Deals

Tara Lachapelle is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

Western Digital shareholders were already disillusioned with the company's planned takeover of SanDisk. Today, they like it even less. 

The bad news, in a nutshell: A Chinese company canceled its plan to make a $3.8 billion investment in Western Digital after the U.S. regulatory body that investigates purchases by foreign entities signaled it would scrutinize the transaction (the implication being that it would probably be blocked). Without the investment, Western Digital has less cash to fund its merger with SanDisk.

Deal Hesitation
Both stocks have fallen since the merger was announced. Still, the benefits of joining forces may outweigh the concerns being raised.
Source: Bloomberg

This was always a possibility, but an unlikely one, according to the companies and analysts that cover them. Most figured the deal involving China's Tsinghua Unisplendour would breeze by regulators because it was relatively small (only a 15 percent stake) and because Western Digital's hard-drive storage assets weren't the type of technology expected to raise national security red flags. 

Now, Western Digital is commencing plan B. The company is lowering the cash portion of the SanDisk takeover offer by 21 percent to $67.50 a share and raising the stock exchange ratio to 0.2387. The new terms equate to roughly $16 billion, before accounting for SanDisk's net cash position. Western Digital shares fell Tuesday, giving it a market value of $10 billion, down from $17 billion in October when the deal was struck.

Even before the Chinese investment was derailed, one of Western Digital's top 10 shareholders said it should scrap the SanDisk deal and cut its losses by paying the $184 million breakup fee. The dissenting investment firm, Alken Asset Management of London, sees that as a small price to pay to avert a potentially destructive takeover of what it called "a melting franchise." In a letter made public Monday, Alken cited increasing competition facing SanDisk, financial hardship at SanDisk's partner Toshiba, volatile capital markets and post-deal leverage for Western Digital that will be far above that of peers.

With all this angst, why even bother with the deal, right? Why not listen to Alken? Pay the fee, walk away and be free of this mess.

Well, Western Digital needs this merger and the long-term benefits probably outweigh these snags. The company's revenue is declining as the market for the kind of computer hard drives it makes continues to shrink. Without getting into the weeds on the tech specs, buying SanDisk allows Western Digital to diversify into the faster-growing side of the storage industry and really dominate it. It's already the leader in hard-drive storage, and the acquisition would make it the No. 2 player in solid-state storage. According to estimates from Benchmark Co., more than 90 percent of data will be stored on one of these types of drives, and storage demand overall will grow 15 percent compounded annually over the next three years.

Sales Slump
In the past year, Western Digital's revenue has fallen 12 percent. That's its biggest decline on a rolling 12-month basis since 2000.
Source: Bloomberg

But like many of the transactions that came amid the recent merger boom, the concerns relating to the SanDisk purchase are less about rationale and have more to do with price. Alken says Western Digital is overpaying. And as Alken notes, if investors looked for any steer from the bank that provided the fairness opinion, they wouldn't get it. According to JPMorgan's analysis, SanDisk was worth anywhere from $48 a share to around $130 a share. That's not helpful.

But here's what we can say about price: While the semiconductor and storage industry has been consolidating at borderline unjustifiably rich prices, Western Digital's merger with SanDisk would be one of the least expensive relative to Ebitda and revenue. 

Stacking Up
The price Western Digital has agreed to pay for SanDisk is being scrutinized by an investor as the stock falls. But other recent industry deals have been even pricier.
Source: Bloomberg

Without the acquisition, it's unclear how Western Digital stems its declining sales. But with it, Western Digital can add revenue while cutting costs substantially -- $500 million of annual run-rate synergies within 18 months after the transaction closes and more than $1 billion by 2020. That means Western Digital may eventually double its Ebitda, according to Sachin Shah, a special situations analyst at Albert Fried & Co. If those synergies are feasible, it's hard to see how Western Digital is overpaying when they're getting this opportunity, he said. 

Another point of contention for Western Digital shareholders has been the valuation discount versus Seagate Technology, Western Digital's closest competitor. Both stocks have tumbled amid a tough environment for computer components, but Seagate still fetches the higher multiples. The SanDisk merger may be Western Digital's best hope of closing that gap, as well as expanding margins. We'll find out whether enough Western Digital shareholders agree when they vote on the transaction next month.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Tara Lachapelle in New York at tlachapelle@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net