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Morningstar | Western Digital Reports Revenue Miss and Poor Outlook for Fiscal 2019; Lowering FVE to $67. See Updated Analyst Note from 25 Oct 2018

Western Digital’s fiscal first-quarter results were far below the company’s previous guidance for revenue while earnings came in at the low-range of guidance. More importantly, however, was management’s outlook for the full-year performance that was far below our expectations, particularly with regards to the enterprise storage market. While demand for hard-disk drives, or HDDs, over the past few quarters had exceeded our expectations, we were surprised by management's expectation of an abrupt pause in demand for high-capacity storage products. Equally impactful, if slightly less surprising, was the expectation for price declines for NAND to increase throughout the year. In light of the news, we are cutting our near-term forecasts for the firm and, in turn, we are lowering our fair value estimate to $67 per share from $75. With competitor Seagate announcing next week, we will be watching closely to see if further details on flash weakness require other changes to our near-term forecast.

First-quarter revenue decreased by 3% year over year to $5.0 billion, a 2% sequential decline. Sales from client devices products declined by 1% year over year to $2.65 billion as declines in compute storage largely offset gains in embedded mobile products and surveillance HDDs. Sales into data centers grew by 6% to $1.4 billion versus the prior-year period, primarily due to demand for capacity storage. While we believe the firm’s portfolio high-capacity enterprise products should help offset declines in HDD products in client devices, management expects an immediate slowdown in cloud infrastructure spending to curb near-term growth from these products. Finally, sales for client solutions declined by 18% year over year, falling to $0.9 billion in quarterly sales and reflecting the weakness in flash pricing. Adjusted gross margins in the quarter declined 300 basis points sequentially to 38% due to weakness in flash pricing and we expect this dynamic to carry into the next quarter.

Revenue is expected to decline significantly to $4.3 billion at the midpoint of guidance, which would represent a year-over-year decline of more than 19%. Management is currently forecasting adjusted gross margins declining another 500 basis points to 33% in the upcoming quarter as they work to reduce excess capacity. In response to the ongoing pricing declines, management announced plans to reduce wafer production and further delay investments in capital equipment needed to produce NAND, after signaling in the previous quarter plans to slow investment. While we expect investments to decline from our previous estimate of nearly 7% of sales, the nature of 3D NAND manufacturing, particularly at 64 and 96-layer levels, is extremely capital intensive so we believe there is a limit to the amount of investment reduction the firm can achieve.