Western Digital Investor Alken Votes Against Acquisition of SanDisk

Alken Asset Management, a London-based investment manager that, as of December 31, 2015, held more than five million shares of Western Digital Corporation stock intends to vote against the acquisition of SanDisk Corporation at the upcoming special meeting of Western Digital shareholders, scheduled for March 15, 2016, by voting “no” on Proposal 1.

“The management team of Western Digital is exceptionally talented,” said Vincent Rech, analyst at Alken Asset Management. “However, the price being paid for SanDisk is excessive in light of the changing landscape for SanDisk’s products and capital markets considerations, including the trading price of Western Digital stock, changes in the valuations of the peer companies and issues presented by the heavy debt load Western Digital would be forced to carry to complete the transaction.”

Alken has released below an open letter to the board of directors of Western Digital.

Dear Ladies and Gentlemen:

Alken Asset Management is the investment manager to various funds and accounts that have been a significant shareholder of Western Digital Corporation since 2010. As of December 31, 2015, we were the beneficial owner of more than five million shares, making us one of Western Digital’s top ten shareholders, according to FactSet. We own the stock because we have tremendous respect for the executives who lead the company and for the execution, strategy and shareholder value creation for which they have been responsible.

We are, however, gravely concerned about the SanDisk acquisition. As you know, on October 21, 2015, Western Digital announced its intention to acquire SanDisk for a total consideration of approximately $19 billion. By all accounts at the time, the price that Western Digital agreed to pay for SanDisk was substantial, representing a greater than 70% premium to SanDisk’s share price at the end of September 2015. We understand from reading the S-4 registration statement filed on February 4, 2016, that Western Digital was the only party to make an offer for SanDisk, despite a process run by Goldman Sachs.

Since the agreement was signed, because of changes in SanDisk’s markets and business, as well as capital market factors, the price has proven to be simply too high. We believe the capital markets agree. That is why Western Digital’s stock price, as of Friday, has declined more than 40% since the deal was announced, underperforming both the S&P 500 and the company’s main competitor, Seagate Technology.

We believe this marked stock price underperformance is largely the result of the market’s recognition of the over-priced acquisition and its implications for Western Digital’s prospects, balance sheet and valuation.

For the reasons noted below, and after a careful review of the transaction, we have concluded that the acquisition of SanDisk on the terms contained in the merger agreement is not in the best interests of Western Digital or its shareholders. We therefore intend to vote against the NASDAQ Stock Issuance Proposal at the forthcoming special meeting, scheduled to be held on March 15, 2015, and urge you to reconsider and cancel the SanDisk transaction. As you undoubtedly know, if Western Digital shareholders reject Proposal 1, you will likely be in a position to cancel the transaction by paying $185 million to SanDisk, a relatively small break-up fee. We would certainly support such an action.
As noted, we have reached our conclusion after careful consideration of the deal.

Our principal reasons for opposing the transaction are as follows:

Changes in the Outlook for SanDisk
In our opinion, several important long-term issues have emerged since the time of announcement:

On October 20, 2015, a few hours before Western Digital and SanDisk publicly announced the Transaction, Intel revealed plans to spend up to $5.5bn to convert production at their Dalian facility to make non-volatile memory. This move has been perceived as a significant shift in Intel manufacturing strategy in partnership with Micron and in our view raises concern of increased long term supply and competition in the NAND market. See Notes A and B.
On November 5, 2015, a Tsinghua Unigroup subsidiary announced plans to invest 60 billion yuan ($9bn) to build a memory chip factory. This in our view raises concern of a new entrant in the NAND market, increasing long term supply and competition. See Notes C and D.
SanDisk is reliant on its partnership with Toshiba to manufacture NAND. On February 4, 2016, Toshiba announced its biggest ever annual loss. Since the announcement of the Transaction the share price of Toshiba has been cut in half. We are concerned that persisting issues at Toshiba could pose a threat to its ability to adequately finance the NAND operations. See Notes E, F and G.

Reflecting long term concerns above, as well as short term weakness, EPS expectations for SanDisk and its four direct NAND competitors (Micron, Toshiba, Samsung and SK Hynix) have come down more than 30% since the announcement of the Transaction. See Note I. The market now expects the NAND market to be more competitive – and profit more elusive – than at the time the Transaction was originally negotiated. In our view, this change in market dynamics means the price negotiated for SanDisk is too high.

SanDisk Was Already Experiencing Significant Headwinds
SanDisk specifically has suffered significant business challenges recently, causing us to worry as well about paying top dollar for a melting franchise. In four of the five years ending December 31, 2014, SanDisk generated operating income of $1.5 billion or more. Last year, operating income was just $616 million, the lowest level since 2009 despite having certain benefits, such as:

Cost reduction in 2015 because of the significant weakening in the Japanese yen relative to the U.S. Dollar; and
A highly cost-competitive technology at the moment (15-nanometer 2D NAND), which may not be sustained in the future as the industry moves to 3D NAND architecture.

However SanDisk generated in 2015 less than half the level of net income it generated in each of 2013 and 2014 (and less than it has generated since 2007), as it suffered a major reduction in revenue from its top customer (Apple) and others, substantial gross margin erosion and increased R&D expenses.

It is unclear if the outlook is any brighter. According to FactSet, the mean of sellside 2016 EPS estimates has been cut in half over the last twelve months, and EBITDA estimates have been cut almost as much. It appears that Western Digital is buying a business that faces significant headwinds – less revenue, a tougher pricing and margin environment while the need for R&D spending continues unabated.

We note as well that at the time of the negotiation, many sellside analysts had reservations about SanDisk’s opportunities and valuation. In fact, more than 60% of the research analysts covering SanDisk in September 2015 when the stock was trading in the $50s, rated the stock a “hold” or a “sell” according to FactSet.

Market Multiples and Stock Prices Have Declined
Perhaps in recognition for the sector’s challenges, the stock market is valuing each dollar of profit less than it was at the time of the announcement of the transaction. In its fairness opinion analysis, Merrill Lynch examined trading multiples of the companies it regarded as peers of SanDisk. Since the time of Merrill Lynch’s analysis, those multiples have compressed. According to FactSet, each dollar of EBITDA, for example, is receiving about one multiple-point less from the market and stock prices of the Merrill Lynch peer companies (which include seven storage and chip companies) have declined by nearly 15% on average through Friday. Even if the prospects for NAND and SanDisk had not diminished, these capital market changes alone would warrant a significant reduction in the transaction price.

Unconvincing Strategic Rationale and Uncertain Synergies
The majority of the Transaction synergies are expected to come from vertical integration, allowing Western Digital to purchase NAND at a better price for its enterprise solid state drive business (7% of Western Digital 2015 revenues). See Note H.

To achieve vertical integration on a relatively small part of its business, we believe that Western Digital is paying an acquisition premium on the entire SanDisk business, which consists overwhelmingly of revenues unrelated to enterprise solid state drives (such as NAND for smartphone, PC, memory card, etc.) and where we anticipate few, if any, synergies.

Substantial Decrease in Financial Flexibility
The transaction also involves significant new leverage, which imposes serious financial risks for the company and lowers Western Digital’s operating, strategic and financial flexibility. The combined company is expected to carry approximately $14 billion of debt on the balance sheet. Excluding future benefits related to the Transaction and MOFCOM synergies, this represents a pro forma net debt to EBITDA of 2.3x in our calculation, above relevant semiconductor peers. See Note J.

We also note that Western Digital expects to issue approximately $5.1 billion in secured and unsecured notes in lieu of drawing the Bridge Facilities. Since the announcement of the Transaction U.S corporate spreads have deteriorated, making this debt more expensive to finance. In a rapidly evolving market, especially with increasing competitive pressures, we are concerned that accepting this significant interest burden for many years to come may be unwise.

Unhelpful Fairness Opinions
In reviewing the registration statement, we cannot help but also note that the fairness opinions leave quite a lot to be desired. Among other things, those opinions are so imprecise on their face (“calculating” that fair value for SanDisk is as little as $48 per share or as much as $130 per share) as to be practically useless. As troubling, the Merrill Lynch opinion contained acknowledged errors at the time the Board reviewed it and voted on the Transaction. See Note K.

The two opinions rendered for the Board also:

used techniques, peer companies and precedent transactions that were different from one another and different from the ones used by the investment bank working for SanDisk (which produced lower “fair” values for SanDisk);
appeared to have largely disregarded the trading price of SanDisk’s stock as a valuation marker; and
were rendered by investment banks whose compensation was largely dependent on the transaction being approved by the Board and shareholders, creating a substantial conflict of interest.

See Note L.

We note as well that Bank of America / Merrill Lynch stood to make well over $100 million if the merger agreement were approved because exposure to certain SanDisk warrants and hedging transactions. It appears this was known to Bank of America / Merrill Lynch prior to the rendering of its fairness opinion. See Note M.

Even with these issues, the only techniques used by Merrill Lynch and JP Morgan that suggested a “fair price” was at or above the negotiated price involved fully crediting SanDisk’s forward projections (and sometimes required synergies on top). But SanDisk management has not proven to be reliable forecasters. In January 2015, SanDisk’s CFO predicted that 2015 revenue would be “similar to slightly higher than in 2014.” In actuality, SanDisk’s 2015 revenue came in 16% below that of 2014. See Note N.

We have confidence in the board and the Western Digital management team. But, we do not believe that the SanDisk acquisition, as currently structured and priced, is in the best interest of the company or its shareholders. We urge the board to consider any and all approaches to cancelling the transaction. We note that if we, and our fellow shareholders, vote against the transaction, the board may be able to walk away from the deal with a relatively small break-up fee.

Frankly, such an action would likely be no surprise to SanDisk or its investors. At Friday’s closing price, SanDisk is trading at a substantial discount (12% to 20% depending on various contingencies) to the consideration SanDisk shareholders would receive if the transaction closed. SanDisk shareholders themselves seemingly recognize the meaningful probability that Western Digital shareholders will reject the transaction and that SanDisk will continue to be an independent company, with diminished prospects.

And for our part, we would much prefer to own Western Digital as a standalone company. Adjusting for $19 in excess cash per share on its balance sheet, Western Digital is trading at a mere 4.0x P/E on 2017 consensus EPS compared to 8.4x for Seagate Technology.

Accordingly, we intend to vote against the transaction by rejecting Proposal 1 at the special meeting of shareholders to be held on March 15, 2015.

We welcome your feedback.

Sincerely,

//s//

Nicolas Walewski
Managing Partner
Alken Asset Management

Vincent Rech
Analyst
Alken Asset Management

Notes:
A.
B. Credit Suisse – Micron – Implications of INTC’S 3D NAND Fab, October 21, 2015.
C.
D. Bernstein – Tsinghua Moves to Build a Memory Fab…What does it Mean? November 6, 2015.
E.
F. Bernstein – Toshiba FQ3: More Skeletons out of the Closet, February 4, 2016.
G.
H. Stifel – W. Digital + SanDisk Deep Dive: Vertical Innovation + Vertical Integration = Strong Long-Term Strategy, November 16, 2015.
I. According to Bloomberg, from October 20, 2015 to February 19, 2016, consensus estimates for 2016 and 2017 EPS in U.S. Dollars for SanDisk have declined by 28% and 29%, respectively; for SK Hynix have declined by 35% and 31%, respectively; for Micron (August year-end) by 60% and 42% respectively; for Samsung by 17% and 18%, respectively; and for Toshiba by 39% (year ending March 2017) and 33% (year ending March 2018).
J. Registration Statement at page 205 and FactSet leverage statistics.
K. Registration Statement at page 114 (Subsequent to the meeting … of the Western Digital’s board of directors, BofA Merrill Lynch discovered a miscalculation.)
L. Registration Statement at pages 109 to 133.
M. Registration Statement at pages 91, 97-98.
N. SanDisk Corp. Q4 2014 Earnings Call, January 21, 2015.

About Alken Asset Management
Alken Asset Management is a London based independent investment manager with $9 billion in assets under management as of February 19, 2016. Founded in 2005 by Nicolas Walewski, the firm manages Long Only and Long Short equity funds as well as managed accounts on behalf of a significant number of investors worldwide. Fundamental research, stock picking and long term investing are at the centre of Alken’s investment philosophy. Its track record of investing in the stock market spans more than 18 years.