WESTERN DIGITAL FIRST QUARTER ENDED OCTOBER 1, 2010 CONFERENCE CALL REMARKS, 10/19/10

Special Note

Statements in these posted remarks that relate to future results and events, and other forward-looking statements in these remarks, are based on Western Digital Corporation’s current expectations.  Actual results in future periods may differ materially from those currently expected or desired because of a number of risks and uncertainties.  These risk factors include:

  • the impact of continued uncertainty and volatility in global economic conditions;
  • supply and demand conditions in the hard drive industry;
  • actions by competitors;
  • unexpected advances in competing technologies;
  • uncertainties related to the development and introduction of products based on new technologies and expansion into new data storage markets;
  • business conditions and growth in the various hard drive markets; pricing trends and fluctuations in average selling prices;
  • changes in the availability and cost of commodity materials and specialized product components that WD does not make internally; and
  • other factors listed in our periodic SEC filings and on this website in Risk Factors.

Robert Blair - Investor Relations

I want to mention that we will be making forward-looking statements in our comments and in response to your questions concerning: the role and growth of digital content; growth opportunities for storage companies and our responses thereto; industry inventory, pricing and demand; our business model; our position in the industry; the total available market for hard drives in the December quarter; our expected capital expenditures, depreciation and amortization and tax rate for fiscal 2011; our share repurchase plans; and our financial results expectations for the December quarter, including revenue, expenses, tax rate, share count, and earnings per share.  These forward-looking statements are based on management’s current expectations and are subject to risks and uncertainties that could cause actual results to differ materially, including those listed in our 10-K filed with the SEC on August 13, 2010. We undertake no obligation to update our forward-looking statements to reflect new information or events, and you should not assume later in the quarter that the comments we make today are still valid.

I also want to note that copies of remarks from today’s call will be available on the Investor section of Western Digital’s website immediately following the conclusion of this call.

 

John Coyne - President & Chief Executive Officer

Good afternoon and thank you for joining us today. With me are Tim Leyden, recently named chief operating officer, and Wolfgang Nickl, our newly-appointed chief financial officer.

Although my titles of president and CEO are unchanged, my emphasis has shifted to how we can best leverage our resources to accelerate our growth in the years ahead.  As the new leader of all WD operations and keeper of our low cost model, Tim will discuss current industry dynamics and the company’s performance in the September quarter, while Wolfgang will report on our financial results and provide our outlook for the December quarter.

With the advantage of a deeply experienced, dedicated and passionate team, we are excited as we lead WD into its fifth decade.

As we look out over the next 10 years, the role of digital content in our daily lives at home and in the workplace will become increasingly ubiquitous with the explosion of data and video-rich-applications creating huge amounts of digital content that need to be stored and managed. This will be driven by both the traditional computing markets and by new or evolutionary platforms such as handheld devices, televisions and other home entertainment devices where the analog to digital conversion is in its infancy. In addition to the continuing growth of traditional PC platforms, the growth of cloud computing, tablet computing, and the proliferation of smart-phones creates a myriad of opportunities for storage companies in traditional hard drive and emerging solid state drive markets. 

We will shape the future of WD by sorting through all of these opportunities and acting decisively in our core business and in our business development efforts to continue delivering value to customers and shareholders. You have seen some early indications of one new strategic direction for WD, into the movement of data and content around the home, with our WD TV Live media players, our WD My Book Live network storage solutions and most recently our WD LiveWire powerline network offering.  Going forward we are looking for ways in which to pursue strategic growth initiatives such as this, both organically and through acquisition.

Turning to the current hard drive industry environment, we are again reminded that this is a competitive industry of seasons and cycles.  The management of supply and demand remains an imperfect science. The moderation in industry demand growth in the last two quarters came on the heels of an unprecedented four quarters of strong sequential growth coming out of the Great Recession. As an industry we clearly over-shot the recent market demand and we have spent the last six months correcting for that. We believe this will prove to be an interlude to a resumption of the industry’s traditional cadence of growth over the last 10 years.  Having said this, it is important to note that growth has not disappeared in the hard drive industry post-recession. Expected year-on-year volume growth in calendar year 2010 of 15 percent brings the five year industry CAGR, which includes the recession of late 2008, to about 11 percent, while the average growth rate over the last 10 years has been 12.5 percent.

In the last two quarters, some competitors have made aggressive bids to recover market share. This is a scenario we have seen play out from time to time over the years in the drive industry. Our observation is that these are temporary skirmishes which do not derail our fundamental long term profitable growth story, as we address these challenges with the tested business model we have developed and honed over time.

For the last 10 years, WD has been navigating these industry swings and consistently winning share with our focus on customer value by having the lowest cost model in the industry.  We have grown revenues by 18 percent annually over the last ten years and by 22 percent annually for the last five years, by providing exceptional value to our customers through the high quality, reliability, and desirability of our products along with predictable availability and competitive prices.  At the same time, we have expanded our full year gross margins from 11 percent in 2001 to 24 percent in 2010.  This was accomplished primarily through successful vertical integration, expanding our product breadth, delighting our customers, and execution of our low cost model. We will continue with this approach as we go forward.

Tim Leyden will now comment on how the September quarter played out for WD and the industry…


Closing Remarks
In closing, I’d like to thank you all of you for joining us today. We appreciate your questions and interest in the company and the industry and we look forward to seeing you again in another quarter.

 

 

Tim Leyden - Chief Operating Officer

As John indicated, we have navigated through multiple market-driven supply/demand imbalances in the hard drive industry and WD remains prepared to address them with what we believe is the industry’s lowest cost model.  Continuing our unwavering focus on low cost leadership is my top priority in my new position. This coupled with a focus on staying on the industry areal density curve, a continued appreciation of customer needs and a broad and diverse set of competitive product offerings in all segments will keep us in an advantaged position.  This proven approach to the hard drive business has served us, our customers and our shareholders well over the last 10 years.

As John mentioned earlier, we saw an unprecedented four consecutive quarters of increasing hard drive shipments from April 2009 to March 2010, and it is now apparent that we have been experiencing a correction of PC makers’ inventories beginning in the June quarter of this year.  Despite weak demand for the first two months of the September quarter and a quieter than normal Back-to-School season, industry shipments nevertheless climbed towards the high end of our 165 million unit forecast for the September quarter, but to accomplish this, shipment volumes in week 13 were over twice the average of the previous 12 weeks. 

In light of the sluggish demand in July and August, we reduced our build plans for September, delayed our capital spending and selectively stepped back from participating in some very aggressive pricing at the end of the quarter. The lower than expected demand earlier in the quarter led to a build-up of manufacturer’s inventory during the first 8 weeks of the quarter and, contrary to prior fiscal first quarter historical trends, this contributed to aggressive pricing during the remainder of the quarter. We maintained share in the 3.5-inch market and yielded 1.5 points of share in 2.5-inch as a result of our temporary pullback.  We exited the quarter with well controlled inventories in each of our segments.  

We expect that the incremental part of the week 13 shipment will be consumed during the current quarter, because customers will not wish to carry this inventory into a seasonally weaker March quarter, and we believe this sets the stage for a TAM in the December quarter that will be essentially flat with the September quarter.

We believe that HDD hardware and software are pivotal to the data and content management infrastructure ecosystem. The value delivered is not proportionately rewarded in the broader marketplace, particularly when the level of unique skills and investments in technology and capital are taken into consideration.  Consequently, we are in the midst of reviewing the comparative returns on investment that we are currently achieving across our customer and product ranges with a view to reaching the levels of ROI we need in order to continue investing and to provide the product availability that the market demands. As the industry’s lowest cost provider, we believe that it is in the best interests of our customers and shareholders that we offer products at a price that covers the costs of doing business and provides the margin and the funding required to continue investing in order to remain a valued HDD supplier on a long-term sustainable basis.

Looking at our served markets in the September quarter, in the compute space we saw a continuation of softness in consumer demand in all channels with somewhat of an offset coming from healthier desktop and commercial notebook demand. We expect desktop demand to be marginally down and notebook demand to be marginally up in the December quarter.

In the enterprise segment we saw continued demand strength particularly in Enterprise SATA with the traditional enterprise segment being essentially flat sequentially.  We expect overall enterprise demand to show some modest growth in the December quarter.

In the non-compute space, we saw the CE market volumes decline marginally quarter-on-quarter as the market tracked historical seasonal demand patterns. At the same time, the Branded Products market showed seasonal demand strength with both 3.5-inch and 2.5-inch categories showing growth.

We expect the non-compute space to be essentially flat in the December quarter as healthy volume increases in Branded and CE are offset by the seasonal decline in gaming volumes.

Geographically, Asia showed continued strength, Europe showed the best comparative improvement from the previous quarter helped by the currency appreciation, while the U.S. market was up modestly from the prior quarter.

We shipped 50.7 million units in the September quarter, up 15 percent from the year-ago period, while the overall market grew by 8 percent. Revenues totaled $2.4 billion, gross margin was 18.2 percent and we remained solidly profitable with net income of $197 million. Importantly, we continued to generate strong cash flow from operations of $390 million.

We continue to invest in the business and are doing so by improving and expanding our operations and by enhancing our product lineup, both in our industry-leading hard drive offerings and in the nascent but promising market for management of content in the home.

In our traditional businesses: 

  • We delivered new models of our popular My Book and My Passport external hard drives with USB 3.0 connectivity and up to 3 terabytes of storage, significantly improving content transfer speeds and providing our customers with future-proofing as newer PCs and other devices begin shipping in volume with USB 3.0;
  • And in the component space we began shipping the highest areal density 3.5-inch hard drive in the industry, the WD Caviar Green 3 TB, which fits 750 GB on each of its four platters.

Reflecting our increasing focus on enabling a comprehensive and easy-to-use experience for management of content in the home, we have added several new products and features, including:

  • The WD LiveWire Powerline AV Network Kit, a HomePlug AV compatible solution that enables consumers to use their existing electrical wiring to extend secure high-speed Internet connections throughout the home;
  • The My Book Live home network drive which gives consumers the fastest storage of - and access to - their content and provides a seamless setup for centralizing digital media in the home;
  • The 1 TB WD Elements Play Multimedia drive with High Definition capability on board, and
  • We also recently introduced the newest version of WD Photos, our photo viewer application now optimized for the iPad,
    the iPhone 4 and iPod touch. WD Photos enables users to view photos stored on their WD home network drives from any location.

I will now turn the call over to Wolfgang Nickl for a review of our Q1 financial performance and our outlook for the second quarter.

 

Wolfgang Nickl - Senior Vice President Finance & Chief Operating Officer

I would like to refer you to a new and expanded summary of financial information that has been posted to the Investor Relations section of our website.  Much of the data that we have recited during past conference calls is included in that fact sheet.  During my prepared remarks, I will focus on highlights and significant changes in some of our key metrics.  At the end of this call, the summary of financial information will be updated to include our
Q2 guidance, which I will discuss in a few moments.

The September quarter was characterized by unusually aggressive pricing that lasted throughout the quarter, with like-for-like price declines in excess of 8 percent.  Pricing pressure was most prevalent in the 2.5-inch segment.  We made a conscious decision to limit our participation in this segment in an effort to optimize profitability.  Our flexible operating model allowed us to adjust our operating expenses to offset the impact of pricing on operating margin and close the quarter near the midpoint of our EPS guidance range.  We actively managed capital receipts and working capital and generated significant free cash flow.

Revenue for the first fiscal quarter was $2.4 billion, up 9 percent from the prior year and 1 percent sequentially. This included $51 million of sales of media from our newly acquired Singapore media facility to fulfill contractual obligations carrying over from Hoya’s existing sales commitments. We do not expect any external media sales in Q2.  Hard drive shipments totaled 50.7 million units, up 15 percent from the prior-year period and 2 percent sequentially. Revenue from sales of WD TV Media Players, WD Livewire Network Kits and solid-state drives totaled approximately $33 million, roughly flat with the prior year and up 22 percent from the June quarter.

Average hard drive selling price was approximately $46 per unit, down $3 from the year-ago quarter and down $1 from the June quarter.

Revenue from sales of our branded products, including WD TV and WD Livewire products, was $425 million, up 11 percent from $382 million in the year-ago quarter and 6 percent sequentially from $400 million in the June quarter. 

There was no customer that comprised 10 percent or more of our total revenue.

Our gross margin for the quarter was 18.2 percent, down from 23.3 percent in the year-ago quarter and down from 22.5 percent in the June quarter.  The lower than expected gross margin percentage was primarily due to the price declines I referred to earlier.  Product and segment mix, as well as product cost decline, were largely in line with our expectations.  

Total R&D and SG&A spending was $226 million, or 9.4 percent of revenue. This compares with $195 million, or 8.8 percent of revenue in the year-ago quarter, and $242 million, or 10.2 percent of revenue in the June quarter.  As a reminder, total operating expenses for the June quarter included $27 million of litigation settlements. 

Operating income was $211 million, or 8.8 percent of revenue.  This compares with $319 million, or 14.4 percent of revenue in the year-ago quarter, and $293 million, or 12.3 percent of revenue in the June quarter.

Net interest and other non-operating expenses were less than $1 million.

Tax expense for the September quarter was $14 million, or 6.6 percent of pretax income.

Our net income totaled $197 million, or $0.84 per share.  This compares with $288 million, or $1.25 per share, and $265 million, or $1.13 per share in the year-ago and June quarters, respectively.

Turning to the balance sheet, we generated $390 million in cash flow from operations during the September quarter.

Our cash conversion cycle for the first quarter was a negative 3 days. This consisted of 50 days of receivables outstanding, 26 days of inventory or 14 turns, and 79 days of payables. 

Capital additions for the September quarter totaled $200 million, lower than our July projection of $275 million, as we scaled back in line with lower shipments.  Depreciation and amortization expense for the first quarter totaled $150 million.

We continue to expect our capital expenditures for fiscal 2011 to be between 7 percent and 8 percent of revenue, with an additional $200 million related to our 6-inch to 8-inch wafer conversion and some expenditure to optimize the output from our recently acquired media facility in Singapore.  Depreciation and amortization is expected to be about $630 million for the fiscal year.

We made $25 million of debt repayment installments during the first quarter, and thereby reduced our debt balance to $375 million.

We exited fiscal Q1 with cash and cash equivalents of $2.9 billion, an increase of $124 million from the June quarter. 

During the quarter, we repurchased 1.8 million shares at a total cost of $50 million. The balance remaining on our stock repurchase authorization is $416 million.

From a balance sheet strategy perspective, our first priority is to create shareholder value through strategic investments both in markets currently served and adjacent markets. Any larger-scale share buybacks would be considered only after we have exhausted our strategic options.

Now, turning to our expectation for fiscal Q2.

Historically industry shipments increase by 5 to 7 percent from the September to the December quarter. As Tim mentioned, we have seen approximately twice the shipment volume in the last week of last quarter than in average of the preceding 12 weeks of the quarter.  We believe that customers will not want to carry extra inventory into the March quarter and therefore expect some inventory correction. We consequently assume that the December quarter industry TAM will be roughly flat with the September quarter at around 165 million units.

Some of the aggressive pricing we have seen last quarter has carried over into this quarter and our guidance includes like-for-like price declines of approximately 5 percent. We are actively reviewing our planned shipment portfolio to identify business that is not meeting our business model requirement. Where contractual obligations do not exist we may reduce our shipments of low contribution products and seek to shift sales to more profitable segments.

As previously indicated, we are currently calibrating our new Singapore Media facility to our own recipes and as a result we are experiencing a dilution of gross margin of 50 basis points during this quarter.

Accordingly, our guidance for fiscal Q2 is as follows:

We expect revenue to be in the range from $2.3 billion to $2.4 billion. 

R&D and SG&A spending is expected to total approximately $230 million. 

Our net interest expense is projected to be about $1 million.

We expect our tax rate to be within our business model of 6-9 percent.

We anticipate our share count to be approximately 235 million.

We estimate earnings per share of between $0.50 and $0.60 for the December quarter.

Operator, we are now ready to open the call for questions.