How Elliott Associates’ proposal to split two businesses at Western Digital may build value

Business: Western Digital is a number one developer, producer, and supplier of knowledge storage gadgets and options and operates in two market-leading franchises: onerous disk drives (“HDD”) and NAND flash reminiscence (“Flash”). These two businesses got here collectively by way of the $19 billion acquisition of SanDisk in 2016, which led the corporate to diversify its practically five-decade enterprise away from HDD and it turned one of many largest Flash gamers within the business.

Stock Market Value: $18.6B ($59.45 per share)

On May 3, 2022, Elliott despatched a letter to Western Digital’s board, expressing its perception that the corporate ought to separate its NAND flash reminiscence enterprise. Elliott known as on the board to conduct a full strategic assessment and expressed its perception that such a separation could lead on to a inventory worth of $100+ per share by the top of 2023.

The firm is likely one of the largest suppliers of storage elements for information infrastructure globally and has constructed a profitable HDD enterprise. However, the HDD business started a sluggish decline in 2013 as desktop and pocket book PCs transitioned towards quicker NAND flash solid-state drives (SSDs). So, in 2015 the company announced it could purchase SanDisk for $19 billion to enter the higher-growth Flash business. In the years following this acquisition, the HDD business rebounded and has now grow to be a progress market once more, with Western Digital as one of many two dominant suppliers of this expertise, behind Seagate. Western Digital is the one firm at this time that operates in each HDD and NAND flash.

In the final six years, the corporate has underperformed in a number of areas. First, they’ve tried to ship on the strategic synergies of a mixed HDD and Flash portfolio however have misplaced market share in each HDD and Flash. Second, the operational missteps have persistently led to unfulfilled monetary targets together with in income compound annual progress price, gross margins, working bills and working margin. Third, the corporate has poor inventory worth efficiency, returning -23.10%, 6.14% and -39.57% over the previous 1-, 3- and 5-year intervals versus -0.89%, 41.07% and 74.0% for the S&P 500, respectively. 

In its letter, Elliott makes a convincing argument that the rationale why Western Digital is underperforming is as a result of the two businesses shouldn’t be in the identical firm. Both businesses are stable and have good market share however would have considerably extra value as standalones. HDD and Flash are completely completely different applied sciences: spinning mechanical disks versus modern semiconductor gadgets. The manufacturing processes are separate and whereas the businesses share frequent prospects, the merchandise could be in competitors in sure use circumstances.

Prior to the SanDisk acquisition, Western Digital persistently had the next price-earnings ratio than its closest peer, Seagate. Since the acquisition, Seagate has had a considerably increased price-earnings ratio. Today, Western Digital has an enterprise value of $21 billion, in contrast to the mixed $34 billion professional forma enterprise value of Western Digital and SanDisk once they introduced the acquisition six years in the past, representing $13 billion of value loss. By distinction, in the identical interval, Seagate grew its enterprise value from $17 billion to $22 billion. When Western Digital introduced its acquisition of SanDisk, its inventory was buying and selling at $75 per share. Six years later, the inventory has declined by practically 30% to $53 per share. In the identical time interval, the S&P 500 and Nasdaq elevated by 103% and 190%, respectively. Seagate (the corporate’s closest HDD peer) has outperformed Western Digital by 278% over the past decade, and Micron (its closest NAND peer) has outperformed Western Digital by 868% over the past decade.

Elliott believes that Western Digital’s valuation at this time displays the market’s view that proudly owning HDD and Flash collectively yields a conflict of synergies by way of operational and monetary efficiency. Accordingly, they’re calling on the corporate to discover a full separation of the Flash enterprise, which they consider could lead on to a inventory worth of $100+ per share by the top of 2023, and so they illustrate the trail to get there.

Western Digital’s HDD enterprise has 38% market share (versus 46% for Seagate), $9.4 billion of income (versus $12 billion for Seagate), 21% progress price (versus 18% for Seagate) and each firms have a 30% gross revenue margin. Using Seagate’s multiples of 1.8x LTM income and 6.1x LTM gross revenue, Western Digital’s HDD enterprise would have a value of $17 billion.

Western Digital’s Flash enterprise generates $10 billion in income and related businesses have been acquired at multiples of 1.7-1.9x income. This would attribute a minimal of a $17 billion value to the Flash enterprise. But this isn’t the traditional name for strategic motion. Elliott is placing their cash the place their mouth is and providing $1+ billion of incremental fairness capital into the Flash enterprise at an enterprise value of $17 billion to $20 billion, which could be utilized both in a spin-off transaction or as fairness financing in a sale or merger with a strategic companion. Essentially, Elliott is expressing their willingness to take part within the acquisition of the Flash enterprise with a $1 billion funding. So, Elliott sees every enterprise valued at roughly $17 billion, whereas your complete enterprise value of the corporate is $21 billion.

If Elliott does get the Flash enterprise divested at the value they’re placing their very own cash behind, that might attribute a $4 billion valuation for your complete HDD enterprise. There is nice cause to consider that there are patrons on the market for the Flash enterprise, particularly with a mix of Western Digital’s Flash enterprise with its three way partnership companion Kioxia. Western Digital’s interest in acquiring Kioxia is nicely documented over time, together with a proposal in 2017 and the rumored $20 billion transaction value final yr (1.7x LTM income). In the previous 5 years, Kioxia has been publicly rumored to obtain curiosity from a protracted record of different strategic and monetary events.  

Their plan may resonate favorably with the corporate’s present board and administration crew. The resolution to purchase SanDisk predates the corporate’s CEO, David Goeckeler, and his management crew, practically all of whom had been employed in 2020 or later. In reality, Goeckeler’s first operational transfer was separating HDD and Flash inside Western Digital. It shouldn’t be a giant step to get the board to separate it into a unique firm, notably since solely two of Western Digital’s present ten administrators had been on the board for the SanDisk acquisition. Moreover, shareholder activism is in regards to the energy of persuasion and the ability of the argument, and Elliott makes a really compelling argument right here.

It must also be famous that Elliott reported an approximate $1 billion funding within the firm however has not filed a 13D regardless of having a roughly 6% place. Based on their historical past and philosophy, that’s seemingly as a result of Elliott is utilizing swaps and different derivatives to build their place and people forms of securities usually are not required to be included in “useful possession” for the needs of 13D filings at this time. The use of swaps on this method is the topic of a present Securities and Exchange Commission proposal and will very nicely change within the quick time period, forcing Elliott to file a 13D on this funding.

Ken Squire is the founder and president of 13D Monitor, an institutional analysis service on shareholder activism, and he’s the founder and portfolio supervisor of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments. Squire can be the creator of the AESG™ funding class, an activist funding type centered on bettering ESG practices of portfolio firms.