Western Digital's Arbitration Case Against Toshiba Feels Like a Negotiating Ploy

 | May 15, 2017 | 10:17 PM EDT
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If war is the continuation of politics by other means, as Clausewitz famously put it, then Western Digital's (WDC)  decision to involve an arbitration court in its battle to make a winning bid for Toshiba's flash memory unit is arguably negotiation by other means.

Western badly wants at least a stake in Toshiba's flash operations, the world's second-largest after Samsung's, and sees an opportunity to amplify the pressure it can place on Toshiba to agree to a deal to Western's liking. The end result could be a compromise with the Japanese government, the other big outside party that cares strongly about who the cash-strapped conglomerate ultimately sells to.

On Sunday, Western announced its SanDisk unit, which has a series of flash R&D/manufacturing joint ventures with Toshiba that rely on equipment installed within Toshiba plants, has requested that the International Court of Arbitration (ICC) arbitrate its demand that Toshiba "unwind" the transferring of its JV interests to its Toshiba Memory subsidiary, which is on the block. It also wants an injunction preventing Toshiba from "transferring its Flash JV interests, or any interest in an affiliate that holds its Flash JV interests, without SanDisk's consent."

The arbitration case could take up to a year to be resolved by a three-member panel, should a settlement not be reached. It will be heard in San Francisco, not far from SanDisk's Silicon Valley headquarters.

Western insists it still wants to "work with Toshiba to achieve a favorable outcome for all parties." The remarks come less than a month after Western CFO Mark Long said the company was in talks with two Japanese investment funds, known as INCJ and Development Bank of Japan, about a bid for Toshiba's flash unit. Prior to that, CEO Steve Milligan wrote a letter to Toshiba's board objecting to rival bids -- particularly one from Broadcom (AVGO) , which has aggressively cut spending at several acquired companies and could potentially use Toshiba's flash unit to compete against SanDisk for data center clients.

Other reported bidders for the Toshiba unit include Apple (AAPL) , South Korea's SK Hynix, Foxconn parent Hon Hai Precision and P-E firms Bain and KKR. With SanDisk and Toshiba's JV agreements explicitly stating that neither party can transfer a JV interest without the other's consent, the odds of Western winning its arbitration case are pretty good, and Toshiba has to be well aware of that. Last week, The Japan Times reported Toshiba is thinking of extending a May 19 deadline to end the bidding for its flash unit to month's end or later, due to Western's continued objections.

But if Toshiba's ugly financial situation -- its motivation, of course, for trying to sell the flash unit -- fails to improve, having an arbitration court rule in Western's favor in the spring of 2018 could very much feel like a pyrrhic victory. Toshiba has $7.1 billion in net debt (compares with a $9.1 billion market cap) and is still reeling from the giant losses recorded for its Westinghouse nuclear power unit, which recently filed for Chapter 11. Free cash flow (FCF) totaled negative $6.3 billion in fiscal 2017 (ended in March), and while analysts on average expect $1.5 billion in positive FCF for fiscal 2018, that's predicated on nuclear losses drastically narrowing.

Further financial pain could easily motivate Toshiba to pare capital spending at its flash operations, which in turn would hurt SanDisk. In March 2016, Toshiba announced it plans to spend $3.2 billion through fiscal 2019 to build a new plant dedicated to producing high-density 3D NAND chips. SanDisk certainly doesn't want to see any of that spending halted.

Western must be aware just as well as Toshiba is aware of its odds of losing the arbitration case. Western probably also realizes that, as much as it might like to single-handedly buy Toshiba's flash unit, such a deal could be hard to financially swing. Though a flash memory boom cycle has strengthened Western's cash flow profile, the company still has $7.4 billion in net debt, and (given the dollar figures attached to rival bids) buying the Toshiba unit is bound to cost over $15 billion. And given its current situation, one has to assume that Toshiba will want to be paid solely in cash.

Meanwhile, the Japanese government, viewing the Toshiba unit as a crown jewel of the local chip industry, has badly sought to keep the business in Japanese hands. The Financial Times reported over the weekend that the government had discussed providing INCJ with $7.9 billion in bank loans to support a bid that would also feature the Development Bank of Japan and KKR. It added INCJ remained "unconvinced" that the deal was in its interests.

A revised deal in which Western and Japanese investors both maintained large stakes, and which featured capital spending commitments, could be an effective compromise. It would further increase Western's flash exposure as solid-state drives gradually eat away at the company's core hard drive business, while preventing the Toshiba unit from completely falling into foreign hands. Moreover, past reports have suggested a deal involving a U.S. company would be relatively palatable to Tokyo, given U.S.-Japanese security ties.

The question of who (if anyone) has a majority stake could be a sticking point, and a slew of other issues would have to be worked out. But considering the potential costs of standing pat, each side has strong incentives work something out.

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