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Morningstar | Western’s Mixed Quarter Combines with Mixed Outlook; Lowering FVE to $63; Shares Undervalued. See Updated Analyst Note from 29 Apr 2019

Western Digital’s fiscal third-quarter results were mixed as revenue was within the company’s previous guidance, but adjusted earnings were lower than we expected due to poor utilization and an inventory charge. We have been awaiting confirmation that the storage market would recover in the back half of 2019 as presaged by management a few quarters ago and the firm reiterated this view, with expectations for improvements from both flash and hard disk drives, or HDDs. However, while our revenue expectations for the upcoming quarter and the next year have undergone just minor adjustments, we are lowering our fair value estimate to $63 from $67 reflecting our expectation of slower margin recovery, while we also adjust our cost of capital to reflect the company’s financial position. While Western has a very high uncertainty and no-moat rating, we believe there remains a potential margin of safety at current prices.

Total revenue in the third quarter was $3.7 billion which represented a sequential decline of 13%. Flash sales continued to be negatively impacted by ongoing price decreases, declining 32% year over year while HDD sales were flat sequentially and down 22% year over year. Sales of the firm’s high capacity drive products were better than management anticipated leading to the data center and enterprise segment growing by nearly 16% sequentially. Western’s enterprise NVMe SSDs also contributed to the solid performance in the segment. However, both client devices (which includes mobile, desktop, and gaming storage) and client solutions (branded HDD, flash, and renewables), experienced large declines over the same period, 27% and 15%, respectively. Client devices declined amid a weak smartphone environment while revenue from notebook and desktop products was lower due to the flash pricing environment.

Gross margins were significantly lower than we anticipated, plummeting nearly 900 basis points sequentially to 15.8% due to a combination of an underutilization charge of $148 million from Western’s portion of the joint venture with Toshiba and an additional $110 million inventory write-down charge. After adjusting for these and other factors, gross margin was 25.3% during the quarter, equivalent to nearly 300 basis points lower than management’s prior guidance. Adjusted earnings per share were $0.17, below the previously guided range of $0.40 to $0.60.

Guidance for the upcoming quarter assumes sales between $3.6 and $3.8 billion which implies nearly 1% sequential growth at the midpoint of guidance due to the slowly improving storage environment. Gross margins are expected to remain weak sequentially, at 24% to 25% due to the ongoing utilization rate. Management was confident however regarding the current cost-saving initiatives which it expects to complete by the end of calendar 2019 and we believe it will help the firm get back to low teens operating margin in fiscal 2021. Finally, the firm announced an amendment to an existing debt covenant, adjusting the definition of EBITDA used in the agreement to give the firm more headroom to operate and more accurately reflect the operations between Western and Toshiba’s joint venture.