Western Digital Corporation — Fiscal 2016 Form 10-K Summary
Business context and reporting period
Western Digital develops and supplies hard disk drives, solid-state and NAND-flash products, datacenter systems, client devices, removable storage, software and related intellectual-property licenses. The filing covers the 52-week fiscal year ended July 1, 2016. Fiscal 2015 was a 53-week year, which affects comparability.
Fiscal 2016 was a transformational year: Western Digital acquired SanDisk on May 12, 2016, and began integrating its HGST and WD operations after MOFCOM permitted substantial integration in October 2015. SanDisk contributed $793 million of post-acquisition revenue.
Key financial metrics
| Metric | Fiscal 2016 | Fiscal 2015 | Change |
|---|---|---|---|
| Net revenue | $12.994 billion | $14.572 billion | Down 11% |
| Gross profit | $3.435 billion | $4.221 billion | Down $786 million |
| Gross margin | 26.4% | 29.0% | Down 2.6 percentage points |
| Operating income | $466 million | $1.611 billion | Down 71% |
| Operating margin | 3.6% | 11.1% | Down 7.5 percentage points |
| Net income | $242 million | $1.465 billion | Down 83% |
| Diluted EPS | $1.00 | $6.18 | Down 84% |
| Cash flow from operations | $1.983 billion | $2.242 billion | Down $259 million |
| Capital expenditures | $584 million | $612 million | Down $28 million |
| Cash and cash equivalents | $8.151 billion | $5.024 billion | Up $3.127 billion |
| Total debt | $17.526 billion | $2.312 billion | Significantly higher after SanDisk financing |
HDD shipments declined to 185 million units from 229 million, primarily because of weaker demand, particularly in the PC market. HDD average selling price increased to $61 from $60, largely due to product mix. International sales represented 72% of revenue, compared with 79% in fiscal 2015. No customer represented at least 10% of fiscal 2016 revenue; the top ten customers represented 43%.
Research and development expense was $1.627 billion, or 12.5% of revenue. SG&A expense rose to $997 million from $788 million, primarily reflecting SanDisk expenses, merger costs and integration activities. The company declared $2.00 per share of dividends, totaling $490 million.
Material changes versus the prior comparable period
- Revenue and HDD volumes declined materially because of softer demand and continued PC-market weakness. Distributors represented 20% of revenue versus 23% in fiscal 2015, while OEM revenue increased to 66% from 64%.
- Gross margin declined because of lower HDD volume and related fixed-cost absorption, accelerated depreciation and restructuring effects. Sales incentive and marketing programs increased to 13% of gross revenue from 10%.
- Operating income included $345 million of employee termination, asset impairment and other charges, compared with $176 million in fiscal 2015, plus $159 million of SanDisk acquisition-related costs and $143 million of cost-savings initiative charges.
- Interest expense increased to $266 million from $49 million as a result of acquisition-related debt. Other expense included costs associated with settling SanDisk debt instruments and writing off debt issuance costs.
- Net cash used in investing activities increased to $9.608 billion, principally because of $9.835 billion of acquisitions, net of cash acquired, including SanDisk.
- Cash conversion cycle increased to 44 days from 21 days, driven primarily by the inclusion of SanDisk balance-sheet accounts at year-end while its income statement was included for only part of the year.
Guidance, outlook, commentary, risks and unusual items
Management expects the combined company to benefit from broader storage offerings, vertical integration into NAND, access to solid-state technology and potential integration synergies. The company announced development of BiCS3 3D NAND with 64 layers and expects continued transition from 2D NAND to 3D NAND.
Fiscal 2017 capital investment was expected to be approximately $2.6 billion to $3.0 billion, including Flash Ventures and other property and equipment. Management expected to fund approximately $1.0 billion to $1.4 billion from company cash. The filing does not provide formal revenue or earnings guidance.
- Leverage and liquidity: Total indebtedness was $17.5 billion at July 1, 2016, with $1.0 billion of revolving-credit availability. The $3.0 billion bridge loan was repaid on July 21, 2016. On August 17, 2016, the company issued a new $3.0 billion Term Loan B-1 and prepaid $750 million of prior U.S. Term Loan B; an approximately $230 million debt-extinguishment charge was expected in the first quarter of fiscal 2017.
- Restructuring: The HGST/WD restructuring was expected to generate total pre-tax charges of $400 million, including $275 million of cash expenditures, and to be substantially complete by the end of calendar 2017. Fiscal 2016 charges were $82 million, excluding related accelerated depreciation.
- Facility closure: The Odawara, Japan facility closure generated $152 million of charges and $48 million of accelerated depreciation in fiscal 2016; activities were substantially complete at year-end.
- Flash Ventures: Western Digital owns 49.9% of the Toshiba ventures, is generally committed to purchase half of output or fund half of fixed costs, and guaranteed approximately $1.151 billion of lease obligations. Maximum reasonably estimable exposure to Flash Ventures was $2.356 billion.
- Tax matters: An IRS examination sought $795 million of additional federal tax, subject to interest, primarily related to transfer pricing and intercompany balances. Unrecognized tax benefits were $491 million, plus $75 million of accrued interest and penalties.
- Litigation: The filing describes intellectual-property, antitrust, securities and German copyright-levy matters. Potential German copyright-levy losses were estimated at up to $123 million, including accrued amounts; other litigation outcomes were not clearly quantifiable.
- Fourth quarter: Revenue was $3.495 billion, gross profit was $821 million, operating loss was $195 million and net loss was $366 million, or $1.40 diluted loss per share. The quarter included $122 million of restructuring and facility-closure charges and $116 million of SanDisk acquisition costs. The company also recorded an additional $15 million of fourth-quarter and full-year expenses after preliminary results, reducing fiscal-year operating income to $466 million and net income to $242 million.
Management stated that cash, operating cash generation and available credit facilities were sufficient for working capital, debt, dividends and capital expenditures for at least the following twelve months. Internal control over financial reporting was reported effective, although SanDisk’s controls were excluded from management’s assessment; SanDisk represented 17% of consolidated assets and 6% of fiscal 2016 revenue.
Most important facts for investors to verify
- Whether SanDisk and HGST integration delivers the expected revenue, cost and technology synergies without additional material charges.
- Debt paydown, interest expense, covenant compliance and liquidity after the SanDisk acquisition and subsequent refinancing.
- Progress, capital requirements, yields and customer adoption associated with the 3D NAND transition.
- HDD demand trends, PC-market exposure, pricing pressure, product mix and gross-margin recovery.
- Cash conversion, inventory levels and the effect of SanDisk-related working-capital requirements.
- Flash Ventures purchase commitments, lease guarantees, Toshiba relationship risks and Japanese-yen exposure.
- Resolution and potential cash impact of the IRS examination, unrecognized tax benefits and disclosed litigation.
- The sustainability of the $0.50 quarterly dividend given leverage, capital-investment needs and the company’s stated right to modify or suspend the policy.