Western Digital Corporation: Fiscal 2018 Second-Quarter 10-Q Summary
Business context and reporting period
Western Digital develops and supplies data-storage devices and solutions across Client Devices, Data Center Devices and Solutions, and Client Solutions, including HDD, SSD, flash-memory, storage systems, and related intellectual-property licensing. This unaudited Form 10-Q covers the 13-week quarter and six months ended December 29, 2017, compared with the periods ended December 30, 2016.
Financial performance and condition
| Metric | Q2 FY2018 | Q2 FY2017 | Six months FY2018 | Six months FY2017 |
|---|---|---|---|---|
| Revenue | $5.336 billion | $4.888 billion | $10.517 billion | $9.602 billion |
| Gross profit | $2.013 billion | $1.533 billion | $3.926 billion | $2.868 billion |
| Gross margin | 37.7% | 31.4% | 37.3% | 29.9% |
| Operating income | $955 million | $545 million | $1.860 billion | $777 million |
| Operating margin | 17.9% | 11.1% | 17.7% | 8.1% |
| Net income (loss) | $(823) million | $235 million | $(142) million | $(131) million |
| Diluted EPS | $(2.78) | $0.80 | $(0.48) | $(0.46) |
Revenue increased 9.2% year over year in the quarter and 9.5% for the first six months. Management attributed growth primarily to favorable flash-memory demand and portfolio expansion. Q2 revenue by end market was approximately 50% Client Devices, 27% Data Center Devices and Solutions, and 24% Client Solutions. Exabytes shipped increased to 95 from 78.
Gross-margin expansion reflected favorable flash demand, production-cost improvements from technology transitions, and a higher flash-product mix. Operating expenses were $1.058 billion in Q2 and $2.066 billion for the first six months. Research and development increased 7.5% year over year in Q2, while selling, general and administrative expense increased 6.4%.
The reported net loss was driven primarily by $1.66 billion of provisional one-time mandatory deemed repatriation tax expense under the Tax Cuts and Jobs Act, partly offset by an $88 million provisional deferred-tax remeasurement benefit. Excluding these tax-reform items, management stated that the effective tax rate would have been approximately 4%.
Cash flow from operations was $2.315 billion for the first six months, compared with $1.500 billion in the prior-year period. Capital expenditures were $416 million, and net cash used in investing activities was $1.007 billion, including $621 million of notes receivable issuances to Flash Ventures and $99 million for acquisitions. Financing activities used $1.391 billion, including $4.114 billion of debt repayments, $2.963 billion of new debt proceeds, and $295 million of dividends.
Cash and cash equivalents were $6.272 billion at December 29, 2017, compared with $6.354 billion at June 30, 2017. Including marketable securities, liquidity was $6.389 billion. Total debt principal was $12.237 billion, with $12.051 billion of carrying value after issuance costs and discounts. The company had no borrowings under its $1.5 billion revolving credit facility and was in compliance with its debt covenants.
Material changes versus the prior comparable period
- Revenue increased $448 million, or 9.2%, in Q2 and $915 million, or 9.5%, for the first six months.
- Gross margin expanded by 6.3 percentage points in Q2 and 7.4 percentage points for the first six months.
- Operating income increased 75.2% in Q2 and 139.4% for the first six months.
- Net income shifted from a $235 million profit to an $823 million loss in Q2, primarily because of the provisional tax-reform charge. Six-month net loss was $142 million versus $131 million in the prior year.
- Cash flow from operations increased $815 million year over year, while investing cash use increased from $316 million to $1.007 billion, primarily because of higher Flash Ventures funding and acquisitions.
- Debt principal declined from $13.356 billion at June 30, 2017 to $12.237 billion. The company replaced the U.S. Term Loan B-2 with a $2.96 billion U.S. Term Loan B-3 at a lower rate and repaid the Euro Term Loan B-2 using cash.
- Tegile Systems and Upthere were acquired for an aggregate $99 million in cash; their revenues and earnings were not material during the period.
- Two acquired in-process research and development projects totaling $616 million reached technological feasibility and began amortization over an estimated four-year life.
Guidance, outlook, commentary, risks and unusual items
No specific revenue or earnings guidance is provided in the filing. Management expects fiscal 2018 cash use for property, plant and equipment and net Flash Ventures notes receivable and equity-investment activity of approximately $1.50 billion to $1.90 billion.
Western Digital expects to fund approximately $950 million of its share of Fab 6 start-up and equipment costs, primarily during calendar 2018. The company also made net payments of $1.2 billion to Flash Ventures during Q2 and $2.0 billion during the first six months. Its maximum estimable Flash Ventures exposure was $3.054 billion, including $1.267 billion of notes receivable, $578 million of equity investments, $941 million of operating-lease guarantees, and $268 million of inventory and prepayments.
The company announced planned refinancing transactions consisting of $2.30 billion of 4.750% notes due 2026, $1.00 billion of 1.5% convertible notes due 2024, and a proposed Term Loan A increase. Proceeds were intended to refinance or redeem the 10.500% unsecured notes due 2024 and 7.375% secured notes due 2023. Completion was subject to customary conditions. Management expected the transactions and planned share repurchases to reduce debt by approximately $1.00 billion and cash by approximately $2.40 billion relative to December 29, 2017.
Since December 29, 2017, the company had repurchased approximately $151 million of common stock at $87.08 per share and announced an intention to repurchase up to $500 million in connection with the refinancing. The company continued to declare a quarterly dividend of $0.50 per share.
Key risks include dependence on Toshiba Memory Corporation and Flash Ventures for NAND supply and technology development; execution and funding risks related to 3D NAND and Fab 6; significant leverage and variable-rate debt; volatile storage demand, pricing, and gross margins; customer and supplier concentration; technology-transition and product-qualification risk; acquisition and integration risk; foreign-exchange exposure; cybersecurity and intellectual-property litigation; and potential changes in tax obligations.
Other material contingencies include a provisional $1.657 billion mandatory repatriation-tax liability payable over eight years, approximately $529 million of unrecognized tax benefits plus $94 million of related interest and penalties, and an IRS dispute seeking additional federal tax of $795 million plus interest. Potential German copyright-levy losses were estimated at up to $177 million, inclusive of accrued amounts. The filing states that the ultimate outcomes of these matters cannot be predicted with certainty.
Important facts for investors to verify
- Whether the provisional Tax Cuts and Jobs Act tax amounts, including the $1.66 billion repatriation-tax charge, are revised during the permitted measurement period.
- Completion, pricing, and final proceeds of the announced refinancing transactions and their effect on interest expense, debt maturities, liquidity, and covenants.
- Actual 2018 spending for Fab 6, Flash Ventures, capital expenditures, and related guarantees or funding commitments.
- Flash Ventures’ ability to deliver sufficient 3D NAND capacity and maintain competitive costs following the Toshiba settlement and ownership transition.
- Whether strong flash demand and the 37.7% Q2 gross margin are sustainable amid potential NAND oversupply, pricing declines, and product-mix changes.
- Resolution of the IRS examination, unrecognized tax benefits, German copyright-levy matter, and other pending litigation.
- Progress integrating SanDisk, Tegile, Upthere, and remaining HGST and WD systems and operations.