Western Digital Corporation — Fiscal Q3 2019 Form 10-Q Summary
Business context and reporting period
Western Digital develops and supplies data-storage devices and solutions across Client Devices, Data Center Devices and Solutions, and Client Solutions, including HDD, flash-based products, SSDs, and related intellectual-property licensing. The filing covers the 13-week quarter and nine months ended March 29, 2019, compared with the periods ended March 30, 2018. Fiscal 2019 ends June 28, 2019.
Key financial metrics
| Metric | Q3 FY2019 | Q3 FY2018 | 9M FY2019 | 9M FY2018 |
|---|---|---|---|---|
| Revenue | $3.674 billion | $5.013 billion | $12.935 billion | $15.530 billion |
| Gross profit | $579 million | $1.927 billion | $3.287 billion | $5.853 billion |
| Gross margin | 15.8% | 38.4% | 25.4% | 37.7% |
| Operating income (loss) | $(394) million | $914 million | $468 million | $2.774 billion |
| Net income (loss) | $(581) million | $61 million | $(557) million | $(81) million |
| Diluted EPS | $(1.99) | $0.20 | $(1.91) | $(0.27) |
| Operating cash flow | Not separately provided | Not separately provided | $1.378 billion | $3.342 billion |
As of March 29, 2019, cash and cash equivalents were $3.682 billion, or $3.801 billion including available-for-sale securities. Principal debt was $10.762 billion, with $2.25 billion of undrawn revolving-credit capacity. Debt, net of cash and cash equivalents, was approximately $7.08 billion. Current liabilities were $4.212 billion and total shareholders’ equity was $10.214 billion.
- Revenue declined 26.7% in the quarter and 16.7% for the nine months.
- Flash-based revenue was $1.610 billion in the quarter, down from $2.373 billion; HDD revenue was $2.064 billion, down from $2.640 billion.
- Quarterly revenue declined across Client Devices, Data Center Devices and Solutions, and Client Solutions.
- Quarterly cash conversion cycle increased to 76 days from 44 days, reflecting higher inventory days.
- The company paid $438 million of dividends and repurchased $563 million of common stock during the nine months.
Material changes versus the prior comparable period
- Lower flash average selling prices per gigabyte, lower HDD sales, weaker flash demand, and adverse product mix materially reduced revenue and gross margin.
- Gross margin fell 22.6 percentage points in the quarter, primarily because of pricing pressure, flash underutilization, inventory charges, and other cost items.
- Flash manufacturing underutilization charges were $148 million in the quarter and $197 million year to date. The company temporarily reduced utilization at Flash Ventures because of excess flash supply relative to demand.
- The company recorded a $110 million cost-of-revenue charge, primarily to reduce flash multi-chip package component inventory to net realizable value.
- Research and development expense decreased 9.6% in the quarter and 9.0% year to date; selling, general and administrative expense decreased 6.1% and 9.2%, respectively.
- Employee termination, asset impairment, and other charges increased to $76 million in the quarter from $35 million, mainly due to business realignment and facility-closure actions.
- Interest and other expense improved substantially versus the prior year because the prior-year period included an approximately $854 million debt-extinguishment loss and higher debt-related costs.
- The nine-month effective tax rate was distorted by discrete Tax Cuts and Jobs Act items, including the change in the company’s indefinite reinvestment assertion and adjustments to the mandatory deemed repatriation tax.
Guidance, outlook, management commentary, risks and unusual items
- Management expects additional flash underutilization charges of approximately $55 million to $75 million by the end of fiscal 2019, subject to market conditions.
- Cost and expense reduction actions, including the closure of the Kuala Lumpur HDD facility, are expected to reduce annualized cost of revenue and operating expenses by approximately $800 million, split approximately equally between the two categories.
- The Kuala Lumpur facility closure is expected to be substantially completed in the fourth quarter of fiscal 2019 and is expected to generate total pretax charges of approximately $110 million; $16 million was recognized during the first nine months of fiscal 2019.
- Fiscal 2019 cash use for capital expenditures and net Flash Ventures notes receivable and equity-investment activity is expected to be approximately $1.50 billion to $1.90 billion.
- Management believes cash, operating cash flow, and available credit facilities will cover working capital, debt service, dividends, repurchases, and capital-expenditure needs for at least the next twelve months.
- Flash Ventures remains a major exposure: Western Digital is generally committed to purchase approximately 50% of output, fund half of fixed costs regardless of purchases, and fund approximately 49.9% to 50.0% of capital investments when operating cash flow is insufficient. The company’s maximum reasonably estimable Flash Ventures exposure was $4.098 billion, including $1.421 billion of lease guarantees.
- Western Digital completed an April 2019 amendment to its credit agreement that provided additional covenant flexibility. The company was in compliance with its covenants at March 29, 2019, but significant deterioration in adjusted EBITDA could still create covenant and default risk.
- Approximately 68% of debt was at variable rates. After interest-rate swaps, $5.33 billion remained effectively exposed to variable interest rates; a one-percentage-point increase would increase annual interest expense by approximately $53 million.
- The IRS is seeking additional federal tax of approximately $516 million for fiscal years 2008–2009 and approximately $549 million for fiscal years 2010–2012, plus interest. The company has filed petitions in U.S. Tax Court and disputes the proposed adjustments.
- Unrecognized tax benefits were approximately $708 million, with accrued interest and penalties of approximately $120 million; the timing of potential cash payments is not reasonably estimable.
- A securities class-action matter related to former SanDisk disclosures reached a settlement in March 2019, subject to formal ratification and court approval. The related charge was recorded in SG&A, but the filing text does not provide the settlement amount.
- In April 2019, the company completed a sale-and-leaseback of its Fremont facility for $115 million and expects to recognize an approximate $25 million loss. The facility was leased back for 15 years, with renewal options.
- Principal ongoing risks include flash oversupply and price erosion, dependence on Toshiba Memory Corporation and Flash Ventures, technology-transition execution, supply-chain concentration, customer concentration, high leverage, foreign exchange and interest-rate exposure, tax disputes, litigation, cyber risks, and manufacturing or geopolitical disruptions.
Most important facts for an investor to verify
- Whether flash pricing and supply-demand conditions improve sufficiently to eliminate or reduce expected underutilization charges.
- Progress and realized savings from the $800 million annualized cost-reduction program and completion costs for the Kuala Lumpur closure.
- Revenue, gross-margin, inventory, and cash-flow trends, particularly the elevated 101 inventory days and 76-day cash conversion cycle.
- Compliance with amended leverage and interest-coverage covenants as operating results and adjusted EBITDA change.
- Cash requirements and exposure arising from Flash Ventures, including the $1.421 billion lease guarantee and continuing capital-funding obligations.
- Resolution and potential cash impact of the IRS tax disputes, $1.103 billion remaining mandatory deemed repatriation tax obligation, and unrecognized tax benefits.
- Whether dividends and repurchases remain sustainable while the company carries approximately $10.76 billion of principal debt and funds capital investments.