Team Shark

Finance 425
Professor Gary Koppenhaver
NYSE: WDC
April 19, 2007
Current Price: $16.83 (4/18/07)
Company, Industry and Competition

Western Digital operates within the Computer Storage Devices industry, with its headquarters in Lake

Forest, California. The company focuses exclusively on the development, design, manufacturing and selling of hard

drives for computers, mobile devices, enterprise products, and consumer electronics. Many of the company’s hard

drives can be found in notable devices such as MP3 players, the Xbox 360, printers, servers, digital cameras, cell

phones, and recording equipment. These products are sold to distributors, retailers, and resellers of internal and

external hard drives.

Western Digital currently has a dozen sales offices within the United States, as well as 28 international

locations throughout North America, Asia, and Europe. Most of the company’s hard drives are assembled in

Malaysia and Thailand, while some are manufactured in Fremont, California. The majority of Western Digital’s

products are sold in Asia and the Americas (38% of sales in each market respectively), while 28% of sales are

generated in Europe. Western Digital is currently focusing more of its sales in Asia, where the growth of mobile

devices is the strongest. While Western Digital does generate much of its revenue from computers (71%), the

company has focused most of its recent growth on consumer electronics and external hard drives.

The Computer Storage Devices industry continues to grow, mainly due to the expanding electronics market

and need for updated and more efficient hard drives. The industry contains many companies who manufacture hard

drives, as well as other products. Since Western Digital focuses only on hard drives, it competes directly with

Seagate and SanDisk. Other competitors within the industry also include: EMC, Toshiba and Micron. While the

industry contains 29 companies, Western Digital has the seventh highest market capitalization, $8.3 billion less than

its key competitor Seagate. The industry’s current operating margin is struggling compared to the S&P 500, with

rates of 8.37% and 19.65%, respectively. Though the industry’s return on equity of 10.38% trails the S&P’s

20.29%, the Computer Storage Devices industry’s five-year sales growth rate has eclipsed the S&P with rates of

15.68% and 13.29%, respectively.

Recently, the industry has fallen behind the performance of the S&P 500. While the Storage Device

industry has lagged as much as 1.5% behind the S&P (as of April 10, 2007), the industry has recently surpassed the
returns of the index. As of April 16, the industry has a current value of 1141.19 (finance.yahoo.com). Below is a

graph charting the recent performance of the industry and the S&P 500.

Shareholder Letter Evaluation

Western Digital’s 2006 shareholder letter, written by their Chairman of the Board, Matthew Massengill,

was adequate but what made it really stand out in a good way was what was said in the annual report. The letter

itself did a good job of talking about recent performance and the reasons behind it, but was fairly vague on growth

potential in the future. However, what was lacking in the letter was more than made up for in the actual report. The

report consisted of multiple pages of both growth potentials as well as pitfalls, in great detail. The report also laid

out a specific strategic vision of which product categories and markets they intend to focus on in the future. The only

detail that we found missing was any discussion about negatives in the past.

The letter’s tone was fairly personal and honest. We didn’t feel like the company was trying to hide

anything from the shareholder, and felt that the relationship was intended to be a long one. Another positive was that

clichés were kept to a minimum, and most statements were supported by facts. Due to these factors, we awarded the

shareholder letter combined with the annual report a letter grade of a B+.

DuPont Analysis

DuPont analysis is a technique used by many analysts to break down the different components (operating

margin, tax burden, asset turnover, interest burden, and financial leverage) which make up a particular firm’s

implied return on equity. It is beneficial because of its ability to pinpoint components of concern in relation to the
industry as well as the S&P 500 index. All of our DuPont data was extrapolated from Reuters.com. As found on our

calculations spreadsheet at the end of this document, in the DuPont analysis, Western Digital greatly outperformed

the industry and the S&P 500 with its current implied ROE of 38.98% compared to 11.12% and 31.44%

respectively. Better performance than the industry was found in four of the five areas, all except interest burden.

The most encouraging margin over the industry we saw was the company’s asset turnover of 2.27, which was more

than double the industry’s of 0.85 and the S&P 500’s .97. Asset turnover is essential because it is a measure of how

quickly a company can convert assets into cash. High asset turnover is extremely good to see when it is coupled

with an operating profit margin of 8.45%, still higher than the industry’s 8.37%.

The next two components we looked at in our analysis are the tax burden and interest burden. Western

Digital’s tax burden is actually 103.26%, which is bizarre, but this is due to an accounting error made in 2001

concerning the valuing of certain exercised stock options. This was discovered and credited to this year’s earnings.

Therefore, a more accurate measure of their tax situation would be their five year average tax burden of nearly

100%, still well above the industry and the market. The interest burden is smaller than the industry but not

significant enough to make an impact on ROE.

The final component left to analyze is the financial leverage of Western Digital. High leverage can be a

way to greatly increase profits, but only as long as the return on new investments turns out to be higher than the

required debt payments. However, high leverage also adds more risk to the security. More risk to a security can

result in a higher discount rate used to value a stock, which produces a lower intrinsic value. Currently Western

Digital’s financial leverage is 1.86, which is slightly higher than the industry’s of 1.61. However, it is encouraging

to see a steady decrease in this measurement over the last few years, which can be seen by their higher five-year

average of 2.52.

One Dollar Premise

One financial tenet to be addressed is the one-dollar premise. This is a measurement of how many dollars

of market value can be generated by one dollar of retained earnings and is a very good indication of whether

management is making the right decision to be retaining the earnings or not. The “premise” is that for every one

dollar of retained earnings, at least one dollar of market value should be generated. If this is not the case, then the

earnings should be paid back to the shareholders in the form of dividends or buybacks, rather than be reinvested.
This figure is found by dividing the five-year change in market value by the five-year accumulated retained

earnings. The five year values are for 2002 – 2006. The change in market value was found by using the closing share

prices on the last trading day of June for each of the two years, respectively, because the financial statements are

dated June 30. The one-dollar premise was calculated to be an impressive $7.31. This means that for every $1.00 of

retained earnings over the last five years, $7.31 was generated. This is an outstanding indicator not only of

management’s ability to find profitable new investments, but also their decision making prowess in the allocation of

cash to these projects.

This is an extremely important measure to analyze Western Digital’s managerial performance, simply

because they have no capital allocation, meaning all earnings have been retained. This is evident because they do not

pay dividends and they have not repurchased any shares in the last five years.

Value or Glamour?

When using a Contrarian investment strategy, it is important to determine whether a stock is a glamour

stock or a value stock. A value stock is one that would be considered currently out of favor and at an attractive

price, while a glamour stock would be one that has been returning well, making it somewhat in favor, but probably

overpriced. To earn above average returns, our goal as an investor would be to find undervalued value stocks to

invest in, creating a margin of safety for ourselves. The following is a table using the four ratios used to test for

glamour or value in Rockwell Collins.

Western Digital S&P 500 Glamour/Value

Earnings Yield 11.67% 4.89% Value
Instiutional Ownership 85.45% 70.13% Glamour
Five-Year Sales Growth 17.32% 13.29% Glamour
Price/Book 2.7 4.06 Value
Price/Cash Flow 6.05 14.94 Value

According to the above table, three of the five measurements used indicate value while two indicate

glamour. Therefore, the decision is not totally decisive, however, we place more emphasis on the earnings yield and

price/book measurements as stronger indicators of value, and these are significantly better than the S&P 500. We

view these as the most important because if they indicate glamour this means that the market is likely to be overly

optimistic about future earnings, which could result in an overvalued stock. Also, the price/cash flow is well under
the market. Since Western Digital is more value than glamour, it would be currently undervalued, giving us

potentially above-average returns in the future, as the market price returns to its intrinsic value.

Stock Price Riskiness and Volatility

Both systematic risk and total risk were measured for this stock. The measure of systematic risk used was

beta, and it is currently 1.27. The beta of the market is one, so what this means, is that changes in the market will be

reflected in changes in Rockwell’s stock by approximately 127% of the value of the market changes. A total risk

measure was calculated by using the past ten years of monthly returns (found using adjusted closes from

yahoo.com), finding the standard deviation of them, and then annualizing by multiplying by time or in this case the

square root of 12. The total risk from April 1997 – April 2007 was 77.58%, which is high compared to the market

and other stocks we have analyzed, which indicates this stock is quite volatile, but some of this can be attributed to

the fact that it has a low price, which means any small change in the outlook of the company is magnified. At one

point in 2002, the stock price was even as low as $3.00.

Past stock performance over the last five years has seen a fairly consistent upward trend. Over the last five

years it has had about a 250% increase overall in stock price. It is nice to see from a value investing perspective that

it reached a plateau over the past year, but currently could be considered in a slight trough. This could indicate a

buying opportunity for us.

Another measure of a stock’s risk and volatility is a company’s consistency of ROE. This was determined

by dividing the average ROE over a certain period by the standard deviation over the same time period. For the

analysis, we were asked to use ten years of data for this measurement, however, we excluded two high outliers and

one low outlier that would have greatly skewed this measurement. The consistency we found was 0.42, which

means that the ROE is fairly inconsistent, which can also be associated with the entire tech industry as a whole.

Quality of Owner’s Earnings

Owner’s earnings are a measurement which Warren Buffett is a big advocate of examining as a measure of

a company’s cash flow. He defines it as subtracting a company’s capital expenditures for the year from their total

cash from operations for the year. This number is then divided by the number of shares outstanding to give us a per-

share value. The five year average owner’s earnings is for the years 2003-2007 and comes to $0.81 per-share and
the current owner’s earnings is for the year 2007 and comes to $1.18 per-share. In order to find this figure for 2007,

we had two quarters of data which we had to annualize by multiplying by two. Therefore, this needs to be taken into

account, that our 2007 figure is half projection, half historical data.

To compare numbers from year to year, we calculated two owner’s earnings growth rates, a five year

average and a current growth rate, respectively. The five year average number we came up with was 81.62%, which

was found by taking an average of the four year-to-year growth rates spanning 2003 to 2007. Two of the four rates

calculated actually produced negative values, resulting in fairly inconsistent owner’s earnings. The current growth

rate from 2006 to 2007 was projected to be 163.05%. We found that the cash from operations has mostly increased

from year to year, with a couple small downturns while capital expenditures have increased every year. Therefore,

this resulted in our two negative year-to-year growth rates for the periods in which cash from operations decreased

but capital expenditures increased. From the shareholder letter, we learned the reasons for much of the increased

capital expenditures are due to increased research and development for the consumer electronics market. This is the

area Western Digital foresees much of their future cash flow growth coming from.

Intrinsic Value/Margin of Safety

Intrinsic Value is a measure Buffett stresses very much. He won’t purchase a stock unless he has a “margin

of safety”, that is, his intrinsic value is significantly more than the current market value. Essentially, he buys stocks

at a discount. Therefore, if the stock does do poorly, theoretically, over time the stock will gravitate to its intrinsic

value. Even though the firm does relatively poorly, the investor will have a safety net, still generating an acceptable

rate of return.

To calculate our intrinsic value, we used Western Digital’s five-year average owner’s earnings per-share of

$0.81 as the initial cash flow rather than the current owner’s earnings of $1.18. We wanted to be more conservative

in our intrinsic valuation, so we used the smaller of the two. The discount rate was found using the Capital Asset

Pricing Model equation with a risk-free rate of 5.5% (the current yield of a 3-month treasury bill), a market premium

of 7%, and a beta of 1.2. This creates a required rate of return of 14.39% which was used for our discount rate. A

normal growth rate of 5% was used, and for the first five to ten years, a supernormal growth rate of 44.35% was

used. The supernormal rate was found by multiplying our five year average ROE by one minus the five year payout

ratio. The payout ratio, as discussed earlier, was zero due to no dividends or buybacks. This was our implied growth
rate, which was used because our owner’s earnings growth rates were significantly higher, so we went with the more

conservative rate. This resulted in a final intrinsic value of $71.12, resulting in an extremely high margin of safety

of 322.57%.

Recommendation

It is our recommendation to purchase 500 shares of Western Digital common stock which totals to a dollar

value of $8415. This would be paid for out of $24,205.82 of available funds. We are recommending this buy

decision for a number of reasons, the first of which is the financial stability of the company. This is evidenced by its

extremely impressive DuPont analysis, beating the market and industry in most categories, all except for interest

burden and the profit margin relative to the market. We are especially pleased with its asset turnover, decreasing

leverage, and its implied ROE compared to that of its industry and the S&P 500. It is clearly one of the top

companies among its competitors, namely Seagate Technologies who’s ROE was only 9.62%.

Secondly, we are also impressed with Western Digital’s ability to manage and produce cash flows

effectively in the past as well as assuredly into the future. Its past can be measured by its tremendous one dollar

premise value of $7.31 and its current owner’s earnings growth rate of 163.05%. Therefore, it is obvious the cash the

company is reinvesting is being put to good use.

Although the future is difficult to predict, we have found three main opportunities for future cash flow

growth. The first potential for growth we see is for the company’s PC division, which accounts for 71% of total

sales. The opportunity lies in the increasing demand for external hard drives. According to the annual report, in the

year 2001 there were 50% more hard drives sold than PCs, and in 2005 there were 74% more hard drives sold than

PCs, indicating a very strong growth for this market.

Another potential for growth we found is the growth we have seen lately in the consumer electronics

market for hard drives. The number of mobile devices requiring hard drives such as MP3 players, Digital Cameras,

and PDAs is consistently climbing. Western Digital has focused enough research and development over the past five

years on this market, to keep up with the current trends as this demand grows.

Lastly, we see the geographical expansion into the Asian market as an excellent potential for growth.

Currently, this area is the fastest growing market for consumer electronics, and Western Digital currently attributes

over a third of their revenue to this location and plans on increasing that further. In summation, we believe the future
looks positive for Western Digital, and it is the right time to buy, as evidenced by the current price relative to the

intrinsic value found, giving us an immense margin of safety.

Reversal Criteria

In order for us to recommend a sell proposition for this stock in the future, two of the following three

events would need to occur. The first is if the implied ROE were to fall within 5% of the industry average, since the

industry overall has a weak ROE of 11.12%, which would mean a decrease of about 22% for Western Digital’s

ROE. Since we have seen such an increase in revenues from Asia in the past years from 29% to 36% from 2004 –

2006, along with a planned further increase, another indication to sell would be if we saw two consecutive years of

decreases in revenue from this market. Finally, we have such an impressive margin of safety at this point, if it was

to fall to 25% or less, that would be a good indication to reevaluate our decision. A falling margin of safety would

also probably indicate a negative outlook on their currently positive owner’s earnings.