Leading data storage manufacturer Western Digital (NASDAQ: WDC) announced better-than-expected results in the Q3 FY2023 quarter, with revenue down 36% year on year to $2.8 billion. However, guidance for the next quarter was less impressive, coming in at $2.5 billion at the midpoint, being 11.9% below analyst estimates. Western Digital made a GAAP loss of $572 million, down on its profit of $25 million, in the same quarter last year.
Western Digital (WDC) Q3 FY2023 Highlights:
- Revenue: $2.8 billion vs analyst estimates of $2.69 billion (4.29% beat)
- EPS (non-GAAP): -$1.37 vs analyst estimates of -$1.56
- Revenue guidance for Q4 2023 is $2.5 billion at the midpoint, below analyst estimates of $2.84 billion
- Free cash flow was negative $527 million, compared to negative free cash flow of $240 million in previous quarter
- Inventory Days Outstanding: 144, up from 133 previous quarter
- Gross Margin (GAAP): 10.2%, down from 32.8% same quarter last year
Founded in 1970 by a Motorola employee, Western Digital (NASDAQ: WDC) is a leading producer of hard disk drives, SSDs and flash memory.
Originally a producer of calculator chips, Western Digital refocused on hard disk drives in 1978, and created the original ATA hard disk drive standard used in PCs. HDDs were one of the most competitive, low margin, tech markets for decades until a wave of consolidation shrank the market to two main players; Western Digital and Seagate, following Western Digital’s acquisition of Hitachi Global Storage in 2015. That same year the company acquired SanDisk, one of the largest producers of flash memory.
The SanDisk acquisition brought Western Digital into a partnership with Toshiba (now named Kioxia) in Flash Ventures, the largest producer of flash memory semiconductors in the world, and diversified Western Digital’s revenues equally across HDD and flash memory, each of which today account for roughly half of its revenues.
Western Digital’s peers and competitors include Seagate (NASDAQ:STX), SK Hynix (KOSI:000660), and Samsung (KOSI:005930).Memory Semiconductors
The global memory chip market has become concentrated due to the highly commoditized nature of these semiconductors. Despite the market consolidation, DRAM and NAND are subject to wide pricing swings as supply and demand ebbs and flows. This plays itself out in the business models of memory producers, where the large, fixed cost bases required to produce memory chips in volume can become very profitable during times of rising prices due to high demand and tight supply but also can result in periods of low profitability when more supply is brought online or demand drops.
Sales Growth
Western Digital's revenue has been declining over the last three years, dropping annually on average by 2.2%. Last year the quarterly revenue declined from $4.38 billion to $2.8 billion. Semiconductors are a cyclical industry and long-term investors should be prepared for periods of high growth, followed by periods of revenue contractions (which can sometimes offer opportune times to buy).
Despite Western Digital revenues beating analyst estimates, this was still a slow quarter with a 36% revenue decline.
Western Digital's revenue growth has decelerated for the last three quarters and the company expects growth to turn negative next quarter guiding to a 44.8% year on year decline, while analysts are estimating a NTM revenue decline of 3.03%.
Product Demand & Outstanding Inventory
Days Inventory Outstanding (DIO) are an important metric for chipmakers, as it reflects the capital intensity of the business and the cyclical nature of semiconductor supply and demand. In a tight supply environment, inventories tend to be stable, allowing chipmakers to exert pricing power. Steadily increasing DIO can be a warning sign that demand is weak, and if inventories continue to rise the company may have to downsize production.
This quarter, Western Digital’s inventory days came in at 144, 42 days above the five year average, suggesting that that inventory has grown to higher levels than what we used to see in the past.
Pricing Power
Western Digital's gross profit margin, how much the company gets to keep after paying the costs of manufacturing its products, came in at 10.2% in Q3, down 22.6 percentage points year on year.
Western Digital' gross margins have been trending down over the past year, averaging 19.2%. The weakness isn't great as Western Digital's margins are already below other semiconductor companies as is, reflective of weakening pricing and cost controls.
Profitability
Western Digital reported an operating margin of -10.8% in Q3, down 25.7 percentage points year on year. Operating margins are one of the best measures of profitability, telling us how much the company gets to keep after paying the costs of manufacturing the product, selling and marketing it and most importantly, keeping products relevant through research and development spending.
Operating margins have been trending up over the last year, averaging 2.26%. A welcome development for Western Digital, as its operating margins are below industry average, a result of a cost structure that isn't particularly efficient.
Earnings, Cash & Competitive Moat
Wall St analysts are expecting earnings per share to decline 197% over the next twelve months, although estimates are likely to change post earnings.
Earnings are important, but we believe cash is king as you cannot pay bills with accounting profits. Western Digital's free cash flow came in at -$527 million in Q3, down 456% year on year.
Western Digital didn't produce any free cash flow in the last year, so shareholders will want to see that improve in the short term.
Over the last 5 years Western Digital has reported an average return on invested capital (ROIC) of just 3.62%. This suggests it may struggle to find compelling reinvestment opportunities within the business.
Key Takeaways from Western Digital's Q3 Results
Since it has still been burning cash over the last twelve months it is worth keeping an eye on Western Digital’s balance sheet, but we note that with a market capitalization of $10.7 billion and more than $2.22 billion in cash, the company has the capacity to continue to prioritise growth over profitability.
We were impressed by Western Digital outperforming analysts’ earnings expectations for revenue and EPS. On the other hand, it was less good to see that the revenue growth was quite weak and both revenue, gross margin, and EPS guidance for the next quarter missed analysts' expectations. Overall, this quarter's results were mixed and could have been better. The company is up 3.1% on the results and currently trades at $35.25 per share.
Is Now The Time?
When considering Western Digital, investors should take into account its valuation and business qualities, as well as what happened in the latest quarter. We cheer for everyone who is making the lives of others easier through technology, but in the case of Western Digital we will be cheering from the sidelines. Its revenue growth has been very weak, and analysts expect growth rates to deteriorate from there. And on top of that, unfortunately its its relatively low return on invested capital suggests suboptimal growth prospects, and operating margins reveal subpar cost controls compared to other semiconductor businesses.
Western Digital's price to earnings ratio based on the next twelve months is -24.7x. While we have no doubt one can find things to like about the company, and the price is not completely unreasonable, we think that at the moment there might be better opportunities in the market.
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