Owing to its broad exposure to favorable growth trends in data creation, accumulation, and storage, data storage giant Western Digital Corp (NASDAQ:WDC) has been one of Wall Street’s favorites over the past two years.
During that stretch, WDC stock has run from $40 to $80 as revenue growth has surged, margins have improved, and earnings have soared.
But in mid-March, WDC was a $110 stock. That means that despite doubling over the past two years, Western Digital Corp stock is actually nearly 30% off recent highs.
Why the recent struggles? Prices in the company’s core NAND market are dropping due to capacity build-out, a fear that has always been present in the notoriously cyclical semiconductor market. This price normalization will lead to gross margin erosion, something that management hinted at in last quarter’s conference call.
Consequently, with price normalization and margin erosion on the horizon, investors flocked toward the exits after last quarter’s earnings report.
But that near-term bear thesis lacks scope. In the bigger picture, demand catalysts remain strong thanks to a surge in big data. So long as this demand remains strong, the pricing environment in WDC’s core markets will remain strong, and margins will remain healthy. Thus, while earnings may compress over the next several years, they will still be big.
More importantly, they will be more than big enough to warrant the current valuation. That is why I’m a buyer of WDC stock here and now after this recent selloff.
Here’s a deeper look.
Secular Tailwinds Support Growth Narrative
For all intents and purposes, WDC is a big-data growth story. And big data is currently and will continue to be one of the biggest growth drivers in the market.
We are increasingly moving toward an era where data is the new currency. This is very clear when it comes to social media, where companies like Facebook, Inc. (NASDAQ:FB) and Twitter Inc (NYSE:TWTR) offer highly valuable services for free in exchange for data.
But they aren’t alone. Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG) offers Google Search for free. Microsoft Corporation (NASDAQ:MSFT) offers Bing search for free. YouTube is free. Instagram is free. Pretty much every online news service is free.
How can all these internet giants offer such hugely valuable services for free? Because they can monetize each platform through leveraging data to create targeted advertising solutions.
There are examples of this across the internet, and they all converge to support the thesis that data is the new currency. As such, these big internet giants will continue to generate and store data at a robust rate over the next several years.
That creates an exceptionally favorable demand backdrop for WDC. So favorable that regardless of capacity build-out, it will be tough for supply to outstrip demand to a point where product prices get crushed.
In other words, WDC product prices will inevitably fall as supply builds. But such declines will be moderate due to the burgeoning demand backdrop.
Western Digital Corp Stock Is Undervalued
Western Digital Corp stock doesn’t seem priced appropriately considering this still red-hot demand.
In the company’s long-term model, revenue growth is supposed to range between 4% and 8%, while gross margins are supposed to range between 33% and 38%. Obviously, over the past year, WDC has operated at levels above those ranges due to huge demand catalysts converging with still limited supply.
But supply will eventually catch up, and WDC’s operating metrics will fall back into those long-term ranges.
Even in a worst-case scenario, though, WDC should still be able to grow revenues around 4% per year (versus 6% per year over the past five years) and maintain gross margins around 33%.
Assuming a consistent opex rate of 17%, that equates to roughly 16% operating margins. That combination of 4% revenue growth and 16% operating margins makes me believe that WDC can do about $9 in earnings per share in five years.
A market-average 16-times forward multiple on those $9 earnings implies a four-year forward price target of $144. Discounted back by 10% per year, that equates to a present value of just under $100.
Bottom Line on WDC Stock
At $110, WDC stock got ahead of itself.
But at around $82, WDC stock is materially undervalued considering still-robust demand in big-data markets.
As of this writing, Luke Lango was long WDC, FB, and GOOG.