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Morningstar | Western Reports In line Quarter but Turbulence Lies Ahead; Maintaining $67 FVE

Western Digital announced fiscal second-quarter results which were roughly in line with company’s previous guidance and our estimates. The flash and hard disk drive, or HDD, environments were difficult, as expected, with steep price declines in the former and drops in bit output for the latter. Management’s guidance and commentary regarding the next two quarters suggested that storage demand weakness would continue but reiterated the expectation of a strong recovery starting in the first half of fiscal 2020. We continue to project flat revenue on average over our five-year explicit forecast as HDD declines and flash gains largely offset each other, though we do expect incremental improvements in profitability. We are maintaining our fair value estimate of $67. While shares traded up sharply on the news, we still see significant upside at current valuations, though we acknowledge that the no-moat storage company is in for a rocky near term.

Second-quarter sales decreased by 16% sequentially and 21% year over year to $4.2 billion. By technology, sales from flash decreased by 18% year over year due to the aforementioned pricing environment. HDD sales declined by 24%, predominantly as a result of the slowdown in cloud investment, with total HDD exabytes output decreasing by 12% over the same period. As a result, sales from the data center segment fell to $1.07 billion, down 25% versus a year-ago period. Sales from client devices products declined by 16% year over year to $2.2 billion amid weak mobile demand and NAND pricing pressure. Adjusted gross margins in the quarter deteriorated by more than 600 basis points sequentially to 31.3%, well below management’s prior estimate of 33%. Flash pricing weakness was the major cause with gross margins plummeting from 44% in the first quarter to 35%. Adjusted earnings per share came in at the low-end of previous guidance at $1.45 per share.

Management expects revenue to decline sequentially by more 12.5% to $3.7 billion at the midpoint of guidance, with the environment for flash and high-capacity HDDs remaining hostile. While management is working quickly to reduce costs amid the ongoing revenue headwinds, even expediting the planned closure of the firm’s HDD manufacturing location in Kuala Lumpur, gross margins in the third quarter are expected to contract by 300 basis points to 28%. In total, the firm expects to realize $800 million in annualized cost reductions between both operating expenses and cost of goods sold with the majority of these efforts focused on efficiency improvements in the HDD markets. However, these efforts will take the next four quarters to be realized. Using the midpoint of guidance, management expects adjusted earnings to decline sequentially by 6% in the third quarter to $0.50 per share.