Western Digital Corporation — Fiscal 2014 Second-Quarter 10-Q
Reporting period: Fiscal quarter ended December 27, 2013, consisting of 13 weeks; six-month period ended December 27, 2013. Western Digital develops and manufactures hard drives and solid-state storage products under the HGST, WD and G-Technology brands.
Financial performance and position
| Metric | Three months ended Dec. 27, 2013 | Prior-year period | Six months ended Dec. 27, 2013 | Prior-year period |
|---|---|---|---|---|
| Revenue | $3.972 billion | $3.824 billion | $7.776 billion | $7.859 billion |
| Gross profit | $1.141 billion | $1.059 billion | $2.229 billion | $2.252 billion |
| Gross margin | 28.7% | 27.7% | 28.7% | 28.7% |
| Operating income | $478 million | $478 million | $1.020 billion | $1.070 billion |
| Net income | $430 million | $335 million | $925 million | $854 million |
| Diluted EPS | $1.77 | $1.36 | $3.81 | $3.43 |
- Quarterly revenue increased 4%; six-month revenue declined 1%.
- Quarterly net income increased 28%, while six-month net income increased 8%; quarterly diluted EPS rose 30% and six-month diluted EPS rose 11%.
- Quarterly operating margin was 12.0%, compared with 12.5% in the prior year; six-month operating margin was 13.1%, compared with 13.6%.
- Hard-drive shipments increased 7% year over year to 63.1 million units in the quarter and 3% to 125.7 million units for six months. Average selling price declined to $60 from $62 in the quarter and to $59 from $62 for six months, primarily due to competitive pricing.
- Non-PC markets represented 54% of quarterly revenue, versus 49% in the prior year. Enterprise SSD revenue increased to $155 million from $89 million.
- Research and development expense increased 11% quarterly to $421 million; selling, general and administrative expense increased 41% to $229 million. Increases reflected acquired businesses and stock-appreciation-rights valuation expense.
- Quarterly operating cash flow was $727 million. Six-month operating cash flow was $1.406 billion, compared with $1.708 billion in the prior year.
- Six-month investing cash outflow was $1.125 billion, including $823 million for acquisitions and $306 million for capital expenditures. Financing cash flow was positive $65 million, including $500 million of revolving-credit borrowings, offset by $300 million of share repurchases, $118 million of dividends and $115 million of debt repayment.
- Cash and cash equivalents were $4.655 billion at December 27, 2013, up from $4.309 billion at June 28, 2013. Accounts receivable were $1.959 billion and inventories were $1.293 billion.
- Reported debt at quarter-end included $500 million of short-term debt, $230 million of current long-term debt and $1.610 billion of long-term debt. The underlying credit facility balance was $2.3 billion, consisting of a $1.8 billion term loan and $500 million revolver balance.
- Warranty accrual was $190 million at quarter-end, including $73 million classified as long term. The company reported a $263 million liability for unrecognized tax benefits, including $222 million expected to require cash payment.
Material changes versus the prior comparable period
- Revenue growth and higher unit shipments were offset by lower ASPs. Operational efficiencies increased quarterly gross margin by 100 basis points.
- Operating income was flat despite higher gross profit because operating expenses increased and included $13 million of Seagate arbitration-related interest charges. The prior-year quarter included $41 million of employee termination, asset impairment and contract charges, whereas no such restructuring charges were recorded in the current quarter.
- The effective tax burden was materially lower: quarterly tax provision declined to $37 million from $133 million and six-month provision declined to $74 million from $192 million. The prior-year six-month period included an $88 million charge related to California deferred tax assets.
- The company acquired VeloBit, sTec and Virident during fiscal 2014. The acquisitions were intended to expand enterprise SSD, server-side flash and storage software capabilities; their reported revenue and net income contributions were immaterial during the periods presented.
- Goodwill increased to $2.555 billion from $1.954 billion, primarily reflecting acquisition accounting, including $505 million of preliminary Virident goodwill and $85 million of preliminary sTec goodwill.
- The company repurchased 4.3 million shares for $300 million during the six months and had $1.7 billion remaining under its authorization at quarter-end. It declared a quarterly dividend of $0.30 per share.
Guidance, outlook, risks and unusual items
- Management expected March-quarter hard-drive industry shipments and company revenue to decrease slightly from the December quarter because of seasonality.
- The company estimated overall hard-drive industry shipments at approximately 142 million units for the December quarter, up 5% year over year and 1% sequentially.
- On January 9, 2014, the company replaced its existing credit facility with a new $4.0 billion unsecured facility: a $2.5 billion term loan and a $1.5 billion revolving facility. The company used cash to repay the prior $2.3 billion balance and reported $2.5 billion outstanding under the new term loan at filing.
- Required principal payments under the new term loan total $63 million for the remainder of fiscal 2014, followed by scheduled payments through fiscal 2019, including a $1.7 billion final balance in fiscal 2019. The company reported compliance with all covenants.
- The principal contingent exposure is the Seagate arbitration. The accrued amount was $732 million at quarter-end, consisting of the $630.4 million final award plus statutory interest. The Minnesota Supreme Court accepted the company’s appeal, with oral argument scheduled for February 5, 2014. A required payment could reduce liquidity and foreign cash.
- Approximately $4.0 billion of cash was held outside the United States and was generally intended to remain invested in foreign operations. Repatriation could generate additional U.S. tax.
- Key operating risks include competitive pricing and ASP erosion, declining PC demand, substitution by SSDs and mobile devices, customer concentration, technology transitions, supply-chain and manufacturing disruptions, product warranty claims, foreign-currency exposure, cyber attacks, acquisitions and litigation.
- Foreign-exchange contracts had $73 million of liabilities at quarter-end, and $60 million of net unrealized losses was expected to be reclassified into earnings within 12 months. A 1% increase in variable interest rates was estimated to increase annual interest expense by approximately $25 million.
- Disclosure controls and internal control over financial reporting were assessed as effective at December 27, 2013.
Important facts for investors to verify
- Whether the Seagate arbitration award is ultimately enforced and whether the $732 million accrual is sufficient.
- The effect of the refinancing, scheduled debt amortization, interest rates and covenant requirements on liquidity and capital allocation.
- Whether SSD and non-PC growth offsets PC-market weakness and continuing ASP pressure.
- Integration progress and returns from the Virident, sTec and VeloBit acquisitions, including the substantial preliminary goodwill balances.
- Trends in gross margin, inventory, warranty claims, customer incentives and competitive pricing.
- Developments in IRS examinations and the $263 million unrecognized-tax-benefit liability.
- Future share repurchases and dividends relative to operating cash flow and debt repayments.