Global Technology| July 22, 2015 DDoowwnnggrraaddiinngg WWeesstteerrnn DDiiggiittaall Downgrading Western Digital (WDC) to EW, from OW, with $70 PT Downgrading to Equal-weight from Overweight: Our prior Overweight view was that the combination of 1) upside from cloud orders, 2) benefits of a consolidated industry including more stable pricing, 3) better execution in flash storage with recent acquisitions, 4) potential upside from MOFCOM decision allowing for incremental cost reductions. While some of these catalysts are still in play – including industry consolidation and better execution outside of HDDs – the combination of lower demand from cloud customers and no evidence of a MOFCOM decision near-term make us believe earnings estimates and valuation multiples may be pressured near-term. As a result of our lowered view on cloud capex (accounts for as much as 12% of revenue, higher percent of profits), we lower our FY16 (fiscal year-end June 2016) revenue and EPS to $13.3B and $6.35, from $14.6B and $8.66 previously. Our estimates are now well below consensus (by 6% for Revenue and 16% for EPS). Additionally, slower unit growth in the cloud category, combined with lower client and enterprise units, will pressure fixed cost absorption. Our lowered estimates still assume WD can deliver gross margin in the bottom half of its 27-32% gross margin target, but weaker volume and enterprise/cloud mix could push it lower in the absence of meaningful flash storage growth or additional cost cutting opportunities. Lower PT to $70 from $113: Our prior $113 PT credited WDC with multiple expansion from historical levels as cloud became a larger growth driver and inventory/pricing behavior reflected a more consolidated industry. We now believe that with weaker demand across PC, enterprise, and cloud that P/E is likely to return to levels closer to the three year average range of 8-10x. Our $70 PT is based on 11x our lowered FY16 EPS of $6.35 as compared to a 13x P/E implied by our prior target of $113. The new 11x P/E is a point higher than Seagate's to reflect optionality from MOFCOM decision related cost take-outs and better execution in flash and is toward the low-end of IT Hardware ranges, reflecting our view that top-line will decline by 9% in FY16 and EPS by 16% (more than revenue due to margin weakness from lower fixed cost absorption and fewer mix benefits). Where we could be wrong – bull/bear case view: Our bull case of $119 stock price assumes the weakness in cloud data center growth is more moderate, allowing WD to hit at least the midpoint of its 27-32% gross margin target range and that MOFCOM approval allows for additional reductions in operating expenses. These upside drivers allow EPS to grow 13% this fiscal year, ahead of the bull case EPS trends for Seagate due to more OpEx opportunities from consolidating HGST assets if MOFCOM approves. In our bull case we assume shares can reach recent peak P/E of 14x given double-digit earnings growth. Our bear case of $45 assumes gross margin at the low-end of the 27-32% target range as weaker volumes and lack of MOFCOM approval offsets improving mix from the emerging flash segment. 10x bear case EPS of $4.50 assumes P/E multiple returns to the high-end of WD’s three year average range of 8-10x and in-line with the lower end of ranges for IT Hardware peers. 28