Western Digital Corporation — Fiscal Q2 2013 Form 10-Q
Business context and reporting period
Western Digital develops and manufactures storage products under the WD, HGST and G-Technology brands, including hard drives, solid-state drives, networking equipment and home entertainment products. The filing covers the 13-week quarter and six months ended December 28, 2012, compared with December 30, 2011. HGST results are included following the March 8, 2012 acquisition.
Financial performance and liquidity
| Metric | Three months ended Dec. 28, 2012 | Prior year | Six months ended Dec. 28, 2012 | Prior year |
|---|---|---|---|---|
| Revenue | $3.824 billion | $1.995 billion | $7.859 billion | $4.689 billion |
| Gross margin | $1.059 billion; 27.7% | $648 million; 32.5% | $2.252 billion; 28.7% | $1.189 billion; 25.4% |
| Operating income | $478 million; 12.5% | $162 million; 8.1% | $1.070 billion; 13.6% | $421 million; 9.0% |
| Net income | $335 million | $145 million | $854 million | $384 million |
| Diluted EPS | $1.36 | $0.61 | $3.43 | $1.62 |
- Quarterly revenue increased 92% and six-month revenue increased 68%, primarily reflecting the HGST acquisition and recovery from prior-year Thailand flood-related supply constraints.
- Hard-drive shipments increased 108% year over year to 59.2 million units in the quarter; six-month shipments increased 41% to 121.7 million units.
- Quarterly average selling price declined 10% to $62 because the prior-year period benefited from unusually high flood-related pricing. Six-month ASP increased 15% to $62.
- Quarterly operating expenses were $581 million, including $41 million of employee termination, asset impairment and other charges. Research and development expense rose 98% year over year to $378 million.
- Six-month cash flow from operations was $1.708 billion, compared with $730 million in the prior year; second-quarter operating cash flow was $772 million.
- Cash and cash equivalents were $3.816 billion at December 28, 2012, up from $3.208 billion at June 29, 2012. Approximately $1.4 billion was held outside the United States.
- Total debt on the balance sheet was $2.128 billion, consisting of $288 million current debt and $1.840 billion long-term debt. The term loan balance was approximately $2.1 billion, with a 2.21% variable interest rate; the full $500 million revolving facility remained available. The company was in compliance with its debt covenants.
- Six-month capital expenditures were $628 million. Financing uses included $364 million of share repurchases, $121 million of dividends and $58 million of debt repayment.
Material changes versus the prior comparable period
- Results benefited materially from the inclusion of HGST, while the prior-year comparison was depressed by Thailand flooding and related industry supply constraints.
- Quarterly gross margin declined from 32.5% to 27.7% as flood-related pricing benefits normalized; six-month gross margin improved from 25.4% to 28.7%.
- Sales incentive and marketing programs increased to 9% of quarterly gross revenue from 1% in the prior-year quarter, reflecting more normal competitive and supply conditions.
- The company began returning capital through a $0.25 quarterly dividend and repurchased 4.2 million shares for $146 million during the quarter. The remaining repurchase authorization was $2.448 billion at quarter-end.
- The company recorded an $88 million charge to reduce California deferred tax assets following Proposition 39. The six-month tax provision was $192 million versus $34 million in the prior year.
- HGST purchase accounting remained preliminary; a $37 million working-capital adjustment reduced the purchase price and goodwill during the quarter.
Guidance, outlook, commentary and risks
- Management expected March-quarter industry hard-drive shipments to be flat to slightly down sequentially and company revenue to decrease slightly from the December quarter due to demand conditions, seasonal mix and the conclusion of the Toshiba 3.5-inch contract manufacturing arrangement.
- Management cited soft demand related to macroeconomic uncertainty, weak PC demand and customer inventory rebalancing. Non-compute and enterprise markets represented 49% of hard-drive revenue, compared with 33% in the prior-year period.
- On January 23, 2013, the company announced a voluntary separation program for U.S.-based WD employees. The number of participants and related charges were not yet estimable; completion was expected by the first quarter of fiscal 2014.
- The American Taxpayer Relief Act was expected to generate a $30 million to $40 million R&D tax benefit in the fiscal third quarter.
- Seagate appealed the vacation of a $630.4 million arbitration award. If the award were reinstated, statutory interest at 10% from the original award date could materially affect financial condition, results and cash flows.
- The IRS had proposed approximately $970 million of income adjustments for fiscal 2006 and 2007, primarily involving transfer pricing and intercompany transactions. The company disputed the proposed adjustments and reported $276 million of unrecognized tax benefits.
- Key operating risks include hard-drive and PC demand volatility, declining ASPs, competition from solid-state and other storage technologies, concentrated suppliers and manufacturing sites, component costs and availability, product defects and warranty exposure, foreign-exchange risk, customer concentration, acquisition integration and regulatory restrictions requiring HGST to remain an independent competitor.
Important facts for investors to verify
- Reconcile the year-over-year growth attributable to HGST with organic revenue, shipment and margin trends.
- Monitor quarterly gross margin, ASPs, sales incentives, product mix and the effect of the Toshiba manufacturing transition.
- Assess debt repayment requirements, variable-rate exposure and liquidity after dividends, repurchases and capital expenditures.
- Track the Seagate appeal and rehearing risk, including potential reinstatement of the $630.4 million award plus interest.
- Review the IRS examination, unrecognized tax benefits and the timing of the anticipated R&D tax credit.
- Evaluate restructuring costs from the voluntary separation program and the company’s ability to align capacity and expenses with softer demand.