Among the many sectors that have benefitted by the market’s rally off of a Christmas Eve low, semiconductors have used broad market sentiment to drive into solid intermediate-term upward trends. As measured by the iShares Semiconductor ETF (SOXX), the sector is up about 34% from that late-2018 low, and 24% year-to-date.
There are a couple of primary pressures that I believe have weighed on the semiconductor industry, really since the beginning of 2018. After leading the market’s bullish rally for most of the last several years, investors finally began to turn wary that the sector could maintain its strength last year, which began pushing stocks in the sector into wide, volatile swings between high and low price extremes. As data began to emerge showing that many of the industries semiconductors service, such as memory and storage, were dealing with higher-than-expected inventory levels, that concern seemed to find a foothold.
Next, geopolitics came to play, as tariffs and trade tensions between the U.S., China and America’s other largest trading partners increased investor uncertainty. The fact that intellectual property protections have been a centerpiece of the Trump administration’s justification for tariffs against China only added fuel to that fire. Oversupply, combined with increasing costs from tariffs on both sides of the negotiating table, a lot of semiconductor stocks into downward trends through most of last year.
Western Digital Corporation (WDC) is a good example of a stock that has borne the brunt of market sentiment against the semiconductor sector, and the storage industry in particular. Hard drive manufacturers have been coming under fire for quite some time now, as companies like WDC and Seagate Technology (STX) are also having to deal with the perception – which I don’t believe is incorrect – that traditional drive storage technology is outdated. Not only is it being replaced by newer technology like NAND and solid-state storage, but these companies are also being pressured by increasing competition from other well-known businesses as well. These are pressures that have been manifested in the last couple of quarters of earnings reports for WDC, as cash flow, earnings, and Net Income have all shown signs of deterioration.
I don’t believe the news, however is all bad for WDC. The company is hardly standing still in finding ways to grow its business; it acquired Sandisk in 2016 specifically to facilitate a push away from traditional disk storage and into a leading position in the same, highly competitive memory space that I just mentioned. They have also been leveraging their long-standing expertise in the enterprise market, where data center storage is expected to continue to be a growth market well into 2022. How big is that market expected to grow? One report I recently saw forecast that by 2025, the global datasphere (think cloud storage for big business) will reach 175 zettabytes. In layman’s terms, that is equivalent to a trillion gigabytes, and that would represent an increase from about 33 zettabytes in 2018. That increase in demand is going to put a lot of pressure on data center companies, and creates a massive opportunity for the semiconductor companies that can keep up. I think WDC is in a good position for that, and even with the stock up more than 36% year-to-date, I think there is more in store for the future. Let’s run through the numbers as they stand now so you can make your own decision.
Fundamental and Value Profile
Western Digital Corporation (Western Digital) is a developer, manufacturer and provider of data storage devices and solutions that address the needs of the information technology (IT) industry and the infrastructure that enables the proliferation of data in virtually every industry. The Company’s portfolio of offerings addresses three categories: Datacenter Devices and Solutions (capacity and performance enterprise hard disk drives (HDDs), enterprise solid state drives (SSDs), datacenter software and system solutions); Client Devices (mobile, desktop, gaming and digital video hard drives, client SSDs, embedded products and wafers), and Client Solutions (removable products, hard drive content solutions and flash content solutions). The Company develops and manufactures a portion of the recording heads and magnetic media used in its hard drive products. WDC has a current market cap of about $14.7 billion.
Earnings and Sales Growth: Over the last twelve months, earnings declined by almost -67.5%, while revenue declined about -21%. That negative pattern persisted in the last quarter, where earnings dropped by -57.55%, and sales -15.8%. Additionally, the company’s margin profile is showing significant signs of deterioration, as Net Income as a percentage of Revenues dropped from 4.33% in the last twelve months to -11.5% in the last quarter. A red flag? Certainly; I take this as a clear indication that the market forces I wrote about at the beginning of today’s post have had a dramatic effect on the company’s core business.
Free Cash Flow: Even with the troubling pattern I just wrote about, WDC’s free cash flow is solid, at $2.1 billion over the last twelve months. This number translates to a useful Free Cash Flow Yield of 15%. Not to be ignored is the fact that in the second quarter of 2018, Free Cash Flow was about $3.5 billion; however this is a good indication that even as it is dealing with serious pressures, the company has retained healthy cash flow.
Debt/Equity: WDC’s debt to equity ratio is a generally manageable .95. The company’s balance sheet indicates that they should have no problem servicing the debt they have, with about $4.1 billion in cash and $10.3 billion in long-term debt.
Dividend: WDC’s annual divided is $2.00 per share, which translates to a yield of 3.96% at the stock’s current price.
Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for WDC is $37.52 and translates to a Price/Book ratio of 1.34 at the stock’s current price. The stock’s historical average Price/Book ratio is 1.82, meaning that the stock is currently sitting about 36% below that average. That puts a long-term target price for the stock at about $68 per share, which is a level the stock last saw in August of 2018. The stock is almost more than 100% below its historical Price/Cash Flow average; and that would put a long-term target above $100, and near the stock’s all-time highs from March of last year in sight. I’m not sure the stock will be able to rebound that strongly within the next year, however it does help support the notion that from its current price, the stock has plenty of upside to work with.
Here’s a look at the stock’s latest technical chart.
Current Price Action/Trends and Pivots: The red diagonal line measures the length of the stock’s downward trend from $107 a year ago until the end of December when it bottomed around $34; it also informs the Fibonacci trend retracement lines shown on the right side of the chart. The stock has rallied nearly 50% from that low point. Since the end of February, the stock has started to establish a fairly narrow consolidation range, with support at around $45 and resistance at around $50 per share. If the stock drops below support, it should have room to drop quickly down to its trend low point, while a break above $51 should give the stock good reason to test the 38.2% retracement line at around $62.
Near-term Keys: I like the value proposition for WDC, and I think that even with the warning signs coming from the company’s negative Net Income, WDC’s long-term prospects for the long-term are very interesting. If you prefer to look for shorter-term trading opportunities, you could use a break above $51 as an opportunity to buy the stock or work with call options with a target at around $62 per share. A break below support at $45 would be a strong signal to short the stock or buy put options with an eye on the trend low at around $35 per share.