A Western Digital office building is shown on January 24, 2017 in Irvine, California, United States.
Mike Blake | Reuters
Company: Western Digital (WDC)
Business: Western Digital is a leading designer, manufacturer and supplier of data storage devices and solutions and operates two market-leading franchises: Hard Disk Drives (“HDD”) and NAND Flash Memory (“Flash”). These two companies came together through SanDisk’s $19 billion acquisition in 2016, which prompted the company to diversify its nearly five-decade-old business away from HDDs and become one of the industry’s biggest flash players.
market value: $18.6 billion ($59.45 per share)
Activist: Elliott Associates
Percentage ownership: ~6.0%
average cost: n / A
Activist Comment: Elliott is a very successful and savvy activist investor, particularly in the technology sector. Her team includes analysts from leading technology private equity firms, engineers, operating partners – former technology CEOs and COOs. They also hire specialist and general business consultants, cost analysts and industry specialists when evaluating an investment. They often watch companies many years before investing and have an extensive roster of impressive board candidates.
What’s happening?
On May 3, 2022, Elliott sent a letter to Western Digital’s board of directors, expressing his belief that the company should divest its NAND flash memory business. Elliott called on the board to conduct a full strategic review and expressed his belief that such a split could result in a stock price in excess of $100 per share by the end of 2023.
Behind the scenes
As new “activists” came onto the scene, we’ve seen a fair amount of “business sell” activism with no detailed plan or reason for it. We have criticized this style of activism as short-term and greedy. Those activists who didn’t understand why we were so critical should read Elliott’s letter as an example of a well thought out, thoroughly analyzed, shareholder-focused strategic activism campaign. Elliott provides a detailed 13-page letter explaining why the company’s two businesses need to be separated and a plan to achieve the separation, which is in the best interests of shareholders.
The company is one of the world’s largest suppliers of storage components for data infrastructure and has built a successful HDD business. However, the HDD industry began a slow decline in 2013 as desktop and notebook PCs transitioned to faster NAND flash solid state drives (SSDs). Therefore, in 2015, the company announced it would acquire SanDisk for $19 billion to enter the higher-growth flash industry. In the years following this acquisition, the HDD industry recovered and has now become a growing market again, with Western Digital being one of the two dominant providers of this technology behind Seagate. Western Digital is the only company today that works with both HDD and NAND flash.
Over the past six years, the company has underperformed in several areas. First, they have attempted to leverage the strategic synergies of a combined HDD and flash portfolio, but have lost market share in both HDD and flash. Second, its operational missteps have consistently resulted in unmet financial targets, including compound annual revenue growth rate, gross margin, operating expenses, and operating margin. Third, the company has had poor stock price performance, generating returns of -23.10%, 6.14% and -39.57% over the last 1-, 3- and 5-year periods, respectively, versus -0.89%, 41, 07% and 74.0% for the S&P 500.
In his letter, Elliott makes a compelling argument that the reason Western Digital underperformed is that the two companies should not be part of the same entity. Both companies are solid and have good market share, but would have significantly higher value as individual companies. HDD and Flash are completely different technologies: spinning mechanical hard drives versus state-of-the-art semiconductor devices. The manufacturing processes are separate and while the companies share common customers, the products may compete in certain use cases.
Prior to the SanDisk acquisition, Western Digital consistently had a higher price-to-earnings multiple than its closest competitor, Seagate. Seagate has had a significantly higher price-to-earnings ratio since the acquisition. Today, Western Digital has an enterprise value of $21 billion, compared to the combined pro forma enterprise value of Western Digital and SanDisk of $34 billion when they announced the acquisition six years ago, a decrease in value of $13 billion -equivalent to dollars. In contrast, Seagate increased its enterprise value from $17 billion to $22 billion over the same period. When Western Digital announced its acquisition of SanDisk, the stock was trading at $75 per share. Six years later, the stock is down almost 30% to $53 per share. During the same period, the S&P 500 and Nasdaq are up 103% and 190%, respectively. Seagate (the company’s closest HDD competitor) has outperformed Western Digital by 278% over the past decade, and Micron (its closest NAND competitor) has outperformed Western Digital by 868% over the past decade.
Elliott believes that Western Digital’s valuation today reflects the market’s view that co-owning HDD and Flash results in a clash of synergies in terms of operational and financial performance. Accordingly, they are urging the company to explore a full divestment of the Flash business, which they believe could result in a share price of over $100 per share by the end of 2023, and they are illustrating how to get there.
Western Digital’s HDD business has a 38% market share (vs. 46% for Seagate), revenue of $9.4 billion (vs. $12 billion for Seagate), a growth rate of 21% (vs % for Seagate) and both companies have gross margins of 30%. Using Seagate’s multiples of 1.8x LTM revenue and 6.1x LTM gross profit, Western Digital’s HDD business would be valued at $17 billion.
Western Digital’s flash business has sales of $10 billion, and similar companies have been acquired at multiples of 1.7 to 1.9 times sales. This would give the Flash deal a value of at least $17 billion. But this is not the normal call for strategic action. Elliott is putting his money into action, offering over $1 billion in additional equity to the Flash business at an enterprise value of $17 billion to $20 billion, either in a spin-off transaction or as equity financing Can be used in a company sale or merger with a strategic partner. Essentially, Elliott is expressing a willingness to participate in acquiring the Flash business with a $1 billion investment. So, Elliott estimates that each company is worth about $17 billion, while the company’s total enterprise value is $21 billion.
If Elliott divests the flash business at the value they’re putting their own money into, it would value the entire HDD business at $4 billion. There’s good reason to believe there are buyers for the flash business, particularly with a combination of Western Digital’s flash business and its joint venture partner Kioxia. Western Digital’s interest in acquiring Kioxia has been well documented over the years, including a bid in 2017 and the reported $20 billion transaction value last year (1.7x LTM earnings). Over the past five years, Kioxia has been publicly rumored to be attracting interest from a long list of other strategic and financial parties.
Your plan could resonate positively with the company’s current board and management team. The decision to acquire SanDisk rests with the company’s CEO, David Goeckeler, and his executive team, almost all of whom were hired in 2020 or later. In fact, Goeckeler’s first operational step was the separation of HDD and Flash within Western Digital. It’s not a big step to get the board to split it up into another company, especially since only two of Western Digital’s current 10 directors were on the board when it acquired SanDisk. Furthermore, shareholder activism is about persuasion and argument, and Elliott makes a very compelling argument here.
It should also be noted that Elliott has reported an investment of approximately $1 billion in the company but has not filed a 13D, despite having an approximately 6% position. Based on their history and philosophy, this is likely because Elliott uses swaps and other derivatives to build their position and these types of securities are not required to be included in “beneficial ownership” for 13D filing purposes at this time. Using swaps in this way is the subject of a recent proposal from the Securities and Exchange Commission, and could very well change in the short term, forcing Elliott to file a 13D filing on that investment.
Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and he is the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of 13D activist assets. Squire is also the creator of the AESG™ investment category, an activist investment style focused on improving portfolio companies’ ESG practices.