Western Digital Earnings: HDD and Flash Downturns Have Yet To Trough; Maintain $42 FVE

We maintain our $42 fair value estimate for Western Digital WDC shares after the firm’s fiscal third-quarter results met our expectations. Western Digital’s sales and profits are suffering from simultaneous downturns for its hard disk drive, or HDD, and flash businesses. The firm’s current downcycle appears set to endure longer than management had initially expected, which aligns with peer Seagate’s commentary from its own earnings release a few weeks ago. We continue to anticipate a recovery beginning in fiscal 2024, but are pushing out a meaningful rebound for a couple quarters from now in our forecast. Sharp downturns like the current one for Western Digital reflect its vulnerability to market dynamics and lack of an economic moat, in our view. Shares are undervalued, but we recommend investors seek moatier names amid current turmoil.

Fiscal third-quarter sales of $2.8 billion dropped 36% year over year and 10% sequentially. Flash sales continued their precipitous downturn and led overall firm declines, with a drop of 21% sequentially and 42% year over year to $1.3 billion. HDD sales rose modestly sequentially behind incrementally better sales into cloud customers, which continue to work through heightened drive inventory that lowers their near-term demand.

Non-GAAP gross margin dropped precipitously to 10.6%, which represents a 2110 basis point drop year over year and 680 basis point decline sequentially. Underutilization charges at Western Digital’s production sites exacerbate margin pressure from lower volumes, leading to the poor figure. We estimate a roughly 8% gross margin impact from underutilization alone. Poor gross margin pushed non-GAAP operating margin to a dismal negative 10.8%.

Management guidance implies Western Digital has not hit the trough of the current downturn. A fiscal fourth-quarter sales midpoint of $2.5 billion implies a 11% sequential decline and earnings guidance implies further margin compression.