Business Context and Reporting Period
Western Digital Corporation is a global provider of hard disk drives, solid-state and NAND flash storage products, data-center solutions, client devices and client solutions, including related intellectual-property licensing. This unaudited Form 10-Q covers fiscal second-quarter and first-half 2017, consisting of 13-week and 26-week periods ended December 30, 2016, compared with periods ended January 1, 2016. Fiscal 2017 includes the SanDisk acquisition completed in May 2016.
Key Financial Metrics
| Metric | Three months ended Dec. 30, 2016 | Change vs. prior comparable period | Six months ended Dec. 30, 2016 |
|---|---|---|---|
| Revenue | $4.888 billion | Up 47% | $9.602 billion, up 44% |
| Gross profit | $1.533 billion | Up 69% | $2.868 billion, up 54% |
| Gross margin | 31.4% | Up from 27.3% | 29.9%, up from 27.9% |
| Operating income | $545 million | Up 117% | $777 million, up 36% |
| Net income (loss) | $235 million | Down from $251 million | $(131) million, versus $534 million profit |
| Diluted EPS | $0.80 | Down from $1.07 | $(0.46), versus $2.28 |
| Operating cash flow | Not separately provided | — | $1.500 billion, versus $1.143 billion |
Quarterly performance benefited from SanDisk NAND-flash revenue, higher NAND margins, higher HDD average selling prices and integration-related cost improvements. Results were reduced by $259 million of quarterly charges affecting gross profit, including acquired-intangible amortization, stock-based compensation, cost-saving initiatives and acquisition-related costs. Six-month charges affecting gross profit totaled $523 million.
Liquidity, Debt and Capital Structure
- Cash and cash equivalents were $4.940 billion at December 30, 2016, down from $8.151 billion at July 1, 2016; $3.9 billion was held outside the United States.
- Total debt was $13.299 billion, with $12.944 billion classified as long-term debt. The $3.0 billion bridge loan outstanding at July 1, 2016 was fully repaid.
- The $1.0 billion revolving credit facility was undrawn, and the company stated that it was in compliance with debt and Flash Ventures covenants.
- Net cash used in financing was $4.386 billion, primarily reflecting $8.254 billion of debt repayments, partially offset by $3.992 billion of new debt proceeds. Dividends paid were $284 million.
- Capital expenditures were $330 million for the first half. Management expected approximately $700 million to $1.1 billion of fiscal-2017 cash usage for capital expenditures and net Flash Ventures notes receivable and equity-investment activity.
- Variable-rate debt totaled approximately $8.0 billion; a one-percentage-point increase in applicable rates would increase annual interest expense by an estimated $71 million.
Material Changes Versus the Prior Comparable Period
- Revenue increased substantially due primarily to the inclusion of SanDisk NAND-flash products; HDD shipments declined to 44 million units in the quarter from 49 million and to 92 million in the first half from 101 million.
- HDD average selling price increased to $62 per unit in the quarter from $61, while exabytes shipped increased to 78 from 69.
- Revenue mix shifted toward Client Solutions and away from Data Center Devices and Solutions. Client Solutions represented 22% of quarterly revenue versus 14% previously; Data Center Devices and Solutions represented 29% versus 38%.
- Research and development expense increased 50% quarterly and 58% for the first half, while selling, general and administrative expense increased 50% and 75%, respectively, primarily because of SanDisk-related operations and investment.
- Interest expense increased to $205 million for the quarter and $441 million for the first half, largely because of acquisition financing. Six-month other expense included approximately $227 million of debt-issuance-cost write-offs associated with refinancing.
- The first-half net loss and 362% effective tax rate were driven largely by discrete tax effects, including $90 million of SanDisk integration tax expense, a $109 million valuation allowance on acquired tax attributes and a $96 million benefit from deductible debt-refinancing costs.
- Other comprehensive loss was $312 million for the quarter and $300 million for the first half, primarily reflecting foreign-currency translation and foreign-exchange-contract losses.
Outlook, Commentary, Risks and Unusual Items
Management stated that existing cash, operating cash generation and available credit facilities were expected to be sufficient for working capital, debt, dividend and capital-expenditure requirements for at least the next twelve months. The filing does not provide clear formal revenue or earnings guidance.
- SanDisk and HGST/WD integration remains a central execution issue. The company expects HGST/WD integration to continue through the end of calendar 2017 and may incur additional restructuring, amortization and integration costs.
- Flash Ventures, the 49.9%-owned Toshiba joint venture, creates supply, investment and counterparty exposure. The company’s maximum reasonably estimable exposure was $2.210 billion, including $1.102 billion of lease guarantees.
- Total contractual obligations were $25.804 billion, including $13.299 billion of debt, $5.288 billion of debt interest and $6.336 billion of Flash Ventures and other related commitments.
- Unrecognized tax benefits, including interest and penalties, totaled $561 million; $445 million could result in potential cash payments. The IRS has proposed additional federal tax expense of $795 million plus interest for fiscal years 2006–2009, although the company disputes the proposed adjustments.
- Legal matters include intellectual-property, antitrust, securities and German copyright-levy proceedings. Potential German copyright-levy losses were estimated at up to $133 million, including accrued amounts; the filing states that other litigation exposures generally cannot be reasonably estimated.
- Key operating risks include NAND and HDD pricing volatility, technology transitions including 3D NAND, declining PC demand, customer concentration, supply-chain interruptions, foreign-exchange exposure, cyber risks, manufacturing concentration and high leverage.
Investor Verification Checklist
- Verify the sustainability of revenue and margin gains attributable to SanDisk and whether NAND pricing, supply and 3D NAND transitions support continued improvement.
- Reconcile debt maturities, variable-rate exposure, covenant headroom and the company’s ability to fund scheduled repayments while maintaining dividends and investment.
- Assess cash conversion, inventory growth, foreign-held cash and the timing of Flash Ventures capital and guarantee commitments.
- Track SanDisk and HGST/WD integration costs, expected synergies, restructuring activity and any additional intangible-asset or goodwill adjustments.
- Monitor the IRS examination, unrecognized tax benefits, pending litigation and potential German copyright-levy exposure.
- Confirm the absence of formal full-year revenue or earnings guidance in this filing and distinguish management’s liquidity and spending expectations from financial guidance.