Western Digital Corporation: Fiscal 2011 Second Quarter
Reporting period: Form 10-Q for the 13 weeks ended December 31, 2010, with six-month results compared with the six months ended January 1, 2010. The company designs, manufactures and sells hard drives, solid-state drives and media players worldwide.
Financial performance
| Metric | Three months ended Dec. 31, 2010 | Prior-year period | Six months ended Dec. 31, 2010 | Prior-year period |
|---|---|---|---|---|
| Revenue | $2.475 billion | $2.619 billion | $4.871 billion | $4.827 billion |
| Gross margin | $475 million; 19.2% | $687 million; 26.2% | $912 million; 18.7% | $1.201 billion; 24.9% |
| Operating income | $240 million; 9.7% | $473 million; 18.1% | $451 million; 9.3% | $792 million; 16.4% |
| Net income | $225 million; 9.1% | $429 million; 16.4% | $422 million; 8.7% | $717 million; 14.9% |
| Diluted EPS | $0.96 | $1.85 | $1.80 | $3.10 |
- Hard-drive shipments increased 5% year over year to 52.2 million units in the quarter and 10% to 102.9 million units for the six-month period.
- Average selling price declined 10% year over year, from $52 to $47 per unit in the quarter and from $51 to $46 for six months, primarily due to competitive pricing.
- Research and development expense increased 10% in the quarter to $169 million and 14% for six months to $336 million, reflecting continued product-development investment.
- Sales, general and administrative expense increased 10% in the quarter to $66 million and 11% for six months to $125 million.
- Sales incentives and marketing programs represented 10% of gross revenue in the quarter and 11% for six months, compared with 7% in each prior-year period.
Cash flow, liquidity and debt
- Second-quarter operating cash flow was $505 million. Six-month operating cash flow was $895 million, compared with $991 million in the prior-year period.
- Six-month capital expenditures were $450 million, compared with $375 million previously. Fiscal 2011 capital expenditures were expected to be 7% to 8% of revenue, plus up to $200 million for wafer-fabrication conversion and magnetic-media operations.
- Cash and cash equivalents totaled $3.110 billion at December 31, 2010, up from $2.734 billion at July 2, 2010. The company stated that cash and operating cash flow should satisfy foreseeable working-capital and capital-expenditure needs.
- Total debt was $350 million, consisting of $119 million current and $231 million long-term. The variable-rate term loan had a 1.56% rate and required principal payments of $56 million through the remainder of 2011, $144 million in 2012 and $150 million in 2013. The company was in compliance with its covenants.
- The company repurchased $50 million of common stock during the six-month period and had repurchased 20 million shares for $334 million since the program began.
Material changes and outlook
- Quarterly revenue declined 5% despite 5% higher unit shipments because of lower ASPs. Six-month revenue increased 1%, but gross margin fell 620 basis points and operating income declined 43% from the comparable period.
- Management attributed the margin deterioration primarily to competitive pricing. Non-desktop markets represented 65% of hard-drive revenue, compared with 66% in the prior-year quarter.
- Management expected industry shipments and Western Digital revenue to decline in the March quarter because of normal seasonality and inventory adjustments in PC manufacturers’ supply chains.
- Fiscal 2011 depreciation and amortization was expected to be approximately $620 million. No specific revenue or earnings guidance was provided in the filing.
- The company began shipping a 3.5-inch WD Caviar Green 3 TB drive in October 2010 and continued investments in enterprise, solid-state, consumer-electronics and branded-storage markets.
Risks, contingencies and unusual items
- The IRS proposed an approximately $300 million income adjustment related to the company’s 2006 and 2007 audits. Western Digital disputed the adjustment. The company reported approximately $240 million of unrecognized tax benefits, including $139 million expected to require cash payment within one to five years; the timing and ultimate amount remain uncertain.
- Outstanding legal matters included multiple patent disputes, Seagate trade-secret arbitration with a plenary hearing scheduled for May 2011, and employment-related class actions. The company stated that amounts related to most matters were not reasonably estimable; an employment settlement had been accrued in an immaterial amount.
- Warranty accrual was $176 million at December 31, 2010, including $41 million classified as non-current. Changes in product-return rates, repair costs or customer claims could materially affect margins.
- Key operating risks include continuing ASP erosion, intense industry competition, oversupply, customer concentration, component shortages and commodity-price volatility, reliance on concentrated manufacturing facilities in Asia, technology transitions, alternative storage technologies such as solid-state drives, foreign-currency exposure and global economic weakness.
- The company hedged Thai baht, Malaysian ringgit, euro and British pound exposures with contracts having a total fair value of $29 million at December 31, 2010. A one-percentage-point increase in the term-loan variable interest rate would increase annual interest expense by approximately $4 million.
- Management concluded that disclosure controls and procedures were effective, with no material change in internal control over financial reporting during the quarter.
Investor verification points
- Verify whether the expected March-quarter seasonal decline and PC inventory adjustments occurred, and assess subsequent revenue and shipment trends.
- Track ASPs, pricing incentives, product mix and gross margin recovery, as these were the primary drivers of the year-over-year earnings decline.
- Monitor the IRS examination, the proposed $300 million adjustment and changes in unrecognized tax benefits and cash tax obligations.
- Review the status and potential financial impact of patent litigation and Seagate arbitration.
- Compare planned fiscal 2011 capital expenditures and approximately $620 million of depreciation and amortization with actual spending and cash generation.
- Assess exposure to manufacturing disruptions, component shortages, customer concentration and competition from solid-state and other storage technologies.