After falling 25% during the last six months, Western Digital (WDC) stock is soaring 15% in response to an investment by China’s Unisplendour where WDC essentially set the terms.
The amount of leverage that Western Digital possessed in working out this deal, combined with WDC’s valuation and business prospects, suggests more upside ahead.
WDC Has Its Way With Unis
The reason that Western Digital stock jumped 15% on Wednesday has nothing to do with the investment by Unis itself, but rather the terms that WDC forced upon Unis.
WDC sold Unis newly issued stock, which causes dilution and forces Unis to purchase more stock to gain the same 15% stake. Furthermore, WDC is requiring that Unis hold these shares for a term of at least five years.
In exchange, Unis obtains WDC stock ownership and gets one person on the board of directors. However, if for any reason Unis’s ownership slips below 10%, it loses that board seat, which is essentially the only extra Unis gained in this deal. So, in the event that Western Digital makes a big acquisition and uses mostly stock, Unis may be forced to buy additional stock, or lose its board seat altogether.
Finally, WDC didn’t just sell Unis 15% of its company with tough restrictions that Unis must honor, it did so at a near 35% premium to WDC’s closing price on Tuesday. Collectively, these terms prove that Unis was desperate to own WDC stock and saw something in Western Digital that the market is missing.
Why Was Unis Willing to Pay?
First and foremost, Western Digital is a maker of hard disk drives, or HDDs, storage products used in PCs, laptops, DVRs and in data centers among other things. WDC owns nearly 45% of the HDD market worldwide, and in addition to HDDs, WDC is involved in the sale of other storage products like solid state drives, more commonly known as SSDs.
Therefore, WDC’s business may sound boring, and even discouraging given the declines in PC sales over the last half-decade, but WDC’s operating outlook is improving fast. This means that Unis may have made a great long-term investment.
For example, Western Digital’s SSD business is thriving. While small (accounting for just 7.5% of total revenue), its revenue increased 115% year-over-year in WDC’s fiscal fourth quarter. Also, WDC has found ways to survive and prosper despite a less-than-stellar PC industry. Back in 2012, over 65% of WDC’s revenue came from PC-related applications. Today, just 35% come from PC-related apps.
The reason for this reversal is the rise of cloud services and the need for HDDs to store information on the cloud. Therefore, WDC loses business from PCs and laptops, but gains from the growth of cloud services.
With that said, if PC demand were to ever increase, WDC would be there to gain. Thankfully, PCs are showing some signs of life.
Citi and Wells Fargo analysts observe that DRAM spot prices have started to stabilize, suggesting a bottom for PC sales. Also, both firms identified accelerated shipment growth in Taiwan, a key manufacturer for PCs.
Longbow Research observed that HDD makers have underperformed PC shipments in 2015, thereby affecting HDD inventory in a positive way for the likes of WDC. Lastly, Pacific Crest followed these calls by recently reporting that September notebook sales have topped expectations to the tune of 5% to 10%.
What Does This Mean?
In other words, WDC’s inventory levels are low and demand in the PC industry is accelerating.
This bodes well for WDC stock, which still trades around 30% off of its 52-week high. WDC stock trades at just 10 times next year’s expected earnings, still very cheap even after its pop on Wednesday.
This suggests that while WDC appears to have gotten the better end of its deal with Unis, Unis might actually come out on top, as will investors that buy behind this news.
As of this writing, Brian Nichols did not own shares of WDC, but may initiate a long position within the next 72 hours.
