Thursday, August 5, 2010

Yes To Higher Tax Rates?

Western Digital Corp (WDC) trades at a P/E of just 4.5, despite having cash of $2.7 billion against debt of just $400 million. Subtracting the net cash position from the company's market cap (as we have previously done with other companies) gives the company a P/E of under 3! It is rare to find a large cap trading at such a low P/E, particularly in a growth industry (the company sells hard drives, which more and more of the devices we use rely on). But before jumping in, investors should be aware of a couple of caveats.

One may ask why the company is not busy buying back shares at these prices using its strong cash position. The first problem is that the $2.7 billion in cash is not freely distributable to company shareholders. The company earned this money through its international subsidiaries, and would be subject to a large tax payment (in excess of $1 billion) if it repatriated these funds. As a result, the company is incentivized to continually re-invest this money overseas, which could lead to poor allocation decisions and which can't be used to reward shareholders any time soon.

This same issue also affects the company's earnings, which are abnormally high relative to the company's operating income. This is because the company is using a very low tax rate, thanks to tax holidays in some of its foreign jurisdictions. But some of these tax holidays will expire soon. Furthermore, if shareholders ever expect to get paid, repatriation taxes (which are not currently accounted for by the company) will have to be paid. Therefore, the currently low tax rate, which is contributing to the high earnings, may not be sustainable.

Accounting for these tax issues raises the adjusted P/E of the company by a few points, but still leaves it looking grossly undervalued. Part of the reason is that the company is currently experiencing peak operating margins. The company has been better at cutting costs and being more productive than the competition, but as the competition catches up, margins for Western Digital should come down. Over the last 10 years, the company has averaged operating margins of under 8% of revenue, but this year the company pulled in margins of 15%. This has made this year's earnings high, but as competitors ramp up production, prices for hard drive units continue to fall, and in this somewhat commodity-like sector, Western Digital does not have a lot of control over pricing. Value investors prefer not to invest in companies that do not have a lot of control when it comes to pricing, and prefer to use average earnings over current earnings.

Despite these warnings, Western Digital may still hold appeal for value investors, particularly if its price continues to fall. For a good discussion of WDC's competitive position, have a look at Tom Armistead's article here.

Disclosure: None

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