Western Digital Corporation — Fiscal 2015 First-Quarter Form 10-Q
Reporting period: Quarter ended October 3, 2014. The quarter contained 14 weeks versus 13 weeks in the prior-year quarter ended September 27, 2013. Fiscal 2015 contains 53 weeks and ends July 3, 2015.
Business Context
Western Digital develops and manufactures data-storage solutions, principally hard disk drives, as well as solid-state drives, network-attached storage, personal cloud products and enterprise storage solutions. Operations are conducted through the HGST and WD subsidiaries. Enterprise SSD revenue increased to $156 million from $106 million, and 55% of revenue came from non-PC markets versus 53% in the prior-year period.
Key Financial Metrics
| Metric | Q1 FY2015 | Q1 FY2014 | Change |
|---|---|---|---|
| Revenue | $3.943 billion | $3.804 billion | +4% |
| Gross profit | $1.149 billion | $1.099 billion | +5% |
| Gross margin | 29.1% | 28.9% | +20 basis points |
| Operating income | $469 million | $542 million | -13% |
| Operating margin | 11.9% | 14.2% | -230 basis points |
| Net income | $423 million | $495 million | -15% |
| Diluted EPS | $1.76 | $2.05 | -14% |
| Net margin | 10.7% | 13.0% | -230 basis points |
| Cash flow from operations | $827 million | $680 million | +$147 million |
- Hard-drive shipments were 64.7 million units, up 3% from 62.6 million; average selling price remained approximately $58 per unit.
- Gross-margin improvement reflected stronger seasonal product mix and strength in the capacity-enterprise business.
- Research and development expense increased 9% to $437 million, and selling, general and administrative expense increased 67% to $220 million.
- SG&A included the absence of a $65 million flood-related insurance recovery recorded in the prior-year period. Higher expenses also reflected the acquired Virident and sTec businesses and the additional week.
- Cash and cash equivalents were $5.159 billion at October 3, 2014, compared with $4.804 billion at June 27, 2014. Including short-term investments, liquidity was approximately $5.381 billion.
- Total debt was approximately $2.406 billion, consisting primarily of a $2.4 billion term loan; no revolving credit facility balance was outstanding. The term loan carried a variable interest rate of 1.66%.
- Total assets were $15.652 billion and shareholders’ equity was $8.963 billion at quarter-end.
Material Changes Versus the Prior Comparable Period
- Revenue increased 4%, supported by higher unit shipments and the extra week; pricing was stable.
- Gross profit increased 5%, while gross margin expanded modestly to 29.1%.
- Operating income and net income declined because operating expenses grew substantially faster than revenue. R&D increased primarily from acquisitions and the extra week; SG&A also reflected the prior-year insurance recovery.
- Operating cash flow improved to $827 million from $680 million, aided by working-capital inflows, while financing cash flow shifted from $240 million provided to $346 million used.
- The company repurchased 2.2 million shares for $223 million and paid or declared $94 million of dividends, equal to $0.40 per share.
- Investing cash use declined to $126 million from $360 million, as the prior-year period included acquisition spending.
- Foreign-exchange contracts generated a $26 million after-tax unrealized loss in other comprehensive income, versus a $16 million gain in the prior-year period.
Guidance, Outlook, Risks and Unusual Items
Management expected overall hard-drive industry shipments and company revenue to decrease moderately in the quarter ending January 2, 2015, primarily because it would contain 13 weeks versus 14 weeks in the September quarter.
- On October 8, 2014, the Minnesota Supreme Court affirmed the Seagate arbitration award. Western Digital paid Seagate $773.4 million on October 14, 2014, using cash held by a foreign subsidiary. This payment occurred after quarter-end and is therefore a significant subsequent liquidity event.
- The company accrued $772 million for the arbitration award at October 3, 2014 and recorded $14 million of related charges during the quarter.
- The company stated that cash, operating cash flow and available credit facilities were sufficient for at least the next twelve months. Approximately $4.0 billion of cash and cash equivalents was held outside the United States and was intended to remain indefinitely reinvested in foreign operations.
- Principal risks include hard-drive price erosion, volatile demand and gross margins, PC-market weakness, competition from NAND and other storage technologies, technology-transition execution, customer concentration, dependence on suppliers and manufacturing facilities, product-quality and warranty exposure, foreign-exchange movements, litigation, tax audits and restrictive debt covenants.
- The IRS has proposed approximately $200 million of adjustments related to intercompany payable balances for fiscal years 2006 through 2009. Management disagrees with the proposed adjustments; the ultimate outcome is uncertain.
- Tax holidays in Malaysia, the Philippines, Singapore and Thailand expire at various dates from 2015 through 2025, creating potential future effective-tax-rate pressure.
- The company remained in compliance with its credit-agreement covenants, and management reported effective disclosure controls and internal control over financial reporting.
Important Facts for Investors to Verify
- Verify the post-quarter-end $773.4 million Seagate payment and its effect on subsequent cash balances, debt repayment and capital allocation.
- Assess whether the expected moderate December-quarter decline was solely calendar-related or also reflected underlying industry demand, pricing or mix trends.
- Monitor operating-expense growth, particularly R&D and SG&A, and whether acquired SSD businesses are contributing sufficient revenue and profitability.
- Review the term-loan repayment schedule, variable-rate exposure and compliance with leverage and interest-coverage covenants.
- Evaluate sustainability of the 29.1% gross margin amid pricing pressure, competition from alternative storage technologies and customer concentration.
- Track the IRS tax examination, foreign tax holidays, unrecognized tax benefits of approximately $307 million and potential cash tax payments.
- Review warranty estimates, supplier commitments, outstanding intellectual-property matters and the potential effect of future litigation or product-quality claims.