This post by Barry Pasikov is excerpted from a letter of Hazelton Capital Partners.
Over the last few months, Western Digital and Toshiba Corp have been embroiled in a legal dispute over their joint venture (JV) that manufactures NAND flash. The battle began soon after Toshiba recorded huge cost overruns and losses from the nuclear power division it purchased from Westinghouse. In order to cover those losses and underpin its balance sheet, Toshiba has been forced to sell its prized NAND Flash business that is jointly owned with Western Digital. According to Western Digital, the terms of their joint venture require Western Digital’s approval before Toshiba can sell its stake. Even though Western Digital is also one of the bidders for Toshiba’s portion of the JV, Toshiba has ignored Western Digital’s claim and has chosen a consortium that includes Bain Capital, and rival NAND manufacturer SK Hynix as its lead bidder. In May, Western Digital began arbitration proceedings over a potential sale, stalling the transaction.
With all this uncertainty, why continue to own Western Digital?
Western Digital has been a centerpiece of the portfolio for seven-and-a-half years and a top five holding for the past four years. Over that period of time, uncertainty has consistently hung over this company like the Sword of Damocles. At the time of our initial investment in 2009, Western Digital was a hard disk drive (HDD) manufacturer with a 30% market share. The major reason why the company’s stock was so cheaply priced was because the market believed Western Digital would follow the same path as Kodak and Motorola, pioneers and innovators of their industry, who failed to transition to the new burgeoning mobile world. NAND flash storage is the technology used in all mobile devices and is a more advanced technology than HDD: It is faster, lighter, has a smaller footprint, and uses less energy – perfect for mobility. In late 2015, to remedy its dependence on HDD, Western Digital announced the purchase of SanDisk (a leading manufacturer of NAND and JV partner with Toshiba).
The digital storage industry has historically been plagued with technology obsolescence, fierce competition, and quick, repetitive business cycles. These factors still exist, but their impact is muted as the industry has matured and consolidated. With the speed of technology innovation slowing, and the cost to retool becoming more expensive, the duration of a digital storage business cycle has expanded. As many in the industry have become “rational” about their investments, the peak to trough of the cycle has also become less dramatic.
Western Digital recently traded around 7x earnings and below that for earnings projected out to 2018 – Not quite the levels when the Fund initially invested in the company, but cheap nonetheless. The company’s current free cash flow run rate is $3 billion and it expects to add another $300 million from ongoing integration of both HGST and SanDisk by year end. Hazelton Capital Partners still believes there to be significant upside opportunity with our investment and is comfortable holding the position.