Western Digital (WDC) – Disk Driving

by riskreversal September 27, 2016 1:50 pm • Trade Ideas

Earlier this year, hard disk drive maker Western Digital (WDC) closed its $16 billion acquisition for nand flash storage maker Sandisk. The date of the deal closing was May 16th,  a three and a half year low (circled) for the stock. But since then, the stock has risen nearly 70%:

WDC since Jan 2015 from Bloomberg
WDC since Jan 2015 from Bloomberg

WDC’s largest customers are PC and smartphone makers like Apple, HP, Huawei, Lenovo, LG & Samsung, contract manufacturers like Avnet, Quanta & Wistron and finally, telecom service providers like China Unicom & China Mobile.  The global penetration of smartphones in emerging markets and the recent bump in PC sales have been beneficial for WDC sales in the near term, while synergies (cost cuts) of the Sandisk deal should help buoy profitability. A few weeks ago the company raised full year guidance.  

WDC sells commodity products into cyclical end markets. That’s one reason it trades well below a market multiple.  Does the stock have a little more juice left in its can? Will investors look for cheap tech (trades 13x expected f2017, 10x expected f2018) with yield (current div yield 3.4%) with broad exposure across multiple tech platforms and the potential for continued cost cuts? Maybe.

But it’s a highly levered company with a $16.7bn market cap with $17b in debt and $8.4b in cash, and if the PC and smartphone cycle were to turn lower, investors might start reconsidering what the proper multiple is for a highly levered cyclical tech company.

The company will report fQ1 results the last week of October. With the pre-announcement out of the way, and a potential tailwind from INTC’s results, maybe the stock breaks-out out above $60 prior to results and makes a run to $70. Heck it’s still red on the year by about 1%, so that dosn’t seem like a stretch.  This sort of momentum trade isn’t my cup of tea (the stock has already rallied about $10, or about 20% since its Sept 7th pre-announcement.) But those that like those trades can define risk to play for continuation of that momentum, while defining their risk.

Volatility: With the recent breakout (in mid Sept, getting above resistance established in late July) implied options volatility has actually ticked higher. But it’s still from a fairly low base, so options remain fairly cheap:

[caption id="attachment_66637" align="aligncenter" width="693"]screen-shot-2016-09-27-at-10-57-35-am From LiveVol Pro[/caption]

So What’s the Trade?

Again, this is not our cup of tea, especially with the stock up 3% today, and up 20% since its Sept 7th pre-announcement, but for those looking for a defined risk momentum long entry, one way to protect against a temporary pullback of the recent strength, while financing fairly cheap vol in an out month is to sell a shorter dated higher strike call and buy a closer to the money longer dated call:

WDC ($59) Buy the Oct/Nov 62.5/60 call calendar for 2.30
  • Sell 1 Oct 62.5 call at .60
  • Buy 1 Nov 60 call for 2.90

Rationale – This trade is buying a close to the money November calls for cheap vol that capture earnings, BUT, with the idea that it will be financed in the near term, also protecting a little and buying time in what is clearly a momentum trade with the risk that entails. Ideally, the stock goes higher from here but stays below 62.5 into Oct expiration. In that case, the Oct calls can be closed at a profit (lower than the sale due to decay), and then rolled out to November (ideally to the 65s or higher).

The point is it’s tough to jump into a momentum trade like this after such a strong move in the near term. This offsets some of that risk. There is a very small risk of the stock gapping substantially higher (above 62.5) in the next few weeks which isn’t great for the trade. But again, that’s a small risk and under most scenarios a move higher to 62.5 near term would be a good thing because the Nov 60 calls have much more deltas than the Oct 62.5s and having to get out of the Oct calls too early is a good problem to have. Even with a gap higher this trade is profitable, but a slower creep higher is best.

The biggest risk of course is that the stock loses its momentum and goes lower. But this is a defined risk. The most that can be lost is 2.30. And by selling the October calls that will decay faster than Nov on a down move, it’s unlikely that the entire 2.30 is lost.