Western Digital Corporation 10-Q Summary
Business context and reporting period
Western Digital develops and supplies hard disk drives, flash-based storage, and related data-storage solutions across Client Devices, Data Center Devices and Solutions, and Client Solutions. This unaudited filing covers the quarter and nine months ended April 3, 2020. Fiscal 2020 has 53 weeks, with the first quarter containing 14 weeks and the remaining quarters containing 13 weeks.
Key financial metrics
| Metric | Q3 FY2020 | Q3 FY2019 | 9M FY2020 | 9M FY2019 |
|---|---|---|---|---|
| Revenue | $4.175 billion | $3.674 billion | $12.449 billion | $12.935 billion |
| Gross profit | $1.005 billion | $579 million | $2.698 billion | $3.287 billion |
| Gross margin | 24.1% | 15.8% | 21.7% | 25.4% |
| Operating income (loss) | $153 million | $(394) million | $74 million | $468 million |
| Net income (loss) | $17 million | $(581) million | $(398) million | $(557) million |
| Diluted EPS | $0.06 | $(1.99) | $(1.34) | $(1.91) |
- Q3 revenue increased 14%, driven by higher HDD and flash volumes, despite lower average selling prices. Nine-month revenue declined 4%, primarily because of pricing pressure and lower Client Devices revenue.
- Q3 revenue was approximately 51% HDD and 49% flash-based. HDD revenue was $2.114 billion and flash-based revenue was $2.061 billion.
- Q3 Data Center Devices and Solutions revenue rose 22% to $1.523 billion, while Client Devices revenue rose 13% to $1.831 billion and Client Solutions revenue rose 2% to $821 million.
- Q3 operating expenses declined 12% to $852 million, including lower SG&A and restructuring-related charges. R&D increased 3% to $563 million.
- Q3 income before taxes was $46 million and income tax expense was $29 million, producing a 63% effective tax rate. The nine-month effective tax rate was negative 72% because of the pretax loss and discrete tax items.
- Cash and cash equivalents were $2.943 billion at April 3, 2020, compared with $3.455 billion at June 28, 2019. Approximately $2.14 billion was held outside the United States.
- Nine-month operating cash flow was $652 million, down from $1.378 billion in the prior-year period. Investing activities provided $192 million, while financing activities used $1.354 billion.
- Nine-month capital expenditures were $432 million. Management expected fiscal 2020 company and Flash Ventures capital expenditures to total approximately $1.7 billion.
- Total debt principal was $9.774 billion, including $286 million classified as current; long-term debt, net of issuance costs and discounts, was $9.343 billion. The company had $2.25 billion available under its revolving credit facility and was in compliance with applicable financial covenants.
Material changes versus the prior comparable period
- Q3 gross margin expanded 8 percentage points, largely because the prior-year quarter included $148 million of flash manufacturing underutilization charges, a $110 million flash inventory valuation charge, and $43 million of additional acquired-intangible amortization.
- Nine-month gross margin contracted 3 percentage points. Aggregate unusual and acquisition-related costs were $534 million in the current period versus $945 million in the prior-year period, but lower revenue and pricing pressure outweighed those savings.
- Interest expense declined as a result of debt repayment and lower benchmark rates. The company repaid $919 million of debt during the first nine months, including $725 million of voluntary prepayments on its U.S. Term Loan B-4.
- Western Digital sold IntelliFlash for $28 million, collectible over three years, and completed the sale of ActiveScale. The IntelliFlash transaction generated an approximately $17 million gain; the related businesses were not material and were not reported as discontinued operations.
- The company adopted the new lease standard at the beginning of fiscal 2020, increasing lease assets and liabilities by $221 million and reducing opening retained earnings by $5 million.
- The company declared $1.50 per share of dividends during the nine months, but subsequently suspended its quarterly dividend to reinvest in the business and support deleveraging. No stock repurchases were made during the period.
Guidance, outlook, commentary, and risks
- Management stated that Q3 revenue was not significantly affected by COVID-19. Capacity enterprise products benefited from increased cloud demand, while retail sales in Client Solutions were reduced by brick-and-mortar disruptions.
- COVID-19 caused approximately $13 million of Q3 cost-of-revenue charges from under-absorbed overhead, higher logistics costs, and other expenses. Management expected COVID-19-related charges to be higher in Q4, partially offset by increased product pricing.
- Management expected flash pricing to continue improving in the near term if supply and demand became more closely aligned, but provided no clear full-year revenue or earnings guidance in the filing.
- Initial output from the K1 flash facility began in Q3, although meaningful output was not expected until the end of calendar 2020. Remaining committed K1 prepayments were $205 million, with approximately $65 million of equipment and relocation costs expected in Q4.
- Flash Ventures represented a significant strategic and financial commitment. The company’s maximum reasonably estimable exposure was $4.452 billion, including $1.535 billion of notes receivable, $622 million of equity investments, $1.827 billion of operating lease guarantees, and $468 million of inventory and prepayments.
- Flash Ventures lease guarantees totaled approximately $1.827 billion. A cancellation event could accelerate the underlying obligations and require the company to fund guaranteed amounts.
- COVID-19, global economic weakness, supply-chain disruption, declining average selling prices, technology transitions, reliance on Kioxia and Flash Ventures, customer concentration, foreign-exchange exposure, and high leverage remain material risks.
- The IRS is challenging transfer-pricing and other tax positions for fiscal years 2008–2012. Proposed additional federal tax totaled approximately $1.065 billion before interest and penalties, and the IRS asserted $340 million of penalties in May 2020. The company intends to contest the matter.
- Unrecognized tax benefits were approximately $710 million, with approximately $136 million of accrued interest and penalties; approximately $716 million could result in potential cash payments, although timing was not estimable.
- Management believed available cash, operating cash flow, and credit facilities would be sufficient for working capital, debt, and capital expenditure needs for at least the next twelve months.
Important facts for investors to verify
- Whether COVID-19 materially affected fourth-quarter revenue, margins, manufacturing utilization, logistics costs, and customer demand after the reporting date.
- The pace of flash-price recovery, K1 production ramp, and the level of fixed-cost obligations and capital funding required by Flash Ventures.
- Progress on debt reduction, covenant headroom, refinancing needs, variable-rate exposure, and the availability of the revolving credit facility.
- The timing and outcome of the IRS Tax Court proceedings, including potential tax, interest, and penalty payments.
- Whether and when Western Digital resumes its dividend or share repurchases, and the effect of the suspension on capital allocation.
- Execution of the Storage Systems exit, cost-reduction initiatives, and the company’s ability to sustain the improved quarterly gross margin.