WESTERN DIGITAL CORP quarterly report, Q3 FY2017

Western Digital Corporation: Fiscal 2017 Third-Quarter 10-Q Summary

Business context and reporting period

Western Digital develops and manufactures hard-disk drives, solid-state and NAND flash storage products, data-center solutions, client devices and client solutions, and earns license and royalty revenue. The filing covers the 13 weeks ended March 31, 2017, and the nine months ended March 31, 2017. Fiscal 2017 ends June 30, 2017. Results include SanDisk, acquired in May 2016, and ongoing integration of SanDisk and HGST operations.

Key financial metrics

Metric	Q3 FY2017	Q3 FY2016	9M FY2017	9M FY2016
Revenue	$4.649 billion	$2.822 billion	$14.251 billion	$9.499 billion
Gross profit	$1.523 billion	$753 million	$4.391 billion	$2.614 billion
Gross margin	32.8%	26.7%	30.8%	27.5%
Operating income	$525 million	$88 million	$1.302 billion	$661 million
Operating margin	11.3%	3.1%	9.1%	7.0%
Net income	$248 million	$74 million	$117 million	$608 million
Diluted EPS	$0.83	$0.32	$0.40	$2.60

Q3 revenue increased 65% year over year, principally from SanDisk NAND flash products, partly offset by lower PC and enterprise HDD shipments. Q3 net margin was approximately 5.3%, versus 2.6% in the prior-year quarter. Nine-month net income declined despite higher revenue and operating income, primarily because of substantially higher interest and other expense, including debt-related charges, and higher taxes.

• Q3 interest and other expense was $221 million versus $8 million in the prior-year quarter; nine-month expense was $948 million versus $23 million.
• Q3 income tax expense was $56 million, with an 18% effective tax rate. Nine-month tax expense was $237 million, with a 67% effective tax rate, including SanDisk integration tax expense and a valuation allowance on acquired tax attributes.
• Q3 operating expenses were $998 million, including $613 million of R&D, $346 million of SG&A and $39 million of termination, impairment and other charges.
• Exabytes shipped increased to 74 in Q3 from 63 in the prior-year quarter; nine-month shipments increased to 232 from 196.

Cash flow, liquidity and capital structure

• Nine-month operating cash flow was $2.498 billion, up from $1.628 billion. Capital expenditures were $453 million, compared with $433 million.
• Investing cash flow was negative $446 million, including $224 million of net investment in or loans to Flash Ventures and a net decrease of $231 million in marketable securities.
• Financing cash flow was negative $4.546 billion, reflecting $12.179 billion of debt repayments, $7.908 billion of debt proceeds and $428 million of dividends paid.
• Cash and cash equivalents were $5.652 billion at March 31, 2017, compared with $8.151 billion at July 1, 2016. Total cash, cash equivalents and marketable securities were $5.766 billion.
• Total debt was $13.301 billion, including $12.907 billion of long-term debt and $181 million of current debt. The $3.0 billion bridge loan outstanding at July 1, 2016 had been repaid.
• The revolving credit facility was undrawn, with $1.0 billion of stated availability. Management said available cash, operating cash flow and credit facilities should be sufficient for at least the next 12 months.
• Approximately $8.0 billion of debt carried variable interest rates. A one-percentage-point increase in applicable variable rates would increase annual interest expense by approximately $71 million.

Material changes versus the prior comparable period

• The SanDisk acquisition materially increased revenue, NAND exposure, R&D and SG&A, while improving Q3 and nine-month gross margins through higher NAND margins and integration-related cost improvements.
• Revenue mix shifted toward Client Solutions and away from Data Center Devices and Solutions. Q3 mix was 50% Client Devices, 22% Client Solutions and 28% Data Center Devices and Solutions, versus 49%, 12% and 39%, respectively, in the prior-year quarter.
• Q3 restructuring and other charges fell to $39 million from $140 million; nine-month charges fell to $152 million from $223 million.
• During Q3, Western Digital refinanced the U.S. Term Loan B-1 and Euro Term Loan B-1 with lower-rate B-2 facilities. The refinancing generated a $7 million debt-extinguishment charge in Q3. Nine-month other expense also included earlier debt refinancing costs and convertible debt settlement losses.
• The company paid $494 million in cash and issued 0.3 million shares for convertible-note conversions and repurchases during the nine months. Only $35 million of 2020 convertible notes and an immaterial amount of 2017 notes remained outstanding at quarter end.
• Inventory increased to $2.254 billion from $2.129 billion at the beginning of the fiscal year, and the cash conversion cycle increased to 32 days from 22 days.

Outlook, commentary, risks and unusual items

• Management expected fiscal 2017 cash use for capital expenditures and net Flash Ventures notes receivable and equity investment activity of approximately $0.5 billion to $0.9 billion.
• Approximately $4.3 billion of cash and cash equivalents was held outside the United States. Management expected to continue permanently reinvesting foreign earnings; repatriation could create additional taxes.
• Flash Ventures represented $1.291 billion of notes receivable and equity investments and a maximum reasonably estimable loss exposure of $2.362 billion, including $1.048 billion of guaranteed equipment lease obligations. Western Digital is committed to purchasing approximately 50% of forecast Flash Ventures wafer output and funding its share of certain investments.
• Toshiba’s financial distress and possible sale of its memory business created uncertainty regarding Flash Ventures’ funding, governance, technology transitions, capacity expansion and NAND supply. The filing identifies this as a significant business risk.
• SanDisk and HGST integration remained ongoing. The company expected HGST and WD integration to continue through calendar 2017 and recognized that anticipated synergies, cost savings and integration timing were uncertain.
• The IRS had proposed additional federal tax adjustments totaling $795 million, subject to interest, primarily involving transfer pricing and intercompany balances. The company disputed the proposed adjustments. Unrecognized tax benefits, including interest and penalties, totaled $597 million, of which $467 million could result in cash payments; timing was not estimable.
• Material risk areas include NAND and HDD pricing volatility, PC-market weakness, customer and supplier concentration, technology transitions including 3D NAND, foreign exchange, variable-rate debt, manufacturing disruptions, cybersecurity, intellectual-property and antitrust litigation, and product warranty exposure.
• Reported commitments totaled $26.550 billion, including $13.301 billion of debt, $4.865 billion of debt interest, $7.312 billion of Flash Ventures and other related commitments, $895 million of purchase obligations and $177 million of operating leases.
• The company declared a quarterly dividend of $0.50 per share for the quarter ending June 30, 2017. The filing states that the dividend policy may be modified, suspended or canceled.

Important facts for investors to verify

• Whether NAND pricing, 3D NAND production yields and Toshiba-related developments support the reported gross-margin improvement.
• Whether operating cash flow can sustain debt service, dividends, Flash Ventures commitments, capital expenditures and required Term Loan A amortization beginning in September 2017.
• The resolution and potential cash impact of the IRS examination and other unrecognized tax benefits.
• The outcome of SanDisk and HGST integration, including expected synergies, restructuring costs and remaining purchase-accounting adjustments.
• Exposure to Toshiba and Flash Ventures, including the $1.048 billion lease guarantee and the $2.362 billion maximum estimable loss exposure.
• Pending intellectual-property, antitrust, securities and German copyright-levy matters, including potential losses of up to $141 million for the German copyright claims.
• The effect of customer concentration, inventory growth and the increase in the cash conversion cycle on future liquidity and margins.