How Elliott Associates’ Proposal to Split Two Businesses at Western Digital Can Create Value
A Western Digital office building is shown in Irvine, California, U.S., January 24, 2017.
Mike Blake | Reuters
Company: Western Digital (WDC)
Business: Western Digital is a leading developer, manufacturer and supplier of data storage devices and solutions and operates in two market-leading franchises: hard disk drives (“HDD”) and NAND flash memory (“Flash”). These two companies came together through the acquisition of SanDisk for $19 billion in 2016, leading the company to diversify its nearly five-decade business away from hard drives and become one of the largest Flash industry players.
Market value: $18.6 billion ($59.45 per share)
Percentage of ownership: ~6.0%
Average cost: n / A
Activist Comment: Elliott is a very successful and shrewd activist investor, especially in the technology sector. Their team includes analysts from leading technology private equity firms, engineers, operational partners – former technology CEOs and COOs. When evaluating an investment, they also hire specialist and general management consultants, expert cost analysts and industry specialists. They often watch companies for many years before investing and have a large stable of impressive board candidates.
On May 3, 2022, Elliott sent a letter to Western Digital’s board of directors, expressing his belief that the company should spin off its NAND flash memory business. Elliott called on the board to conduct a full strategic review and expressed his belief that such a separation could lead to a stock price of more than $100 per share by the end of 2023.
As new “activists” come onto the scene, we have seen a fair amount of “sell the business” activism without a detailed plan or reason. We have been very critical of this style of activism, deeming it short-term and greedy. Activists who did not understand why we were so critical should read Elliott’s letter as an example of a well-thought-out, deeply analyzed, and shareholder-focused strategic activism campaign. Elliott provides a detailed 13-page letter explaining why the two businesses of the company should be separated and a plan to achieve the separation that 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 hard drive business. However, the hard drive industry began a slow decline in 2013 as desktops and laptops moved to faster NAND flash solid-state drives (SSDs). Thus, in 2015 tthe company announced it would acquire SanDisk for $19 billion to enter the fastest-growing Flash industry. In the years following this acquisition, the hard drive industry rebounded and once again became a growth market, with Western Digital being one of the two main suppliers of this technology, behind Seagate. Western Digital is today the only company that works with both HDD and NAND flash.
Over the past six years, the company has underperformed in several areas. First, they attempted to realize the strategic synergies of a combined HDD and Flash portfolio, but lost market share in both HDD and Flash. Second, operational missteps have consistently led to missed financial targets, including compound annual growth rate of revenue, gross margins, operating expenses, and operating margin. Third, the company is showing poor stock market performance, with returns of -23.10%, 6.14%, and -39.57% over the past 1, 3, and 5-year periods versus -0.89%, 41 .07% and 74.0% for the S&P 500, respectively. .
In his letter, Elliott makes a compelling argument that the reason Western Digital is underperforming is because the two companies shouldn’t be owned by the same company. Both companies are strong and have a good market share, but would be much more valuable as stand-alone entities. Hard disk and flash are totally different technologies: spinning mechanical disks versus advanced solid-state devices. The manufacturing processes are distinct and although 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 ratio than its closest peer, Seagate. Since the acquisition, Seagate has had a significantly higher price-to-earnings ratio. 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 there. is six years old, representing an impairment loss of $13 billion. In contrast, during the same period, Seagate increased its enterprise value from $17 billion to $22 billion. When Western Digital announced its acquisition of SanDisk, its stock was trading at $75 per share. Six years later, the stock has fallen almost 30% to $53 per share. During the same period, the S&P 500 and the Nasdaq rose 103% and 190%, respectively. Seagate (the company’s closest HDD counterpart) has outperformed Western Digital by 278% over the past decade, and Micron (its closest NAND counterpart) has outperformed Western Digital by 868% over the past decade. .
Elliott believes that Western Digital’s valuation today reflects the market view that owning HDD and Flash generates a conflict of synergies in terms of operational and financial performance. As a result, they are asking the company to explore a complete separation from the Flash business, which they believe could lead to a stock price of over $100 per share by the end of 2023, and they illustrate the way to get there.
Western Digital’s HDD business has a market share of 38% (compared to 46% for Seagate), revenue of $9.4 billion (compared to $12 billion for Seagate), a growth rate of 21% (compared to 18% for Seagate) and both companies have a gross profit margin of 30%. . Using Seagate’s multiples of 1.8x LTM revenue and 6.1x LTM gross profit, Western Digital’s HDD business would be worth $17 billion.
Western Digital’s flash business generates $10 billion in revenue, and similar businesses have been acquired at multiples of 1.7 to 1.9 times revenue. This would attribute a minimum value of $17 billion to Flash activity. But this is not the normal call to strategic action. Elliott puts its money where its mouth is and offers over $1 billion in additional equity in Flash business at an enterprise value of $17 billion to $20 billion, which can be used either in a derivative transaction, either as equity financing in a sale or merger with a strategic partner. Essentially, Elliott is expressing its willingness to participate in the acquisition of the Flash business with a $1 billion investment. So Elliott sees each company valued at around $17 billion, while the company’s total enterprise value is $21 billion.
If Elliott secures the divestment of the Flash business at the value at which it invests its own money, that would attribute a $4 billion valuation to the entire HDD business. There’s good reason to believe there are buyers for the Flash business, especially with a combination of Western Digital’s Flash business with joint venture partner Kioxia. Western Digital interest in acquiring Kioxia is well documented over the years, including a proposal in 2017 and the rumor $20 billion deal value last year (1.7 x LTM revenue). Over the past five years, Kioxia has been publicly rumored to receive interest from a long list of other strategic and financial parties.
Their plan may resonate favorably with the company’s current board and management team. The decision to acquire SanDisk predates the company’s CEO David Goeckeler and his management team, almost all of whom were hired in 2020 or later. In fact, Goeckeler’s first operational decision was to separate HDD and Flash within Western Digital. It’s not a big step for the board to separate it into a different company, especially since only two of Western Digital’s current ten directors served on the board for the SanDisk acquisition. Also, shareholder activism is about the power of persuasion and the power of argument, and Elliott makes a very compelling argument here.
It should also be noted that Elliott declared an investment of approximately $1 billion in the company, but did not file a 13D despite having a position of approximately 6%. Based on their history and philosophy, this is likely because Elliott uses swaps and other derivatives to construct its position and these types of securities are not required to be included in “beneficial ownership”. ” for the purposes of 13D repositories for the time being. The use of swaps in this manner is the subject of a current Securities and Exchange Commission proposal and could very well change in the short term, forcing Elliott to file a 13D in this 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 activist investments 13D. Squire is also the creator of the AESG™ investment category, an activist style of investing focused on improving the ESG practices of portfolio companies.