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Friday, September 29, 2006

Bait Shop: Western Digital (WDC)




Western Digital (WDC; $18.20) has been up earlier this week on hopes of a buyout. It began the week around $17.00 and traded just over $18.50 on Wednesday before coming back down. Its shares tried a brief rally earlier today, but it seems that has slowed. A buyout of Western Digital makes sense, although a different scenario makes more sense than rumors that have gone around this week.

Western Digital (WDC) is one to watch in the wave of ongoing mergers and private equity buyouts. In the game of pure hard drives for PC's it and Seagate (STX) are the last of the big independents domiciled in the US, and Western Digital is far behind Seagate. Maxtor used to be there in the space, but Seagate took them out in an acquisition this last May. Western Digital acquired Read-Rite assets in 2003. Disk drive makers do their best to make comparing apples to apples difficult, but historically Western Digital has been thought of as the "value purchase" for hard drive while Seagate has been viewed as the premium brand. If you go in and start comparing prices at Best Buy and again at CDW you will see the pricing differences.

Seagate is significantly larger with a market cap of some $13.3 Billion compared to Western Digital's market cap of $4 Billion. WDC trades at a mere 10.4 P/E ratio (pre-options issues) and if analyst forecasts for fiscal Jun-07 are correct it has a forward P/E of 10.1 and a forward P/E for Jun-08 of merely 9.1. These estimates may change based on the options review. Keep in mind that these can change any time a company speaks and we are going into earnings season in two to three weeks. StarMine rates Bear Stearns and Citigroup as the two top 5-star rated firms covering the stock; and Bear Stearns downgraded the stock in July to Peer Perform and Citigroup downgraded the shares earlier in September to a Hold. Bear Stearns' Andrew Neff hinted as this company being the next logical acquisition in the space, but that was before he downgraded the stock.

This stock has been hovering in a tight range of $16.50 to $18.00 for most of the last two months and its 52-week trading range is $11.25 to $24.70.

The company's new smaller personal and portable storage devices have helped the company ramp up sales in each of the last 3 years and they are projected to post $4.85 Billion for Jun-2007 and $5.15 Billion in Jun-2008 fiscal years. It is very difficult to accurately compare WDC's balance sheet and operating results now that Seagate and Maxtor have just folded into one report, but WDC spends about 6.6% of its revenues toward research and development. Its options review has been an issue. The company has delayed its annual report, and based on comments that some options backdating existed you should just assume there will be restatements.

The open interest in the options is not indicative of an impending merger as the closest strikes only show open interest of 17,000 for October and 5,300 for November. That is only indicative of 2.3 million shares on a fully leveraged basis, and average daily volume in the stock is 3.3 million shares. This month's short interest showed a reading of 9.6+ million shares short, down from 10.1+ million shares short in August.

The rumors out there earlier in the week actually had rumors that Seagate was the would-be acquirer. Since our FTC and DOJ in the U.S. haven't blocked a single merger in years this may be possible for Seagate to get it done, but you should expect PC makers and others to raise hell. The problem I have in a merger of this magnitude is that Seagate wouldn't just dominate the domestic disk drive market, it would own it outright and could put a real squeeze on lower-price PC makers and on consumers. The recent debt offering of Seagate may have fuelled these rumors, and 1 of 100 other possibilities could have fuelled it.

This company actually looks like a private equity firm could pursue it, and if the company wants to sell itself it should go the private equity route. It has a cheap enough "P/E yield," it has essentially no serious long-term debt and it has enough cash and current assets that a private equity acquirer could pay themselves a hell of a dividend after the acquisition. A private equity firm would also have no anti-trust issues, while Seagate should. If Seagate makes an offer, it is quite possible a private equity buyer would consider upping the ante. There are several firms that could do this. Groups like Bain, KKR, Silver Lake, Blackstone, and others could do this in a club deal or individually. The premium on this probably will not be a mega-premium deal because they do not have to worry about rewarding many shareholders that are deeply buried in the name. This stock traded much higher back in 1997, but that is nearly a decade ago and what the stock traded at back then should be as relevant as gold to a dead man.

The company also has already launched its newer wave of personal and portable storage devices, so it is not as dependent on lower-cost internal and external storage devices. That may actually help keep some of the R&D costs at bay, and high R&D costs at most technology companies typically keep private equity firms and other private groups from being interested. It even has factories, so it is not entirely fables like so many other technology companies.

One of the larger overseas competitors could fairly easily try to acquire the company. That is an unknown as to which it would be, but Hitachi, Fujitsu, Toshiba, and Samsung could all pursue the company if they wanted.

Management may be a mixed bag for a potential deal, but that can go either way. It has a relatively young management team compared to many other technology companies that have been around this long, and they are well paid. The top 5 institutional holders also hold about 32% of the stock as of the last filing dates.

There are risks and Seagate isn't the only competitor. The options review and 10-K delays could create further problems. The company could get hosed if Seagate and Maxtor decided to lower apples to apples product costs to PC makers and to the consumer. It competes against Hitachi, Fujitsu, Toshiba, Samsung Electronics, and Seagate. They could develop internal issues, and so on.

The risks here seem reasonable for the rewards, and it is honestly surprising why no one has tried. There is no way to know if the company will meet, beat, or miss estimates next month and it is very likely that the company will only show revenues and promise to show earnings post-options at a later date. This options issue is actually part of why the stock is cheap, and a private equity firm can take advantage of that malaise better than a US-domiciled public company.

This is actually able to be hedged with options as well. The $17.50 Puts for Jan-07 are listed at $1.50, for November they cost $1.00, and they cost $0.45 for October.

On the surface it seems like there is no reason to not have this on the Bait Shop AND on the Technology Value List. There are always risks, but this seems like a very ripe candidate for a deal in a consolidating world.

Jon C. Ogg
September 29, 2006

DISCLAIMER: Information has been taken from sources deemed reliable, but no assurances can be made to the accuracy of any figures, claims, or opinions. This is for informational purposes only and is not to be interpreted as investment advice or a recommendation to buy or sell securities. It is the sole responsibility of each individual to do their own research and form their own opinions. Neither 24/7 Wall St., LLC nor its officers assume any responsibility or liability for investor gains or losses, and neither holds any material knowledge that any merger in any form will occur. The writer of this does not hold any securities in the companies mentioned, and has not been compensated by outside parties to portray this situation in any particular manner.

Jon Ogg can be reached at jonogg@247wallst.com; he does not own securities in the companies he covers.
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