Western Digital Corporation: Fiscal 2014 Third-Quarter 10-Q Summary
Business Context and Reporting Period
Western Digital develops and manufactures hard disk drives and solid-state storage products under the HGST, WD and G-Technology brands. The filing covers the 13-week quarter and nine months ended March 28, 2014, compared with the periods ended March 29, 2013. Fiscal 2014 ends June 27, 2014.
Fiscal-year acquisitions included VeloBit, sTec and Virident, expanding the company’s enterprise SSD, server-side flash and storage-software capabilities. Their consolidated revenue and net income contributions were immaterial for the periods presented.
Financial Performance and Liquidity
| Metric | Q3 FY2014 | Q3 FY2013 | 9M FY2014 | 9M FY2013 |
|---|---|---|---|---|
| Revenue | $3.703 billion | $3.764 billion | $11.479 billion | $11.623 billion |
| Gross profit | $1.060 billion | $1.061 billion | $3.289 billion | $3.313 billion |
| Gross margin | 28.6% | 28.2% | 28.7% | 28.5% |
| Operating income | $419 million | $417 million | $1.439 billion | $1.487 billion |
| Net income | $375 million | $391 million | $1.300 billion | $1.245 billion |
| Diluted EPS | $1.55 | $1.60 | $5.37 | $5.02 |
- Quarterly revenue declined 2%; nine-month revenue declined 1%, primarily because average selling price fell from $61 to $58 per hard-drive unit in the quarter and from $62 to $59 for the nine months.
- Quarterly operating margin was approximately 11.3%, compared with 11.1% in the prior-year quarter. Net margin was approximately 10.1%, compared with 10.4%.
- Research and development expense increased 8% in the quarter and 7% for the nine months, while SG&A increased 9% and 7%, respectively, largely reflecting acquired businesses and stock-appreciation-rights expense.
- Hard-drive shipments were 60.4 million units in the quarter, essentially flat year over year, and 186.2 million units for the nine months, up 2%. Non-PC shipments increased while PC shipments declined.
- Non-PC markets represented 53% of quarterly revenue, compared with 51% a year earlier. Enterprise SSD revenue increased to $134 million from $92 million.
- Cash flow from operations was $697 million in the quarter and $2.104 billion for the nine months, compared with $2.435 billion for the prior-year nine-month period.
- Capital expenditures were $467 million for the nine months, down from $816 million. Acquisitions used $823 million and purchases of investments used $470 million.
- Cash and cash equivalents were $4.569 billion at March 28, 2014, supplemented by $296 million of short-term investments and $188 million of long-term investments. Approximately $2.8 billion of cash was held outside the United States.
- Total debt was approximately $2.469 billion, including $2.5 billion outstanding under a new term loan, partly offset by debt-classification details and repayments. No revolving credit borrowings were outstanding.
- The new credit agreement provides $2.5 billion of term capacity and $1.5 billion of revolving capacity, with an optional additional $1.0 billion. The term loan bore a variable rate of 1.66% at quarter-end, and the company was in compliance with its covenants.
- The company repurchased 2.8 million shares for $244 million during the quarter and 7.1 million shares for $544 million during the nine months. Approximately $1.4 billion remained authorized for repurchases. The quarterly dividend was $0.30 per share.
Material Changes Versus Prior Comparable Period
- Revenue and gross profit were slightly lower, but gross margin improved by 40 basis points in the quarter and 20 basis points for the nine months, primarily due to product mix.
- Quarterly operating income was broadly stable despite higher R&D and SG&A, partly because the prior-year quarter included $63 million of employee termination and other charges.
- Nine-month operating income declined because the current period included $39 million of Seagate arbitration interest charges, while the prior-year period included $130 million of employee termination and other charges.
- Nine-month net income increased despite lower operating income, primarily reflecting lower income tax expense. The prior-year period included an $88 million California deferred-tax-asset charge and a $34 million retroactive R&D tax-credit benefit.
- The company replaced its prior credit facility in January 2014, refinancing the outstanding debt with a new $4.0 billion unsecured facility.
- Goodwill increased to $2.558 billion from $1.954 billion at June 28, 2013, mainly due to acquisitions, while cash increased $260 million from the beginning of the fiscal year.
Guidance, Outlook, Risks and Unusual Items
Management expected overall hard-drive industry shipments and company revenue to decline in the June 27, 2014 quarter because of seasonality. The company estimated industry shipments of approximately 137 million units in the March quarter, up 1% year over year but down 4% sequentially.
- Seagate arbitration: The company had accrued $745 million for the arbitration award, including $13 million of additional interest in the quarter and $39 million for the nine months. The matter was pending before the Minnesota Supreme Court after oral argument on February 5, 2014. If payment is required, management expected it to be funded from foreign cash.
- Tax contingencies: Recorded unrecognized tax benefits were approximately $275 million, including $239 million representing the cash portion. IRS examinations and other tax matters remain unresolved, and the company could be required to record additional tax expense or make future payments.
- Industry and operating risks: Key risks include declining ASPs, pricing pressure, PC-market weakness, shifts toward SSD and other technologies, demand volatility, customer concentration, supplier constraints, manufacturing disruption, product defects and warranty claims, foreign-exchange exposure, intellectual-property litigation, and acquisition-integration risk.
- Regulatory constraints: The company remained subject to MOFCOM restrictions requiring HGST to operate independently for a minimum period following the 2012 acquisition. Western Digital submitted a request in March 2014 to have the restrictions lifted, but the timing and outcome were uncertain.
- Foreign-exchange and interest-rate exposure: The company used short-term currency contracts for hedging. A one-percentage-point increase in variable interest rates was estimated to increase annual interest expense by approximately $25 million.
- Controls: Management concluded that disclosure controls and internal control over financial reporting were effective as of March 28, 2014.
Important Facts for Investors to Verify
- Resolution and potential cash cost of the $745 million Seagate arbitration accrual.
- Sustainability of gross-margin performance as ASP pressure and competitive pricing continue.
- Progress and returns from the Virident, sTec and VeloBit acquisitions and the company’s enterprise SSD strategy.
- Compliance with the new credit agreement, debt amortization schedule and sensitivity to variable interest rates.
- Future effects of IRS examinations and the $275 million unrecognized-tax-benefit liability.
- Cash availability after considering foreign cash restrictions, dividends, share repurchases, capital expenditures and any arbitration payment.
- June-quarter demand, seasonality, PC-market weakness and the pace of growth in non-PC and enterprise storage markets.