WESTERN DIGITAL CORP quarterly report, Q2 FY2015

Western Digital Corporation 10-Q Summary

Business Context and Reporting Period

Western Digital develops and manufactures data-storage products, including hard disk drives, enterprise solid-state drives, direct-attached storage, personal-cloud products and data-center solutions under the HGST, WD and G-Technology brands. The filing covers the 13-week fiscal second quarter ended January 2, 2015, and the six months then ended. Fiscal 2015 is a 53-week year ending July 3, 2015.

Financial Performance and Position

Metric	Three Months Ended January 2, 2015	Prior-Year Quarter	Six Months Ended January 2, 2015	Prior-Year Period
Revenue	$3.888 billion	$3.972 billion	$7.831 billion	$7.776 billion
Gross profit	$1.110 billion	$1.156 billion	$2.259 billion	$2.255 billion
Gross margin	28.5%	29.1%	28.8%	29.0%
Operating income	$466 million	$478 million	$935 million	$1.020 billion
Net income	$438 million	$430 million	$861 million	$925 million
Diluted EPS	$1.84	$1.77	$3.60	$3.81

Quarterly hard-drive shipments were 61.0 million units, down 3% year over year; industry shipments were estimated at approximately 141 million units, down 1%.
Six-month hard-drive shipments were 125.8 million units, essentially flat with 125.7 million units in the prior-year period. Average selling price remained approximately $60 per unit in the quarter and $59 for the six months.
Enterprise SSD revenue increased to $187 million from $155 million in the prior-year quarter.
Quarterly operating margin was 12.0%, compared with 12.0% in the prior-year quarter. Six-month operating margin declined to 11.9% from 13.1%.
Research and development expense increased 2% for the quarter and 6% for the six months, primarily reflecting investment in enterprise SSDs and the inclusion of full-period Virident and sTec costs.
Cash provided by operations was $243 million in the quarter and $1.070 billion for the six months, compared with $1.406 billion for the prior-year six-month period.
Capital expenditures were $306 million for the six months. Net cash used in investing was $254 million.
Net cash used in financing was $718 million, including $532 million of share repurchases, $187 million of dividends and $63 million of debt principal repayments.
Cash and cash equivalents were $4.902 billion at January 2, 2015, including $3.5 billion held outside the United States. Short-term investments were $241 million, and total available-for-sale investments were $465 million.
Total debt was approximately $2.375 billion on the balance sheet, consisting of $125 million current debt and $2.250 billion long-term debt. The term loan balance was approximately $2.4 billion, with a variable interest rate of 1.66%; no revolving credit facility borrowings were outstanding.
The company stated that cash, operating cash flow and available credit facilities should be sufficient for working capital, debt service, capital expenditures, dividends and repurchases for at least the next twelve months.

Material Changes Versus the Prior Comparable Period

Quarterly revenue declined 2% as lower hard-drive shipments offset product-mix changes; six-month revenue increased 1%.
Quarterly gross margin declined 60 basis points, while six-month gross margin declined 20 basis points.
Quarterly operating income declined $12 million, but net income increased $8 million and diluted EPS increased $0.07, helped in part by a lower tax provision and fewer diluted shares.
Six-month operating income fell $85 million and net income fell $64 million, principally reflecting higher operating expenses and lower operating cash generation.
Employee termination, asset impairment and other charges increased to $53 million for the quarter and $62 million for the six months, compared with $23 million and $34 million, respectively.
The quarterly tax provision declined to $20 million from $37 million, including a $16 million benefit from the retroactive extension of the U.S. federal R&D tax credit.
SG&A benefited from a $37 million Thailand-flood insurance recovery. All related insurance claims were closed by January 2, 2015.
The company paid Seagate $773.4 million in October 2014 to satisfy an arbitration award. Seagate claimed an additional approximately $28.9 million of interest, and the matter remained pending before the court at the filing date.

Guidance, Outlook, Risks and Unusual Items

The filing does not provide clear numerical revenue or earnings guidance. Management discussed expectations regarding industry demand and shipments for the quarter ending April 3, 2015, but the supplied filing text does not state a specific forecast.

Management continues to invest in enterprise SSDs and expects digital-data growth to support storage demand, while acknowledging competition from NAND, SSDs and other technologies.
Key operating risks include declining average selling prices, volatile gross margins, excess industry capacity, customer concentration, PC-market weakness, demand forecasting errors, product qualification delays, technology transitions and inventory obsolescence.
Manufacturing and supply-chain risks include dependence on limited suppliers, vertically integrated head and media production, concentrated facilities in Asia, natural disasters, freight disruption, labor issues and shortages or price increases for critical materials.
HGST integration remains subject to regulatory conditions imposed by China’s Ministry of Commerce. These conditions limit integration and may delay anticipated synergies; the company had requested that the restrictions be lifted.
Warranty accrual was $223 million at January 2, 2015, compared with $190 million at December 27, 2013. Actual product returns, repair costs or customer claims could differ materially from estimates.
The company recorded a non-material accrual for German copyright levies and disclosed that reasonably possible losses could total up to $90 million, including the amount accrued.
The German copyright-levy judgment for certain 2008-2010 sales had not established an exact amount; WD Germany intended to appeal.
The IRS proposed adjustments totaling approximately $200 million relating to intercompany payable balances for fiscal years 2006 through 2009. The company disagrees with the proposed adjustments; the ultimate tax outcome remains uncertain.
Unrecognized tax benefits were approximately $316 million, including a cash portion of $259 million, with estimated future payments over one to eight years.
Foreign-exchange hedges had a net unrealized loss of approximately $45 million at January 2, 2015, and $39 million of net unrealized losses were expected to be reclassified into earnings within twelve months.
A 1% increase in the variable interest rate on the term loan and revolving facility would increase annual interest expense by approximately $24 million.
After quarter-end, the company authorized an additional $2.0 billion for share repurchases, extending the program through February 3, 2020. It also declared a quarterly dividend of $0.50 per share, compared with $0.40 per share for the quarter ended January 2, 2015.

Important Facts for Investors to Verify

Whether hard-drive demand, shipments and pricing improve or deteriorate in subsequent quarters, particularly in the PC, cloud, enterprise and SSD markets.
The sustainability of gross margins amid pricing pressure, product-mix changes, customer incentives and component costs.
The cash-flow impact of the Seagate arbitration payment, ongoing debt amortization, capital expenditures, dividends and expanded repurchases.
The outcome and potential financial exposure from Seagate’s additional interest claim, German copyright-levy proceedings, intellectual-property litigation and other contingencies.
The resolution of the IRS tax examination and the company’s ability to maintain foreign tax holidays and manage unrecognized tax benefits.
Progress in integrating HGST and realizing synergies after regulatory restrictions are lifted or modified.
Warranty trends, restructuring charges and any impairment or inventory-obsolescence charges associated with technology transitions.