Western Digital Corporation — Fiscal 2011 First-Quarter 10-Q
Business context and reporting period
Western Digital designs, manufactures and sells hard drives, solid-state drives and media players worldwide through OEM, ODM, distribution and retail channels. The fiscal quarter ended October 1, 2010 and consisted of 13 weeks; the comparable quarter ended October 2, 2009. Fiscal 2011 is scheduled to end July 1, 2011.
Financial performance and liquidity
| Metric | Q1 FY2011 | Q1 FY2010 | Change |
|---|---|---|---|
| Net revenue | $2,396 million | $2,208 million | 9% |
| Gross margin | $437 million; 18.2% | $514 million; 23.3% | Down $77 million; down 5.1 percentage points |
| Operating income | $211 million; 8.8% | $319 million; 14.4% | Down $108 million |
| Net income | $197 million; 8.2% | $288 million; 13.0% | Down $91 million |
| Diluted EPS | $0.84 | $1.25 | Down $0.41 |
| Cash flow from operations | $390 million | $434 million | Down $44 million |
- Hard-drive shipments rose 15% to 50.7 million units, while average selling price declined 6% to $46 per unit from $49.
- Non-desktop markets represented 64% of hard-drive revenue in both periods. Revenue mix was 50% OEM, 32% distributors and 18% retailers; no single customer represented at least 10% of revenue, while the top 10 customers represented 50%.
- Research and development expense increased 18% to $167 million, or 7.0% of revenue, reflecting continued product-development investment. SG&A increased 11% to $59 million.
- Cash and cash equivalents were $2.858 billion at October 1, 2010, compared with $2.734 billion at July 2, 2010. Net cash increased $124 million during the quarter.
- Capital expenditures were $200 million. Financing cash outflows included $50 million of share repurchases and $25 million of debt repayment.
- Total debt was $375 million, comprising $113 million current and $262 million long-term debt. The variable-rate term loan matures February 11, 2013, and the company was in compliance with its covenants.
- Cash conversion cycle was negative three days, compared with negative four days in the prior-year quarter. Days sales outstanding increased to 50, days in inventory to 26, and days payable outstanding to 79.
Material changes versus the prior comparable period
- Revenue growth was driven primarily by higher unit shipments, but aggressive industry pricing reduced average selling prices and compressed gross margin.
- Gross margin declined from 23.3% to 18.2%, and operating margin declined from 14.4% to 8.8%.
- Operating expenses increased $31 million, led by higher R&D and sales and marketing spending.
- Income tax expense declined to $14 million from $29 million, primarily reflecting foreign tax holidays and current-year tax credits.
- Cash generation remained strong but declined from the prior-year period, while capital spending and share repurchases increased cash uses.
- Sales incentive and marketing programs increased to 11% of gross revenue from 7%, increasing the sensitivity of reported revenue to pricing and channel conditions.
Guidance, outlook, risks and unusual items
- Management expected December-quarter industry shipments to be flat with the September quarter, continued competitive pricing, and company revenue to be flat to slightly down sequentially.
- Fiscal 2011 capital expenditures were expected to equal 7%–8% of revenue plus approximately $200 million for wafer-fabrication conversion and magnetic-media operations. Depreciation and amortization was expected to be approximately $630 million.
- Management stated that existing cash, cash equivalents and operating cash flow should fund foreseeable working-capital and capital-expenditure needs.
- Key risks include hard-drive price erosion, oversupply, demand volatility, customer concentration and bargaining power, competition from solid-state and other storage technologies, component shortages, supplier dependence, manufacturing concentration in Asia, foreign-exchange exposure, product defects and warranty claims, and global economic weakness.
- The warranty accrual was $173 million at October 1, 2010, including $42 million classified as non-current. Actual return rates and repair costs could materially differ from estimates.
- Unrecognized tax benefits were approximately $229 million; the cash liability was stated as $133 million, with IRS examinations ongoing. The filing did not provide a clear estimate of any change expected within the next 12 months.
- Pending matters included patent litigation, Seagate trade-secret arbitration, and employment-related class actions. The MagSil patent matter was settled and dismissed in July 2010, with the financial impact accrued in fiscal 2010. The proposed settlement of one employment action required final court approval.
- The company held $15 million of auction-rate securities classified as long-term investments and used foreign-exchange contracts with a reported fair value of $56 million to hedge currency exposure.
- Management concluded that disclosure controls and procedures were effective as of October 1, 2010, with no material change in internal control over financial reporting.
Important facts for investors to verify
- Whether sustained pricing pressure continues to reduce ASPs and gross margin in subsequent quarters.
- Whether the December-quarter revenue outlook of flat to slightly down was achieved and how unit shipments and product mix developed.
- The pace and return on the planned capital expenditures, including wafer conversion and magnetic-media investments.
- Changes in warranty accruals, product-return rates and any product-quality or epidemic-failure claims.
- Developments in the disclosed patent, trade-secret arbitration and employment proceedings, including potential financial exposure.
- Future cash requirements for debt repayment, unrecognized tax benefits, supplier commitments and share repurchases.
- Exposure to solid-state storage, customer consolidation, component availability and disruptions at concentrated manufacturing facilities.