Western Digital Corporation: Fiscal 2010 Third-Quarter Form 10-Q
Business context and reporting period
Western Digital designs, manufactures and sells hard disk drives, solid-state drives, media players and external storage products. The filing covers the 13-week quarter and nine months ended April 2, 2010, compared with the periods ended March 27, 2009. Fiscal 2010 ends July 2, 2010.
Management reported stronger-than-expected industry demand of approximately 163 million hard drives in the March quarter, supported by consumer and commercial demand, particularly in emerging markets. Western Digital shipped 51.1 million hard drives during the quarter.
Financial performance and liquidity
| Metric | Three months ended Apr. 2, 2010 | Three months ended Mar. 27, 2009 | Change |
|---|---|---|---|
| Revenue | $2.641 billion | $1.592 billion | +66% |
| Gross margin | $665 million; 25.2% | $253 million; 15.9% | +930 basis points |
| Operating income | $441 million; 16.7% | $61 million; 3.8% | +$380 million |
| Net income | $400 million; 15.1% | $50 million; 3.1% | +700% |
| Diluted EPS | $1.71 | $0.22 | +$1.49 |
| Hard drive shipments | 51.1 million | 31.6 million | +62% |
| Hard drive ASP | $51 | $50 | +2% |
For the nine months ended April 2, 2010, revenue was $7.468 billion, gross margin was $1.866 billion, operating income was $1.233 billion and net income was $1.118 billion. Compared with the prior-year nine-month period, revenue increased 35%, gross margin increased 93%, operating income increased from $310 million, and net income increased from $274 million.
Operating expenses were $224 million in the quarter and $633 million year to date. Research and development increased 28% year over year in the quarter to $160 million, while selling, general and administrative expense increased 31% to $64 million. The prior-year periods included $4 million of restructuring expense and $14 million of acquired in-process research and development expense; no such charges were recorded in the current quarter.
Cash flow from operations was $588 million in the third quarter and $1.579 billion for the first nine months, compared with $956 million for the prior-year nine-month period. Capital expenditures were $552 million year to date, compared with $408 million in the prior-year period. Cash and cash equivalents were $2.826 billion at April 2, 2010, up from $1.794 billion at July 3, 2009.
Total debt was $425 million at April 2, 2010, consisting of $100 million classified as current and $325 million classified as long term. The term loan carried a variable interest rate of 1.50%; the full $250 million revolving facility remained available, and the company was in compliance with its covenants. The company stated that cash, cash equivalents and operating cash flow should meet foreseeable working capital and capital expenditure needs.
Working capital increased substantially: total current assets were $4.778 billion and current liabilities were $1.957 billion. The cash conversion cycle improved to negative three days from five days in the prior-year quarter.
Material changes versus the prior comparable period
- Revenue growth was driven primarily by a 62% increase in unit shipments rather than pricing; quarterly ASP increased only 2%.
- Non-desktop products represented 62% of hard drive revenue, compared with 58% in the prior-year quarter. These products include notebook, consumer electronics, enterprise and WD-branded products.
- Gross margin improved materially because of lower costs, favorable product mix and a moderate pricing environment.
- Operating leverage was significant: operating expenses rose 17%, while gross margin increased 163% in the quarter.
- Asia accounted for 52% of quarterly revenue, up from 46%; the Americas represented 24% and Europe, the Middle East and Africa represented 24%.
- No customer represented at least 10% of quarterly revenue, although Hewlett-Packard represented at least 10% of nine-month revenue. The top ten customers collectively represented 51% of quarterly revenue.
- Inventories increased to $507 million from $376 million at the prior fiscal year-end, while accounts receivable increased to $1.257 billion from $926 million.
Guidance, outlook, risks and unusual items
Management expected June-quarter revenue to decline from the March quarter because of typical seasonal demand patterns. Operating expenses were expected to increase slightly as the company continued investing in new products and technology. For fiscal 2010, excluding the pending Hoya acquisition, capital expenditures were expected to be at the high end of the previously projected $650 million to $750 million range, with depreciation and amortization of approximately $520 million.
On April 27, 2010, after the quarter ended, Western Digital agreed to acquire the magnetic media sputtering operations of Hoya Corporation and Hoya Magnetics Singapore for approximately $235 million, payable in cash at closing. The transaction was expected to close in the fourth quarter of fiscal 2010, subject to customary conditions, and was intended to support anticipated hard drive demand.
Key risks include hard drive price erosion and oversupply, demand volatility, competition from solid-state and other storage technologies, dependence on a limited number of suppliers and concentrated Asian manufacturing facilities, component shortages, foreign currency exposure, customer concentration and credit risk, product defects and warranty claims, intellectual property litigation, and potential restructuring or impairment charges if demand weakens.
The warranty accrual was $164 million at April 2, 2010, including $40 million classified in non-current liabilities. Management cautioned that actual product returns and repair costs could differ materially from estimates. The company also reported approximately $215 million of unrecognized tax benefits, including a cash liability of $120 million, and stated that the timing and ultimate amount could change as tax audits proceed.
Pending legal matters included several patent infringement cases and a putative employee class action. The filing states that the ultimate outcomes are uncertain and that monetary exposure cannot be predicted with assurance. The company reported no material off-balance-sheet financing arrangements.
Important facts for investors to verify
- Whether demand and the substantial year-over-year shipment growth continued after the March quarter, particularly given management's expected seasonal June-quarter revenue decline.
- Whether gross margin remained near the 25.2% quarterly level as pricing, product mix, component costs and industry competition changed.
- The closing, purchase-price accounting and operational benefits of the approximately $235 million Hoya acquisition.
- Capital expenditure execution and cash generation relative to the projected $650 million to $750 million fiscal-year range.
- Changes in the $425 million term-loan balance, variable interest rates and covenant compliance.
- Warranty trends, product-return rates and any quality-related charges that could reduce margins.
- Developments in patent litigation, employment litigation and IRS examinations, including potential effects on cash taxes and earnings.
- Customer concentration, pricing concessions and exposure to oversupply, competing storage technologies and foreign currency movements.