Leading data storage manufacturer Western Digital (NASDAQ: WDC) beat analysts' expectations in Q1 FY2024, with revenue down 26.4% year on year to $2.75 billion. The company also expects next quarter's revenue to be around $2.95 billion, in line with analysts' estimates. Turning to EPS, Western Digital made a non-GAAP loss of $1.76 per share, down from its profit of $0.20 per share in the same quarter last year.
Western Digital (WDC) Q1 FY2024 Highlights:
- Revenue: $2.75 billion vs analyst estimates of $2.66 billion (3.28% beat)
- EPS (non-GAAP): -$1.76 vs analyst estimates of -$1.90
- Revenue Guidance for Q2 2024 is $2.95 billion at the midpoint, above analyst estimates of $2.94 billion
- Free Cash Flow was -$544 million compared to -$219 million in the previous quarter
- Inventory Days Outstanding: 120, down from 130 in the previous quarter
- Gross Margin (GAAP): 3.6%, down from 26.3% in the 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).
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.
Western Digital's revenue has been declining over the last three years, dropping by 9.07% on average per year. This quarter, its revenue declined from $3.74 billion in the same quarter last year to $2.75 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).
Even though Western Digital surpassed analysts' revenue estimates, this was a slow quarter for the company as its revenue dropped 26.4% year on year. This could mean that the current downcycle is deepening.
Western Digital may be headed for an upturn. Although the company is guiding for a year-on-year revenue decline of 5.05% next quarter, analysts are expecting revenue to grow 17.3% over the next 12 months.
Product Demand & Outstanding Inventory
Days Inventory Outstanding (DIO) is an important metric for chipmakers, as it reflects a business' capital intensity 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 DIO came in at 120, which is 13 days above its five-year average. These numbers suggest that despite the recent decrease, the company's inventory levels are higher than what we've seen in the past.
In the semiconductor industry, a company's gross profit margin is a critical metric to track because it sheds light on its pricing power, complexity of products, and ability to procure raw materials, equipment, and labor. Western Digital's gross profit margin, which shows how much money the company gets to keep after paying key materials, input, and manufacturing costs, came in at 3.6% in Q1, down 22.7 percentage points year on year.
Western Digital's gross margins have been trending down over the last 12 months, averaging 8.56%. This weakness isn't great as Western Digital's margins are already far below other semiconductor companies and suggest shrinking pricing power and loose cost controls.
Western Digital reported an operating margin of -16.1% in Q1, down 24.3 percentage points year on year. Operating margins are one of the best measures of profitability because they tell us how much money a company takes home after manufacturing its products, marketing and selling them, and, importantly, keeping them relevant through research and development.
Western Digital's operating margins have been trending down over the last year, averaging -12.2%. This is a bad sign for Western Digital, whose margins are already among the lowest for semiconductors. The company will have to improve its relatively inefficient operating model.
Earnings, Cash & Competitive Moat
Wall Street expects earnings per share to decline 15.1% over the next 12 months, although estimates will likely change after earnings.
Although earnings are important, we believe cash is king because you can't use accounting profits to pay the bills. Western Digital's free cash flow came in at -$544 million in Q1, up 153% year on year.
As you can see above, Western Digital failed to produce positive free cash flow over the last 12 months and shareholders will likely want to see an improvement in the coming quarters.
Over the last five years, Western Digital has reported an average return on invested capital (ROIC) of just 0.81%. This suggests it struggled to find compelling reinvestment opportunities within the business.
Key Takeaways from Western Digital's Q1 Results
Although Western Digital, which has a market capitalization of $12.6 billion, has been burning cash over the last 12 months, its more than $2.03 billion in cash on hand gives it the flexibility to continue prioritizing growth over profitability.
We were impressed by how significantly Western Digital blew past analysts' EPS expectations this quarter, driven by strong outperformance in its flash memory division. We were also glad its inventory levels shrunk. On the other hand, its operating margin fell and its gross margin shrunk. Zooming out, we think this was still a decent, albeit mixed, quarter, showing that the company is staying on track. Aside from the earnings print, Western Digital said it would separate its HDD and flash memory businesses into two independent, public companies. The spin-off comes after activist hedge fund Elliot Management disclosed a nearly $1 billion stake in the company last year. Elliot is known for pushing its portfolio companies to pursue value-added strategies for shareholders. The transaction is targeted for the second half of calendar year 2024, and the stock is up 11.5% after reporting. It currently trades at $43.45 per share.
Is Now The Time?
When considering an investment in Western Digital, investors should take into account its valuation and business qualities as well as what's happened in the latest quarter.
We cheer for everyone who's making the lives of others easier through technology, but in the case of Western Digital, we'll be cheering from the sidelines. Its revenue growth has been poor over the last three years, and analysts expect growth to deteriorate from here. On top of that, its relatively low ROIC suggests suboptimal profitability prospects and its operating margins reveal subpar cost controls compared to other semiconductor businesses.
Western Digital's price-to-earnings ratio based on the next 12 months is -25.5x. 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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