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WESTERN DIGITAL CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) This information should be read in conjunction with the unaudited condensed consolidated financial statements and the notes thereto included in this Quarterly Report on Form 10-Q, and the audited consolidated financial statements and notes thereto and Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, contained in our Annual Report on Form 10-K for the year ended July 1, 2011. Unless otherwise indicated, references herein to specific years and quarters are to our fiscal years and fiscal quarters. As used herein, the terms "we," "us," "our," the "Company" and "WD" refer to Western Digital Corporation and its subsidiaries. Forward-Looking Statements This document contains forward-looking statements within the meaning of the federal securities laws. Any statements that do not relate to historical or current facts or matters are forward-looking statements. You can identify some of the forward-looking statements by the use of forward-looking words, such as "may," "will," "could," "would," "project," "believe," "anticipate," "expect," "estimate," "continue," "potential," "plan," "forecast," and the like, or the use of future tense. Statements concerning current conditions may also be forward-looking if they imply a continuation of current conditions. Examples of forward-looking statements include, but are not limited to, statements concerning: • expectations regarding industry demand in the June quarter and the ability of the industry to support this demand; • expectations regarding the shipment of drives in the June quarter with sliders produced in our Penang, Malaysia facility; • expectations concerning the anticipated benefits of our acquisition of Viviti Technologies Ltd., until recently known as Hitachi Global Storage Technologies Holdings Pte. Ltd.; • demand for hard drives and solid-state drives in the various markets and factors contributing to such demand; • our plans to continue to develop new products and expand into new storage markets and into emerging economic markets; • our entry into and position in the traditional enterprise market; • emergence of new storage markets for hard drives; • emergence of competing storage technologies; • our share repurchase plans; • our stock price volatility; • expectations regarding the outcome of legal proceedings in which we are involved, including the outcome of our motion to vacate the award entered against us in our arbitration with Seagate Technology LLC and, if necessary, our appeal of the award; 22 -------------------------------------------------------------------------------- Table of Contents • our beliefs regarding the adequacy of our tax provisions and the timing of future payments, if any, relating to the unrecognized tax benefits; • contributions to our pension plans in fiscal 2012; • expectations regarding our capital expenditure plans in fiscal 2012 and calendar 2012, and depreciation and amortization for fiscal 2012;and • our beliefs regarding the sufficiency of our cash and cash equivalents to meet our working capital, capital expenditure and other cash needs. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. You are urged to carefully review the disclosures we make concerning risks and other factors that may affect our business and operating results, including those made in Part II, Item 1A of this Quarterly Report on Form 10-Q, and any of those made in our other reports filed with the Securities and Exchange Commission (the "SEC"). You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this document. We do not intend, and undertake no obligation, to publish revised forward-looking statements to reflect events or circumstances after the date of this document or to reflect the occurrence of unanticipated events. Our Company We are a global provider of solutions for the collection, storage, management, protection and use of digital content, including audio and video. Our principal products are hard drives, which are devices that use one or more rotating magnetic disks ("magnetic media") to store and allow fast access to data. Hard drives are currently the primary storage medium for digital content. Our hard drives are used in desktop and notebook computers, corporate and cloud computing data centers, home entertainment equipment and stand-alone consumer storage devices. In addition to hard drives, we offer solid-state drives and home entertainment and networking products. Acquisition Hitachi Global Storage Technologies Holdings Pte. Ltd. ("HGST") Acquisition On March 8, 2012 ( the "Closing Date"), we, through Western Digital Ireland ("WDI"), our indirect wholly-owned subsidiary, completed the acquisition (the "Acquisition") of all the issued and outstanding paid-up share capital of Viviti Technologies Ltd., until recently known as Hitachi Global Storage Technologies Holdings Pte. Ltd. ("HGST"), from Hitachi Ltd. ("Hitachi"), pursuant to a Stock Purchase Agreement, dated March 7, 2011, among us, WDI, Hitachi and HGST (the "SPA"). The Acquisition is intended over time, and subject to compliance with applicable regulatory conditions imposed on the Acquisition, to result in a more efficient and innovative customer-focused storage company, with significant operating scale, strong global talent and a broad product lineup backed by a rich technology portfolio. The preliminary, aggregate purchase price of the Acquisition amounted to approximately $4.7 billion, which was paid on the Closing Date and funded with existing cash, new debt, and 25 million newly issued shares of our common stock. The cash portion of the purchase price is subject to a post-closing adjustment (an increase or a decrease) that has not been determined for changes in the working capital of HGST and certain other payments and expenses. Following the issuance of the 25 million shares of our common stock to Hitachi in accordance with the SPA, Hitachi owns approximately ten percent of our outstanding shares of common stock. The shares issued to Hitachi are subject to a restriction that limits their trade or transfer for one year from the Closing Date. Pursuant to the terms of a separate Investor Rights Agreement we entered into with Hitachi in connection with the Acquisition, Hitachi has the right to designate two individuals (the "Hitachi Designees") to serve as directors on our Board of Directors. This right will terminate (i) with respect to one of the Hitachi Designees, at the end of the second full calendar year following the Closing Date, (ii) in the event Hitachi ceases to beneficially own at least 50% of the shares of our common stock it received in connection with the Acquisition, (iii) if Hitachi has sold at least 10% of the shares of our common stock it received in connection with the Acquisition, in the event that Hitachi ceases to beneficially own at least 5% of our outstanding common stock, (iv) upon Hitachi's breach of certain standstill or transfer restriction obligations of the Investor Rights Agreement, or (v) upon Hitachi's material breach of a separate Agreement Not to Compete that we entered into with Hitachi on the Closing Date. 23 -------------------------------------------------------------------------------- Table of Contents On the Closing Date, WDC, WDI and Western Digital Technologies, Inc. ("WDT") entered into a five-year credit agreement (the "Credit Facility") with Bank of America, N.A., as administrative agent, swing line lender and L/C issuer, and the lenders party thereto. The Credit Facility provides for $2.8 billion of unsecured loan facilities consisting of a $2.3 billion term loan facility and a $500 million revolving credit facility. The only borrower under the term loan facility is WDI and the revolving credit facility is available to both WDI and WDT. The $2.3 billion term loans and $500 million revolving loans were used, together with additional cash and the 25 million newly issued shares of our common stock, to fund the Acquisition. See "Liquidity and Capital Resources-Contractual Obligations and Commitments" for a further description of the Credit Facility. Maintenance of Competitive Requirement In connection with the regulatory approval process of the Acquisition, we agreed to certain conditions required by the Chinese Ministry of Commerce ("MOFCOM"), including adopting measures to maintain HGST as an independent competitor until MOFCOM agrees otherwise (with the minimum period being two years). We are working closely with MOFCOM to finalize an operations plan that is expected to outline in more detail the conditions of the competitive requirement. Regulatory Conditions In connection with the regulatory approval process, we announced on February 28, 2012 that we had reached an agreement with Toshiba Corporation ("Toshiba") to, subject to regulatory approval, divest certain assets related to the production of 3.5-inch hard drives to address the requirements of regulatory agencies that had conditionally approved the Acquisition. In addition, subject to completion of the divestiture transaction, we agreed to the purchase of Toshiba Storage Device (Thailand) Company Limited ("TSDT") by WDI. The net assets of TSDT consist primarily of real estate and receivables. The divestiture transaction and the acquisition of TSDT are not expected to have a material impact on our consolidated financial statements. This divestiture transaction has received all required regulatory approvals and must be completed within the time periods agreed upon with the jurisdictions whose approval of the Acquisition was conditioned on the divestiture, subject to any extensions that are obtained. Thailand Flooding We suspended production in all of our Thailand manufacturing facilities during the week of October 10, 2011 due to severe flooding in Thailand, where flood waters inundated our facilities and submerged certain equipment located there. The flooded facilities in Thailand included our magnetic head slider fabrication facilities, which supplied a substantial majority of our magnetic head requirements prior to the flooding. The flooded facilities in Thailand also included our hard drive, head gimbal assembly ("HGA") and head stack assembly ("HSA") facilities. In addition to the temporary suspension of our Thailand operations and the internal slider shortages, we experienced other shortages of component parts in the December and March quarters from vendors located in several Thailand industrial parks that were flooded or affected by protective plant shutdowns. Since the flooding, we have restarted and continue to increase hard drive production capacity and have recommenced slider production in Thailand. We are also extending slider production capacity into Malaysia and expect to begin shipping hard drives with sliders produced in Malaysia in the June quarter. We believe we now have the capability to adequately meet anticipated customer demand. In the three and nine months ended March 30, 2012, we recorded $15 million and $214 million of charges related to the flooding, respectively. Total charges in the three months ended March 30, 2012 included $10 million of fixed asset impairments, $22 million of recovery charges and $4 million in wage continuation during the shutdown period of our facilities, offset by $21 million of insurance recoveries and other cost reimbursements. Total charges in the nine months ended March 30, 2012 included $119 million of fixed asset impairments, $61 million of recovery charges, $28 million of write-downs of damaged inventory and $27 million in wage continuation during the shutdown period of our facilities, offset by $21 million of insurance recoveries and other cost reimbursements. We maintain insurance coverage that provides property and business interruption coverage in the event of losses arising from flooding. We have submitted claims to our insurers and are awaiting a determination of how much of our total losses will be covered by insurance. It is reasonably possible that the final losses that we incur in connection with the flood damage and our business interruption will exceed the limits of our insurance policies. 24-------------------------------------------------------------------------------- Table of Contents Third Quarter Overview In accordance with U.S. generally accepted accounting principles ("U.S. GAAP"), operating results for HGST prior to the date of the Acquisition are not included in our operating results, affecting our discussion of changes in our revenues and expenses for the periods prior to the Acquisition as compared to the periods after the Acquisition. For the March quarter, we believe that overall hard drive industry shipments totaled approximately 146 million units, down 9% from the prior-year period and up 23% sequentially from the December quarter. We also believe that the industry growth in the March quarter compared to the December quarter was a result of the industry recovering from the Thailand flooding. The following table sets forth, for the periods presented, selected summary information from our condensed consolidated statements of income by dollars and percentage of net revenue (in millions, except percentages): Three Months Ended Nine Months Ended Mar. 30, Apr. 1, Mar. 30, Apr. 1, 2012 2011 2012 2011 Net revenue $ 3,035 100.0 % $ 2,252 100.0 % $ 7,724 100.0 % $ 7,123 100.0 % Gross margin 977 32.2 410 18.2 2,166 28.0 1,322 18.6 Total operating expenses 435 14.3 252 11.2 1,203 15.6 713 10.0 Operating income 542 17.9 158 7.0 963 12.5 609 8.5 Net income 483 15.9 146 6.5 867 11.2 568 8.0 The following is a summary of our financial performance for the third quarter of 2012: • Consolidated net revenue totaled $3.0 billion. • HGST contributed $614 million to our consolidated net revenue. • 30% of our hard drive revenue was derived from non-compute and enterprise markets, which include CE products, enterprise applications, and branded products, as compared to 36% in the prior-year period. • Hard drive unit shipments decreased by 11% from the prior-year period to 44.2 million units. • Gross margin increased to 32.2%, compared to 18.2% for the prior-year period. • Operating income, including a net $15 million of charges related to the Thailand flooding and $33 million of Acquisition-related expenses, was $542 million, an increase of $384 million from the prior-year period. • We generated $1.2 billion in cash flow from operations in the third quarter of fiscal 2012, and we finished the quarter with $3.4 billion in cash and cash equivalents. For the June quarter, we expect overall hard drive industry shipments to be approximately 155 to 160 million units. We believe there is sufficient capacity in the industry to support demand. As our recovery from the Thailand flooding is essentially complete, we believe our pricing in the June quarter will be reflective of current market conditions. We believe our revenue in the June quarter, which will include a full-quarter of HGST revenue, will significantly increase from the March quarter. 25 -------------------------------------------------------------------------------- Table of Contents Results of Operations Net Revenue Three Months Nine Months Ended Ended (in millions, except percentages and Mar. 30, Apr. 1, Percentage Mar. 30, Apr. 1, Percentage average selling price) 2012 2011 Change 2012 2011 Change Net revenue $ 3,035 $ 2,252 35 % $ 7,724 $ 7,123 8 % Average selling price (per unit)* $ 68 $ 45 51 % $ 59 $ 46 28 % Revenues by Geography (%) Americas 21 % 22 % 21 % 23 % Europe, Middle East and Africa 18 24 20 24 Asia 61 54 59 53 Revenues by Channel (%) OEM 64 % 47 % 59 % 47 % Distributors 28 33 27 33 Retailers 8 20 14 20 Unit Shipments* Compute 34.0 36.3 96.5 111.7 Non-compute 6.6 11.2 26.3 34.2 Enterprise 3.6 2.3 7.7 6.9 Total units shipped 44.2 49.8 (11 )% 130.5 152.8 (15 )% * Based on sales of hard drive units only. For the quarter ended March 30, 2012, net revenue was $3.0 billion, an increase of 35% from the prior-year period. Our newly acquired operations from HGST contributed $614 million in net revenue. Total hard drive shipments decreased to 44.2 million units for the quarter ended March 30, 2012 as compared to 49.8 million units in the prior-year period. For the nine months ended March 30, 2012, net revenue was $7.7 billion, an increase of 8% from the prior-year period. Total hard drive shipments decreased to 130.5 million units for the nine months ended March 30, 2012, as compared to 152.8 million units for the prior-year period. These increases in net revenue resulted primarily from an increase in average selling price ("ASP") and the contribution of the newly acquired operations of HGST, partially offset by a decrease in shipments. For the quarter ended March 30, 2012, ASP increased by $23, from $45 to $68. For the nine months ended March 30, 2012, ASP increased by $13, from $46 to $59. These increases in ASP for the three and nine months ended March 30, 2012 were directly related to the severe supply constraints across the hard drive industry brought about by the Thailand floods. Changes in revenue by geography and channel generally reflect normal fluctuations in market demand and competitive dynamics. However, during the three and nine months ended March 30, 2012, changes in revenue by geography and channel reflected our efforts to allocate products to our customers by balancing their immediate needs with their prevailing inventory positions in order to maximize the availability of hard drive products to the end customer within the shortest time horizon. For the three and nine months ended March 30, 2012, no customer accounted for 10% or more of our net revenue. In accordance with standard industry practice, we have sales incentive and marketing programs that provide customers with price protection and other incentives or reimbursements that are recorded as a reduction to gross revenue. For both the three and nine months ended March 30, 2012, these programs represented 5% of gross revenues, compared to 12% and 11% in the comparative prior-year period. These amounts generally vary according to several factors, including industry conditions, seasonal demand, competitor actions, channel mix and overall availability of product. However, for the December and March quarters, sales incentive and marketing programs were significantly reduced due to the severe supply constraints across the hard drive industry brought about by the Thailand floods. Gross Margin Three Months Nine Months Ended Ended Mar. 30, Apr. 1, Percentage Mar. 30, Apr. 1, Percentage (in millions, except percentages) 2012 2011 Change 2012 2011 Change Net revenue $ 3,035 $ 2,252 35 % $ 7,724 $ 7,123 8 % Gross margin 977 410 138 % 2,166 1,322 64 % Gross margin % 32.2 % 18.2 % 28.0 % 18.6 % For the three months ended March 30, 2012, gross margin as a percentage of revenue increased to 32.2% as compared to 18.2% for the prior-year period. For the nine months ended March 30, 2012, gross margin as a percentage of revenue increased to 28.0% as compared to 18.6% for the prior-year period. These increases were primarily a result of higher ASPs, partially offset by increased costs per unit due to lower capacity utilization, increased use of air freight as opposed to less expensive sea freight, a higher mix of externally procured heads and higher costs for other components, in each case as a result of the impact of the Thailand flooding on our production and supply chain partners. In addition, the Company had an offset to gross margin of $91 million for costs recognized upon the sale of inventory that was written-up to fair value and $9 million for amortization of intangibles related to the Acquisition. In the fourth quarter of fiscal 2012, we estimate intangible asset amortization of $40 million to be included within cost of revenue. 26-------------------------------------------------------------------------------- Table of Contents Operating Expenses Three Months Nine Months Ended Ended Mar. 30, Apr. 1, Percentage Mar. 30, Apr. 1, Percentage (in millions, except percentages) 2012 2011 Change 2012 2011 Change R&D expense $ 265 $ 179 48 % $ 649 $ 515 26 % SG&A expense 155 73 112 % 340 198 72 % Charges related to flooding, net 15 - - 214 - - Total operating expenses $ 435 $ 252 $ 1,203 $ 713 Research and development ("R&D") expense was $265 million for the three months ended March 30, 2012, an increase of $86 million from the prior-year period. For the nine months ended March 30, 2012, R&D expense was $649 million, an increase of $134 million from the prior-year period. These increases were primarily due to the continued investment in product development to support new programs and increases in variable incentive compensation, as well as the inclusion of HGST's R&D activities since the Closing Date. As a percentage of net revenue, R&D expense increased to 8.7% and 8.4% in the three and nine months ended March 30, 2012, respectively, compared to 7.9% and 7.2% in the prior-year periods. Selling, general and administrative ("SG&A") expense was $155 million for the three months ended March 30, 2012, an increase of $82 million over the prior-year period. For the nine months ended March 30, 2012, SG&A expense was $340 million, an increase of $142 million over the prior-year period. These increases were primarily due to incremental acquisition-related expenses of $23 million and $44 million in the three and nine months ended March 30, 2012, respectively, and increases in variable incentive compensation, as well as the inclusion of SG&A expense from HGST since the Closing Date. SG&A expense as a percentage of net revenue increased to 5.1% and 4.4% in the three and nine months ended March 30, 2012, respectively, compared to 3.2% and 2.8% in the comparative prior-year periods. In the fourth quarter of fiscal 2012, we estimate intangible asset amortization of $10 million to be included within selling, general and administrative expense. During the three months ended March 30, 2012, we recorded $15 million of charges related to the flooding, including $10 million of fixed asset impairments, $22 million of recovery charges and $4 million in wage continuation during the shutdown period of our facilities, offset by $21 million of insurance recoveries and other cost reimbursements. During the nine months ended March 30, 2012, we recorded $214 million of charges related to the flooding, including $119 million of fixed asset impairments, $61 million of recovery charges, $28 million of write-downs of damaged inventory and $27 million in wage continuation during the shutdown period of our facilities, offset by $21 million of insurance recoveries and other cost reimbursements. Other Income (Expense) Interest income for the three and nine months ended March 30, 2012 increased $1 million and $3 million, respectively, as compared to the prior-year periods primarily due to higher average daily invested cash balances for the periods. Interest and other expense for the three and nine months ended March 30, 2012 increased $6 million and $11 million, respectively, as compared to the prior-year periods. These increases were primarily due to interest on an increased debt balance and $1 million and $7 million of debt commitment fees incurred prior to the closing of the Acquisition in the three and nine months ended March 30, 2012, respectively. Income Tax Provision Our income tax provision for the three months ended March 30, 2012 was $55 million as compared to $13 million in the prior-year period. Our income tax provision for the nine months ended March 30, 2012 was $88 million as compared to $41 million in the prior-year period. The differences between the effective tax rate and the U.S. Federal statutory rate are primarily due to tax holidays in Malaysia, the Philippines, Singapore and Thailand that expire at various dates through 2023 and the current year generation of income tax credits. In the three months ended March 30, 2012, we recorded a net increase of $45 million in our liability for unrecognized tax benefits. This includes $41 million related to the Acquisition. As of March 30, 2012, we had a recorded liability for unrecognized tax benefits of approximately $277 million. Interest and penalties recognized on such amounts were not material. 27-------------------------------------------------------------------------------- Table of Contents The Internal Revenue Service ("IRS") has completed its field examination of the federal income tax returns for fiscal years 2006 and 2007 for us and calendar years 2005 and 2006 for Komag, Incorporated ("Komag"), which was acquired by us on September 5, 2007. In September 2011, we received a final Revenue Agent Report ("RAR") and Closing Agreement with respect to the years under examination for Komag. This agreement resulted in an immaterial benefit to our income tax provision. We have also received RARs from the IRS that seek adjustments to income before income taxes of approximately $970 million in connection with unresolved issues related primarily to transfer pricing and certain other intercompany transactions. We disagree with the proposed adjustments. In May 2011, we filed a protest with the IRS Appeals Office regarding the proposed adjustments. Meetings with the Appeals Office began in February 2012. In January 2012, the IRS commenced an examination of our fiscal years 2008 and 2009 and Komag's fiscal year ended September 5, 2007. We believe that adequate provision has been made for any adjustments that may result from tax audits. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in our tax audits are resolved in a manner not consistent with management's expectations, we could be required to adjust our provision for income taxes in the period such resolution occurs. As of March 30, 2012, it is not possible to estimate the amount of change, if any, in the unrecognized tax benefits that is reasonably possible within the next twelve months. Any significant change in the amount of our unrecognized tax benefits would most likely result from additional information or settlements relating to the examination of our tax returns. Arbitration Award As disclosed above in Part I, Item 1, Note 5 in the Notes to Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, on November 18, 2011, a sole arbitrator ruled against us in an arbitration in Minnesota. The arbitration involves claims brought by Seagate Technology LLC against us and a now former employee, alleging misappropriation of confidential information and trade secrets. The arbitrator issued an interim award against us in the amount of $525 million plus pre-award interest. On January 23, 2012, the arbitrator issued a final award adding pre-award interest in the amount of $105.4 million, for a total award of $630.4 million. On January 23, 2012, we filed a petition in the District Court of Hennepin County, Minnesota to have the final arbitration award vacated. A hearing on the petition to vacate was held on March 1, 2012. Interest (as simple interest, not compounding) on the final award ($630.4 million) also accrues at the Minnesota statutory rate of 10% per year while we pursue our motion to vacate the award, and if necessary, an appeal if the motion to vacate the award is unsuccessful. We intend to pursue vigorously our motion to vacate the award and, if necessary, to appeal the award if it is confirmed by the District Court of Hennepin County Minnesota. The Company does not believe it is probable that the arbitrator's award will be sustained and accordingly has not recorded any cost or liability for the arbitrator's award in excess of the amount previously accrued by the Company ($25 million). We cannot make any assurances that we will be successful in our efforts to vacate the award or to overturn the award on appeal. If we are unsuccessful in these efforts, payment of the award, including interest, would adversely affect our financial condition, results of operations and cash flows. We will also be required to record a liability for the award if we should determine it is probable we will be required to pay the award. |