Driving a Hard-Drive Bargain

We know: Traditional hard drives are passé. Apple Computer's (AAPL) new iPod Nano portable music player, after all, uses flash memory to achieve a storage capacity that previously would've required a hard drive. And it does so with no moving parts. But then, if flash drives are taking over the world, why are profits for our hard-drive maker on track to jump 22% this year? And why are they projected to increase by 15% annually over the next five years?

We'll look into that in a moment. The aforementioned stock caught our attention recently by turning up in our Free Cash Flow screen. Like earnings, free cash flow is more or less a measure of income. The basic difference between it and earnings is the treatment of large investments in plants and equipment, called capital expenditures. In calculating their earnings companies treat these outlays as if they happened little by little each quarter, even though the money is really spent all at once. The process is called depreciation. Free cash flow ignores depreciation and instead just looks at cash coming into and going out of the till.

Unlike earnings, the free cash a company generates represents real funds that can be spent on things like dividends, share repurchases and debt payments. That makes free cash flow at once a measure of income and a gauge of financial strength. It also makes shares of companies with low price/free-cash-flow ratios well worth a look. For example, in a free cash flow write-up a year ago ("Puff Daddy") we highlighted Rofin-Sinar (RSTI), a maker of all kinds of lasers, including ones that cut tiny holes in cigarettes to regulate nicotine flow. (Wheeze holes, we dubbed them.) Its shares have since gained 28%, vs. the Standard & Poor's 500 index's 8% climb.

Use our stock screener and Free Cash Flow recipe anytime you like to run our search for yourself. Recently it produced a list of eight survivors from a starting database of more than 9,000. Let's look at our hard-drive maker.

With trailing 12-month sales of $3.6 billion, Lake Forest, Calif.-based Western Digital (WDC) is roughly the same size as competitor Maxtor (MXO) and about half as big as Seagate Technology (STX). About three-quarters of the company's sales come from PC hard drives. The rest come from consumer electronics like set-top boxes and digital video recorders, as well as videogame consoles.

Early summer is typically a slow time for hard-drive makers. But the results for Western Digital's fiscal fourth quarter ended July 1 looked anything but slow. Sales increased 26% year-over-year to $940 million. Analysts say the company benefited from strong demand and a shortfall in supply from Maxtor. Earnings for the quarter jumped to $41 million from $30 million, even after subtracting $19 million for a one-time lawsuit settlement. Per-share earnings of 27 cents topped analysts' estimates by three cents. Gross margin climbed 3.5 percentage points to 17%.

"We continue to increase our presence in markets for hard drives such as notebook PCs, enterprise applications and personal and digital video recorders while maintaining our leadership in the high-volume desktop PC business," said Chief Executive Matt Massengill in a July 28 press release. The percentage of sales that came from non-desktop-PC hard drives (that is, sales that came from laptops or consumer electronics) during the quarter increased to 23% from 15% a year ago. That, despite the company's decision not to supply hard drives for Microsoft's (MSFT) Xbox 360 game console, expected to hit stores in November. Western Digital makes hard drives for the current generation of Xbox. Margins for the product are notoriously low.

Industry watchers say hard-drive prices should remain favorable for manufacturers. They've historically been prone to overproducing when prices are high, but capacity at the moment is constrained by a shortage of hard drive innards made by companies like Komag (KOMG). Western Digital is faring better than competitors because it's well-stocked on magnetic disks, and it makes many of its drive heads in-house. Robert Citra, an analyst with Fulcrum Global Partners, calls that a good thing for the hard-drive market, comparing it with "keeping the bottle away from an alcoholic."

Citra figures the Western Digital shares, which go for less than $13 apiece at the moment, could fetch $20, or about 14 times his calendar 2006 earnings estimate, within a year. "WDC shows some of the hard-drive market's best execution, upside potential from new mobile ramps, attractive low-cost/fast-follower strategy and competitive per-drive economics," he wrote in a July 29 research note. By "mobile ramps" Citra refers to Western Digital's 2.5-inch notebook hard drive called "Scorpio," which was released last October and is selling well. He expects the drives to add 7% to the company's sales next year, and points out that its one-inch drives, which should be available by the end of the year, could find a home in hand-held consumer electronics like digital cameras and cellphones. (Citra doesn't own shares of Western Digital; Fulcrum Global Partners doesn't have an investment-banking relationship with the company.)

Shares of Western Digital may now be too cheap to ignore. They trade at 11 times forecasted earnings for fiscal 2006, which ends in June. Subtract the $2.52 a share the company holds in net cash and that P/E ratio falls to eight. The average historical P/E ratio for hard-drive makers is 12 to 15. Shares of Western Digital trade at 12 times trailing 12-month free cash flow, about half the median for data-storage companies. Free cash flow for the company is projected to fall slightly to $218 million in 2006 from $227 million in 2005, but to jump to more than $300 million in 2007. Western Digital doesn't pay a dividend, but it spent $30 million on its own shares last quarter. Considering the stock's valuation, that seems like a sound investment.