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Western Digital is probably cheap [ClearOnMoney]
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Western Digital is probably cheap

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Commentary

Western Digital is probably cheap

5 Jan 2011 by Jim Fickett.

Western Digital, a hard drive manufacturer, has shown strong earnings growth and currently has a price/earnings ratio of only 6. The company is facing a major challenge in probably having to switch to a completely new technology over the next decade. There is a good chance they will do it. If so, and if current earnings are sustainable, then the current price is a bargain.

Earlier this week, John Dorfman, who writes a Bloomberg investing column, brought up the topic of stocks with very low price/earnings ratios.

I was curious about what would happen if one were to take low P-E investing to an extreme. So, beginning in 1999, I have tracked the one-year performance of the 10 stocks that begin the year with the lowest P-E ratios. …

The compound annual return on the outlier stocks for the years 1999 through 2010 was 16 percent, compared with 1.5 percent for the Standard & Poor’s 500 stock index.

Of course there is usually some reason for the low price, and some of the stocks have NOT performed very well.

This year, one of the 10 stocks with the lowest P/E is Western Digital, a manufacturer of hard disk drives (HDDs).

Also sporting a multiple of six is Western Digital Corp. of Lake Forest, California, the world’s second-largest disk-drive maker by revenue. I mentioned it last week as one of my 10 favorite stocks for 2011.

Western Digital is a very solid company. Their 10-K annual report filing is a pleasure to read, with financial results, strategy, and risks all laid out very clearly. Earnings have grown strongly, rising from $1.76 per share in 2006 to $5.93 in 2010. The company has a very strong reputation for making a quality product, and if you read reviews on the web sites of computer parts suppliers you will see that many customers are almost fanatically loyal. And the market they are in, while competitive, is certainly not lacking in opportunities. With more and more cloud computing, and videos seemingly multiplying without bound, the demand for storage continues to rise rapidly.

The main reason Western Digital's price is so low is that hard drives, their core product, are probably on the way out. You have probably noticed how USB thumb drives have increased in capacity by a factor of several hundred in just a few years, and how memory chips in cameras can now cheaply hold huge numbers of pictures. This is all a function of flash memory (memory that maintains the data even when the power is off) rapidly getting denser and cheaper. In fact, though hard drives are also gaining capacity and getting cheaper, the pace of improvement for flash memory is considerably faster. Most people in the computer industry think the days of the hard drive are numbered.

All this means it is very difficult to know whether Western Digital's earnings are sustainable, of even whether they will grow or shrink in the longer term.

Of course Western Digital knows all this. In 2009 they bought a company that makes so-called Solid-State Disks (SSDs), meaning a flash memory storage module in a hard-disk form factor. They are now selling what may turn out to be a long-term replacement for the hard drive, and the product is well accepted.

The big, vague question is where all this will go. First, hard drives will not disappear soon. iSuppli, a computer market analysis company, writes,

For 2010, SSDs will see increased penetration in the enterprise server, desktop and notebook segments— three traditional storage areas also served by the rival HDD technology. Penetration rates will roughly triple this year in both the enterprise server and desktop segments—increasing to 1.7 percent from 0.6 percent in the former, and to 1.2 percent from 0.4 percent in the latter. Among notebooks, where SSD penetration remains highest, penetration will climb 0.6 points to 2.3 percent …

All told, iSuppli does not expect SSD to threaten HDD dominance in the overall PC, server and storage markets within the next five years. Instead, the technology will likely coexist with HDD in all the service markets, with HDD actually benefitting from SSD implementation.

And the CTO of Hitachi, one of the main manufacturers of storage systems, says,

There's still a 10- to 12-year development road map ahead for spinning disk drives, but the technology's inherent limitations will eventually force a shift to something new …

While the price can be expected to drop, Yoshida says it may not happen as fast as some people expect. Flash is not produced in the same types of quantities as spinning disks and it will therefore be hard to eliminate the price gap between SSD and hard drives, he says. …

But the flash technology used in enterprise storage products today can wear down after about 100,000 writes, Yoshida notes. Vendors are trying to make flash more durable, but ultimately it may not be enough to make flash a suitable replacement for hard disks, Yoshida suggests.

All this means that Western Digital will have strong earnings from hard drives for at least several more years, and has considerable time to make the switch to new technologies. In my opinion the company has excellent skills in finding the right tradeoff between cost and performance in the components that make up an HDD or SDD, and is also very strong in making the interface between the storage device and the operating system smooth and reliable. So I think the rosy scenario, in which Western Digital has strong HDD earnings for several more years, and then switches successfully to a new technology, has pretty high probability.

I am a very conservative investor, and there is not quite the margin of safety here that I would like. Yet I would still bet this stock will be higher by the end of the year.