LOVETT EQUITY RESEARCH

Western Digital (WDC)

Intrinsic Value = $45 September 30, 2010
Margin of Safety Price = $29.19 Douglas L. Lovett, CFA
Current Price = $28.39 (904) 537-9682
douglas.lovett@gmail.com
Information Technology - Computer Storage & Peripherals
Market Data
52-Week Range $47.44 - $23.06
Market Cap (m) $ 6,615

Fundamental Data
Dividend Yield (%) 0.0%
Debt / Cap 7.8%
ROE 35.0%

Valuation Data
Intrinsic Value (m) $ 10,462
Current Discount 36.8%

Value (industry comp) N/A

Current Discount

Value (5-year avg. P/E) $52.59

Current Discount 46.0%

2008A 2009A 2010A 2011E 2012E 2013E 2014E 2015E

Revenue (m) 8,074 7,453 9,850 9,850 10,343 11,118 12,230 13,453
EPS $3.84 $2.08 $5.93 $3.55 $3.09 $3.14 $2.84 $2.96
Average P/E 7.3 9.0 6.0 8.0 9.2 9.0 10.0 9.6
Average Price/Book 2.5 1.6 1.4 1.2 1.0 0.9 0.8 0.7
FCF/Share $2.42 $3.28 $5.14 $1.56 $2.56 $2.53 $2.46 $2.81
ROIC 59.3% 26.7% 60.3% 29.7% 23.3% 22.6% 19.8% 20.2%

Investment Conclusion
Western Digital is a leading producer of hard drives. The industry has grown substantially over the last decade and WDC has
repositioned itself within the industry to increase its market share. Overall industry growth should persist due to ever increasing needs
for digital storage. However, the industry is plagued by periodic supply/demand imbalances and pricing pressures. Slowing PC
demand is currently putting pressure on hard drive sales and prices have slipped. WDC's stock is currently down 35% this year and
now more than fully discounts the pricing issues.

Current Issues
• Slowing PC demand has led to a decline in hard drive sales and pricing.

Why WDC is a Buy

• Demand for storage will continue to grow over the next several years.
• WDC is a leader in the faster growing 2.5" drives and has lowered its exposure to slower growing desktop computers.
• WDC has re-entered the enterprise drive market and could increase its share of this segment.
• Rock solid balance sheet provides ability to weather temporary industry headwinds.
• My intrinsic value estimate provides significant appreciation potential with reasonable estimates.
• The company began buying back stock in the last quarter after more than a year with no buybacks.

Risks
• Undifferentiated products & pricing pressure.
• Solid State Drives pose a significant long-term threat to the hard drive industry.
• Hard drive as loss leader - some of WDC's competitors operate in several businesses and could sell hard drives at a loss.
• Tablet computers will eat into sales of notebook and netbook computers.
Western Digital (WDC)
Investment Thesis
The hard drive industry posted strong growth
over the past several years. Industry-wide unit
sales increased from 227 million units in 2003 to
558 million units in 2009 (16.2% CAGR). Drivers
of this growth were exponential growth in digital
media, corporate demands for increased network
storage and back-up, growth in consumer devices
which utilize hard drives such as digital video
recorders and gaming systems, and consumer’s
desire to back-up digital content. All of these
trends seem likely to continue to produce strong
growth in storage demand in the coming years.
The industry also benefited from consolidation
over the past several years. In the early 1990s four
competitors accounted for roughly 80% of the
market. In the late 1990s, the technology boom
fueled a bout of new entrants resulting in
overcapacity and losses for all involved. After the
tech bust, these new entrants exited the business
and the industry began rationalizing. In 2009,
three companies (WDC, Seagate, and Hitachi)
controlled nearly 80% of the market and five
companies (including Toshiba and Samsung)
accounted for 99%. With a handful of rational
players, the industry now sports strong economics.
Amid this consolidation, WDC additionally
benefited from a change in focus. In 2004, the
company derived 86% of its revenue from hard
drives installed in desktop computers. The
company anticipated the shift from desktop to
laptop computers and the growth in other non-
desktop uses for hard drives and began decreasing
its focus on the desktop market. During fiscal
2010, desktop revenue was down to 36%. WDC is
now one of the leaders in supplying the faster
growing market for laptops and during fiscal 2010
passed Seagate as the largest supplier of hard
drives by units.
Departing from its prior strategy, WDC acquired
two companies since 2003 to vertically integrate its
operations. WDC acquired Read-Rite in 2003 and
Komag in 2007. These companies produce two
of the primary components of hard drives – disk
platters and write heads. Komag’s acquisition in
2007 contributed a significant amount of revenue,
Page 2
net profit, and total assets to WDC’s financial
statements and boosted profitability.
WDC has invested substantially in R&D and has
generally been very successful in developing new
products to meet market demand. In 2009, the
company acquired Silicon Systems to compete in
the market for solid state drives (SSDs). These
devices could pose a long-term threat to the hard
drive market but their high price should limit
adoption for the next 3-5 years. WDC has also re-
entered the highly profitable enterprise market as
2.5” drives become more common in enterprise
applications.
Although the hard drive industry has come a long
way in the past decade, it is still subject to periodic
bouts of supply/demand imbalances and pricing
pressures. During the quarter ended June 30,
2010, demand slowed from the strong recovery
over the previous year. European customers
slowed their tech purchases, electronics
manufacturers began destocking their hard drive
inventories, and the hard drive manufacturers did
not adjust their output quickly enough. As a
result, WDC’s average sales price declined from
$51 per unit in the prior quarter to $47.
As a result of this weakness, WDC’s share price
declined by over 45% this year (currently about
35%). In my opinion, the company likely faces a
couple of weak quarters as PC demand continues
to slow and hard drive producers adjust their
production levels. However, the long term strong
growth trends in demand for storage capacity
remains intact and the shares are priced to provide
a 60% return based on my intrinsic value estimate.
Valuation
I estimate WDC’s shares are worth about $45 per
share. My DCF model forecasts no revenue
growth in fiscal 2011 followed by growth of 5%-
10% in the next four years. I also forecast
significant margin pressure with COGS increasing
to 75-77% over the forecast horizon. High
depreciation expense associated with heavy capital
expenditures helps to drive operating margins to
6.0% by 2015 from 2010’s record 15.5%.
I forecast the company to continue to spend
roughly 7% of sales on capital expenditures with
Western Digital (WDC)
the exception of 2011 when an additional $200
million will be spent to convert one facility. These
capital expenditures will increase the invested
capital and, combined with slower profit growth,
result in a 2015 ROIC estimate of 20.2%.
I use a cost of equity of 10.5%, and when
combined with the minimal debt of the company,
a WACC of 10.47% to discount the company’s
cash flows.
Bear Case
I believe there are two possible bear scenarios –
solid state drives and the current weakness in the
PC market.
Solid state drives could pose a major threat to
hard drives given their lack of moving parts and
faster access speeds. However, they are currently
significantly more expensive than traditional hard
drives. SSDs should not become a threat for at
least 3-5 years and WDC recently acquired an SSD
manufacturer to address this market.
Should the current weakness in PCs continue for a
prolonged period and result in a long stretch of
lower hard drive demand and pricing pressure,
today’s share price for WDC may be justified and
perhaps even too high.
Growth Prospects
WDC’s growth rate should decline over the next
few years. Since 2003, WDC’s revenue has grown
at an average of 20% per year as the hard drive
market has grown and the company has gained
market share. I do not expect this market share
growth to continue and forecast that the company
will grow in line with the industry. IDC forecasts
a CAGR of 12.4% in PC shipments from 2009-
2014. Historically, hard drive shipments have
exceeded those of PCs – in 2009, hard drive sales
outpaced PCs by approximately 86%. However,
in my valuation model, I am assuming relatively
modest growth capping out at 10% in 2014 and
2015 as I believe economic headwinds will
pressure growth.
Profitability
WDC has exhibited strong profitability in the past
five years. It has posted average operating
Page 3
margins of 10.2%, average net margins of 10.1%,
and average return on invested capital of 62.4%. I
forecast all of these measures to decline in the
next five years as the company ceases to gain
market share and overall industry growth declines
from recent high rates.
Financial Condition
WDC’s balance sheet is strong. The company has
$400 million in debt which is offset by $2.7 billion
in cash. It recently cancelled its $250 revolving
credit line. I expect the firm can finance its
growth from free cash flow and cash on hand. I
do not expect any new debt to appear on the
balance sheet.
Risks
In my view, the company faces four primary risks:
Undifferentiated products & pricing pressure
All hard drive makers have to deal with the
undifferentiated nature of their products. Because
hard drives are standardized and end users have
very little brand preference, the industry is very
competitive. Demand can change fairly quickly
which leads to bouts of supply/demand
imbalances and pricing pressures.
Solid State Drives
Solid state drives pose a significant long-term
threat to the hard drive industry. SSDs are storage
devices made with semiconductor-based memory,
contain no moving parts (and are thus less prone
to crash), and have faster access times than hard
drives. Although much more expensive than hard
drives currently, declining prices may make SSDs
economically feasible for some hard drive
applications in the future.
Hard drive as loss leader
Three of the primary competitors in the hard
drive industry produce a multitude of electronic
equipment. As such, they can sell hard drives at a
loss while earning profits on the other products
(including computers) that they sell.
Tablet Computing
The rise of tablet computers – which have no hard
drives – will undoubtedly eat into the sales of
laptop computers which do contain hard drives.
Western Digital (WDC) Page 4

However, I expect this trend to be only a minor

headwind to the overall hard drive industry. First,
the amount of memory on tablets is relatively
small. Therefore, consumers will still need to
maintain other means of storage for their digital
content (either external drives or online storage –
both of which utilize hard drives). Secondly, the
sales of tablet computers – estimated at 48 million
units in 2011 – will remain a drop in the bucket
compared to the estimated 650 million hard drives
sold in 2010.

Disclosure
The author’s family owns WDC common stock.
 Appendix
2004 2005 2006 2007 2008 2009 2010
Non-Desktop Revenue 14% 21% 29% 43% 56% 62% 64%
(as a % of total revenue)

Revenue by Channel
OEM 51% 58% 54% 48% 51% 54% 51%
Distributor 42% 36% 39% 36% 31% 26% 31%
Retail 7% 6% 7% 16% 18% 20% 18%
100% 100% 100% 100% 100% 100% 100%

Revenue by Geography
US 37% 35% 32% 33% 24% 20% 19%
Asia 29% 33% 36% 34% 41% 49% 53%
Europe, Middle East & Africa 30% 29% 28% 29% 29% 27% 23%
Other 4% 3% 4% 5% 5% 4% 5%
100% 100% 100% 100% 100% 100% 100%