Suddenly, rising in sympathy with NVIDIA Corporation (NVDA), chip stocks are hot again. Western Digital Corporation (NASDAQ:WDC), a maker of both hard drives and NAND flash technology, has soared over 50% year to date after a multi-year slump, taking Western Digital just a notch above its 2021 highs.

Hopeful investors are banking on a number of things for Western Digital: increased valuation amid an upcoming spinoff of Western Digital into two companies; secular tailwinds in generative AI driving increased need for storage, and sustained high NAND flash prices to keep Western Digital's margins afloat.

I last wrote a bearish article on Western Digital in early 2021, when the stock was then peaking at a multi-year high. Now, amid new industry dynamics and a sharp resurgence in growth, I'm turning my rating around on Western Digital to a buy rating, ahead of its planned spin-offs.

We need to acknowledge that there are risks and contingencies on which a sustained rally for Western Digital is possible (which we'll discuss later in this article), but on the whole - I expect multiple catalysts to be able to continue lifting Western Digital, especially if one or both of the Western Digital companies post-spinoff reinstate the company's dividend (Western Digital paid a $0.50 quarterly dividend period to storage markets tanking in 2020).

Hot memory market

The first factor we should highlight: the memory market is heating up at the moment. We can attribute the majority of the boost to secular tailwinds from generative AI demand. AI, as most investors are aware, requires massive amounts of data on which generative models answer queries and generate responses. This, in turn, has facilitated demand for cheap, fast storage. Though these are certainly commodity inputs, Western Digital (along with rival Micron Technology, Inc. (MU)) has long been one of the leaders in storage hardware, positioning it to benefit tremendously from increased pricing, particularly for NAND flash memory.

In Western Digital's most recent quarter, fiscal Q3 (the March quarter), revenue soared 23% y/y to $3.46 billion, decimating Wall Street's expectations of $3.35 billion (+20% y/y). Gross margins, meanwhile, also soared 19 points y/y driven by favorable NAND flash pricing to 29.3%, which in turn also drove substantial operating income, EPS, and free cash flow - versus sharp losses last year.

The company expects this trend to continue well into Q4: with guidance of $3.60-$3.80 billion in revenue representing 40% y/y growth at the midpoint, and gross margins improving three to five points sequentially to a range of 32-34%.

Spinoff takes advantage of a favorable market position

It's important to recognize that Western Digital's success of late is driven by the flash segment, though the HDD (hard drive) segment has also produced growth.

The chart above splits out the flash and HDD segments. Flash revenue grew 30% y/y while HDD revenue grew at a slower 17% y/y pace.

But importantly, it's NAND pricing that is driving the revenue growth. Actual exabyte shipments in Q3 for flash actually fell -15% sequentially versus Q2, but was more than offset by an 18% sequential increase in pricing (driving a 2% sequential increase in flash revenue).

NAND has always been a very cyclical industry, which is why Western Digital and many of its peers typically trade at a P/E multiple below the broader market indices.

In a recent June investor presentation to highlight NAND industry dynamics as well as its decision to split out the NAND flash segment into its own company, Western Digital's flash segment executives highlighted how the NAND industry has been plagued by a poor 2022-2023 for several reasons.

The COVID era pulled in demand into 2021 (the stock's prior high) and early 2022, especially compounded by cloud hyperscalers (think Meta Platforms, Inc. (META)) investing heavily in data centers at that time in anticipation of heavier traffic. Compounded with lower costs of capital in the COVID era amid lower interest rates, Western Digital and its peers engaged in a capex race in order to maintain market share, which caused lower NAND pricing and oversupply.

Now, however, the company believes it is exiting those dynamics. The oversupply in the market is naturally curing, while new AI-driven demand is driving flash pricing higher. In the investor presentation "New Era of NAND," the company's flash segment EVP cited that he believes that the industry is headed toward a period of more than 100% demand relative to fully utilized supply capacity, which is a driver for continued price increases in NAND flash.

This is the rationale for Western Digital's plan to split its flash unit into its own business, which was first announced in October 2023. As a reminder, the company currently operates its flash segment as a joint venture with a Japanese company called Kioxia (with 50.1% ownership), which in turn is backed by another memory industry rival SK Hynix. The companies are jointly responsible for flash innovation, but Kioxia handles more of the manufacturing load with responsibility over wafer builds.

Valuation to be unlocked with spinoff, but keep risks in mind

Large corporate spinoffs are rare, especially in the tech sector (the most major recent one that comes to mind is HP, which split apart into the software business Hewlett Packard Enterprise Company (HPE) and printer and PC maker HP Inc. (HPQ)). The motivation is almost always to increase valuation multiples for a higher-value segment: in Western Digital's case, the flash segment which it believes can get back up to peak-level margins.

As a combined company at the moment, Western Digital trades at a cheap 9.8x forward P/E relative to consensus expectations of $8.01 in pro forma EPS for the next fiscal year FY25 (the year for Western Digital ending in June 2025).

In my view, the spinoff has the potential to accord higher multiples to the flash unit, boosting all-in value for investors today. We do have to keep several risks in mind, however:

• Memory industry cyclicality is a reality of the business. Western Digital is smartly spinning off its flash segment at what it believes to be a favorable time, but periods of oversupply and weak demand have always been a feature of the memory industry.
• Current growth drivers could have a very short tail. What happened in the early COVID era, with hyperscalers pulling in their data center investments only to cool off demand between 2022-2023, could very well apply to the current AI-driven period as well.
• Debt load. Western Digital is still heavily indebted, with the consolidated company currently holding $5.0 billion of debt at just shy of a 3x leverage ratio.

Key takeaways

Despite risks, I do find Western Digital to be an attractive short to medium-term investment. Once details of the spinoff are finalized, I do believe there is an opportunity for investors to reap value from this stock beyond its current <10x P/E multiple, especially as the company continues to expect sequential improvement in NAND industry dynamics with improved growth and margins expected in Q4.

Use any near-term dips as a buying opportunity.