Should WDC Acquire Kioxia?

Single star from the post's second chart.Over the past couple of months rumors asserted that Western Digital (WDC) was in talks to acquire joint venture partner Kioxia.  This is not the first time such rumors have emerged.  In November of 2020, when Kioxia was expected to make its initial public offering, WDC was rumored to be in such talks, and before that, in early 2017, when Toshiba first started to plan to spin off its NAND flash and SSD business, WDC was rumored to have plans to take the company over.

In fact the whole slow ordeal of the spin-off, which wasn’t finalized for another 18 months, was a constant stream of rumors and leaks, just one of several symptoms of the management malaise that was tearing Toshiba apart.

What none of these rumors considers, and which seems pretty clear to The SSD Guy, is that a Kioxia acquisition might actually not be in WDC’s best interest.  I’ll tell you why.

Kioxia and WDC are in a mutually beneficial relationship which has succeeded wonderfully for a couple of decades.  Production facilities are owned 50.1% by Kioxia and 49.9% by WDC, and WDC is allowed to take up to 49.9% of the fab’s output.  Chips are jointly designed and developed, as are the wafer processes.  The companies compete directly against each other in the market.

But WDC is generally much more profitable than Kioxia.  The chart below helps to illustrate this.  It plots the two companies’ profit margins by calendar quarter:

Column chart of Kioxia and WDC percent margins, 2017 through 2021

Please note that the two companies don’t report their numbers the same way, so WDC’s columns (green) show flash gross margins while Kioxia’s (red) show operating margins, which are always lower than gross margins.  Still, the difference between the two companies is significant, especially in low-margin quarters.  (The missing quarters 2Q18 & 3Q18 were not reported by Kioxia as it was being spun off by Toshiba.)

Why would this be, particularly when both companies make and use the same chips?

It comes down to two things:

      1. WDC focuses its sales efforts on higher-margin products and rarely engages in discrete chip sales, opting instead to sell more SSDs, with a lesser focus on lower-margin USB flash drives and flash cards.  Toshiba sells chips, cards, USB flash drives, and SSDs.
      2. WDC has the option of taking LESS than 49.9% of the fab’s output if there’s an oversupply.  In such agreements it is typical for the reduction to be planned ahead by only one quarter.

This second point is very important.  If NAND flash goes into an oversupply, then WDC can take only as much NAND as its customers demand, while Kioxia ends up not only with more chips than it needs from its 50.1% share of the JV’s output, but also it’s saddled with the product that WDC didn’t choose to take.

Say, for example, that the market is oversupplied by 1%.  The JV will then produce 1% more product than either Kioxia or WDC really know what to do with.  They don’t have customer contracts to take these parts.  The typical way to deal with this is to shop them around and take a low price to steal away another company’s business.  The other company will engage in a price war, and prices for the excess parts fall steeply from the prices for the regular business.

So Kioxia sells its 1% of excess output at a very low price, and this drags down profits.  That’s pretty bad, but it gets worse.

Since WDC doesn’t have to take its full 49.9% it doesn’t take its 1% excess — the parts become Kioxia’s.  So Kioxia ends up not only having to sell its own 1% excess at bargain-basement prices, but it has to also sell WDC’s, essentially doubling its excess.  Kioxia becomes the only company with a 2% oversupply, and WDC walks away with almost none.

Can we tell when this has happened?  It’s not too difficult to guess.  The chart below shows Toshiba/Kioxia NAND revenues (red line) and SanDisk/WDC NAND revenues (stacked columns) from 2014-2021.  I have put stars in to draw attention to the times when Kioxia revenues increased while WDC revenues decreased, the likely times during which WDC elected not to take its full share of the output.

Chart overlaying WDC revenues and Kioxia revenues by quarter

(Revenues for 2Q18 & 3Q18 are my estimates, but they don’t make a difference to the point.)

Since the first chart starts at 2017 we don’t have a solid relationship for the first three stars in the chart, but WDC’s revenues were clearly falling more rapidly than Kioxia’s in 2019, and the star in late 2020 indicates the losses that Kioxia suffered in late 2020 and early 2021.

This brings us back to the question of an acquisition: What would a Kioxia acquisition do for WDC?

In a nutshell, WDC would end up having to take all of the output from the JV fab, and this means that it would be less profitable than the company is today.  Would the board and stockholders be happy with that?  I certainly doubt it.

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