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Making Memories Just Got More Expensive

By Jim Pearce on May 26, 2016

After a rocky acquisition, disk drive maker Western Digital’s stock is oversold, and we think it could rise 30% within the next year and a half.

Earlier this month, Western Digital (NSDQ: WDC) bought disk drive maker SanDisk, a deal that has many analysts scrambling to figure out how much revenue the combined companies will generate. Western paid a hefty premium for SanDisk, which drove Western’s share price down to less than half its value before the deal was announced.

Before breaking down this transaction, let’s quickly review the difference between the companies’ two types of storage technologies. Western’s hard disk drive (HDD) is a form of data storage that uses a tiny mechanical arm to search the disk for data and then read it. SanDisk’s solid state drive uses microchips to store data, with no mechanical process required to read it. That means devices using SSD technology work faster and are less likely to break down.

However, HDD is cheaper and became the disk drive technology of choice during the personal computer boom so most PC makers still use it. But PC sales have been dropping globally for several years, as more consumers use mobile devices such as pads, tablets and smartphones as their primary computing tools. That means less demand for HDD chips and shrinking margins for the companies making them.

ssd market share pieMeanwhile, shipments of SDD products are rising because they’re used in portable computing devices where their superior speed and performance are needed to remain competitive. To be clear, total sales volume of HDD chips is still greater than for SSD, but the crossover point is rapidly approaching. That’s why Western Digital felt compelled to move now to lock up the #2 player in this sector before its arch rival, Seagate Technology, snatched up SanDisk.

Western Digital’s purchase of SanDisk is a classic case of “innogration,” a term we coined to describe the combination of innovation and integration that all successful tech companies use to stay at the cutting edge of product development. Innovation is an internal process of research and development, while integration is the external process of buying additional capabilities not available internally. When executed properly, innogration results in a more competitive company that makes a market-leading product in one or more of the major technology convergence categories of mobility, social, cloud and data.

enterprise hdd ssd revenueThe key to successful innogration is correctly judging future consumer demand. When Apple first developed the iPhone, it had no roadmap to use, because the industry leader at that time, Blackberry, only offered apps that supported its use as a phone. But Apple’s visionary leader, Steve Jobs, reckoned that consumers would want their phones to do far more than simply act as communication devices, so he loaded a variety of apps on them that converted a mobile phone to a mini computer. His hunch proved correct, and it revolutionized computing worldwide.

In the case of Western Digital, buying SanDisk is just one step in what is likely to be a series of events designed to bring the company further into the “3-D NAND” business;  3-D NAND stacks SSD chips to create a better flash memory. That better memory is used more and more in personal electronics and emerging markets such as self-driving cars, robots and virtual reality, all of which need gobs of memory.

So Western Digital is also an indirect play on some of the themes in our Special Situations Portfolio, which holds small companies with higher risk/rewards.

Digesting SanDisk

Despite Western Digital’s strong balance sheet, most investors believe the $16 billion it paid for SanDisk was too much. The stock dropped 25%, which was a high price to pay, at least in the short term. Long term the acquisition may pay off if Western Digital can leverage its SanDisk investment.

jim pearce bioHow profitable the SanDisk acquisition becomes is presently unknowable as it depends on a variety of volatile factors, including global demand for PCs, the growth rate for devices using 3-D NAND memory, and the pace at which new applications for emerging technologies using all three types of memory grows.

Regardless, it’s probably safe to say that this transaction won’t help earnings this fiscal year—even after cost savings from cutting redundant operations. What we do know is that as the top HDD manufacturer in the world, and having just acquired the second-largest SSD producer, Western Digital can benefit from sales to virtually all electronic devices using internal memory. That’s a big market.

 And if our Smart Tech Rating model is correct, Western Digital is undervalued and will most likely outperform the overall market over the next two years.

Buy Western Digital up to $49.

 

Options Play

Investors have two ways to profit from Western Digital’s future appreciation. You can buy the stock now, near $45 a share, and if our projection proves true, then that would result in a gain of better than 30% in less than two years. That’s a nice gain, especially in a flat market, but aggressive investors looking for higher returns may want to consider buying a LEAP, or long-term call option, on Western Digital that matures in January 2018.

For example, a call option with a strike price of $45, only slightly out-of-the-money at the moment, can be bought for roughly $8, resulting in a break even point of $53. If the share price of Western Digital gets to $60 in 18 months, then this option would have an intrinsic value of $15 for a gain of better than 80%. Only experienced option traders with a high tolerance for risk should consider engaging in this type of transaction because there is also the risk of full loss.

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