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Morningstar | WDC Updated Forecasts and Estimates from 27 Jul 2018

Western Digital reported fiscal fourth-quarter results that modestly exceeded our expectations, while management provided first-quarter fiscal 2019 guidance on par with our expectations. Demand for hard-disk drives, or HDDs, and flash storage over the past few quarters has exceeded our expectations, but as we previously predicted, the heady flash environment is softening, which we expect will continue beyond 2018. We are encouraged that management sees similar normalization in the back half of 2018, and so we endorse Western Digital’s decision to potentially slow investment in capacity expansion, with the firm opting instead to return capital to investors via a $5 billion share-buyback program. We maintain our fair value estimate of $84 per share for this no-moat firm. Western Digital has made hay while the sun was shining, but leaner times appear to be ahead, and although the shares are trading at a slight discount to our fair value estimate, we encourage prospective investors to wait for a wider margin of safety.

Revenue in the fourth quarter was $5.1 billion, a slight sequential increase and up 6% year over year. Sales from client devices products grew 2% year over year to $2.5 billion, with mobile growth helping to offset poor performance in compute. Cloud infrastructure upgrades have kept demand for Western Digital’s high-capacity drives strong, with data center revenue growing 14% year over year to $1.6 billion in the quarter. We believe the firm’s growing portfolio high-capacity enterprise products should help it continue to benefit from data growth and offset declines in HDD technology. Adjusted gross margins in the quarter declined 30 basis points year over year to 41%, owing to the aforementioned pricing environment in flash. Management’s outlook for first-quarter fiscal 2019 included roughly flat year-over-year revenue of $5.15 billion and a 20- to 30-basis-point sequential decline in adjusted gross margin.

Indicative of the long-term trend away from HDD, management announced plans to close an HDD manufacturing plant in Kuala Lumpur, reducing the firm to three hard drive factories globally. The move will result in $160 million in restructuring costs, with some of that already realized in fiscal 2018 and the remainder to occur over the next two years. In the short term, we expect this will have a slight impact on margins, but in the longer term, rightsizing capacity for this declining technology should help the firm better manage margin performance.