WESTERN DIGITAL CORP quarterly report, Q2 FY2014

Western Digital Corporation — Fiscal 2014 Second-Quarter 10-Q

Reporting period: Fiscal quarter ended December 27, 2013, consisting of 13 weeks; six-month period ended December 27, 2013. Western Digital develops and manufactures hard drives and solid-state storage products under the HGST, WD and G-Technology brands.

Financial performance and position

Metric	Three months ended Dec. 27, 2013	Prior-year period	Six months ended Dec. 27, 2013	Prior-year period
Revenue	$3.972 billion	$3.824 billion	$7.776 billion	$7.859 billion
Gross profit	$1.141 billion	$1.059 billion	$2.229 billion	$2.252 billion
Gross margin	28.7%	27.7%	28.7%	28.7%
Operating income	$478 million	$478 million	$1.020 billion	$1.070 billion
Net income	$430 million	$335 million	$925 million	$854 million
Diluted EPS	$1.77	$1.36	$3.81	$3.43

Quarterly revenue increased 4%; six-month revenue declined 1%.
Quarterly net income increased 28%, while six-month net income increased 8%; quarterly diluted EPS rose 30% and six-month diluted EPS rose 11%.
Quarterly operating margin was 12.0%, compared with 12.5% in the prior year; six-month operating margin was 13.1%, compared with 13.6%.
Hard-drive shipments increased 7% year over year to 63.1 million units in the quarter and 3% to 125.7 million units for six months. Average selling price declined to $60 from $62 in the quarter and to $59 from $62 for six months, primarily due to competitive pricing.
Non-PC markets represented 54% of quarterly revenue, versus 49% in the prior year. Enterprise SSD revenue increased to $155 million from $89 million.
Research and development expense increased 11% quarterly to $421 million; selling, general and administrative expense increased 41% to $229 million. Increases reflected acquired businesses and stock-appreciation-rights valuation expense.
Quarterly operating cash flow was $727 million. Six-month operating cash flow was $1.406 billion, compared with $1.708 billion in the prior year.
Six-month investing cash outflow was $1.125 billion, including $823 million for acquisitions and $306 million for capital expenditures. Financing cash flow was positive $65 million, including $500 million of revolving-credit borrowings, offset by $300 million of share repurchases, $118 million of dividends and $115 million of debt repayment.
Cash and cash equivalents were $4.655 billion at December 27, 2013, up from $4.309 billion at June 28, 2013. Accounts receivable were $1.959 billion and inventories were $1.293 billion.
Reported debt at quarter-end included $500 million of short-term debt, $230 million of current long-term debt and $1.610 billion of long-term debt. The underlying credit facility balance was $2.3 billion, consisting of a $1.8 billion term loan and $500 million revolver balance.
Warranty accrual was $190 million at quarter-end, including $73 million classified as long term. The company reported a $263 million liability for unrecognized tax benefits, including $222 million expected to require cash payment.

Material changes versus the prior comparable period

Revenue growth and higher unit shipments were offset by lower ASPs. Operational efficiencies increased quarterly gross margin by 100 basis points.
Operating income was flat despite higher gross profit because operating expenses increased and included $13 million of Seagate arbitration-related interest charges. The prior-year quarter included $41 million of employee termination, asset impairment and contract charges, whereas no such restructuring charges were recorded in the current quarter.
The effective tax burden was materially lower: quarterly tax provision declined to $37 million from $133 million and six-month provision declined to $74 million from $192 million. The prior-year six-month period included an $88 million charge related to California deferred tax assets.
The company acquired VeloBit, sTec and Virident during fiscal 2014. The acquisitions were intended to expand enterprise SSD, server-side flash and storage software capabilities; their reported revenue and net income contributions were immaterial during the periods presented.
Goodwill increased to $2.555 billion from $1.954 billion, primarily reflecting acquisition accounting, including $505 million of preliminary Virident goodwill and $85 million of preliminary sTec goodwill.
The company repurchased 4.3 million shares for $300 million during the six months and had $1.7 billion remaining under its authorization at quarter-end. It declared a quarterly dividend of $0.30 per share.

Guidance, outlook, risks and unusual items

Management expected March-quarter hard-drive industry shipments and company revenue to decrease slightly from the December quarter because of seasonality.
The company estimated overall hard-drive industry shipments at approximately 142 million units for the December quarter, up 5% year over year and 1% sequentially.
On January 9, 2014, the company replaced its existing credit facility with a new $4.0 billion unsecured facility: a $2.5 billion term loan and a $1.5 billion revolving facility. The company used cash to repay the prior $2.3 billion balance and reported $2.5 billion outstanding under the new term loan at filing.
Required principal payments under the new term loan total $63 million for the remainder of fiscal 2014, followed by scheduled payments through fiscal 2019, including a $1.7 billion final balance in fiscal 2019. The company reported compliance with all covenants.
The principal contingent exposure is the Seagate arbitration. The accrued amount was $732 million at quarter-end, consisting of the $630.4 million final award plus statutory interest. The Minnesota Supreme Court accepted the company’s appeal, with oral argument scheduled for February 5, 2014. A required payment could reduce liquidity and foreign cash.
Approximately $4.0 billion of cash was held outside the United States and was generally intended to remain invested in foreign operations. Repatriation could generate additional U.S. tax.
Key operating risks include competitive pricing and ASP erosion, declining PC demand, substitution by SSDs and mobile devices, customer concentration, technology transitions, supply-chain and manufacturing disruptions, product warranty claims, foreign-currency exposure, cyber attacks, acquisitions and litigation.
Foreign-exchange contracts had $73 million of liabilities at quarter-end, and $60 million of net unrealized losses was expected to be reclassified into earnings within 12 months. A 1% increase in variable interest rates was estimated to increase annual interest expense by approximately $25 million.
Disclosure controls and internal control over financial reporting were assessed as effective at December 27, 2013.

Important facts for investors to verify

Whether the Seagate arbitration award is ultimately enforced and whether the $732 million accrual is sufficient.
The effect of the refinancing, scheduled debt amortization, interest rates and covenant requirements on liquidity and capital allocation.
Whether SSD and non-PC growth offsets PC-market weakness and continuing ASP pressure.
Integration progress and returns from the Virident, sTec and VeloBit acquisitions, including the substantial preliminary goodwill balances.
Trends in gross margin, inventory, warranty claims, customer incentives and competitive pricing.
Developments in IRS examinations and the $263 million unrecognized-tax-benefit liability.
Future share repurchases and dividends relative to operating cash flow and debt repayments.