Western Digital Corporation: Fiscal 2019 Second-Quarter 10-Q
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 HDD, SSD and flash-based products. The filing covers the 13-week quarter and six months ended December 28, 2018, compared with periods ended December 29, 2017.
Key financial metrics
| Metric | Q2 FY2019 | Q2 FY2018 | Six months FY2019 | Six months FY2018 |
|---|---|---|---|---|
| Revenue | $4.233 billion | $5.336 billion | $9.261 billion | $10.517 billion |
| Gross profit | $1.044 billion | $2.013 billion | $2.708 billion | $3.926 billion |
| Gross margin | 24.7% | 37.7% | 29.2% | 37.3% |
| Operating income | $176 million | $955 million | $862 million | $1.860 billion |
| Operating margin | 4.2% | 17.9% | 9.3% | 17.7% |
| Net income (loss) | $(487) million | $(823) million | $24 million | $(142) million |
| Diluted EPS | $(1.68) | $(2.78) | $0.08 | $(0.48) |
- Six-month operating cash flow was $1.174 billion, down from $2.315 billion. Investing cash flow used $725 million, including $500 million of capital expenditures and net funding activity with Flash Ventures. Financing cash flow used $1.438 billion.
- Cash and cash equivalents were $4.013 billion at December 28, 2018, compared with $5.005 billion at June 29, 2018. Cash, cash equivalents and available-for-sale securities totaled $4.130 billion.
- Total debt principal was $10.800 billion, including $7.365 billion of term loans, $2.300 billion of senior unsecured notes and $1.100 billion of convertible notes. The revolving facility was fully repaid, leaving $2.25 billion of borrowing capacity.
- The Company was in compliance with its debt covenants at quarter-end. Management stated that available cash, operating cash flow and credit facilities should be sufficient for at least the next twelve months.
- Quarterly dividends were $0.50 per share. Six-month share repurchases totaled $563 million; $4.50 billion remained available under the repurchase authorization.
Material changes versus the prior comparable period
- Q2 revenue declined 20.7%, primarily because of lower flash average selling prices per gigabyte and lower sales of client compute HDD, capacity and performance enterprise HDD, enterprise SSD, and retail HDD products.
- Six-month revenue declined 11.9%. Q2 revenue decreased across Client Devices by 16.4%, Data Center Devices and Solutions by 25.1%, and Client Solutions by 24.7%.
- Gross margin contracted 13.0 percentage points in Q2 and 8.1 percentage points for the six months, reflecting flash price declines and a $49 million flash manufacturing underutilization charge.
- Operating expenses declined 18.0% in Q2 and 10.6% for the six months, primarily from lower variable compensation, stock-based compensation and other cost reductions; these reductions were insufficient to offset the gross-profit decline.
- Interest and other expense fell to $95 million in Q2 from $181 million, and to $198 million for the six months from $376 million, primarily due to lower debt and lower interest rates.
- Inventory increased to $3.427 billion from $2.944 billion at fiscal year-end. The cash conversion cycle increased to 71 days from 38 days in the prior-year quarter, driven mainly by higher inventory days.
- Top-ten customers represented 47% of revenue in both the quarter and six-month period, versus 42% and 41%, respectively, in the prior-year comparable periods. No individual customer represented 10% or more of revenue.
Guidance, outlook, commentary, risks and unusual items
- Management expects total fiscal 2019 flash manufacturing underutilization charges of $250 million to $300 million, including $49 million recognized through the quarter, with the substantial majority expected by fiscal year-end. The timing and amount may change with market conditions.
- The flash market was normalizing as technology conversions matured and yields improved, increasing supply relative to demand and pressuring flash average selling prices. Western Digital temporarily reduced its utilization of its Flash Ventures capacity.
- Fiscal 2019 expected cash usage for capital expenditures and net Flash Ventures notes receivable and equity investment activity was approximately $1.50 billion to $1.90 billion.
- The Company accelerated closure of its Kuala Lumpur HDD facility and expects the closure to be substantially completed in fiscal Q4 2019. Total pre-tax charges are expected to be approximately $110 million, of which $56 million was recognized in fiscal 2018 and $11 million in the first six months of fiscal 2019.
- Q2 income tax expense was $568 million on $81 million of pretax income, producing a 701% effective tax rate. The result included discrete effects from finalizing Tax Cuts and Jobs Act accounting, including deemed repatriation tax and the decision to repatriate all foreign undistributed earnings.
- The estimated remaining mandatory deemed repatriation tax liability was $1.208 billion, payable through fiscal 2026. Unrecognized tax benefits were approximately $690 million, with $116 million of accrued interest and penalties. The IRS has proposed additional federal tax of approximately $516 million for fiscal years 2008–2009 and $549 million for fiscal years 2010–2012, subject to litigation and interest.
- Flash Ventures exposure included $2.318 billion of notes receivable and investments and $1.313 billion of guaranteed equipment lease obligations. The Company is obligated to purchase approximately half of Flash Ventures’ wafer output or pay half of fixed costs and to fund approximately 49.9% to 50.0% of capital investments when operating cash flow is insufficient.
- Key risks include flash and HDD pricing volatility, excess capacity and inventory, dependence on Toshiba Memory Corporation and Flash Ventures, technology transitions including 3D NAND and MAMR, customer concentration, supply-chain disruption, foreign exchange, tariffs and other trade restrictions, cyber and product-security events, litigation, tax uncertainty, and high leverage.
- Management indicated that sustained operating deterioration could pressure trailing-twelve-month Adjusted EBITDA and create risk of noncompliance with leverage covenants, although the Company was compliant at quarter-end.
Most important facts for investors to verify
- Whether flash pricing and demand stabilize and whether the projected $250 million to $300 million underutilization charge range changes.
- Inventory reduction, cash conversion cycle improvement and the sustainability of operating cash flow.
- Progress and total cost of the Kuala Lumpur facility closure and other cost-reduction actions.
- Debt repayment capacity, covenant headroom, variable-rate exposure and the $2.25 billion revolver availability.
- Cash requirements and guarantee exposure associated with Flash Ventures and the planned $1.50 billion to $1.90 billion fiscal 2019 investment program.
- Resolution of IRS tax disputes, final deemed repatriation tax adjustments and the timing of payments for unrecognized tax benefits.
- Demand, pricing and competitive trends across Client Devices, Data Center Devices and Solutions, and Client Solutions.