Western Digital Corporation 2016 Fiscal Q2 Form 10-Q Summary
Business context and reporting period
Western Digital develops and manufactures data-storage solutions, including HDDs, SSDs, attached storage and data-center systems under the WD and HGST brands. The quarter ended January 1, 2016 comprised 13 weeks; the six-month period comprised 26 weeks, compared with 27 weeks in the prior-year six-month period. Fiscal 2016 is expected to comprise 52 weeks and end July 1, 2016.
Financial performance and liquidity
| Metric | Q2 FY2016 | Q2 FY2015 | Change |
|---|---|---|---|
| Revenue | $3.317 billion | $3.888 billion | Down 15% |
| Gross profit | $906 million | $1.110 billion | Down 18% |
| Gross margin | 27.3% | 28.5% | Down 1.2 points |
| Operating income | $251 million | $466 million | Down 46% |
| Net income | $251 million | $438 million | Down 43% |
| Diluted EPS | $1.07 | $1.84 | Down 42% |
| Operating margin | 7.6% | 12.0% | Down 4.4 points |
For the six months ended January 1, 2016, revenue was $6.677 billion, gross profit was $1.861 billion, operating income was $573 million and net income was $534 million, compared with $7.831 billion, $2.259 billion, $935 million and $861 million, respectively, in the prior-year period. Six-month gross margin was 27.9% versus 28.8%; operating margin was 8.6% versus 11.9%.
- HDD shipments declined 19% year over year to 49.7 million units in the quarter and 101.4 million units for the six months. Management estimated total industry HDD shipments at approximately 115 million units, down 18% year over year.
- HDD average selling price increased to $61 per unit from $60 in the quarter and to $61 from $59 for the six-month period. Enterprise SSD revenue increased to $270 million from $187 million.
- Gross-margin pressure reflected product mix and lower-volume absorption. Revenue incentive and marketing programs increased to 13% of gross revenue in the quarter from 10%.
- Quarterly operating cash flow was $598 million. Six-month cash flow from operations was $1.143 billion, compared with $1.070 billion in the prior year.
- Six-month capital expenditures were $300 million. Investing cash outflow was $454 million and financing cash outflow was $350 million.
- Cash and cash equivalents were $5.363 billion at January 1, 2016, supplemented by $497 million of short-term investments and $234 million of long-term investments. Approximately $4.9 billion of cash and cash equivalents was held outside the United States.
- Total debt was approximately $2.5 billion, consisting primarily of a $2.3 billion term loan and $255 million drawn under the revolving facility. The $255 million revolving balance was repaid on January 15, 2016. The company was in compliance with its debt covenants at quarter-end.
- The company declared a quarterly dividend of $0.50 per share and paid $231 million of dividends during the six months. Share repurchases were suspended in connection with the planned SanDisk merger; no shares were repurchased during the quarter.
Material changes versus the prior comparable period
- Revenue declined 15%, primarily because of weaker demand and lower HDD volumes, partly offset by higher HDD ASPs and product mix.
- HDD shipments fell 19%, with PC units declining to 27.8 million from 36.6 million and non-PC units declining to 21.9 million from 24.4 million.
- R&D expense decreased 9% in the quarter, while SG&A expense increased 26%, primarily due to acquisition-related and cost-saving initiative expenses.
- Operating expenses included $32 million of charges related to the Seagate arbitration award, compared with $1 million in the prior-year quarter. The additional post-award interest was paid in January 2016, and the matter was resolved through a stipulation of dismissal.
- Six-month restructuring, asset impairment and other charges increased to $83 million from $62 million, although quarterly charges decreased to $27 million from $53 million.
- Net income benefited from a $30 million retroactive U.S. federal R&D tax credit and a $34 million restructuring-related tax benefit. The quarter reported a $7 million tax benefit compared with $20 million of tax expense in the prior-year quarter.
Guidance, outlook, commentary and unusual items
- Management characterized the demand environment as soft, driven largely by challenging global economic conditions, and highlighted continued PC-market deterioration, competitive pricing pressure, technology transitions and HDD-to-SSD substitution as risks.
- The company announced closure of its Odawara, Japan, wafer facility. It expects approximately $200 million of pretax charges, including $90 million of asset charges, $90 million of employee termination costs and $20 million of contract and other costs; approximately $110 million is expected to be cash expenditure. A $20 million accelerated-depreciation charge was recorded in the quarter, with most remaining charges expected in the third quarter of fiscal 2016.
- The planned SanDisk merger valued SanDisk at approximately $18.9 billion, or $86.50 per share based on the transaction terms. Western Digital expected to raise approximately $18.1 billion of new debt facilities and expected the merger to close in the fourth quarter of fiscal 2016. The filing states that certain regulatory clearances had been obtained, but other closing conditions remained.
- The planned $3.8 billion Unisplendour equity investment remained subject to CFIUS and other regulatory approvals and customary conditions. The CFIUS notice was refiled in January 2016; completion was not assured.
- The company expected to integrate substantial portions of HGST and WD through the end of calendar year 2017, while maintaining separate WD and HGST sales teams for two years under the MOFCOM decision.
- Management stated that existing cash, operating cash flow and available credit facilities were expected to fund working capital, debt, dividends and capital expenditures for at least the next twelve months, but the proposed SanDisk transaction would materially increase leverage and reduce liquidity flexibility.
Key risks and contingencies
- Completion risk for the SanDisk merger and Unis investment, including regulatory approvals, shareholder approvals, financing availability and pending merger-related litigation.
- Potential SanDisk termination fees of up to approximately $1.06 billion payable by Western Digital in specified circumstances; other termination fees could be up to $553.3 million.
- Planned merger financing would substantially increase debt, interest expense, refinancing risk and covenant constraints.
- The IRS has proposed adjustments that could increase federal tax expense by approximately $795 million, plus interest. The company disputes the proposed adjustments. Unrecognized tax benefits were approximately $375 million, including $272 million that could result in potential cash payments.
- German copyright-levy matters could result in losses of up to $109 million, including accrued amounts; the exact judgment amount had not been determined.
- Warranty estimates, product defects, inventory obsolescence, goodwill impairment, foreign exchange, supplier concentration, manufacturing disruptions and customer concentration could materially affect future results.
Investor verification checklist
- Verify the timing and final terms of the SanDisk merger, including regulatory and shareholder approvals, financing, leverage and any termination-fee exposure.
- Verify whether the Unis investment closed and assess its effect on dilution, liquidity and merger consideration.
- Track HDD industry shipments, PC and non-PC demand, HDD ASPs, SSD revenue growth and gross-margin trends.
- Assess the actual timing and cash cost of the Odawara facility closure and other restructuring actions.
- Review the IRS examination, unrecognized tax benefits and potential cash-tax exposure.
- Monitor debt repayment, interest-rate sensitivity, covenant compliance and the location and repatriation constraints of cash balances.
- Evaluate warranty, litigation, copyright-levy and goodwill-impairment developments that could create material charges.