WESTERN DIGITAL CORP quarterly report, Q3 FY2012

Western Digital Corporation: Fiscal 2012 Third-Quarter Form 10-Q

Reporting period: Three and nine months ended March 30, 2012, compared with April 1, 2011. Each third quarter comprised 13 weeks. Western Digital designs and manufactures hard disk drives, solid-state drives, and storage, networking, and home entertainment products.

Business Context and Major Transaction

On March 8, 2012, Western Digital completed its approximately $4.7 billion acquisition of Viviti Technologies Ltd., formerly Hitachi Global Storage Technologies Holdings Pte. Ltd. (HGST).
HGST contributed $614 million of revenue and $40 million of net income from the acquisition date through March 30, 2012.
The acquisition was funded with approximately $3.7 billion of cash and new debt and 25 million newly issued Western Digital shares valued at $877 million. Hitachi owned approximately 10% of Western Digital after the issuance.
Acquisition accounting remained preliminary, including approximately $1.7 billion of goodwill and $793 million of acquired identifiable intangible assets.

Financial Performance

Metric	Q3 FY2012	Q3 FY2011	Change
Revenue	$3.035 billion	$2.252 billion	+35%
Gross margin	$977 million; 32.2%	$410 million; 18.2%	+14.0 percentage points
Operating income	$542 million	$158 million	+$384 million
Net income	$483 million	$146 million	+231%
Diluted EPS	$1.96	$0.62	+216%
Operating cash flow	$1.2 billion	Not separately provided for the quarter	—

Nine-month results: Revenue was $7.724 billion, up 8%; gross margin was $2.166 billion, or 28.0%, versus 18.6%; operating income was $963 million versus $609 million; and net income was $867 million versus $568 million. Nine-month diluted EPS was $3.61 versus $2.42.

Hard-drive shipments declined 11% year over year in the quarter to 44.2 million units and declined 15% for the nine months to 130.5 million units.
Average selling price increased to $68 per drive from $45 in the prior-year quarter, primarily because Thailand-related industry supply constraints supported pricing.
Non-compute and enterprise markets represented 30% of hard-drive revenue, compared with 36% in the prior-year quarter.
Research and development expense increased 48% to $265 million; SG&A increased 112% to $155 million, reflecting HGST operations, higher incentive compensation, and acquisition-related expenses.

Cash Flow, Liquidity, Debt, and Balance Sheet

Nine-month operating cash flow was $1.938 billion, compared with $1.208 billion in the prior-year period.
Nine-month investing cash outflow was $3.934 billion, including $3.541 billion for the HGST acquisition and $393 million of capital expenditures.
Nine-month financing cash inflow was $1.889 billion, principally reflecting $2.775 billion of new debt proceeds, partly offset by $935 million of debt repayments.
Cash and cash equivalents were $3.377 billion at March 30, 2012, compared with $3.490 billion at July 1, 2011. Approximately $2.1 billion was held outside the United States.
The new unsecured credit facility provided $2.3 billion of term loans and a $500 million revolving facility. At quarter-end, $2.2 billion of term debt and the full $500 million revolving balance were outstanding; the stated interest rate was 2.24%.
Term-loan principal payments total $58 million through the remainder of fiscal 2012, $230 million annually in fiscal 2013 through 2016, and approximately $1.3 billion in fiscal 2017. The facility matures March 8, 2017.
Management expected cash, cash equivalents, and operating cash generation to satisfy working-capital and capital-expenditure needs for the next 12 months. The company was in compliance with debt covenants at March 30, 2012.
Fiscal 2012 capital expenditures were expected to be approximately $750 million, including capacity restoration and supply-chain infrastructure.

Material Changes and Unusual Items

Thailand flooding: Net flood-related charges were $15 million in the quarter and $214 million for the nine months, including asset impairments, recovery charges, inventory write-downs, and wage continuation, partially offset by $21 million of insurance recoveries and reimbursements. An $8 million accrued balance remained at quarter-end, and insurance recovery remained uncertain.
Acquisition-related costs: The company recorded $34 million of acquisition-related expenses in the quarter through the closing date, including $33 million in SG&A and $1 million of debt commitment fees. Acquired inventory fair-value step-up costs reduced gross margin by $91 million, and acquired-intangible amortization reduced gross margin by $9 million.
Warranty: The warranty accrual increased to $278 million, including $139 million of liabilities assumed in the HGST acquisition.
Share repurchases: No shares were repurchased during the nine months ended March 30, 2012. Between March 30 and May 8, 2012, the company repurchased 7.8 million shares for $305 million.

Guidance, Outlook, and Management Commentary

Management expected June-quarter industry hard-drive shipments of approximately 155 million to 160 million units and believed industry capacity was sufficient to meet demand.
Management stated that flooding recovery was essentially complete, with pricing expected to reflect current market conditions. Revenue was expected to increase significantly from the March quarter because the June quarter would include a full quarter of HGST revenue.
Production had resumed in Thailand, and the company was expanding slider production in Malaysia, with shipments using Malaysian-produced sliders expected in the June quarter.
Management estimated fourth-quarter fiscal 2012 amortization of approximately $40 million in cost of revenue and $10 million in SG&A related to acquired intangible assets.
Regulatory conditions required divestiture of certain 3.5-inch hard-drive assets to Toshiba and the acquisition of certain Toshiba Thailand assets. The divestiture had received required approvals but still had to be completed within agreed time periods. MOFCOM also required HGST to remain an independent competitor for at least two years.

Key Risks and Contingencies

Seagate arbitration: A final arbitration award of $630.4 million, plus continuing simple interest at 10% annually, was pending challenge in Minnesota. Western Digital had accrued $25 million and estimated reasonably possible additional exposure of up to $605.4 million, excluding further interest. Management did not believe sustaining the award was probable, but no assurance was provided.
The company faced unresolved IRS matters involving proposed adjustments to income before taxes of approximately $970 million. Recorded unrecognized tax benefits totaled approximately $277 million, and the company could not estimate reasonably possible changes within the following 12 months.
Key operating risks included renewed component shortages, higher component and freight costs, under-absorption of manufacturing assets, loss of market share, product qualification delays, pricing pressure, industry cyclicality, and competition from solid-state storage.
HGST integration and realization of acquisition synergies were subject to regulatory restrictions, potential restructuring charges, preliminary purchase-price allocations, assumed liabilities, and systems and control integration risks.
Variable-rate debt created interest-rate exposure; a one-percentage-point increase in the term-loan interest rate would increase annual interest expense by approximately $27 million.

Important Facts for Investors to Verify

Whether post-flood production capacity, component costs, pricing, and market share support margins after supply constraints normalize.
The final purchase-price allocation for HGST, including goodwill, intangible assets, acquired liabilities, and any resulting impairment risk.
The outcome of the Seagate arbitration challenge and the potential cash, earnings, and balance-sheet impact of the $630.4 million award plus accrued interest.
Completion of the Toshiba divestiture and compliance with MOFCOM’s requirement to maintain HGST as an independent competitor.
Debt repayment progress, covenant headroom, refinancing needs, and the effect of variable interest rates on cash flow.
Resolution of IRS examinations and the potential effect on unrecognized tax benefits, taxes payable, and future earnings.
The sustainability of the quarter’s 32.2% gross margin, which benefited materially from elevated industry pricing and reduced customer incentive programs during the flood-related supply shortage.