Investors Forgive Western Digital for Lower Earnings

Hard drive maker Western Digital WDC announced a drop in earnings of nearly 36%, with revenue of $2 billion yielding just $145 million in profits for the second fiscal quarter of 2012. Those figures are down considerably from last year's results, with Q2 2011 earnings clocking in at $225 million on $2.48 billion gross income. Investors are unphased by the drop, with the stock skyrocketing over 4.6% in after-hours trading on Monday to the $36.30 range. That climb is after a U-shaped day that left the stock nearly flat by the closing bell, when WDC traded for $34.71--an increase of just six cents for the day. The market seems to be assuming that the fall in profit is a one-time deal resulting from the costs of acquiring Hitachi Global Storage Technologies and the slowing output due to floods in Thailand, where the majority of the company's products are produced. Without losses due to both one-offs, the firm would have experienced earnings per share of $1.51, or $358 million, as opposed to the actual EPS of 61 cents a share. WD has been an industry leader for quite some time, and it spearheaded growth in the consumer market with its My Book and My Passport product lines, which helped the company grow by 70% in the past five years--and that's including the percipitous crash at the end of 2008, from which the company quickly recovered. Analysts have been largely bullish on Western Digital for a while as the company saw its EPS steadily rise at the beginning of 2011 despite a brief fall in Q3 2011 to 66 cents per share. However, solid earnings did not help the company's P/E ratio, which has risen steadily since a low of around 5 in the middle of 2010. While the company enjoyed increased demand for its products, especially its external storage solutions, it has struggled to maintain healthy operating margin, although at 8.87%, it is near double Seagate STX, its biggest competitor. Western Digital has also outperformed Seagate in both the long term, which was relatively late to the external storage market for consumers while Samsung gobbled up market share for its internal hard drives. Its FreeAgent drives still fail to impress many consumers. Western Digital faced a number of setbacks in recent years, most notably the closure of the company's Thai factory in Bang Pa-in, which closed in October. WD produces around 60% of its hard drives in Thailand, so the blow to the company's production chain was considerable. However, a quicker-than-expected recover and a resumption of Thailand operations a week ahead of schedule helped the share price resurge in November and December, when shares rose over 16% to levels near its recent price of $34.25. However, investors cannot consider the floods history quite yet, as the company announced in December that costs from the flood will be reflected in the company's balance sheet in Q2 2012. Previous estimates of $225-275 million may be overblown thanks to the quick recovery. Another concern for Western Digital is a change in the digital storage landscape, as physical memory gets cheaper and cloud storage becomes the next big thing in content delivery. While the company is flirting with personal cloud products such as the My Book Live Duo while staying ahead of the game with partnerships with Netflix and Hulu, it may find itself needing to reposition fast as consumers move towards cloud storage solutions such as Apple's iCloud, which appeals to Apple users thanks to a seamless integration with the company's popular iOS devices and Mac platform. A broader move to cloud storage could make Western Digital yesterday's technology. In addition, the move away from physical hard drives and towards flash storage, which are more durable, lighter, and reliable than hard drives thanks to having no moving parts, is going to benefit companies already in that sector such as SanDisk SNDK, which has seen a steady decline in earnings and stock price since 2009. SanDisk also has an operating margin nearly twice of WD, even after a huge drop in 2011 due in part to increased competition in the sector and lower prices. Another issue for Western Digital was its acquisition of Hitachi GST, which was delayed at the end of 2011 as the companies awaited regulatory approval from the European Commission. The deal, first announced in March 2011, helped the company spike to its 52-week high, only for the price to fall to below pre-announcement levels by the end of the year as the company reported solid earnings that failed to wow the market. The Hitachi deal cannot be stopped forever, and it seems closer than ever, after Europe approved the deal in November and Japan gave it the green light just before New Year's. While word is waiting from China, an end to the delayed acquisition seems closer than ever.