and could further contribute to declines if the adoption of SSDs is accelerates more than analysts are currently anticipating.

Fall 2016


CATALYSTS

SanDisk Acquisition

On May 12, 2016 Western Digital completed a $19 billion acquisition of SanDisk, a leader in Solid State Drive (SSD) storage that uses high-density NAND flash technology. SSD’s have become more popular due to their simplicity and ability to perform faster than traditional HDDs. For this reason, SSDs have been displacing HDDs. The acquisition of SanDisk provides a unique hedge against the displacement of WDC’s core HDD product. SanDisk was a dominant player in the SSD market and now gives WDC 22% market share in SSDs to go along with the company’s 44% market share in HDDs. Over the next 5 years the global enterprise SSD market is projected to grow at a CAGR of 17% as cloud applications become more prevalent in businesses. The growth of 3D NAND will also help drive the SSD market going forward as capacity will expand. SanDisk’s SSD business gives WDC exposure to a higher growth area that will lead to a better product mix and help offset headwinds in the company’s HDD business. SanDisk has a partnership with rival Toshiba in NAND production, which the company has stated will still continue now that SanDisk is apart of Western Digital. Toshiba/SanDisk were able to maintain a cost advantage over competitors in planar NAND production, as they were able to achieve the lowest cost/bit due to the operational efficiency that the two companies were able to establish. The acquisition doubles WDC’s total addressable market (TAM) and enhances the company’s position within the industry, as they are able to meet all types of storage demands. This will help drive multiple expansion as the company enters into areas of higher growth and also lead to cost savings due to the similarities of the two businesses. Management anticipates that the acquisition will lead to $500 million in synergies by the end of FY 2017 and $1.1 billion by FY 2020. The positive Q1 2017 EPS guidance increase indicates that the company is experiencing operational efficiencies resulting from the integration of SanDisk. This supports our belief that the company will be able to continue its execution of this integration faster than expected and allow them to extract additional cost synergies. We view the accretion of this acquisition very positively as Western Digital is proactively positioning itself to adapt to changes in the memory industry.

Improvements in HDD Business

Western Digital’s core HDD business has been declining due to the adoption of SSDs and slowdown in PC shipments. Although SSDs are likely to be the main source of memory storage in the long-term, there are short-term tailwinds that will allow WDC’s HDD business to outperform expectations in the short-term. The shrinking demand caused an oversupply in the HDD market, which caused utilization levels for both Western Digital and its main HDD competitor Seagate to fall to 68% and 74% respectively in CY 2015. Utilization levels are correlated to gross margin, so the decrease in efficiency negatively affected margins. To combat this, WDC and STX have both been proactive in reducing their manufacturing footprint in order to return production back to more efficient levels. Utilization rates should bounce back to over 80% in CY 2017 due to more efficient production levels as well as the continued consolidation of the Hitachi HDD business that WDC acquired in 2012. The increased in efficiency would lead to margin expansion in WDC’s HDD business from 29% in FY 2015 to over 33% in FY 2017. The growth opportunity for HDD lies in enterprise data centers where the total addressable market (TAM) is projected to grow by a 10% CAGR for HDDs through FY 2020. HDDs are less likely to get displaced by SSDs in data centers due to the high-capacity demands that cause the low-cost HDDs to remain a popular storage product. In FY 2016 WDC saw Exabyte growth of 47% YoY. The company began ramping up production of its 10-terabyte HDD helium drive in September 2016, replacing the old 8-terabyte drives. Management commentary suggests that the product refresh is gaining marketplace momentum and will drive market share gain at the expense of Seagate, which is still primarily selling its 8 TB drive. The product refresh will help rejuvenate sales and is targeted to attack the growing enterprise data center market. A 3% market share gain in the overall HDD market would lead to an additional $750 million in revenue for FY 2017. The increasingly positive commentary leads us to believe that this is achievable. Although these are all minor changes in a secularly declining business, these are all positives and will lead to improvements in Western Digital’s core business and help drive an earnings beat against expectations that have been beaten down by bearish sentiment on The Street.

Fall 2016


Shifting Fundamentals in NAND Market

Western Digital is well positioned within the NAND market to be the beneficiary when prices rise. NAND is a type of flash memory that is non-volatile, meaning that it can hold saved data even when it is powered off. This has lead to it being commonly used in SSDs, smartphones, tablets, and other devices using flash memory. The NAND market has seen prices drastically decline during 2016, with an estimated oversupply of 5.2 billion GB. However, we are seeing a fundamental shift in the supply and demand within the NAND industry that will lead to NAND prices rising again. The industry’s transition from 2D NAND to 3D NAND has left manufactures to focus on spending their capital expenditures on the production of 3D NAND, which is leading to an undersupply in the NAND market since the ramp up in 3D NAND adoption continues to get pushed back as manufacturers attempt to maintain a similar cost/bit as they had in 2D NAND. Demand for NAND across the industry is projected to rise 37.8% in 2017 as handsets (Mobile phones, tablets, SSDs, etc.) are rapidly increasing the NAND content within each system in order to maximize the amount of memory capacity. Although growth in the overall shipments of handsets has slowed, the increase in content per system will drive demand for NAND and is forecasted to potentially lead to an undersupply of 5 billion GB on the NAND market in 2017. The combination of supply shortages and an increasing demand for more NAND will lead to prices rising. The undersupply could become even more severe if the industry transition to 3D NAND does not go as smooth as anticipated. There are already signs that this may be the case due to the difficulty of maintaining the same cost advantages that 2D NAND had.

Western Digital is uniquely positioned within the market to take advantage of rising NAND prices in the short-term. With competitors Samsung, Intel, Micron, and SK Hynix all focused on producing new 3D NAND chips, there has been a gap in 2D NAND supply that Western Digital is going to be able to fill and benefit from the rising prices. All of WDC’s competitors are developing 32, 48, and 64-layer 3D NAND, with 32 and 48-layer chips already being available on the market. SanDisk (now Western Digital) has a joint-venture with Toshiba to produce 3D-NAND as well, but are only producing 64-layer chips and have halted the production of 32 and 48-layer 3D NAND in order to continue the production of planar NAND. 32 and 48-layer 3D NAND chips are being manufactured at a higher cost than planar NAND and cost parity in 3D NAND is not expected to happen until 64-layer chips are produced. Western Digital and Toshiba are the first to successfully create 64-layer 3D NAND with their BiCS3 chip. 64-layer chips aren’t expected to ramp up in production until 2h 2017, thus creating a market opportunity for WDC to continue selling their cost-effective 2D NAND while competitors are short on supply and producing more costly 3D NAND. This gives WDC an advantage over the next 12 months as NAND prices will rise while WDC is able to maintain the same cost efficiency while competitors will see their costs rise. SanDisk has historically had a cost advantage in its 2D NAND production, which should continue as it transitions to 3D NAND as the company has shown that it has the discipline to only produce the most cost-effective chips.

Fall 2016


FINANCIALS

Revenue Western Digital was organized into two operating segments that have been aggregated into one reportable operating segment, hard drives. Since FY 2014, Western Digital has experienced a YoY negative growth rate. Revenue in FY 2016 experienced a -10.8% YoY growth at $12.9 billion compared to FY 2015 recorded revenue of $14.6 billion. The decline in revenue can be attributed to the decrease of PC shipments that has experienced a negative growth rate since early FY 2012. PCs are not being adopted in households and the market has been facing continuous challenges from longer-PC life cycles and competition from mobile phones, tablets, etc. The company suffered a -19% drop in PC and Non-PC shipments due to lower HDD unit shipments. The displacement of HDDs by SSDs was a main driver behind WDC’s falling revenue since HDDs represent the company’s core business. Western Digital generates 79% of its revenue internationally, which exposes it to currency translation headwinds and helped contribute to the company’s -3.7% revenue decline in FY 2015. Western Digital is aggressively entering the flash memory space with its acquisition of SanDisk. Entering the SSD market provides a growth driver going forward as the TAM of the SSD market is projected to grow at 14% CAGR in Client Devices and a 15% CAGR in Data Center Devices through FY 2020. Western Digital has gained a competitive advantage by becoming the first company to successfully produce 64-layer 3D NAND. This technology will enable capacities up to half a terabit on one chip and volume shipments for the market are expected to occur in the first half of FY 2017. The NAND market is expected to grow by 4% in FY 2016 and 11% in FY 2017. Western Digital raised guidance at a recent technology conference and now anticipates $4.45-4.55 billion in revenue in Q1 2017 and $17 billion for FY 2017. Many companies, such as Hewlett-Packard (HPQ) are recognizing that memory suppliers will fall short in the future and are moving to incremental purchases and increase its memory inventory to protect itself from future supply shortages. This is creating a short-term tailwind for Western Digital since SanDisk supplies all flash memory products to Hewlett-Packard. We believe the better product mix and the tight NAND supply environment will drive revenue growth in the future while being able to improve costs as WDC transitions its business. In FY 2017 revenue is projected to grow 34.9%, mainly due to SanDisk’s sales becoming accretive, and then grow at a 4.84% CAGR from FY 2018 - FY 2021.

Margins

Western Digital’s margins have been stable with the exception of FY 2012 - FY 2013 and FY 2015 - FY 2016 as a result of the company’s acquisitions of Hitachi and SanDisk. Operating Margin in FY 2012 - FY 2013 declined by 650 bps and Net Income margin declined by 780 bps. This was due to a run up in the company’s operating expenses caused by the integration of Hitachi. Margins declined in FY 2016 due to the increase in interest payments resulting from financing the SanDisk acquisition, along with a decline HDD sales due to the unfavorable PC environment. In 2h 2015 PC sales reached an all time low, declining by -10.4%. Decline in PC shipments for the first half of FY 2016 continued to hurt margins because it led to shrinking demand for HDDs, causing prices to fall. Shrinking demand and an oversupply in the HDD market caused capacity utilization levels to fall to 68% in CY 2015. The decrease in efficiency negatively affected margins since the utilization rate has proven to be correlated to gross margin. In order to drive margin expansion, WDC and STX have both proactively managed their HDD production to reduce the oversupply and limit the decline of ASPs. In CY 2017, the utilization rate should bounce back to over 80%. The increase in efficiency will be the main driving force behind the company’s margin expansion within its HDD business as the company’s utilization rate has been correlated with the gross margin of the HDD business. The undersupply in the NAND market and increase in demand for NAND content will drive price increases in the short-term and allow for margin expansion within SSDs as well. Western Digital is well positioned to take advantage of rising NAND prices in the short-term. We forecast gross margin expanding 240 bps to 37.9% by 2019 due to these initiatives.

Fall 2016


Earnings

Western Digital has been able to beat EPS estimates in 9 of its last 12 quarters. The company delivered a solid earnings beat in its most recent quarter by posting EPS of $0.79, 11.3% above consensus estimates. FY 2016 EPS declined by 39.5% YoY to $4.17, which is a result of a drop in net income due to falling revenues and a jump in the interest expense caused by the financing of the SanDisk acquisition. Net income has decreased by 38.24% YoY and LT Debt has increased 564.9% YoY due to the acquisition. The company’s largest miss was in Q3 FY 2016 when the company missed expectations by -5.50%. WDC stated in its earnings call that they underestimated the weakness of the PC market. The company saw steeper than expected price declines in the enterprise market as well. The stock traded down after the earnings release due to the declining PC market for HDDs and also feared that the increase in debt would cause higher interest payments and negatively affect EPS. The company has since refinanced some of that debt, alleviating some investors’ fears. Management raised EPS guidance and is now expected to be in the range of $1.00-$1.05 compared with earlier guidance of $0.85-$0.90. EPS is projected to grow 6.7% YoY to $4.45 in FY 2017 and then grow at a CAGR of 34.75% from FY 2018 - FY 2021. Operational efficiencies and synergies from the Hitachi and SanDisk acquisitions will help drive earnings beats in the near-term, while the continued increase in demand for memory capacity will drive long-term earnings growth.

Cash Flows/Capital Expenditures

Western Digital’s cash flow from operations totaled $1.98 billion for FY 2016, representing a decrease of 11.55% compared to the previous year. This decrease is due to the significant decrease in net income that was generated by lower sales as well as an increase in the interest expense due to the pay down of debt. In 2017, cash flow from operations is expected to grow by 28.49% to $2.55 billion. Management stated during the most recent earnings call that they expect capital expenditures to be in the range of 6% - 8% of total revenue going forward. The company guided that 5% - 7% of HDD revenue will go towards capital expenditures and 8% - 10% for the SanDisk SSD business. Given the huge investment assumptions to integrate SanDisk, there are modest cash flow assumptions in the short-term. However, we expect the market share of the company to grow and have a positive impact on free cash flow going forward. In FY 2017 we forecast free cash flow falling 2.7% in FY 2017 to $1.36 billion but then jumping 53.1% to $2.14 billion in FY 2018, as they will be more positively affected by the SanDisk acquisition.

Debt

Western Digital significantly increased its debt over the past year. Total liabilities increased by 265% to reach $21.7 billion at the end of FY 2016. The high increase of debt is mainly due to the acquisition of SanDisk ($19 billion), which was financed with a combination of cash, common stocks, and debt. The company’s debt to equity ratio has therefore been highly amplified rising from 0.65 in FY 2015 to 1.95 in FY 2016. However, WDC has announced that they are refinancing some of their debt and that there will be a 175 bps reduction in the interest rate for the $3.0 billion secured term B loan that was originally issued for the SanDisk acquisition at a 5.50% rate. We estimate the savings due to the refinancing of those bonds at more than a $100 million per year. Therefore, WDC is expecting to decrease its debt to equity ratio under 1.50 before the end of FY 2017. Western Digital is well positioned to pay down its debt as it has an interest coverage ratio of 4.86x. We do not believe that taking on additional debt will hamper the company’s financial performance as much as The Street initially expected, especially after the refinancing that will reduce the interest rate. The suspension of the company’s share repurchase program will allow the company to spend more free cash flow to pay down its debt, reducing their leverage.

Shareholder Returns Western Digital has shown that the company is committed to returning value to its shareholders. In 2015, the board of director authorized a massive stock repurchase program of $2.0 billion, representing nearly 8.5% of the total outstanding shares of the company. However, the company has since temporarily suspended this in order to payback debt and reduce its leverage. In FY 2015 Western Digital increased its dividend 25% and is now $2.00 per share for the fiscal year. The first dividend payment for FY 2017 will be paid on October 17th. WDC currently has a dividend yield of 3.64%, one of the highest ones in the tech sector. Although the company has suspended its share repurchase program in order to pay back debt from the SanDisk acquisition, but will continue to return value through its dividend.

Fall 2016


VALUATION

Peer Group Analysis

Seagate is an American data storage company headquartered in Cupertino, California. Seagate’s revenue breakdown by geography in FY2016 was as follows: Asia-Pacific (54%), Americas (29%), and EMEA (17%). Like Western Digital, Seagate operates in one reportable segment, electronic storage solutions. In FY 2016, Seagate shipped 169 million units that generated $11.2 billion in revenue, down 23% from revenue of $13.7 billion on 212 million units shipped in FY2015. Seagate is WDC’s largest competitor as they accounted for 39% of market share for HDD shipments in FY 2016. The two companies combine to dominate the HDD market.

Toshiba is a Japanese multinational conglomerate technology corporation headquartered in Tokyo, Japan. Toshiba’s revenue breakdown by geography in FY 2016 was as follows: Japan (40.6%), Asia (27.4%), North America (17.8%), Europe (9.8%), and Other (4.4%). Toshiba operates within three main business segments including Electronic Devices that accounted for 27.6% of total revenue in FY 2016. Toshiba is WDC’s second largest competitor as they accounted for 17% of market share for HDD shipments as well as 6% of market share for SSD shipments in FY 2016. Toshiba is also engaged in a partnership with SanDisk (now Western Digital) for the production of NAND and the companies are currently working on producing 64-layer 3D NAND, which they hope to ramp up production on in 1h 2017.

Samsung is a South Korean multinational conglomerate technology corporation headquartered in Seoul, South Korea. Samsung became a major competitor for Western Digital in the market for SSD after its acquisition of SanDisk. Samsung is the leading company in SSD market share, accounting for 39% of shipments in FY2015. It is also currently the leading company in 3D NAND production as the market transitions from 2D NAND to 3D.

Intel Corporation is an American multinational technology company headquartered in Santa Clara, California. It is one of the world’s largest and highest valued semiconductor chip makers. It operates in two main business segments: Client Computing (58.2% of revenue) and Data Center (28.9% of revenue). Intel is third in market share of SSD at 17% and could continue to gain market share as the market for SSD continues to grow.

Micron is an American global semiconductor corporation headquartered in Boise, Idaho. Micron operates in four main business segments: Compute and Networking (41.5% of revenue), Mobile (22.8% of revenue), Storage (22.8% of revenue), and Embedded (12.3% of revenue). Micron only accounts for 7% of SSD market share. However, as the SSD market continues to expand, companies are fighting for market share and Micron could become a larger player in SSD moving forward.

Fall 2016


Undervaluation

Western Digital is currently trading at a forward P/E multiple of 11.67x, representing a 4.5% discount to its 3-year historical forward P/E spread against its main competitor Seagate. Seagate has also seen its multiple expand to 29.0x due to lower earnings Q3 earnings. Western Digital is currently trading at a 13.2x P/E multiple and has historically traded in line with or at a slight premium to Seagate. Western Digital is also trading at one of the lower P/E multiples in the Tech sector with the Tech industry’s average P/E being 21.6x. Both Western Digital and Seagate began selling off in early 2015 after 1) PC shipments began to drastically decline and 2) SSD adoption started to accelerate, displacing HDDs (WDC and STX’s core product). After Western Digital announced that it was acquiring SanDisk in October 2015, shares sold off an additional 50% over the next three months. Seagate shares followed due to the continued bearish sentiment from The Street regarding the secular decline of HDDs. The SanDisk acquisition gives Western Digital a proven SSD business (WDC now has 22% market share in SSDs) and gives the company a presence in a growth area and serves as a hedge against the displacement of their core product. Seagate has struggled to gain traction in the SSD market and is not as well positioned as WDC is after acquiring the second biggest company in terms of SSD market share. This increases the growth prospects for WDC relative to STX as STX is going to be hit harder by the secular decline of the HDD market, especially if SSD adoption accelerates faster than anticipated. Western Digital is now hedged against this, which will allow the company to return to trading in-line to its historical average against Seagate, and should warrant a premium going forward. WDC also became undervalued relative to STX after the company’s most recent earnings call where STX showed a gain in market share in the HDD market at the expense of WDC. Western Digital has now launched its 10 TB helium HDD that is aimed at targeting the enterprise data center market, the highest growing area of the HDD market and where STX saw market share gains. Management commentary has been very positive and said that it has already gained significant traction as the company is now beginning to ramp up production. The product will be able to regain market share as Seagate is still in the process of mass-producing its 8 TB HDD. The increase in capacity in WDC’s product as well as the company’s ability to leverage its position on the market will help reignite sales in HDD going forward, thus providing another reason why WDC is irrationally trading at a discount relative to its historical average vs. Seagate.

WACC Calculations

The WACC of 8.04% was calculated by first taking the equity and debt weights for the last period. The equity value was calculated at $13.3 billion with a total capital weighting of 61.6%. Net debt value was calculated to be $8.3 billion, implying total capital weight of 38.4%. Cost of equity was calculated to be 11.5% by using the market risk premium of 6.62%, a risk free rate of 1.70%, and a beta of 1.48. After tax cost of debt was found to be 2.5% by tax affecting the pretax cost of debt of 3.0% with an effective tax rate of 16.5%. By adding together, the product of the debt weighting and the cost of debt, and the product of the equity weighting and the cost of equity, we derived a WACC of 8.04%.

Fall 2016


MANAGEMENT

Executives Western Digital’s current CEO Stephen Milligan started off with Western Digital in 2002 as the companies Vice President of Finance. His background is in Accounting. He remained with the company until leaving to join Hitachi GST in 2007 as the companies President and CEO and was credited with turning the company around, which led to it being acquired by Western Digital, prompting his return to the company. His base salary is $1.1 million and as CEO is required to own shares with a market value of 5 times his annual salary in order to link executive compensation to performance. Subsidiary Presidents are required to own 3 times their annual salary in stock and Executive Vice Presidents are required to own 2 times their annual salary in stock.

Board of Directors

Western Digital has a nine-person board that serves one-year terms that come up for reelection at the company’s Annual Meeting each year. The Board of Directors is intending on reducing the board from nine to eight members at the company’s next Annual Meeting. In FY 2015, members of The Board received compensation between $293 thousand and $482 thousand. Members are paid with stock options and cash, with each director receiving around $224,000 in stock options and the remainder of their salary in cash. The current Chairman is Matt Massengill who took over in November 2015. Massengill served as CEO of Western Digital from January 2000 to November 2001 and was President of the company from October 2005 to March 2007. He is also currently serving as the Chairman of The Board for GT Advanced Technologies as well. The Board has another former Western Digital President/CEO, Stephen Milligan, who has served on the board since January 2013. Milligan is currently still serving as the company’s CEO as well. No other board members were Western Digital employees. Board member ages vary from 52 to 59 with tenures varying from 4 months to 16 years.

Committees

• Executive • Audit • Compensation • Governance

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APPENDIX

Exhibit I: Financial Model Forecasts

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Exhibit II: Three-year price graph

Exhibit III: Five-Year LTM P/E vs. Seagate

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Exhibit IV: Three-Year LTM P/E vs. Tech Sector

Exhibit V: Three-Year Historical LTM P/E

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Exhibit VI: Ten-Year Historical Forward EV/EBITDA

Exhibit VII: Three-Year Forward P/E Spread vs. Seagate

Exhibit VIII: Total Addressable Market

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Exhibit IX: Western Digital and Seagate Utilization

Exhibit X: Fair Value Calculations

DISCLAIMER

This report is prepared strictly for educational purposes and should not be used as an actual investment guide. The forward-looking statements contained within are simply the author’s opinions. The writer does not own any Western Digital Corp. (WDC) stock.

TUIA STATEMENT

Established in honor of Professor William C. Dunkelberg, former Dean of the Fox School of Business, for his tireless dedication to educating students in “real-world” principles of economics and business, the William C. Dunkelberg (WCD) Owl Fund will ensure that future generations of students have exposure to a challenging, practical learning experience. Managed by Fox School of Business graduate and undergraduate students with oversight from its Board of Directors, the WCD Owl Fund’s goals are threefold:

• Provide students with hands-on investment management experience • Enable students to work in a team-based setting in consultation with investment professionals. • Connect student participants with nationally recognized money managers and financial institutions

Earnings from the fund will be reinvested net of fund expenses, which are primarily trading and auditing costs and partial scholarships for student participants.

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