Business Context and Reporting Period
Western Digital Corporation filed this unaudited Form 10-Q for its fiscal first quarter ended September 27, 2013. The quarter comprised 13 weeks and is compared with the 13-week period ended September 28, 2012. Western Digital develops and manufactures hard disk drives, solid-state storage products, and related storage solutions under the HGST, WD, and G-Technology brands.
Non-PC markets represented 53% of revenue, up from 46% in the prior-year quarter. Enterprise SSD revenue increased to $106 million from $70 million. Hard-drive industry shipments were estimated at approximately 139 million units, while Western Digital shipped 62.6 million hard-drive units, broadly flat year over year.
Financial Performance and Position
| Metric | Q1 FY2014 | Q1 FY2013 | Change |
|---|---|---|---|
| Revenue | $3.804 billion | $4.035 billion | Down 6% |
| Gross profit | $1.088 billion | $1.193 billion | Down 9% |
| Gross margin | 28.6% | 29.6% | Down 1.0 percentage point |
| Operating income | $542 million | $592 million | Down 8% |
| Operating margin | 14.2% | 14.7% | Down 0.5 percentage point |
| Net income | $495 million | $519 million | Down 5% |
| Diluted earnings per share | $2.05 | $2.06 | Down $0.01 |
| Operating cash flow | $680 million | $936 million | Down 27% |
Average selling price for hard-drive units declined to $58 from $62, primarily because of competitive pricing and product mix. PC hard-drive shipments declined to 40.2 million units from 42.7 million, while non-PC shipments increased to 22.4 million from 19.8 million.
Research and development expense increased to $401 million from $396 million, or 10.5% of revenue versus 9.8%. Selling, general and administrative expense declined to $132 million from $179 million, aided by a $65 million flood-related insurance recovery, partly offset by $13 million of acquisition-related expenses. The income tax provision declined to $37 million from $59 million.
Cash and cash equivalents were $4.869 billion at September 27, 2013, compared with $4.309 billion at June 28, 2013. Total assets were $14.806 billion and shareholders' equity was $8.253 billion. Inventories increased to $1.244 billion from $1.188 billion.
Investing cash outflows were $360 million, including $263 million for acquisitions and $136 million for capital expenditures. Financing cash inflows were $240 million, reflecting $500 million of new revolving debt, offset by $150 million of share repurchases, $59 million of dividends, and $58 million of debt repayment.
Material Changes Versus the Prior Comparable Period
- Revenue declined 6% despite essentially flat hard-drive unit shipments, reflecting a 6% decline in average selling price.
- Gross margin decreased from 29.6% to 28.6% as competitive pricing pressure and product mix reduced profitability.
- Operating expenses declined overall, primarily because the prior-year period included $26 million of employee termination and other charges; the current period included $13 million of Seagate arbitration-related interest charges.
- Operating cash flow declined $256 million, partly because the prior-year period benefited from favorable working-capital changes, including a larger accounts-receivable reduction.
- The company initiated its quarterly dividend program in the prior fiscal year and declared a $0.25-per-share dividend totaling $59 million during the quarter.
- Western Digital repurchased 2.3 million shares for $150 million, leaving $1.820 billion authorized for future repurchases.
- The company acquired VeloBit on July 10, 2013, and sTec on September 12, 2013. The sTec acquisition cost approximately $336 million and added enterprise SSD capabilities; the quarterly financial impact of both acquisitions was immaterial.
Debt, Liquidity, Outlook, and Risks
Total outstanding borrowings under the credit facility were approximately $2.4 billion at quarter-end, including $500 million drawn under the revolving facility. The debt carried a variable interest rate of 2.18%. Annual term-loan principal payments of $230 million are due in fiscal 2014 through fiscal 2016, with approximately $1.3 billion due in March 2017. The company was in compliance with all debt covenants and stated that cash, operating cash flow, and available credit should fund expected needs for at least the next twelve months.
Management expected industry hard-drive shipments and company revenue for the quarter ending December 27, 2013, to remain approximately flat with the September quarter. The filing does not provide a detailed earnings or margin forecast.
The most significant contingency was the Seagate trade-secret arbitration. The company accrued $719 million at September 27, 2013, including the $630.4 million arbitration award and accrued interest. The Minnesota Supreme Court granted Western Digital's petition for review after the Minnesota Court of Appeals had reversed a lower-court decision vacating the award. An additional $13 million of interest was recognized in the quarter.
Other notable risks include hard-drive price erosion, PC-market weakness, competition from SSD and other storage technologies, reliance on concentrated suppliers and manufacturing locations, product warranty and quality exposure, intellectual-property litigation, foreign-exchange risk, tax audits, and the ability to integrate recent acquisitions. Cash held outside the United States increased to $3.5 billion; potential repatriation could create additional U.S. tax costs.
After quarter-end, Western Digital acquired Virident Systems for an estimated $685 million in cash. Initial purchase accounting was incomplete at the filing date. The company also reported that its disclosure controls and internal control over financial reporting were effective.
Investor Verification Checklist
- Verify the sustainability of the 28.6% gross margin amid continued pricing pressure and lower average selling prices.
- Track PC versus non-PC demand, enterprise SSD growth, and whether non-PC expansion offsets further PC-market declines.
- Monitor the Seagate arbitration appeal, the $719 million accrual, potential cash settlement timing, and related interest expense.
- Assess leverage, required $230 million annual term-loan payments, the $500 million revolving draw, and compliance with credit covenants.
- Evaluate the cash impact and strategic returns from the sTec, VeloBit, and post-quarter Virident acquisitions.
- Review the ability to maintain dividends and share repurchases while funding capital expenditures, acquisitions, debt service, and potential litigation payments.
- Monitor warranty accruals, inventory levels, supplier concentration, manufacturing disruption risks, and pending intellectual-property matters.
- Review foreign tax holidays, the $247 million liability for unrecognized tax benefits, and ongoing IRS examinations.