Western Digital Corporation: Fiscal 2019 First-Quarter 10-Q Summary
Business context and reporting period
Western Digital develops and manufactures data-storage devices and solutions across Client Devices, Data Center Devices and Solutions, and Client Solutions, including HDDs, SSDs, flash-based products, and related intellectual-property licensing. The filing covers the 13 weeks ended September 28, 2018, compared with the 13 weeks ended September 29, 2017. Fiscal 2019 ends June 28, 2019.
Key financial metrics
| Metric | Q1 FY2019 | Q1 FY2018 | Change |
|---|---|---|---|
| Revenue | $5.028 billion | $5.181 billion | Down 3.0% |
| Gross profit | $1.664 billion | $1.913 billion | Down 13.0% |
| Gross margin | 33.1% | 36.9% | Down 3.8 percentage points |
| Operating income | $686 million | $905 million | Down 24.2% |
| Operating margin | 13.6% | 17.5% | Down 3.9 percentage points |
| Net income | $511 million | $681 million | Down 25.0% |
| Diluted EPS | $1.71 | $2.23 | Down 23.3% |
| Operating cash flow | $705 million | $1.133 billion | Down $428 million |
| Capital expenditures | $277 million | $160 million | Up $117 million |
Revenue by end market was $2.650 billion for Client Devices, $1.446 billion for Data Center Devices and Solutions, and $932 million for Client Solutions. HDD revenue was $2.494 billion and flash-based revenue was $2.534 billion. Asia represented 57% of revenue, Europe, the Middle East and Africa 18%, and the Americas 25%.
Cash and cash equivalents were $4.646 billion at September 28, 2018, down from $5.005 billion at June 29, 2018. Total cash, cash equivalents, and available-for-sale securities were $4.761 billion. Total debt was $11.337 billion of principal, including $10.930 billion classified as long-term debt after issuance costs and discounts. The company reported $1.75 billion of additional borrowing availability under its revolving credit facility and compliance with all debt covenants.
Net cash used in financing activities was $807 million, including $563 million of share repurchases, $148 million of dividends paid, $66 million of taxes on vested stock awards, and $38 million of debt repayment. The quarterly dividend declared was $0.50 per share. The remaining authorization under the share-repurchase program was $4.50 billion at quarter-end.
Material changes versus the prior comparable period
- Revenue declined primarily because of lower average selling prices per gigabyte for flash products. Client Solutions revenue fell 18.0%, while Data Center Devices and Solutions revenue increased 5.6% and Client Devices revenue declined 1.0%.
- Gross margin contracted to 33.1% from 36.9%, mainly due to flash pricing pressure, partly offset by production-cost improvements, lower acquired-intangible amortization, and lower restructuring and other charges.
- Operating expenses declined 3.0% to $978 million, but operating income fell more sharply because of the gross-profit decline.
- Interest and other expense improved to $103 million from $195 million, principally because of lower interest expense following debt reductions and debt-facility changes.
- The effective tax rate increased to 12% from 4%. The current-period rate benefited from a provisional $52 million tax benefit related to use of fiscal 2018 operating losses against the mandatory deemed repatriation tax.
- Operating cash flow declined as working-capital use increased. The cash conversion cycle increased to 60 days from 37 days, driven primarily by inventory days rising to 84 from 64.
- Top-10-customer concentration increased to 48% of revenue from 42%; two customers represented 11% of revenue in the current quarter versus 10% previously.
Guidance, outlook, commentary, risks, and unusual items
- Management stated that flash demand and supply conditions were normalizing as technology conversions matured and manufacturing yields improved, causing flash average selling prices to decline.
- The company plans to reduce wafer starts and delay flash capital-equipment deployment. It expects calendar-year 2019 flash output to decline approximately 10% to 15%, with most of the reduction by mid-2019.
- Management expects flash underutilization charges of approximately $250 million to $300 million over the remainder of fiscal 2019. The filing states these actions are not expected to require incremental cash payments, although the timing and amount of charges may change with market conditions.
- Fiscal 2019 cash used for property, plant and equipment and net Flash Ventures notes receivable and equity-investment activity is expected to be approximately $1.50 billion to $1.90 billion.
- The company expects available cash, operating cash flow, and credit facilities to meet working-capital, debt, dividend, repurchase, and capital-expenditure needs for at least the next twelve months.
- The Kuala Lumpur HDD manufacturing facility is expected to close substantially by the end of calendar 2019. Total pre-tax charges are expected to be approximately $160 million, including $85 million of employee-termination benefits and $75 million of asset-related, contract-termination, and other charges. The company recorded $4 million in the quarter.
- The provisional mandatory deemed repatriation tax liability was $1.26 billion; $150 million had been paid, leaving a provisional net liability of $1.11 billion payable over eight years. The estimate may change as the company completes its tax accounting.
- The IRS issued a notice of deficiency seeking additional federal tax of approximately $516 million, plus interest, relating to fiscal years through 2009. Western Digital filed a petition in U.S. Tax Court and intends to contest the matter.
- Flash Ventures-related exposure includes $2.028 billion of notes receivable and investments and approximately $1.236 billion of guaranteed lease obligations. The filing identifies a maximum reasonably estimable Flash Ventures loss exposure of $3.623 billion, excluding lost profits.
- Other significant risks include flash-market cyclicality and price erosion, dependence on Toshiba Memory Corporation and Flash Ventures, customer and supplier concentration, high leverage, variable-rate debt, foreign-exchange exposure, technology-transition execution, litigation, tax uncertainty, cybersecurity, and international trade restrictions.
- Western Digital adopted ASC Topic 606 using the modified retrospective method. The adoption increased opening retained earnings by $56 million and did not materially affect the quarter’s financial position, results, or cash flows.
Most important facts for investors to verify
- Whether flash pricing stabilizes and whether the planned 10% to 15% output reduction improves supply-demand balance without causing loss of market share.
- The timing and ultimate amount of the expected $250 million to $300 million flash underutilization charges and the $160 million Kuala Lumpur closure costs.
- Cash generation relative to the planned $1.50 billion to $1.90 billion fiscal-year investment program, dividends, repurchases, and debt obligations.
- Progress in reducing the company’s approximately $11.34 billion debt burden and sensitivity to higher variable interest rates.
- Resolution and potential cash impact of the provisional $1.26 billion repatriation-tax liability, the $516 million IRS deficiency claim, and other unrecognized tax benefits.
- Financial and operational developments at Flash Ventures, including the $1.236 billion lease guarantees and future funding commitments.
- Customer concentration, inventory levels, average selling prices, gross margin trends, and the company’s ability to maintain demand in HDD, SSD, and flash markets.