Dip into This Chipmaker

Rotation among sectors has been the hallmark of the stock market and that has been especially true since the election. But one group that has enjoyed an almost uninterrupted march higher over the past year has been the semiconductors.

As measured by the iShares Philadelphia Semiconductor (SOXX), this field has gained some 60% over the past 52 weeks, 14% year-to-date and now stands at an all-time high.

One name that has done well, though not great, is Western Digital (WDC) which has gained some 50% and just 7% for the respective periods. I think WDC is setting up for a new move, not only to its old highs but continuing up another 25% to 30% over the next 8-12 months.

The three main drivers will be 1) growth in demand for storage 2) margin expansion 3) de-leveraging its balance sheet.

Western Digital is a digital storage company with a product suite including hard disk drives (HDDs), solid-state drives (SSDs), NAND flash memory, hybrid storage products and systems and storage-enabling software.

Expanding Margins: The 2011 tsunami caused massive floods in across Japan and Thailand where most of the chips are manufactured. The ensuing shutdown of many not only constrained supply, which helped stabilize prices, but it precipitated a wave of consolation. WDC bought Hitachi Global Storage Technologies, parts of Toshiba and more recently purchased Sandisk which closed in May 2016.

Western Digital and Seagate Technology (STX) now have essentially a duopoly controlling some 90%, with each having about 45% market share. With consolidation comes more stable pricing and when the industry went from five players to the current two, gross margins have expanded and remained stable. Free cash flow generation has been strong, with both WDC and STX initiating dividends and buying back significant shares. WDC’s margins should continue to expand over the next several years, faster than the market is projecting, as the company extracts synergies from HGST and integrates SanDisk.

Storage demand growth with strong secular underpinning: Data center data demand is growing at 40% a year, and shows no signs of ebbing. The data storage industry has a secular tailwind from the massive explosion of data storage needs, as digital media has exponentially increased with the ubiquity of high-speed broadband in the developed world, the digital distribution of music and video, the migration to cloud-based computing systems, growth of “Internet of Things,” the mapping of the genetic code and personalized medicine.

Repairing Balance Sheet: In late 2015 WDC levered up to acquire SanDisk and it also won the right to integrate all of HGST after receiving approval from China’s Ministry of Commerce in 2015. This forced them to not only redirect cash promised back to shareholders in the form of a dividend, but also the issuance of some $13.2 billion in debt.

But it has committed to de-levering over the next few years. While this means the dividend will likely remain flat, as WDC de-levers, additional value should accrue to equity holders.

From a technical standpoint the chart has good support around the $72-$75 level and this offers a good risk/reward entry point.

I’m targeting the purchase of the 70 strike calls with January 2018 expiration for $8 per contract to give me solid upside exposure with limited downside risk.

— Steve Smith

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About the Author: Steve Smith