Earnings Preview: Western Digital

Western Digital Corp. ( WDC - Analyst Report ) is scheduled to announce its fourth quarter 2012 results on July 25, after the market closes, and we witness downward revisions in analysts’ estimates at this point.

Third Quarter Overview

Western Digital delivered a good third quarter with earnings per share (EPS) of $2.52, sailing past the Zacks Consensus Estimate of $1.58. The quarter’s earnings increased 281.8% year over year!

Revenue saw a 34.8% year-over-year increase, aided by a higher average selling price (ASP). However, TAM (total available market) and volume shipments were considerably lower.

The uneven comparison was due to shortages in HDD supply post the flood in Thailand that halted the entire production. The supply disruption also helped ASPs to shoot up.

Gross margin was 32.2%, up from 18.2% in the year-ago quarter. The increase in gross margin resulted from higher ASPs and a favorable product mix, partially offset by higher costs per unit.

Management’s Expectation

At the third quarter earnings call, Western Digital announced that the impact of the Thai flood was wearing off and that Hitachi’s GST operations had been successfully integrated into the business as a subsidiary. Hence, the company sees plenty of upside opportunities for its business.

For the fourth quarter, Western Digital expects revenue of $4.2 billion to $4.4 billion. TAM for the quarter is expected in the range of 155 million to 160 million units. The company believes that there is sufficient capacity in the industry to support this demand.

Together, R&D and SG&A spending are expected to be approximately $500.0 million. The tax rate will be roughly 9%. Management also expects non-GAAP earnings per share of between $2.35 and $2.55.

Management expects cost pressures to continue, which will be driven by rare earth materials, logistic costs, foreign currency exposure and underutilization of assets due to the lingering effect of the Thailand flood. Management asserted that it will continue to work internally and with its supply partners to find ways to offset these cost challenges. Moreover, the company will continue to invest in innovation to support growth in new products and markets.

Agreement of Analysts

Analysts are positive about the expected production ramp, market share gains and an improved mix from the addition of products from Hitachi’s Global Storage Technology business.

However, they appear to be growing increasingly cautious because of the stabilizing of the HDD market and persistent macro uncertainty that is impacting PC demand, a main source of revenue from the HDD market.

Considering the situation, most analysts are cutting their estimates to reflect equilibrium in the market and the resultant lowering of ASPs.

Therefore, out of the 18 estimates for the fourth quarter, 11 moved downward and one went up over the last thirty days. Out of the 17 estimates for fiscal 2012, 10 estimates moved down and one estimate moved up over the last thirty days. A similar trend was noticed in the estimate revision for fiscal 2013.

Magnitude of Estimate Revisions

Over the past 30 days, the Zacks Consensus Estimates for the fourth quarter and fiscal 2012 plunged 8 cents and 10 cents to $2.46 and $7.62 per share, respectively. However, the trend is not totally negative since despite these reductions, the Zacks Consensus Estimates were still up 21 cents and $1.00 per share for the fourth quarter and fiscal 2012, respectively.

The estimate revisions show that the previous expectations were too high, which were cut later on to reflect market stabilization.

Our Recommendation

Though Western Digital did not cut its annual forecasts, we believe that the reduction in analysts’ expectations is justified. Western Digital’s archrival Seagate Technology Plc ( STX - Analyst Report ) negatively preannounced its fourth quarter revenue and gross margin guidance in June, to account for lower volume shipments stemming from lackluster PC sales and increased adoption of SSDs (solid state drives).

Seagate’s expectations of a lower TAM could prove beneficial for Western Digital, but we believe that the latter will not be able to outperform the industry.

Though some fears of oversupply remain, we believe that Western Digital’s growth prospects remain intact. The company’s decision to buy back additional shares worth $1.5 billion and launch new drives will act as catalysts.

Currently, Western Digital has a Zacks #3 Rank, implying a short-term Hold rating.