WDC is undervalued at $439 vs $517 fair value; long-term contracts through 2031 justify a buy rating with medium conviction.

The proliferation of proxy AI has been very beneficial to Western Digital because these systems create and store more data. Furthermore, the management team assured investors that their clients are looking for long-term agreements, which reduces the cyclical nature of business and creates an increased willingness among investors to pay a higher multiple for the stock.

Finally, the company has become able to impose higher prices, and these higher prices are likely to continue for several years as the company increases its bargaining power under supply and demand dynamics that work in its favor.

But does all this make Western Digital stock a buying opportunity? Let's answer this question together.

Looking at the company's history over the past decade, you can see the cyclical nature of its business.

Fluctuations between ups and downs have always been a common feature in the semiconductor industry. But as mentioned in the introduction, more semiconductor companies such as Western Digital, Micron and others are expected to sign long-term agreements.

Western Digital's management team confirmed that their customers are signing agreements that extend to 2029, 2030, and 2031. This means they are extending many years into the future, giving the company a clearer view, reducing the risks of its investments, and allowing it to plan and create products and services that its customers are looking forward to buying.

Given the increasing lead times, this gives the company a better view of what customers want and when they want it, allowing it to plan, invest and innovate more effectively with less waste and less risk.

The company's revenues are recovering, having jumped to $12.92 billion, and the management team anticipates continued growth in the future.

The accelerated revenue growth was one of the reasons that made investors optimistic about Western Digital. But it's not just about revenue growth. This revenue growth is accompanied by expanding profit margins and higher average selling prices, allowing Western Digital to achieve profit margins unprecedented in the company's history.

Over the past twelve months, the operating margin was 35.6%. This is higher than its previous peak in 2019, when it achieved an operating margin of 19%. Management expects these margins to continue and even increase as they sell their products at higher prices.

As I mentioned earlier, a broader view of the company's operations allows for reduced waste, improved investment, and better planning.

You can see a similar boom if you look at the company’s return on invested capital, which has risen to 84.75% over the past twelve months, again higher than at any point in the company’s previous ten years.

Given the supply dynamics, the shortage of available stock in the market, and the company's long-term agreements, I wouldn't be surprised if the company's return on invested capital remained high for the next four to eight quarters.

I don't expect them to maintain these margin levels for a long period, such as five or ten years, but they can achieve this for the next four to eight quarters, and then stabilize at levels close to 20, 30 or 40% return on invested capital, which would be great for shareholders in the long run.

One of the biggest concerns for investors about Western Digital is that its business is booming, as you have seen, and therefore its earnings per share are at record levels, and investors are curious and concerned about paying a price-to-earnings ratio based on peak earnings.

This is why you see semiconductor companies like Western Digital, Micron, and others being sold at relatively cheap valuations, because investors do not believe that this earnings per share are sustainable.

They believe these are peak levels and that this earnings per share will eventually decline. Currently, Western Digital is trading at a forward price-to-earnings ratio of 13.8, the level at which the stock was trading in 2024 before it experienced a surge in demand and before the spread of agent AI changed the supply and demand dynamics in the storage industry.

Today, I also updated my assessment of Western Digital's discounted cash flows, and my revisions were positive for the company's free cash flow estimates over the next few years, because the last time I assessed the company, the projections I included were worse than what actually happened over the past two months.

Demand for their storage products has increased more over the past few months than I anticipated. Not much, but more than I had previously appreciated. My revisions to free cash flow estimates were upward by about 2% annually over the next few years.

Not huge upward revisions, but they were indeed increases.

This resulted in an intrinsic value or fair value estimate for the company of $517 compared to the current market price of $439. Therefore, Western Digital stock appears to be undervalued when measured using my discounted cash flow model, and there is an upside opportunity of about 18% from here.

So, to answer the question: Do I think Western Digital stock represents a buying opportunity under current market conditions? The answer is yes.

I previously rated the stock as a buy opportunity with low conviction. Here I am raising my confidence level from low to medium, given the changes in industry dynamics and how long-term agreements are extending beyond 2030 and into 2031.

This gives me greater confidence that the volatility of the business is reduced.