Western Digital Corporation — Fiscal 2011 Third-Quarter Form 10-Q
Reporting period: Quarter ended April 1, 2011; 13 weeks. Comparable quarter ended April 2, 2010 also contained 13 weeks. Fiscal 2011 ends July 1, 2011. Western Digital designs, manufactures and sells hard drives, solid-state drives and media players worldwide.
Financial Performance and Position
| Metric | Q3 FY2011 | Q3 FY2010 | 9M FY2011 | 9M FY2010 |
|---|---|---|---|---|
| Revenue | $2,252 million | $2,641 million | $7,123 million | $7,468 million |
| Gross profit | $410 million | $665 million | $1,322 million | $1,866 million |
| Gross margin | 18.2% | 25.2% | 18.6% | 25.0% |
| Operating income | $158 million | $441 million | $609 million | $1,233 million |
| Net income | $146 million | $400 million | $568 million | $1,118 million |
| Diluted EPS | $0.62 | $1.71 | $2.42 | $4.82 |
- Q3 hard-drive shipments were 49.8 million units, down 3% year over year; average selling price declined to $45 from $51.
- For the first nine months, shipments increased 6% to 152.8 million units, but ASP declined to $46 from $51.
- Research and development expense increased 12% in Q3 to $179 million, primarily reflecting continued product-development investment. SG&A increased 14% to $73 million, including $10 million of HGST acquisition expenses.
- Q3 operating margin was approximately 7.0%; net margin was approximately 6.5%. Nine-month operating margin was 8.5% and net margin was 8.0%.
- Q3 operating cash flow was $313 million. Nine-month operating cash flow was $1,208 million, compared with $1,579 million in the prior-year period.
- Capital expenditures were $625 million in the first nine months, compared with $552 million previously. Management expected fiscal-year capital expenditures of $775 million to $800 million and depreciation and amortization of approximately $610 million.
- Cash and cash equivalents were $3.230 billion at April 1, 2011, versus $2.734 billion at July 2, 2010. Total assets were $7.839 billion and shareholders’ equity was $5.316 billion.
- Debt totaled $325 million, consisting of $125 million current and $200 million long term. The variable-rate term loan had a 1.56% interest rate and matured February 11, 2013; the company was in compliance with its covenants.
- Nine-month financing cash flow was negative $87 million, including $75 million of debt repayments and $50 million of share repurchases.
Material Changes Versus the Prior Comparable Period
- Revenue declined 15% in Q3 and 5% for the first nine months, despite higher nine-month unit shipments, because of competitive pricing and lower ASPs.
- Gross margin declined 700 basis points in Q3 and 640 basis points for the first nine months, primarily due to competitive pricing.
- Operating income declined 64% in Q3 and 51% for the first nine months. Net income declined 64% in Q3 and 49% for the first nine months.
- Sales incentives and marketing programs rose to 12% of gross revenue in Q3 from 8% in the prior-year quarter, and to 11% for the nine-month period from 7%.
- Non-desktop products represented 64% of Q3 hard-drive revenue, up from 62%; these products include notebook, consumer-electronics, enterprise and branded products.
- Cash increased by $496 million during the first nine months, but operating cash generation was lower than in the prior year because of reduced earnings.
- The cash conversion cycle increased to 2 days from negative 3 days, with higher days sales outstanding and days in inventory.
Guidance, Outlook, Risks and Unusual Items
- Management expected June-quarter revenue to be flat to slightly down from the March quarter and believed industry shipments would be supply constrained because of the March 11, 2011 Japan earthquake and related events.
- The company estimated March-quarter industry shipments at approximately 160 million units, down 2% year over year and 5% sequentially. It cited normal seasonality, customer inventory adjustments and later-quarter purchases related to supply concerns.
- On March 7, 2011, Western Digital agreed to acquire Hitachi Global Storage Technologies, now Viviti Technologies, for approximately $4.3 billion. Funding was expected to include existing cash, new debt and 25 million newly issued shares. Closing was expected in the first quarter of fiscal 2012, subject to regulatory and other conditions.
- The planned acquisition was supported by negotiated financing of up to $3.0 billion, including a $500 million revolving facility and up to $2.5 billion of term loans. On April 25, 2011, the FTC issued a second request for information, extending the antitrust review period.
- If the acquisition is terminated after March 7, 2012 because required antitrust approval is not obtained or governmental action prevents closing, the company may owe Hitachi a $250 million termination fee.
- Key operating risks include severe price erosion, industry oversupply, component shortages, concentrated manufacturing and suppliers, Japan-related disruptions, foreign-exchange exposure, technology transitions, competition from solid-state storage and customer concentration. The top ten customers represented 49% of Q3 revenue.
- The company carried approximately $246 million of unrecognized tax benefits. IRS examinations include proposed income adjustments of approximately $970 million for Western Digital and $380 million for Komag; the company disputes the proposals and states that adequate provision has been recorded.
- Pending litigation includes intellectual-property matters, including a Convolve trial scheduled for July 5, 2011, and a Seagate trade-secret arbitration hearing scheduled for May 2011. Potential losses were generally not reasonably estimable from the filing.
- Warranty accrual was $174 million at April 1, 2011, including $40 million classified in other liabilities. Changes in product-return rates and repair costs could materially affect future results.
- Management concluded that disclosure controls and procedures were effective as of April 1, 2011, with no material change in internal control over financial reporting during the quarter.
Investor Verification Priorities
- Verify the final status, regulatory remedies, financing, share issuance, purchase price allocation and integration costs related to the HGST acquisition.
- Track ASP trends, sales incentives, industry shipment levels and gross-margin recovery following the sharp Q3 decline.
- Reconcile Japan-related component availability, manufacturing capacity and the effect of supply constraints on June-quarter shipments and pricing.
- Review the proposed IRS adjustments, unrecognized tax benefits and any resulting cash-tax exposure.
- Monitor the Convolve, Seagate and other intellectual-property proceedings, as well as warranty-return trends.
- Assess post-acquisition leverage, covenant requirements, liquidity and the effect of using cash and issuing 25 million shares to fund the transaction.