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The Selloff of Western Digital Stock May Not Be Over

Vince Martin

On a fundamental basis, Western Digital (NASDAQ: WDC ) looks like a screaming buy after a huge pullback. Western Digital stock has dropped 48% from its March highs. As a result, WDC stock trades for less than four times its fiscal 2018 earnings per share, and less than five times its free cash flow.

Fundamentally, there doesn’t seem to be much reason for the huge fall. Western Digital has beaten consensus estimates on the top and bottom lines for nine straight quarters. In its fourth quarter, its  non-GAAP EPS rose 23% year-over-year and its revenue increased 5.7%. That capped off a year during which its adjusted EPS increased a whopping 60%.

The company’s growth is admittedly slowing, but its business still looks stable. Western Digital’s Q1 guidance implies that its revenue will be flat to down 2% year-over-year (though WDC has a history of guiding conservatively). There’s nothing in the numbers that justifies one of the lowest valuations in the entire market.

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And from here, the selloff does seem potentially overdone. But “potentially” is not the same thing as “certainly.” There are reasons why Western Digital stock is being sold off and why Western Digital stock may not be quite the steal it appears to be.

We’ve Been Here Before

Chip, memory, and storage stocks are weak across the board at the moment. Western Digital stock is off 48% from its highs. Seagate Technology (NASDAQ: STX ) is down about 22%, and Micron Technology (NASDAQ: MU ) has tumbled  33%. Even normally staid Intel (NASDAQ: INTC ) has lost 22% of its value. Chip equipment makers Applied Materials (NASDAQ: AMAT ) and Lam Research (NASDAQ: LRCX ) each are down about one-third from their highs.

What we’re seeing is a return of the cyclicality that has long dogged chip, storage, and memory plays. That cyclicality is why multiples in the space tend to stay low. Profits and revenues for storage plays like WDC and Seagate don’t constantly march higher over time; they can swing wildly. And when the cycle turns, it turns quickly and often violently.

Indeed, WDC stock itself has seen such swings in the past. From late 2012 to early 2016, Western Digital stock moved from $32 to $110 and then retreated back below $40. These kinds of moves are par for the course.

Some investors seemed to have at least somewhat forgotten that fact. The increasing demand driven by the proliferation of Internet of Things, cloud services, automotive applications, and smartphones led some investors to believe (and some analysts to argue ) that the space had changed from a cyclical industry to one with secular growth. It’s starting to look like that’s not the case, and the market is reacting accordingly.


NAND Pricing and Western Digital Stock

The headline driver of the recent decline in WDC stock is fear about NAND pricing. Essentially, the bearish argument here is that the company’s earnings have nearly peaked. And analysts have piled on to that argument, with Cowen, RBC, and EvercoreISI all downgrading Western Digital stock in the last month.

The nature and depth of coming NAND pricing declines can be debated. But the broad point needs to be remembered: WDC’s price-earnings multiple of four may seem ridiculous in the context of a market trading at closer to 20 times earnings. WDC’s earnings aren’t sustainable, however. Even WDC bulls need to understand that point. As I’ve argued relative to Micron stock – on which I remain bullish – WDC stock should look cheap on a fundamental basis at this point. The question is how cheap Western Digital stock should be.

Is Western Digital Stock the Best Play?

As I previously noted, WDC stock isn’t the only name suffering a big pullback lately, even though its decline has been larger on a percentage basis. MU’s multiples are in the same ballpark: it trades at under four times the forward consensus EPS estimate. Equipment manufacturers LRCX and AMAT have moved to single-digit forward price-earnings ratios as well.

Honestly, I’d rather own MU or either of the equipment manufacturers. Micron provides NAND and DRAM, and the latter is a better business than Western Digital’s declining hard drive segment. LRCX and AMAT have more diversified offerings and more ability to drive growth from IoT and automotive demand. If the thesis for WDC stock is buying an out-of-favor cyclical at a “cheap” multiple, I see better options for doing that.

The Falling Knife Problem

Meanwhile, there’s no reason why the decline of WDC stock necessarily has to end at $55. More analysts can turn bearish on Western Digital stock. Analysts are lowering their fiscal 2019 and fiscal 2020 estimates for the company, and the estimates could drop further. And the chart shows no indication that WDC stock has bottomed.

Indeed, just a few weeks ago, Western Digital stock stabilized in the low 60s, and it looked like the worst was over. The stock, however, subsequently took another leg down. The 3.6% dividend yield of WDC stock may bring in some buyers, but that yield can easily get to 4% or even 5% if fears about a downturn in the cycle intensify.

On the Sidelines

I don’t mean that Western Digital is a bad company or that Western Digital stock should be shorted. But investors need to understand the full story here, and realize that there is some logic behind the selloff and the low multiples being assigned to Western Digital stock.

There is a case for buying the dip here, and at a certain point even the worst fears surrounding NAND will be priced into WDC stock. Western Digital has a shiny new $5 billion share repurchase program, and it already bought $404 million of its shares between July 25 and August 22. Still, there are real risks here, and real reasons why the stock has fallen so hard. And I wouldn’t assume that Western Digital stock will bounce back quickly  or that the selling pressure on it will end in the near future.

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

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