Western Digital Corporation — Fiscal 2018 Third-Quarter Form 10-Q
Reporting period: Three and nine months ended March 30, 2018; comparable periods ended March 31, 2017. Fiscal 2018 comprises 52 weeks and ends June 29, 2018. Western Digital develops and supplies HDD, flash memory, storage devices and solutions across Client Devices, Data Center Devices and Solutions, and Client Solutions.
Financial Performance and Position
| Metric | Q3 FY2018 | Q3 FY2017 | 9M FY2018 | 9M FY2017 |
|---|---|---|---|---|
| Revenue | $5.013 billion | $4.649 billion | $15.530 billion | $14.251 billion |
| Gross profit | $1.927 billion | $1.523 billion | $5.853 billion | $4.391 billion |
| Gross margin | 38.4% | 32.8% | 37.7% | 30.8% |
| Operating income | $914 million | $525 million | $2.774 billion | $1.302 billion |
| Operating margin | 18.2% | 11.3% | 17.9% | 9.1% |
| Net income (loss) | $61 million | $248 million | $(81) million | $117 million |
| Diluted EPS | $0.20 | $0.83 | $(0.27) | $0.40 |
| Net cash from operations | Not separately provided for the quarter | Not separately provided for the quarter | $3.342 billion | $2.498 billion |
- Q3 revenue increased 7.8%, while nine-month revenue increased 9.0% year over year.
- Q3 gross margin expanded 560 basis points, primarily due to favorable flash demand and mix, higher-margin capacity enterprise HDD, and production-cost improvements from technology transitions.
- Data Center Devices and Solutions revenue increased 25.0% in Q3, driven principally by capacity enterprise HDD demand. Client Devices revenue was relatively flat, while Client Solutions revenue rose 3.9%.
- Exabytes shipped increased to 100 in Q3 from 74 and to 282 for the nine-month period from 232.
- Operating expenses were $1.013 billion in Q3 and $3.079 billion for nine months. Research and development declined modestly, while SG&A increased due to consulting and acquisition-related costs.
- Cash and cash equivalents were $4.963 billion at March 30, 2018, compared with $6.354 billion at June 30, 2017. Total cash, cash equivalents and available-for-sale securities were $5.076 billion.
- Inventories increased to $2.670 billion from $2.341 billion at fiscal year-end; days in inventory rose to 79 from 66 in the comparable prior-year period.
- Principal debt was $11.412 billion, with $11.200 billion reported after issuance costs and discounts. The company had $1.75 billion of additional borrowing availability under its revolving facility and was in compliance with its financial covenants.
- Capital expenditures were $643 million for nine months. Net cash used in investing activities was $1.406 billion, including $1.015 billion of notes receivable issuances to Flash Ventures and $99 million for acquisitions.
- The company paid $443 million of dividends and repurchased $155 million of common stock during the nine months. The remaining authorization under the repurchase program was $1.97 billion.
Material Changes Versus the Prior Comparable Period
- Profitability improved substantially at the operating level, but Q3 net income fell because of an $894 million loss on debt extinguishment associated with refinancing and redemption activity.
- Nine-month net income declined to a loss of $81 million from income of $117 million, primarily because of a provisional $1.66 billion mandatory deemed repatriation tax under the Tax Cuts and Jobs Act and higher debt-extinguishment charges.
- Interest expense declined to $160 million in Q3 from $205 million and to $562 million for nine months from $646 million, reflecting lower debt balances and interest rates.
- The company refinanced significant debt in February 2018, issuing $2.3 billion of 4.750% senior notes due 2026 and $1.1 billion of 1.50% convertible notes due 2024. It also replaced existing term debt with a $5.02 billion Term Loan A-1 and increased its revolving facility to $2.25 billion.
- Revenue mix shifted toward Data Center Devices and Solutions, which represented 33% of Q3 revenue versus 28% in the prior-year quarter. Client Devices declined to 46% from 50%.
- Cash flow from operations increased by $844 million year over year, substantially benefiting from the tax liability recorded under the Tax Cuts and Jobs Act and other working-capital changes.
Outlook, Commentary, Risks and Unusual Items
- Management stated that available cash, operating cash flow and credit facilities should be sufficient for working capital, debt, dividend, repurchase and capital expenditure needs for at least the next twelve months.
- For fiscal 2018, expected cash used for property, plant and equipment and net Flash Ventures notes receivable and equity-investment activity was approximately $1.50 billion to $1.90 billion. The filing does not provide specific revenue or earnings guidance.
- The provisional $1.66 billion repatriation-tax liability is payable over eight years and may change as the company completes its measurement-period analysis. Future tax expense may also be affected by the new minimum tax on foreign earnings and potential changes to indefinite-reinvestment assertions.
- Flash Ventures remains strategically important and supplied the majority of the company’s NAND flash. Western Digital’s maximum reasonably estimable Flash Ventures exposure was $3.588 billion, including $1.109 billion of lease guarantees, $1.547 billion of notes receivable and $613 million of equity investments.
- Key operating risks include NAND supply and technology-transition execution, dependence on Toshiba Memory Corporation and Flash Ventures, volatile HDD and flash pricing, customer concentration, inventory obsolescence, supply-chain disruptions, foreign-exchange exposure, variable-rate debt and high leverage.
- The company reported $505 million of unrecognized tax benefits and $105 million of accrued interest and penalties. The IRS has proposed adjustments that could increase federal tax expense by $795 million plus interest; the company disputes the proposed adjustments.
- Potential legal exposures include intellectual-property, securities, antitrust and German copyright-levy matters. The German copyright matter could result in losses of up to $189 million, inclusive of accrued amounts, if the company does not prevail.
- Recent acquisitions of Tegile Systems and Upthere had immaterial revenue and earnings contributions during the nine-month period.
Investor Verification Checklist
- Verify subsequent changes to the provisional $1.66 billion repatriation-tax estimate and the company’s final treatment of foreign earnings and cash repatriation.
- Assess whether gross-margin strength in flash and enterprise HDD was sustained after the quarter and whether NAND pricing, supply and technology transitions changed.
- Reconcile debt refinancing benefits against the $720 million of make-whole and tender premiums and $176 million of written-off issuance costs.
- Monitor cash deployment, inventory levels, Flash Ventures funding requirements and the $1.109 billion lease-guarantee exposure.
- Review the outcome and potential cash impact of the IRS examination, German copyright-levy litigation and other outstanding legal matters.
- Evaluate leverage, variable-rate exposure and liquidity after dividends, share repurchases, capital expenditures and required tax payments.