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Low expectations offer an advantage: If a company can clear a low-set bar with room to spare, investors will frequently reward the extra little effort with outsized returns. And if it doesn’t, c’est la vie. Who expected otherwise?
High expectations are the corollary. When the bar is set high, investors expect it to be cleared effortlessly and with room to spare. If it isn’t, the market frequently metes out harsh punishment.
Apple (NASDAQ: AAPL) is one company imbued with high expectations and a high-set bar. This week, Apple failed to clear that bar; its shares were punished accordingly.
On the other end of the spectrum resides Western Digital Corp. (NASDAQ: WDC), a large disk-drive manufacturer. Low expectations have set the bar low for Western Digital, which is easy to understand. Growth is difficult to conjure when your primary customers, the PC manufacturers, find growth difficult to conjure.
Uncertainty is the other reason for low expectations and a low-set bar.
Western Digital has attempted to re-fire growth by acquiring SanDisk (NASDAQ: SNDK), a leader in the solid-state storage market. One need not probe the cosmos to understand why Western Digital sees SanDisk as a growth petard.
By taking in SanDisk, Western Digital can exploit new markets. SanDisk is a key provider of flash-technology chips used for data storage in an array of devices – smartphones, tablets and PCs. Flash-based storage systems increasingly serve as primary storage for more devices. SanDisk’s business outpaces overall market growth and presents a higher value proposition.
Cost savings are another selling point. Western Digital anticipates costs to fall $500 million from synergies that should emerge from the SanDisk acquisition. Institutional Shareholder Services, an independent proxy advisory firm, estimates that by combining the two companies, $1.1 billion could be saved within 12 months of closing.
To be sure, synergies need to materialize, and materialize fast. Western Digital is devising a plan with lenders to syndicate a debt package worth $18 billion. A lower cost structure combined with both organizations’ strong cash flow are musts in order to service the debt.
Yes, Western Digital could be overpaying for SanDisk and business synergies, but the potential reward is worth the downside risk. Rumors of the death of PC market, and by way the hard-drive market, have been greatly exaggerated. Hard-drive sales will supply the cash to fund the research and development for future storage, which belongs to SanDisk’s flash storage. The relationship between the two companies could prove more symbiotic than most investors think.
So, I like the deal, but I appear to hold a minority opinion. Western Digital shares have sold off this year, despite decent earnings prospects. Western Digital is still on track to earn $5.80 for fiscal year 2016 (which ends in June). What’s more, Western Digital should earn $6.30 per share in fiscal year 2017. The 2017 estimate could easily be ratcheted higher should the expected SanDisk synergies occur sooner than later.
Based on expected earnings expectations, Western Digital shares trade at only 8 times this year’s EPS estimate. This multiple is below the five- and 10-year historical average. Low expectations have lifted the yield on Western Digital’s shares to above 4%. (For even bigger and stronger yields, click here.)
Few investors expect much from Western Digital, and the bar sits low, but that’s the main attraction.
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