Western Digital Corporation — Fiscal Q1 2010 Form 10-Q
Reporting period: Three months ended October 2, 2009, compared with the three months ended September 26, 2008. Both quarters comprised 13 weeks. Western Digital designs, manufactures and sells hard drives, solid-state drives, media players and branded external storage products.
Financial performance and liquidity
| Metric | Q1 FY2010 | Q1 FY2009 | Change |
|---|---|---|---|
| Revenue | $2,208 million | $2,109 million | 5% |
| Gross margin | $514 million; 23.3% | $424 million; 20.1% | 21% gross profit; margin up 320 bps |
| Operating expenses | $195 million | $190 million | 3% |
| Operating income | $319 million; 14.4% margin | $234 million; 11.1% margin | 36% |
| Net income | $288 million | $211 million | 36% |
| Diluted EPS | $1.25 | $0.93 | 34% |
| Operating cash flow | $434 million | $301 million | 44% |
| Capital expenditures | $176 million | $162 million | 9% |
| Ending cash and equivalents | $2,056 million | $1,213 million | Up $843 million year over year |
Hard drive shipments increased 12% to 44.1 million units, while average selling price declined 8% to approximately $49 per unit. Non-desktop products represented 64% of hard drive revenue versus 61% in the prior-year quarter. Asia accounted for 56% of revenue, and OEM, distributor and retailer channels represented 52%, 31% and 17%, respectively.
The company generated $434 million of operating cash flow and ended the quarter with $2.1 billion of cash and cash equivalents. The cash conversion cycle improved to negative four days from seven days, primarily from lower inventory days and higher payable days. Total debt was $463 million, consisting of $88 million of current debt and $375 million of long-term debt. The company had $250 million of remaining borrowing capacity under its revolving credit facility and was in compliance with covenants.
Material changes versus the prior comparable period
- Revenue increased 5%, primarily from stronger hard drive demand and higher unit shipments, partly offset by lower pricing.
- Gross margin expanded from 20.1% to 23.3%, reflecting moderate price reductions, better factory and supply-chain utilization and favorable product mix.
- Operating income rose 36%; operating margin increased from 11.1% to 14.4%.
- Research and development expense increased 7% to $142 million as the company continued investing in new products. Selling, general and administrative expense declined 7% to $53 million, partly due to the December 2008 restructuring plan.
- Operating cash flow increased to $434 million from $301 million. Financing cash flow improved to positive $4 million from negative $31 million, as the current period had no open-market repurchases and included employee-plan proceeds, partially offset by debt repayment.
- Revenue mix shifted toward non-desktop markets and Asia, while the average selling price declined because of competitive pricing.
Guidance, outlook and management commentary
- Management reported that hard drive demand remained stronger than expected for the second consecutive quarter, supported primarily by consumer demand and social-media-related data growth. Industry shipments were estimated at approximately 152 million units, up 15% sequentially and flat year over year.
- For the December 2009 quarter, management expected revenue to increase slightly, gross margin percentage to remain consistent with the September quarter and operating expenses to increase slightly as investment in products and technology continued.
- For fiscal 2010, capital expenditures were expected to be approximately $650 million and depreciation and amortization approximately $540 million.
- Management believed cash, cash equivalents and operating cash flow would be sufficient to meet foreseeable working-capital needs.
Risks, contingencies and unusual items
- Competition, historical price erosion and potential oversupply could pressure average selling prices and margins. Current-quarter ASP declined to approximately $49.
- Demand remains exposed to global economic conditions, consumer spending, PC and consumer-electronics cycles, customer credit risk and significant customer concentration. The top 10 customers represented 56% of revenue; Dell and Hewlett-Packard each represented at least 10% of revenue.
- Manufacturing is concentrated in facilities in Thailand and Malaysia, creating exposure to natural disasters, political instability, labor disruptions, power outages, pandemics and logistics interruptions. The company also relies on a limited number of qualified suppliers for important components and equipment.
- The company had four disclosed patent-related proceedings and an employment-related class action involving its subsidiary. The filing states that outcomes are uncertain; specified monetary amounts were not provided.
- Warranty accrual increased to $132 million from $119 million at the prior-year comparable period. Actual product failure rates, repair costs or customer claims could materially affect gross margin and income.
- Unrecognized tax benefits were approximately $152 million, including a $16 million increase during the quarter. U.S. and French tax examinations were ongoing, and the potential near-term change could not be reasonably estimated.
- The company held $18 million of auction-rate securities that might not be readily liquidated at par. It also maintained $16 million of foreign-exchange contract assets to hedge Thai baht, Malaysian ringgit, euro and British pound exposure.
- Adoption of several accounting standards in the quarter had no material impact. The company was evaluating the potential effects and timing of adoption of ASU 2009-13 and ASU 2009-14.
- No material subsequent events requiring recognition or disclosure were identified through October 29, 2009. Management concluded that disclosure controls and procedures were effective.
Most important facts for investors to verify
- Whether demand strength and historically low industry inventories persist without a renewed decline in ASPs.
- Whether gross-margin expansion is sustainable after favorable utilization and product-mix effects.
- Progress against the fiscal 2010 capital-expenditure plan of approximately $650 million and its effect on free cash flow.
- Customer concentration, distributor and retail exposure, and credit quality of major customers.
- Status and potential financial impact of patent litigation, the employment matter and U.S. and French tax examinations.
- Warranty-return trends and whether the $132 million warranty accrual adequately reflects product-quality risk.
- Liquidity and valuation of the $18 million auction-rate securities and sensitivity to variable interest rates.
- Exposure to alternative storage technologies, including solid-state storage, and the company’s ability to deliver competitive new products.