3 Reasons Western Digital Corp's Stock Could Fall
Investors have seen many investments soar over the years, only to come crashing down as unpleasant business realities overwhelmed positive sentiment. Western Digital hasn't been such an investment, as its soaring share price of late has reflected strengthening fundamentals in the two-horse race to hard-disk drive (HDD) dominance:
We recently examined three reasons why this strong performance might continue, but informed investors would be well-served to examine both sides of the coin. No business is impregnable, and Western Digital faces several major challenges that might leave investors holding a loss over the coming months or years. Do these threats loom larger than its opportunities? Let's take a closer look to find out.
The hard disk drive market has flatlined in recent years
Western Digital and rival Seagate have both put together strong performances over the past few years, but their financial gains have masked one important fact -- HDD shipments have been slowly dropping for years:
Find more statistics at Statista
Between them, Western Digital and Seagate now sell more than eight out of every ten HDDs shipped worldwide, but both have slid from a post-recession sales peak in 2012. Western Digital shipped 11% fewer units in its latest quarter than it did during the same quarter in 2012, and Seagate shipped 20% fewer units in its latest quarter (both companies reported fourth-quarter earnings for the June quarter) than it did during the same quarter in 2012.
It's important to keep in mind that the fourth quarter of 2012 was a historically high-volume quarter for the industry, but even so, unit shipments have not yet progressed from that point. We looked at Western Digital's market share gains as a factor in its favor in our last analysis, but the company's unit shipments have been effectively flat for years even as it has grabbed share from Seagate:
Seagate Unit Shipments
Western Digital Unit Shipments
Western Digital may be able to improve its financial performance by boosting margins or streamlining its manufacturing, but if it fails to boost its unit sales going forward, its long-term prospects won't be particularly bright -- especially since HDDs have been losing ground to other storage formats in recent years. That brings us to our second risk ...
Western Digital has no real foothold in SSDs or in NAND flash
There's more than one way to store a file. Western Digital is the leading provider of HDDs, but it barely registers when it comes to more portable options -- it has no position in NAND flash memory, which is typically found in smartphones and tablets, and its enterprise solid-state drive (SSD) segment made up a mere 3% of revenue in its latest quarter.
Despite several SSD-centric acquisitions in the last couple of years, Western Digital's revenues from this product line are insignificant compared to the estimated $19.4 billion in revenue the entire SSD industry will generate this year. This is quite a bit lower than the $28.9 billion in revenue Western Digital and Seagate combined to earn in their latest fiscal years, but keep in mind that the SSD market's total revenue was only $9.2 billion in 2012. One segment is booming and the other has flatlined, and Western Digital is leading the flat segment.
Western Digital's lack of NAND flash manufacturing capacity is also likely to crimp its progress, as NAND is used to manufacture SSDs. Vertical integration is evidently helping the big players in NAND succeed in SSDs as well -- Samsung is the largest supplier of both products, with SanDisk and Micron also among the largest suppliers by revenue of both NAND and SSDs. HDDs aren't going away just yet -- not so long as many large tech companies continue building out massive cloud storage divisions -- but their importance is diminishing in a world of more mobile, more portable storage options.
Western Digital's valuation is near its highest level in many years
Some of Western Digital's growth in recent years is certainly due to a rebound from insanely low valuations -- both its P/E and price-to-free-cash-flow ratios were among the absolute lowest of any billion-dollar company not two years ago:
Since the start of 2013, Western Digital's P/E has risen from just 5.2 to 14.6, and its price-to-free-cash-flow has rebounded from 3.6 to reach 10.8. Both improvements represent valuation expansion of almost 200%, and since Western Digital's EPS and free cash flow have both declined since the start of 2013, this means that its share price has grown entirely on the back of strong investor sentiment:
HDD manufacturers have long suffered from low valuations (Seagate's P/E was microscopic for years), but the thing about valuations is that they tend to revert over time, especially if the company's underlying fundamentals don't show the strong growth that can justify higher-than-average ratios. An economic downturn could easily send Western Digital's valuations back to low single-digit territory, and when (not if) that happens, its shares are likely to fall quite a bit if the bottom line doesn't soon show marked improvement.
Three good reasons?
Business history is littered with the corpses of companies that dominated their industries until a better technology came along. No one now expects hard disk drives to fade into obscurity, but few people expected mainframe computers to be completely eclipsed in 1977 (when the first PCs arrived) either. Investors who've thrilled to huge returns from Western Digital's stock should be aware of the risks it also faces -- but it's up to you to decide whether or not these risks are grave enough to sell off your position today.
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The article 3 Reasons Western Digital Corp's Stock Could Fall originally appeared on Fool.com.Alex Planes owns shares of Seagate Technology. The Motley Fool owns shares of Western Digital.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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