Western Digital Boosts Revenue With Hitachi Acquisition

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The disk drive industry has always been one of those cyclical tech sectors that's periodically flooded with overcapacity. Inventories pile up and producers slash prices to clear them out.

It's a nasty business. But there is a solution: Buy out the competition.

This is precisely what market leadersWestern Digital ( WDC ) andSeagate ( STX ) have recently done. Late last year, Seagate purchased Samsung's hard-drive business. In March, Western Digital completed a deal to purchase Hitachi's hard-drive business for $3.9 billion in cash plus 25 million shares.

Now sitting atop the computer-hard-drive storage market with 45% market share, Western Digital has begun to realize the benefits of lessened competition.

In its fiscal fourth quarter of 2012, which ended in June, it easily topped Street estimates. Revenue came in at $4.75 billion, well above the consensus of $4.35 billion. Non-GAAP earnings of $3.35 easily distanced analyst estimates of $2.39.

Pricing was relatively stable, perhaps the biggest factor in the strong performance.

Reducing Competition

"The industry hasn't historically been able to hold the line on pricing," noted Stifel Nicolaus analyst Aaron Rakers. But in reducing the ranks of producers from five to three, Western Digital and Seagate have shown "a willingness to maintain pricing," said Rakers.

Also, more than willingness. Now they're showing the ability to uphold prices. "The pricing environment has remained benign. They're already benefiting from fewer competitors," Rakers added.

Western Digital's new pricing power represents a dramatic reversal of historic trends, noted Jayson Noland, an analyst with Robert Baird. Western Digital last quarter realized an average selling price ( ASP ) of $65 on its drives. But way back in 2007-08, ASPs were in the "mid to high 50s." he said. And in the past, the trend in drives has been for diminishing prices.

"It's a reversal of historic trends in that ASPs have come up as opposed to going down," said Noland.

Regulators fretted, but they did not block the Western Digital buyout of Hitachi.

At the behest of Chinese regulators, Western Digital will operate its legacy and Hitachi businesses as separate subsidiaries for at least two years.

This will reduce any immediate synergistic financial benefits that would come from slashing jobs or shuttering operations. U.S. and European regulators required Western Digital to sell some assets to Toshiba, the third and smallest surviving producer.

Meanwhile, the acquisition of Hitachi brings added benefits beyond pricing power. Hitachi was a major player in what's called enterprise storage. Enterprise storage customers include major computer manufacturers. likeHP ( HPQ ) andIBM ( IBM ), along with high-end storage array vendors likeEMC (EMC).

Enterprise disk drives are more profitable than PC hard drives. It was an increase in enterprise sales that helped Western Digital earn 31.8% margins last quarter.

In announcing strong fourth-quarter results in late July, Chief Executive John Coyne also delivered a forecast that helped push Western Digital shares higher.

"We believe Western Digital can deliver non-GAAP earnings per share of $10 in fiscal 2013," said Coyne. He noted that in making the projection, Western Digital took into account "a soft macroeconomic environment." He assumed only a 5% rate of unit growth in hard-drive demand.

But some analysts are more cautious in their outlooks. Robert Baird analyst Noland believes Western Digital can reach its $10 earnings goal for 2013. But he thinks the company will have a hard time staying at that level. With shares rising from near 32 to a recent 44 after the fourth-quarter report, Noland contends most of the upside "has already been realized."

Even more skeptical is ThinkEquity analyst Rajesh Ghai. Western Digital faces two threats, reasons Ghai. One, pricing power may prove ephemeral. Toshiba is a distant third in the hard-drive market, with a current share of 10% to 15%. But Ghai expects Toshiba to substantially increase its production capacity.

This is precisely the sort of aggressive thrust for market share that periodically sends drive prices tumbling. Competition may have narrowed with the Seagate and Western Digital acquisitions. But Toshiba remains a wild card.

The second threat is more fundamental. Ghai foresees a slowing in PC sales.

And sales of drives for PCs represent the bulk of Western Digital's unit sales.

He is skeptical the market will even grow by the modest 5% that Western Digital executives forecast.

Emerging Countries

"The PC market in the developed world has been declining or flattish. Emerging countries have driven the growth," said Ghai. But he now expects PC growth to slow in emerging markets too. "With the proliferation of tablets, the cannibalization of PCs will spread to the developing world."

Mobile computing often relies on semiconductor memory, not rotating hard drives.

The big question is how soon and how severely the shift to mobile computing will threaten the hard-drive business.

Western Digital executives have argued that hard drives are by no means doomed, noting that mobile computing may not use local drive storage, but creates the need for external "cloud storage."

So even as consumer use of hard drives erodes, massive centralized storage needs to grow.

But Ghai believes hard-drive makers will lose in the transition. He says, for example, that a PC user may have a 500-gigabyte drive.

But music or photos stored in the cloud may go on much larger 3-terabyte drives. The drives, he explains, have six times the capacity, but they don't produce six times the revenues. "Selling a single terabyte drive does not earn the same profit as selling six 5,000 gigabyte drives," said Ghai.

In a cyclical business that deals with memory, it's worth remembering that the good times almost always come to an end.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas

Referenced Stocks: ASP , HPQ , IBM , STX , WDC

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