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

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

Inventory Market Worth: $18.6B ($59.45 per share)

Share Possession: ~6.0%

Common Value: n/a

Activist Commentary: Elliott is a really profitable and astute activist investor, significantly within the expertise sector. Their crew consists of analysts from main tech non-public fairness corporations, engineers, working companions – former expertise CEO and COOs. When evaluating an funding, in addition they rent specialty and common administration consultants, professional value analysts and trade specialists. They usually watch corporations for a few years earlier than investing and have an intensive steady of spectacular board candidates.

On Could 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 may result in a inventory value of $100+ per share by the tip of 2023.

As new “activists” come on to the scene we’ve seen a good quantity of “promote the corporate” activism with no detailed plan or cause why. We’ve been very crucial of this model of activism as quick time period and grasping. These activists who didn’t perceive why we had been being so crucial ought to learn Elliott’s letter for example of effectively thought out, deeply analyzed, shareholder-focused strategic activism marketing campaign. Elliott offers an in depth 13-page letter of why the corporate’s two companies should be separated and a plan to realize the separation that’s in the very best curiosity of shareholders.

The corporate is likely one of the largest suppliers of storage parts for knowledge infrastructure globally and has constructed a profitable HDD enterprise. Nevertheless, the HDD trade 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 corporate introduced it will purchase SanDisk for $19 billion to enter the higher-growth Flash trade. Within the years following this acquisition, the HDD trade rebounded and has now grow to be a development 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 present that operates in each HDD and NAND flash.

Within 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 development charge, gross margins, working bills and working margin. Third, the corporate has poor inventory value 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 explanation why Western Digital is underperforming is as a result of the 2 companies shouldn’t be in the identical firm. Each companies are strong and have good market share however would have considerably extra worth as standalones. HDD and Flash are completely totally different applied sciences: spinning mechanical disks versus modern semiconductor gadgets. The manufacturing processes are separate and whereas the companies share widespread clients, the merchandise might be in competitors in sure use circumstances.

Previous to the SanDisk acquisition, Western Digital persistently had the next price-earnings ratio than its closest peer, Seagate. Because the acquisition, Seagate has had a considerably greater price-earnings ratio. Right this moment, Western Digital has an enterprise worth of $21 billion, in comparison with the mixed $34 billion professional forma enterprise worth of Western Digital and SanDisk after they introduced the acquisition six years in the past, representing $13 billion of worth loss. In contrast, in the identical interval, Seagate grew its enterprise worth 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 almost 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 present 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 imagine may result in a inventory value of $100+ per share by the tip 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% development charge (versus 18% for Seagate) and each corporations have a 30% gross revenue margin. Utilizing Seagate’s multiples of 1.8x LTM income and 6.1x LTM gross revenue, Western Digital’s HDD enterprise would have a price of $17 billion.

Western Digital’s Flash enterprise generates $10 billion in income and related companies have been acquired at multiples of 1.7-1.9x income. This may attribute a minimal of a $17 billion worth to the Flash enterprise. However this isn’t the conventional 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 worth of $17 billion to $20 billion, which might be utilized both in a spin-off transaction or as fairness financing in a sale or merger with a strategic companion. Basically, 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 the whole enterprise worth of the corporate is $21 billion.

If Elliott does get the Flash enterprise divested on the worth they’re placing their very own cash behind, that might attribute a $4 billion valuation for the whole HDD enterprise. There’s good cause to imagine 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 curiosity in buying Kioxia is effectively documented over time, together with a proposal in 2017 and the rumored $20 billion transaction worth final yr (1.7x LTM income). Previously 5 years, Kioxia has been publicly rumored to obtain curiosity from an extended record of different strategic and monetary events.  

Their plan may resonate favorably with the corporate’s present board and administration crew. The choice to accumulate SanDisk predates the corporate’s CEO, David Goeckeler, and his management crew, almost all of whom had been employed in 2020 or later. The truth is, Goeckeler’s first operational transfer was separating HDD and Flash inside Western Digital. It’s not a giant step to get the board to separate it into a unique firm, significantly since solely two of Western Digital’s present ten administrators had been on the board for the SanDisk acquisition. Furthermore, 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 also needs to 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. Primarily based on their historical past and philosophy, that’s doubtless as a result of Elliott is utilizing swaps and different derivatives to construct their place and people sorts of securities are usually not required to be included in “useful possession” for the needs of 13D filings at the moment. The usage of swaps on this method is the topic of a present Securities and Change Fee proposal and will very effectively 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 also be the creator of the AESG™ funding class, an activist funding model targeted on enhancing ESG practices of portfolio corporations.