Western Digital Corporation — Fiscal 2017 First-Quarter Form 10-Q
Reporting period: Three months ended September 30, 2016; comparative period ended October 2, 2015. The fiscal quarter comprised 13 weeks. Western Digital develops and manufactures HDD, SSD, NAND flash, data-center, client-device and client-solution storage products, and earns license and royalty revenue. The results include SanDisk, acquired in May 2016.
Key Financial Metrics
| Metric | Q1 FY2017 | Q1 FY2016 | Change |
|---|---|---|---|
| Revenue | $4.714 billion | $3.360 billion | Up 40% |
| Gross profit | $1.335 billion | $955 million | Up 40% |
| Gross margin | 28.3% | 28.4% | Down 0.1 percentage point |
| Operating income | $232 million | $322 million | Down 28% |
| Operating margin | 4.9% | 9.6% | Down 4.7 percentage points |
| Net income (loss) | $(366) million | $283 million | Declined $649 million |
| Diluted EPS | $(1.28) | $1.21 | Declined $2.49 |
| Operating cash flow | $440 million | $545 million | Down $105 million |
| Capital expenditures | $184 million | $151 million | Up $33 million |
Revenue growth primarily reflected incremental NAND flash revenue from SanDisk, partially offset by lower HDD shipments. HDD shipments declined to 48 million units from 52 million, while HDD average selling price increased to $61 from $60. No customer represented at least 10% of revenue in the current quarter; the top 10 customers represented 43% of revenue.
Financial Position, Debt and Liquidity
- Cash and cash equivalents were $4.077 billion at September 30, 2016, compared with $8.151 billion at July 1, 2016. Short-term investments were $248 million.
- Total debt was $13.370 billion in principal, or $13.133 billion net of issuance costs and discounts. Long-term debt reported on the balance sheet was $13.055 billion.
- The company repaid the $3.0 billion bridge loan, refinanced the U.S. Term Loan B and Euro Term Loan B with new B-1 facilities, and paid $490 million in cash plus shares for convertible-note conversions and repurchases.
- The $1.0 billion revolving credit facility was undrawn. Management stated that available cash, operating cash flow and credit facilities were sufficient for at least the next twelve months.
- Financing activities used $4.312 billion, principally reflecting $8.242 billion of debt repayments, partially offset by $3.992 billion of debt proceeds. Dividends paid were $142 million, and the quarterly dividend was $0.50 per share.
- Management expected fiscal 2017 cash usage for capital expenditures and net Flash Ventures notes receivable and equity investments of approximately $0.6 billion to $1.0 billion.
Material Changes Versus the Prior Comparable Period
- SanDisk materially expanded revenue, NAND exposure, research and development, selling, general and administrative expense, depreciation and amortization, and debt-related costs.
- Research and development expense increased 66% to $639 million, and SG&A increased 106% to $396 million, primarily due to SanDisk.
- Operating expenses increased 74% to $1.103 billion. Acquired-intangible amortization was $263 million versus $23 million in the prior year, and employee termination, asset impairment and other charges were $68 million versus $56 million.
- Interest expense increased to $236 million from $13 million because of acquisition-related debt. Other expense included approximately $227 million of debt issuance-cost and discount write-offs and a $5 million loss on convertible-debt settlement.
- Income tax expense was $95 million, producing a negative 35% effective tax rate, driven by discrete SanDisk integration and acquired tax-attribute valuation-allowance items, partly offset by tax benefits from debt refinancing.
- Cash flow from operations declined despite the revenue increase, while the cash conversion cycle increased to 38 days from 24 days, primarily reflecting higher days in inventory and lower days payable outstanding.
Outlook, Commentary, Risks and Unusual Items
- Management focused on integrating SanDisk and continuing the permitted integration of substantial HGST and WD operations. The HGST integration was expected to continue through calendar 2017, with separate brands and sales teams required until October 19, 2017.
- The newly operational Unis joint venture in China was 49% owned by Western Digital and had no material effect on current-quarter consolidated results.
- Key operating risks include PC-market deterioration, volatile HDD and NAND pricing, intense competition, demand forecasting errors, inventory obsolescence, technology transitions including 3D NAND, manufacturing concentration, supplier constraints and reliance on Toshiba and Flash Ventures.
- Flash Ventures exposure included $1.217 billion of notes receivable and equity investments and $1.235 billion of guaranteed operating lease obligations. The company was committed to purchase approximately 50% of Flash Ventures’ output and fund approximately 49.9% to 50.0% of certain investment needs.
- The company had $13.4 billion of debt and substantial variable-rate exposure. A one-percentage-point increase in applicable variable interest rates was estimated to increase annual interest expense by $66 million.
- Unrecognized tax benefits, including accrued interest and penalties, totaled $563 million; approximately $420 million could result in potential cash payments. An IRS examination proposed additional federal tax expense of $795 million plus interest, although the company disputed the proposed adjustments.
- Reasonably possible losses related to German copyright-levy matters were estimated at up to $133 million, including accrued amounts. The filing states that other disclosed litigation was not expected to be material, but outcomes remain uncertain.
- Goodwill and integration risks were significant. The company cautioned that adverse market conditions or lower forecast cash flows could result in material impairment charges.
Investor Verification Checklist
- Verify the contribution, profitability and cash generation of SanDisk and NAND products separately from the legacy HDD business.
- Track debt reduction, refinancing terms, variable-rate exposure, covenant compliance and the timing of required Term Loan A repayments.
- Assess whether integration savings and operating synergies from SanDisk and HGST are being achieved without additional restructuring or impairment charges.
- Monitor HDD unit demand, NAND pricing, product mix, gross margin and the pace and cost of the 3D NAND transition.
- Review Flash Ventures funding, wafer-purchase commitments, lease guarantees and Toshiba-related counterparty and supply risks.
- Follow the IRS tax dispute, unrecognized tax benefits, litigation contingencies and potential cash tax payments.
- Confirm that liquidity remains adequate after dividends, capital expenditures, Flash Ventures investments and debt service.