WESTERN DIGITAL CORP quarterly report, Q3 FY2016

Western Digital Corporation — Fiscal 2016 Third-Quarter Form 10-Q

Business Context and Reporting Period

Western Digital develops and manufactures data-storage solutions, primarily hard disk drives, enterprise SSDs, storage systems, and related products marketed under the WD and HGST brands. The filing covers the 13-week quarter ended April 1, 2016, and the nine months then ended. The comparable prior-year quarter also comprised 13 weeks, while the prior-year nine-month period comprised 40 weeks versus 39 weeks in fiscal 2016.

Financial Performance and Liquidity

Metric	Q3 FY2016	Q3 FY2015	9M FY2016	9M FY2015
Revenue	$2.822 billion	$3.550 billion	$9.499 billion	$11.381 billion
Gross profit	$753 million	$1.032 billion	$2.614 billion	$3.291 billion
Gross margin	26.7%	29.1%	27.5%	28.9%
Operating income	$88 million	$421 million	$661 million	$1.356 billion
Net income	$74 million	$384 million	$608 million	$1.245 billion
Diluted EPS	$0.32	$1.63	$2.60	$5.23
Operating cash flow	$485 million	Not separately provided	$1.628 billion	$1.754 billion

Quarterly revenue declined 21%, gross profit declined 27%, operating income declined 79%, and net income declined 81% year over year. Nine-month revenue declined 17%, operating income declined 51%, and net income declined 51%. The company attributed lower margins primarily to product mix, lower volume and related fixed-cost absorption, and accelerated depreciation associated with the Odawara facility closure.

HDD shipments were 43.1 million units in the quarter, down 21% year over year; nine-month shipments were 144.5 million units, down 20%.
HDD average selling price was approximately $60 per unit in the quarter versus $61 in the prior-year quarter and remained approximately $60 for the nine-month periods.
Enterprise SSD revenue was $200 million, down from $224 million in the prior-year quarter.
Research and development expense fell 11% in the quarter to $359 million; selling, general and administrative expense fell 17% to $166 million.
Employee termination, asset impairment and other charges were $140 million in the quarter and $223 million year to date, versus $10 million and $72 million, respectively, in the prior-year periods.
Cash and cash equivalents were $5.887 billion at April 1, 2016, compared with $5.024 billion at July 3, 2015. Approximately $5.5 billion was held outside the United States.
Short-term investments were $146 million, down from $262 million at fiscal year-end.
Total debt on the April 1 balance sheet was approximately $2.2 billion, consisting primarily of the term loan; the $255 million revolving-credit balance was repaid in January 2016. The company was in compliance with its debt covenants.
The company declared quarterly dividends of $0.50 per share and paid $347 million in dividends during the first nine months. The share-repurchase program was suspended in connection with the SanDisk transaction.

Material Changes Versus the Prior Comparable Period

Demand weakened materially: management estimated industry HDD shipments at approximately 100 million units, down 20% from the prior-year quarter and 13% sequentially.
Revenue pressure reflected lower HDD volume and a softer demand environment rather than a material change in HDD pricing.
Gross margin contracted by 240 basis points in the quarter and 140 basis points year to date.
Operating expenses increased overall despite lower R&D and SG&A, primarily because of restructuring, facility-closure, impairment and termination costs.
Operating cash flow decreased to $1.628 billion year to date from $1.754 billion, although working-capital changes were more favorable than in the prior year, which included the Seagate arbitration payment.
The company completed the final payment of additional post-award interest to Seagate; the matter was dismissed with prejudice and is closed.
An agreement for Unis to purchase approximately $3.775 billion of Western Digital stock was terminated in February 2016 after CFIUS initiated an investigation. The company stated that the planned China joint venture was not expected to be affected.

Guidance, Outlook, Commentary, Risks and Unusual Items

Management did not provide a conventional quarterly revenue or earnings forecast in the filing. It expects the HDD market to remain exposed to soft demand, PC-market deterioration, competitive pricing, product-mix shifts, technology transitions and industry cyclicality.

The HGST and WD integration restructuring plan is expected to be substantially completed by the end of calendar 2017 and to generate approximately $400 million of pre-tax charges, including approximately $275 million of cash expenditures.
Management separately expects approximately $100 million of additional Odawara-related charges in the fourth quarter of fiscal 2016.
As of May 3, 2016, management expected approximately $800 million of annualized cost savings by the end of calendar 2017, with approximately $800 million of total cash expenditures to achieve the savings, including restructuring, facility consolidation, software implementation and other integration costs.
The planned SanDisk merger had received shareholder approval, U.S. antitrust clearance and several foreign clearances, but remaining regulatory and other closing conditions still created execution and termination risk. A termination fee of up to approximately $1.06 billion could be payable by Western Digital in specified circumstances.
After quarter-end, Western Digital issued $1.875 billion of 7.375% senior secured notes due 2023 and $3.35 billion of 10.5% senior unsecured notes due 2024. It also entered into new credit facilities that included $4.125 billion of Term Loan A, $3.75 billion of U.S. Term Loan B, €885 million of Euro Term Loan B and a $1.0 billion revolving facility. Approximately $10.0 billion had been borrowed under the new financing as of the filing date, with proceeds generally held in escrow pending the merger.
The new financing was intended to fund the SanDisk acquisition, refinance existing debt, and pay transaction expenses. It would materially increase leverage, interest expense, refinancing risk and covenant restrictions.
The IRS had proposed adjustments that could increase federal tax expense by approximately $795 million plus interest. The company disputed the proposed adjustments. Unrecognized tax benefits were approximately $359 million, of which $251 million could result in potential cash payments.
Management noted that subsequent stock-price volatility had reduced market capitalization below shareholders’ equity and that goodwill impairment could become necessary in the near term, potentially resulting in a material charge.
Other disclosed risks include product defects and warranty exposure, supply-chain concentration, foreign-exchange and interest-rate exposure, intellectual-property litigation, cyber and data-security incidents, manufacturing disruptions, customer concentration and dependence on Toshiba-related arrangements following the SanDisk merger.

Investor Verification Checklist

Verify completion and final terms of the SanDisk merger, including regulatory approvals, consideration mix, share issuance and total financing.
Reconcile pro forma debt, cash, interest expense, maturities, mandatory repayments and covenant capacity after the merger.
Assess whether the planned $800 million annualized cost savings and approximately $800 million of implementation cash expenditures remain achievable and on schedule.
Monitor HDD shipment trends, PC demand, ASPs, product mix, customer incentives and gross-margin recovery.
Evaluate the likelihood and timing of the potential $795 million IRS adjustment and other unrecognized tax benefits.
Review goodwill impairment testing and any impairment charges resulting from market capitalization or operating-performance declines.
Track remaining Odawara closure costs, restructuring charges, facility consolidation expenses and their cash-flow effects.
Confirm regulatory, legal and copyright-levy exposures, including the potential for German copyright-levy losses of up to $119 million including accrued amounts.