|Shares Out. (in M):||307||P/E||5.3||5.85|
|Market Cap (in $M):||21,797||P/FCF||6||5.3|
|Net Debt (in $M):||6,426||EBIT||3,974||4,342|
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It is an opportune time to revisit Western Digital (WDC), which was last posted by jmxl961 in May of last year at $89. At that time, the street, based on company guidance, estimated that Western would earn around $12 in fiscal 2018 (ending June 30). Actual earnings for fiscal 2018 came in at almost $15 per share. In terms of risks at the time of the prior write-up, we were much more worried about accelerating HDD secular decline and potential negative outcomes from the messy dispute with Western’s flash partner Toshiba. Neither of these turned out to be worth losing sleep over, but we were willing to live with them to gain exposure to Western’s flash business, with its very strong secular trends, at a very appealing valuation. We did indeed get exposure to strong trends, but it turned out to be a cyclical decline due to NAND over-supply. After a weak revenue and margin guide for the rest of the calendar year, the stock now sits at $71. Even with weaker than originally anticipated flash results, Western should earn $11-12 over the next twelve months, making it the third cheapest name in the S&P 500. The stock price tells us that the market thinks the NAND cycle gets worse before it gets better. We don’t have the clarity at this point to say that the market is wrong on that score. However, we believe that the strong secular trends are still intact and have decent visibility to $15 per share free cash flow and a $150 stock within two to three years. In addition, we suspect that there is limited trading downside from here, as it is difficult to come up with reasonable scenarios where the company earns less than $8. Applying an 8 P/E, gets to $64 per share, or 10% downside. At that price, we would be paying little, if anything, for the NAND business, based on backing out Seagate’s (STX) valuation for Western’s HDD business.
We have arranged this write-up to begin with updates since the last writeup was posted followed by commentary seeking to dispel the main bear points as we see them. Finally, there is additional background information on Western and its business lines for those who are new to the name. Please also see the numerous quality WDC write-ups posted here previously.
Fiscal 2018 earnings results / LT Model Update
Western reported earnings last week for its fiscal year ending June 30. Initial earnings guidance coming into the year was >$13 for fiscal 2018. It was then raised to $13.50-13.75. Actual earnings came in at $14.73. For the quarter, the company met its prior guidance with some impressive cost cutting but took down its margin guidance for the remainder of the calendar year and guided to an underwhelming $5.1-5.2 billion in revenue, flat with the June quarter despite going into what has historically been a seasonally strong period. Margins were guided down almost 300 bps q/q on the back of NAND ASP declines, which we discuss in detail below. Inventories came in high, up almost $600 million y/y, especially considering a flat to declining outlook. The guidance summary for fiscal q1 is as follows:
One of the analysts asked on the call if the prior guidance of $13 per share for calendar 2018 was still good. The company confirmed that it is still confident in exceeding that number. Thankfully, the HDD side of the business is very strong. Gross Margins of Seagate (Western’s public HDD competitor) expanded over 200 bps q/q while guidance called for 5% sequential revenue growth. Both Western and Seagate said they were on allocation in their HDD businesses and running at full utilization. Here are the implied results for the next two quarters and how a full year would look if we annualized those quarters:
In an apparent bone thrown to frustrated investors, management took the opportunity to update its long-term financial model, which the company has operated well above for the past year and a half. Few seemed impressed though, as the stock made a new 52-week low.
We had previously thought that margins might be sustained above 40%. Time will tell if the company is again being conservative. Regardless, the implied $11+ of earnings is enough to support a $71 stock once the negative sentiment eases.
Other relevant updates from the call were that Western and Toshiba were discussing pulling capital from the flash JV to reduce capacity in an over-supplied market and that the company planned on buying $1.6 billion in stock per year as a part of a new $5 billion repurchase program. The tone of the call was positive but the message was muddled. Reporting for the flash business has always been lacking – the company does not even publish revenue and margin for the division. With the rapid deterioration in NAND, investors are trying to find some grounding in the supply demand/macro as well as some issues specific to Western like slower bit growth and SSD execution misses. We left the call frustrated with management but wanting to add to our position given the valuation.
Toshiba dispute resolution
WDC had been engaged in a serious dispute with Toshiba over the sale of its interest in the companies’ three flash JVs. This dispute had prompted concern that Toshiba would block Western from participating in future NAND fabrication facilities, the output of which WDC needs to successfully operate its business. Dating back to 1999, Western (previously SanDisk) and Toshiba have a seventeen-year successful history of working together on manufacturing 13 generations of NAND flash memory. The JVs are widely considered one of the most successful partnerships in the history of the technology industry. The relationship between Toshiba and Western began to fray last year when Toshiba initiated a process to sell its Memory business, which holds its interest in the JV. Toshiba needed to raise capital to cover billions of losses incurred in its Westinghouse Nuclear division. Provisions in the JV agreements give Western broad consent rights in approving any change of control. Western became very concerned when both competitors and key customers began negotiating a transaction with Toshiba without first seeking Western’s consent. The spat quickly devolved into corporate trench warfare, with both companies suing each other in multiple jurisdictions and even locking employees out of offices. WDC was part of a KKR consortium also interested in purchasing the Toshiba interest. Certainly, there were compelling reasons for Western to fully control one of the top two NAND manufacturing companies. WDC, however, was stymied for perhaps overplaying the leverage it had in the situation and not giving Toshiba management enough room to save face in an already humiliating situation. In September, Toshiba agreed to sell its JV interest to a Bain Capital-led group, including WDC competitors Seagate and Hynix, and WDC customer, Apple. This announcement, a clear violation of the JV agreements, put further pressure on the stock.
On December 12, 2017, Western, Toshiba and Bain announced that they had reached a settlement in their dispute. Included in the agreement are: 1) extensions of two of the JVs to 2027 and 2029, 2) participation by Western in Fab 6, the new 3D NAND manufacturing facility planned by Toshiba, 3) agreements to build a new wafer fabrication facility in Japan, 4) renewal of joint R&D commitments, 5) establishment of IP protections in the event Toshiba sells some or all of its JV interest to a third party, especially a customer or competitor, 6) provision of Western’s consent to Toshiba transferring its JV interest. While Western did not exit this fiasco with full ownership of the JV, we are not discouraged by the outcome. Purchasing the balance of the JV would have been a very large $18 billion acquisition, further leveraging WDC to capital-intensive manufacturing near the top of the NAND pricing cycle and adding more debt to the balance sheet. Moreover, the company will retain one of only a few seats at the top NAND manufacturing table, giving it critical influence in NAND development and strategic access to high quality components without the large capital outlay. The settlement also eliminates the significant specter of Western losing access to NAND capacity, the risk we previously had worried about the most in this dispute.
On November 8, 2017, Western announced the repricing of approximately $3 billion of term loans at LIBOR + 2%, 75 bps lower than its prior term loan priced in March 2017. The maturity remained April 29, 2023. Annual interest savings was $22 million.
On November 17, 2017, Western announced the prepayment of €874 Euro-denominated term loans. Interest savings were $28 million + $20 million in hedging cost savings.
On November 29, 2017, Western announced increased capacity on revolver from $1 billion to $1.5 billion. On February 27, 2018, Western further increased its revolver capacity by $750 million to $2.25 billion from $1.5 billion.
On January 29, 2018 Western issued $2.3 billion in 4.75% senior notes due 2026 and $1 billion in 1.5% convertible senior notes due 2024 ($121.91 conversion price, 40% premium at the time) to retire all of its $1.875 billion 7.375% senior notes due 2023 and tender for its $3.35 billion 10.5% senior notes due 2024. To offset potential dilution from the coverts, Western repurchased $155 million of stock in February, with the ability to repurchase an additional $500 million.
The net result of the transactions listed above was to reduce debt by gross $1 billion, term out maturities, increase liquidity and reduce annual interest expense from $808 million to $440 million ($1/share after tax). We were originally not thrilled with the dilution from the converts or the $1 billion of transaction costs and would have preferred the company retire a portion of the debt at maturity. Clearly from here, the converts are way out-of-the-money, and we would happily be diluted at $122 today. Based on our conversations with management and their actions, it appears that management would rather term out debt and keep excess cash to retain the flexibility to 1) execute on acquisitions and, 2) in the absence of deals, buy in shares.
On November 9, 2017 Western announced that it had “board authorization to resume potential repurchases of its common stock under a previously approved repurchase program.” The existing authorization, which was suspended after the Sandisk acquisition announcement, was for $5 billion, of which $2.1 billion was remaining at the time.
Western began buying shares the following quarter, with $155 million of repurchases. Last quarter Western purchased $436 million after indicating it would buy $500 million. The splashy buyback announcements without much follow through are another source of frustration for us. We believe real buybacks will begin in earnest this quarter.
Now that the company resolved its JV dispute with Toshiba, the company is likely to be far more aggressive in repurchasing shares and paying dividends. Prior to April 2015, the dividend had been doubled in a little less than 2.5 years.
Prior to the large acquisitions over the last decade, Western had a stated policy of returning half of its free cash flow to shareholders. We expect that policy to resume now that Western has established itself as a leader in its markets and was unable to execute on buying Toshiba’s memory business. Peer Micron recently announced a similar policy, and Seagate is notoriously very aggressive with capital returns. We could envision Western repurchasing a significant number of shares (20-30% of outstanding) over the next three years and then materially increasing the dividend. Regardless of the specific approach taken, the current valuation calls for more aggressive capital returns in our opinion.,
As of June 30, 2018, WDC had $5 billion of cash, $11.4 billion of gross debt and generated $6.3 billion of EBITDA over the last year. Thus, WDC possesses a very comfortable 1.0x trailing Net Debt/EBITDA despite levering up to pay $14 billion to purchase SanDisk in May 2016. On our base case EBITDA for fiscal 2019, we still expect leverage to be around 1x on net debt/EBITDA, leaving the company with significant financial flexibility to return capital and/or pursue acquisitions.
Western had an average diluted share count of 307 million at the end of the June quarter. With its targeted $1.5 billion in annual share repurchases, and at the current share price, Western could easily retire 7% of its shares annually.
WDC currently pays a $0.50 quarterly dividend, which yields 2.8%. This dividend has not been increased since April 2015 because capital was required to execute the SanDisk acquisition.
Valuation / Model
The uncertainty around the NAND cycle has created a unique opportunity to purchase this storage leader for 6x run rate earnings. Typically, this type of valuation is placed on “melting ice cubes” with declining end markets and deteriorating financial results. Western, however, presents us with strong long-term growth prospects – the company projects a long-term revenue growth rate of 4-8%. Our base case model calls for revenue growth slightly below the low end of that range. We assume a decline in HDD units is offset by ASP growth. Industry revenue growth and margins are currently well ahead of our HDD assumptions. For Flash we assume the current margin environment continues but revenues begin to grow again due to demand elasticity. Assuming Western holds market share, the implied TAM is some $12 billion below industry estimates for 2021.
For operating costs, working off of non-GAAP assumptions, we assume some modest inflation over the next three years. This could flex up or down depending on underlying business strength. For example Western managed costs down last quarter in the face of weak demand. Conversely, we could see the company investing behind strength in the HDD business if that market remains stronger than we assume here. We hit them for stock comp in earnings but assume dilution of 1.5% per annum.. Interest and tax rate are as per guidance, the latter growing to 10% next year. We assume cash capex goes from 6% of revenue to 7%, within the guided long-term range. Now that the company has termed out its debt and further debt paydown is unlikely, we assume that all free cash flow goes to share repurchase at $115 per share. Walking this model forward, we arrive at over $15 per share in 2021 free cash flow. Please note that the 2018 column below is not actual results, but is more of a representation of run rate.
If one assumes that a storage company should trade at 10-11x earnings, the market is telling us that WDC’s earnings should decline to below $8 per share due to weakness in the flash business. Based on the discussion here, we think that is highly unlikely. As earnings grow again after the NAND correction, the company’s price/earnings ratio should rerate higher to 12-14x earnings, implying a WDC stock price above $200. However, to be more conservative we use a 10x multiple on 2021 FCF and still get to a price target of $150.
While one may quibble with the appropriate multiple, there is no denying the fact that without stock price appreciation, Western’s valuation gets cheaper every quarter with the amount of free cash flow coming in. Over the next few years, the company will be able to achieve a net cash position even under the most draconian assumptions. This will allow the company to pursue more aggressive capital allocation strategies, either acquiring suitable companies as it has done in the past, dramatically increasing the dividend, or repurchasing a considerable number of shares. Most likely, some combination of the three will be in order. Regardless of how the company chooses to deploy the free cash flow, the debt paydown should accrete value to the share price. Should the valuation continue to languish for whatever reason, we think the company becomes a target for private equity. The storage space has seen many private equity deals over the years, from Seagate going private to the most recent Bain/Toshiba deal. Western’s cash flow and leverage profile would make it an attractive LBO candidate. We also think Micron would be interested in buying Western at this low valuation. Putting DRAM and NAND together makes good strategic sense, and combining the two companies could be done in a highly accretive way due to potentially vast cost-savings at the fab and corporate levels.
Bear Case 1: Sustained NAND Oversupply
NAND pricing has clearly rolled over for this cycle, so those skeptical of Western’s margins have been proven right so far. Many industry participants indicate that the market is in a state of modest over supply while, on the demand side, mobility has been soft over the last two quarters. Coming into the year, TrendForce forecasted that 2018 NAND flash prices would decline 10-20%. IDC made a grimmer (and, as it turns out, more accurate) forecast, calling for a 35% decline, though they had to take TAM numbers up when the market tightness persisted through the winter (maybe they come back down). Since what appears to be the cyclical peak for margins in the March quarter (~4 months), commodity NAND prices have already declined 35%.
Given the elasticity of demand for NAND and the opacity of supply additions, it is very difficult to predict short-term imbalances. Comments from various companies in the space point to bit supply and demand growing by 40-50% in 2018. Importantly, storage manufacturers like Western can have a very viable business as both pricing and cost roll down the Moore’s Law curve. In fact, storage companies would be unwise not to underwrite sustained double-digit annual ASP declines. As the following graph shows, the trend of NAND price declines is well-established and everyone should expect it to continue. One can run countless scenarios on revenue outcomes with the key variables of bit growth, unit pricing and unit cost.
Western has called for a normalization in pricing and estimates long-term NAND prices will decline 15-20% annually, not dissimilar from the prior five-year period but certainly inconsistent with recent trends. At this pace (-15-20%), given Western’s annual unit cost reduction roadmap of -15-25% annually, Western can deliver sustained solid margins (we believe in the high 40% range). It is no surprise that Western’s margins have eroded with the rapid ASP correction this year. We estimate that Western’s flash margins declined 500 basis points q/q in the June quarter. Our read on the weak results, based on peer results and conversations with various participants, is that mobile phone demand for the quarter was weaker while supply was in line with expectations. We think this might be due in part to over-ordering/a channel inventory correction by customers like Apple. In general terms, this is not a structural change. In the following table we have made a guess on quarterly HDD margin, primarily using STX’s margin as an input and backed into WDC’s implied flash margin:
Rolling up these three variables/assumptions – bit growth, unit cost and ASP – gets to a flash TAM that grows at an 8% CAGR through 2021. We still think these numbers are good, if not conservative; however, visibility into the next year is quite a bit murkier. IDC thinks the flash TAM will decline another 5% to $56 billion in 2019 before beginning to grow again in 2020, but thinks that further price declines will spur new demand and device content gains (e.g., new 512GB smartphones, continued data center strength and higher P.C. attach rates). With bit growth demand growing at 40-50% and costs shrinking at 20%, one must assume very large, sustained pricing declines to claim that revenues will materially decrease. A good rule of thumb is that pricing should decline at half the pace of bit growth. Both Gartner and IDC estimate a $60 billion industry going to $80 billion over the next three years. After the normalization period, our longer-term view is that bit growth should outpace pricing declines, leading to modestly growing revenue and margin. This view was recently confirmed by WDC management on a conference call. The key question is where do normalized flash margins shake out? For our modeling purposes, we are assuming the middle of Western’s new long-term range. Western has been conservative in putting out this range in the past, and we expect the same for the new range. Most importantly though, the current valuation does not force us to underwrite anything higher than really the low end of the range. If it turns out to be better, great. We walk through some of the supply and demand dynamics below in this section. In preview, we believe that demand will surprise to the upside and the supply outlook is very manageable.
Significant capex has been going into NAND supply over the last several years. Worldwide, Gartner estimates some $18-20 billion per year from 2016-2018 is being spent on NAND capacity - up from $14 billion in 2014. Gartner expects this number to stabilize in the $17 billion range during 2019-2021. There is no question that these are massive amounts of capital, but it is required to keep up with NAND demand growth, which is growing at a 40%+ CAGR. Moreover, the 2016-2018 spend should be viewed as catchup, as NAND production capacity growth was only 5% and -1% in 2012 and 2013, respectively, way below end market growth. Additional cap-ex was necessary for NAND producers to transition to 3D NAND, a chip with a new architecture that allows Moore’s Law to continue. There is no question that the 3D transition is going well, and that supply has started growing faster. In 2017, however, NAND was in short supply, and spot prices for NAND remained stubbornly firm, rising some 50% against expect price decline trends. Now that supply has caught up with current demand and prices are falling, industry participants are considering ratcheting back on capex and planning capacity growth. As mentioned above, Western and Toshiba are discussing this currently. Any change in capital would not be visible in capacity until early calendar 2019. Samsung has made similar comments, repurposing at least one fab for DRAM that was previously slated for NAND. While not a duopoly like the HDD industry, the NAND industry is highly consolidated, with Samsung and Western/Toshiba controlling roughly 2/3 of output. Despite the current hopefully temporary over-supply, the players seem to behave rationally. Chinese supply may be a wild card, but it is not a factor currently and is not expected to be for a few years. In addition, the Chinese fabs are multiple technology generations behind the market leaders.
The NAND shortage in 2016-2017 prevented many new NAND applications from ramping and slowed the replacement of HDDs with flash storage. NAND is widely believed to have the most elastic demand profile of any semiconductor – demand is almost insatiable as prices fall. This compares to other components such as microprocessors and DRAM, which have far fewer new applications. Thus, as NAND prices fall, which they inevitably will consistent with Moore’s Law, NAND content in existing end markets increases and countless new applications emerge in a virtuous cycle of additional NAND demand. The same trend occurred with HDDs and virtually every other storage/processer technology. In the early 1980s, one gigabyte of HDD storage cost $500 thousand, making almost all applications uneconomical. Today, it costs a few pennies and is everywhere. The growth in NAND content in each subsequent iPhone model is a perfect example (see chart above right). Mobile phones have been the largest end market for NAND in recent years, accounting for as much as 40% of NAND output and largely contributed to the recent NAND shortage. Average NAND capacity per smartphone was up almost 50% y/y in 2017. Apple launched its iPhone 8 and iPhone X last year, with the highest models holding 256GB of NAND, a far cry from the original iPhone at only 4GB. Samsung has announced its next generation of flagship phones will hold 512GB of NAND; Apple will almost certainly follow suit. As NAND prices decline, Apple and other NAND buyers can continue to increase NAND content in devices without having to raise prices. For this reason, NAND content growth has outpaced smartphone unit growth by more than 5x (see Gartner chart above left).
We suspect investors severely underestimate the magnitude of pent-up NAND demand. First, as mentioned above, high NAND prices slow SSD penetration in PCs. Only 30% of notebook PCs shipped today have SSDs. Gartner projects that mobile and desktop PC units that ship with SSDs will grow to over 70% by 2021. The graph below shows that SSD growth is accelerating because of this while mobile phone growth remains steady. Seagate estimates that incremental NAND capacity just to replace these PC HDDs would require an addition $40 billion of capex, roughly two years of run rate spending. Further contributing to the SSD growth is SSD penetration in cloud and enterprise storage. In the third quarter of 2017, 3.7 EB of SSDs shipped for use in servers, up 150% year/year. Over the last four years, IDC estimates that SSD capacity shipped grew at a 105% CAGR but still only makes up 10% of the total enterprise storage market (HDD + SSD). This demand growth is highly elastic and will increasingly shift from HDDs when NAND pricing resumes its decline. SSD enterprise capacity shipments overtook mission-critical (think “hot data”) HDD capacity shipments in 2016 for the first time. SSDs also became the largest user of NAND flash in the first quarter of 2017, surpassing smartphones. Due to this accelerating growth, in the next few years SSDs will become even more important to the NAND outlook. Today most people think about it as primarily as smartphone input.
The final and potentially most significant area of new NAND demand is IoT devices, which are still relatively in their infancy. In the not too distant future, virtually every electronic device will be connected to the internet and need to store data. When one thinks of data input today, one likely thinks of a person typing on a keyboard. In contrast, IoT devices will be inputting data from sensors that record every imaginable aspect of the world around us. As Peter Levine of venture capital firm Andreesen Horowitz describes the step change coming from IoT data creation, “It will literally be orders of magnitude, in the exact mathematical sense.” (One order of magnitude is 10x; two orders of magnitude is 100x). NAND is the ideal memory for IoT devices considering cost, physical size and speed. We see very little in NAND forecasts that captures the impact from IoT device proliferation, especially as significantly as Mr. Levine expects.
Taking cars as an example, cars connected to the network will send 25 GB to the cloud every hour according to Hitachi. This compares to less than 1 GB for an hour of streaming HD video. Google estimates that a self-driving car will generate 1 GB of data per second. All this data must be at least temporarily stored on the car, and then a curated portion of that data is stored in the cloud. Michael Huonker from Daimler AG R&D forecasts that SSD storage in cars will grow to more than 1 TB per car from almost nothing today. For illustrative purposes, if one assumes that each car sold in the US has this amount of storage, the annual storage demand from cars alone would be about one-third of 2017 NAND output. We don’t expect this anytime soon, though Gartner forecasts that there will be 250 million connected cars on the road by 2020. Of course, this is just one of innumerable potential applications. Considering the cloud storage implications of the data created, one can quickly envision a world where it is virtually impossible to create enough storage capacity to meet the need. The broadening of NAND end markets beyond PCs and phones to the wide variety of IoT devices likely smooths out the product and business cycle as well.
We are confident that between the richer product offering and solid manufacturing, WDC will skillfully navigate any potential brief periods of oversupply and adjust accordingly. Manufacturing of NAND is consolidated among a few players; Samsung and the Toshiba/SanDisk JV hold around 70% market share together, much greater than that in leading edge NAND. Both parties have demonstrated significant discipline. In fact, Samsung recently announced that equipment for a new fab would be for manufacturing DRAM, not NAND. The upshot is that NAND capacity spending is driven by a few disciplined players with varied products competing for capital. Private equity firm Bain Capital entering the mix by acquiring Toshiba should only increase capital discipline. The Toshiba dispute has also likely delayed the Flash JVs own capacity additions. Additional participants who might be attracted to the high margins and growth outlook lack the IP, manufacturing experience and scale required. In addition, the capital alone is daunting – new fabs cost $10 billion. Analysts seem to assume that capital will continue to flow freely into the space. China has indicated that it will enter the market, but this is several years away and will only be for second-tier products. According to Western, these Chinese product roadmaps are multiple product generations behind Samsung and WDC/Toshiba.
The final key consideration when discussing the prospect of sustained NAND oversupply is the fact that Western primarily sells high end SSD drives and NAND solutions, only selling a limited amount of commodity NAND. WDC’s solution product portfolio continues to include more value add such as software, integration, and special purpose chips which fetch up to 6x the price of what commodity drives receive. NAND is actually an input cost to these drives. Yet, the value of their end products to customers is based on market demand for specific products. Just because NAND prices decline does not necessarily mean that ASPs for Western’s products will decline too. Western is in the fortunate position of being able to focus on high margin drives that utilize its specialty software and leading manufacturing and cede low margin commodity share to other players. The fact that WDC currently has the highest gross margins of any NAND producer highlights the value of its solutions and the efficiency of the Toshiba JV (see margin slide on p. 10). So far in this ASP correction though, Western has not been immune to pricing and margin hits: last quarter Western’s flash ASPs declined high-single-digit with a similar decline expected this quarter. We believe part of this decline is due to execution issues with Western’s SSDs. We have a call into the company to get more color on some comments that were made on the conference call confirming these execution issues. It appears Western may have been designed out of a few applications in the quarter, leading to underwhelming bit growth and poor ASPs. All things being equal though, as Western sells more SSDs with its own controllers, the sales mix improves as do average ASP and gross margin.
Bear Point 2 – HDD is in secular decline, so WDC is over-earning. Margins HDD earnings will crater as HDD decline accelerates.
“For capacity storage, hard drives will remain the most cost effective option. They have a substantial cost advantage today and even in 2020 we expect that advantage to remain very significant at four to five times.” – Mark Long, WDC Chief Strategy Officer, Western Digital Analyst Day, 2016
This is the easiest point to get comfortable with in our opinion. The basic bear argument on HDDs is that the secular decline of PCs, the move of storage to the cloud and conjunction with the growth of SSDs are quickly killing the HDD industry. The narrative follows that HDD companies may show decent earnings today, but they have no terminal value, so paying what looks like a cheap multiple is still too expensive. The reality is actually quite different from this. First, we acknowledge PCs are likely in permanent secular decline, and the HDD drives that go into PCs and other consumer devices today are quickly losing share to SSDs. We believe that SSDs will eventually fully replace HDDs in PCs. Gartner forecasts that HDD units shipped will decline by 50% over the next four years. Historically, analysts measured the success of the HDD business in units sold, a vestige of an industry once driven exclusively by PC sales volumes (WDC still reports this every quarter). Thus, as HDD unit declines accelerated with the adoption of flash drives on notebooks and desktops, most analysts deemed the business a commodity with gross margins likely headed to 20%. The view of rapid extinction for HDDs is still very prevalent. The last few years demonstrate a different outcome though. Despite a 40% decline in units, gross margins for HDDs have increased from low twenties to low thirties, and we think could approach the mid-30s. Furthermore, revenue has only declined marginally over the last 6-7 years if you take out the artificial increase in ASPs due to the Thailand floods. How could this be?