Robert Blair - Vice President Investor Relations
Good afternoon everyone.
This conference call will contain forward-looking statements within the meaning of the federal securities laws, including statements concerning: our expected financial performance for our second fiscal quarter ending December 30, 2016; our market positioning and growth opportunities; our strategic platform; integration activities and achievement of synergy goals; demand and market trends; the benefits of our short-term incentive compensation programs; our product portfolio, product features and their benefits, product transitions and other development efforts and customer acceptance of our products; and manufacturing yields and cost improvements. 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 annual report on Form 10-K filed with the SEC on August 29, 2016. We undertake no obligation to update our forward-looking statements to reflect new information or events.
Further, references will be made during this call to non-GAAP financial measures. Reconciliations of the differences between the historical non-GAAP measures we provide during this call to the comparable historical GAAP financial measures will be posted in the Investor Relations section of our website. We have not reconciled our non-GAAP financial measure guidance to the most directly comparable GAAP measures because material items that impact these measures are out of our control and/or cannot be reasonably predicted. Accordingly, a reconciliation of the non-GAAP financial measure guidance to the corresponding GAAP measures is not available without unreasonable effort.
In the question/answer part of today's call we ask that you limit yourselves to one question to allow as many callers as possible to ask their question. I thank you in advance for your cooperation.
With that, I will now turn the call over to our CEO, Steve Milligan.
Steve Milligan - Chief Executive Officer
Good afternoon and thank you for joining us. With me today are Mike Cordano, president and chief operating officer; and Mark Long, chief financial officer. After my opening remarks, Mike will provide a summary of recent business highlights and Mark will cover the fiscal first quarter financials and wrap up with our guidance for the fiscal second quarter.
I am pleased with our performance in the September quarter, our first full quarter as an integrated company following the SanDisk acquisition in May. We reported revenue of $4.7 billion, non-GAAP gross margin of 34% and non-GAAP earnings per share of $1.18 – exceeding our revised guidance in each category.
We continued to experience strong demand throughout the September quarter for both hard drive and flash–based products from all categories of customers, largely driven by cloud and mobility based applications, as well as better-than-expected PC demand and our own outperformance in certain categories. These trends are expected to continue in the December quarter.
We are delivering our financial performance through continued strong execution by the newly combined Western Digital team, demonstrating the power of our broad-based and unique platform. The platform includes an unparalleled breadth of storage product offerings, expanded vertical integration and go-to-market capabilities, an increasing level of customer intimacy and a proven ability to innovate and sustain leadership across multiple storage technologies. We have made significant progress establishing this strategic platform, by combining and leveraging the collective strengths and resources of legacy HGST, SanDisk and WD. Our platform is aligned with our vision of the continued rapid growth of data and its increasing importance in our everyday lives. The power and promise of data is undeniable. It is creating a world that's more predictive, more productive and more personal, enabling smarter decisions, breakthrough discoveries and deeper connections. The Western Digital Platform is at the core of enabling the possibilities of data. It differentiates us from our competitors, and we believe it will drive our company to a future of growth and long-term industry leadership. We are already seeing the benefits of the platform in our differentiated financial results and outlook.
I am very pleased that we have achieved this financial performance while at the same time successfully executing on two top priorities. Namely, the integrations of HGST, SanDisk and WD and the transition to next generation NAND technology. Integration of the three companies is proceeding very well and our synergy achievements are on track. I am also pleased to note that our transition to 3D NAND technology continues to progress as planned, and we will begin a significant commercial ramp of our second generation 3D NAND with 64 layers in the first half of calendar 2017 as previously announced.
Mike Cordano will now report on our business highlights in the September quarter.
Mike Cordano - President & Chief Operating Officer
Thank you, Steve, and good afternoon everyone.
I am pleased with our operational execution and the resulting business performance for the September quarter. The industry supply/demand environment in both HDDs and flash was favorable. With a full quarter of the legacy SanDisk business results integrated into the company, our Q1 report reflects the strength of our broad portfolio addressing a similarly expanded market opportunity. As part of our mission to build a compelling Western Digital platform, we continue to make progress with integrating the HGST and SanDisk businesses and we are on pace with our plan to further streamline our product and technology teams.
Turning to our highlights in the quarter, in datacenter devices and solutions, we delivered solid year-over-year-growth in total exabytes shipped, primarily driven by continued strength in cloud-related demand for our near-line capacity HDDs, with that product category alone driving almost 50% year-over-year growth in exabyte shipped. I am very pleased to report that our industry leading 10 terabyte helium drives gained further adoption at several of our major OEM and cloud customers reflecting the compelling value proposition of this offering. Just two weeks ago, we achieved an important milestone for our HelioSeal platform with cumulative shipments exceeding 10 million units, representing approximately 76 exabytes of storage capacity, since the launch of the platform in late 2013. This technology, now in its third generation, enables even higher density HDDs specifically designed for data center applications and will be able to incorporate future magnetic recording technologies. In datacenter solutions, we are pleased with Softbank's adoption of our InfiniFlash all-flash storage platform for their new software-defined storage solution.
In Client devices, we experienced strong demand for our HDDs and SSDs for PCs as that market continued to show signs of stabilization and we outperformed in both product categories. Our three bits-per-cell based embedded NAND solutions saw increased adoption in mobile phones as this technology offers a compelling value proposition compared to two bits-per-cell based alternatives. I am pleased to note that our embedded three bits-per-cell solutions are now qualified and shipping to the majority of the world's top mobile handset vendors. We are deepening our participation in the automotive, connected home and industrial categories reflecting our commitment to driving innovations beyond the traditional mobile applications. These are important long-term growth opportunities, with longer product cycles, for both our embedded and removable offerings.
Our performance in Client solutions, which includes retail offerings from legacy HGST, SanDisk and WD, was strong during the September quarter and our combined portfolio of Flash and HDD products has generated excellent reception from customers. Following a successful back-to-school sales period, performance in our retail channel remained solid reflecting strength in both demand trends as well as preference for our brands. We demonstrated continued innovation in our removable product categories with the announcement of the world's first one terabyte SD card.
From a NAND technology perspective, we have begun OEM sampling of our second generation 3D NAND technology of 64 layers and we are on track to deliver volume shipments of removable products with this technology in the December quarter. Our previously discussed plan to begin a significant commercial ramp of 64 layer 3D NAND in the first half of calendar year 2017 remains on track. Our first generation of 3D NAND technology with three bits-per-cell in a 48 layer architecture, is shipping in embedded mobile and removable products. We continue to ship products using our 15 nanometer 2D NAND technology which is achieving new manufacturing milestones in terms of yields and cost improvements.
In summary, I am pleased with our first-quarter performance and the execution by our team. The opportunities we are creating through integrating HGST, SanDisk and WD are significant and we are making good progress in setting up Western Digital for long-term growth and success. In the December quarter, we expect overall supply-demand conditions in both HDD and NAND to remain constrained, resulting in favorable industry dynamics. The longer-term drivers of demand for storage are vibrant and we are focused on offering our industry-leading portfolio to drive the best results for our customers and shareholders. With that, I will turn the call over to Mark for the financial discussion.
Mark Long - EVP Finance, Chief Financial & Strategy Officer
Thank you, Mike.
I am encouraged by our financial performance this quarter. Our teams executed well in a solid market environment as we capitalized on our strong product offerings, achieved targeted cost and efficiency improvements and reduced our cost of debt primarily due to two repricing transactions. Our key financial metrics continued to improve following the revised guidance we provided on September 7th due to both favorable market dynamics and consistent execution by our teams.
Our revenue for the September quarter was $4.7 billion dollars, driven by strong performance across each of our end markets. Revenue in Data Center Devices and Solutions was $1.4 billion dollars, Client Devices was $2.3 billion dollars and Client Solutions was $1.0 billion dollars. Our Data Center revenue growth continues to be driven largely by Cloud related storage demand. As a result we saw continued strength in capacity enterprise HDDs, stable demand for performance enterprise HDDs, as well as positive market dynamics for enterprise SSDs. Client Devices benefited from seasonally strong demand for HDDs in gaming and PC applications as well as Flash-based products in PCs and mobile handsets. In Client Solutions, our revenue grew as a function of seasonality and healthy demand for removable and other Flash-based products.
Our non-GAAP gross margin was 33.6% percent, which was up 260 basis points versus the June quarter. We were able to achieve this margin expansion through continued product cost improvements and better than anticipated pricing for certain HDD and Flash products. Our product cost improvements resulted from increased volumes, consistent execution and ongoing progress with our integration activities. Gross margin also benefited from our first full quarter of Flash revenue, which helped to offset the seasonal increase in lower margin HDD gaming revenue, the latter of which typically peaks in the September quarter.
Turning to the discussion of operating expenses, our non-GAAP operating expenses totaled $952 million dollars. We incurred higher short-term incentive compensation due to stronger business performance which nonetheless was partially offset by continued progress towards our integration synergy targets. Let me take a few moments to explain our short-incentive compensation program. It is based on goals set on a semi-annual basis. We believe this semi-annual approach to incentive compensation allows us to effectively navigate changing market environments. To understand the underlying business performance, it is useful to normalize these payments across periods. For example, the payouts in the first six months of calendar 2016 were significantly below target while the payouts for the second half are currently expected to be above target. As a result the annualized payout would be at a roughly 100% target level.
Non-GAAP interest and other expense for the quarter was $227 million dollars. On August 17th we reduced our US Term Loan B balance by $750 million dollars through a voluntary prepayment and repriced the remaining $3.0 billion dollar balance. On September 22nd, we repriced our Euro denominated Term Loan B with a balance of 885 million Euros. The aggregate annual non-GAAP and cash interest savings from the two repricing transactions are approximately $150 million dollars and $120 million dollars, respectively, on a going-forward basis. These transactions resulted in $267 million dollars of debt extinguishment charges in our GAAP interest and other expenses, $227 million dollars of which were non-cash charges.
Our non-GAAP effective tax rate for the September quarter was approximately 16%, within our expected range of 15-20% for this period.
On a non-GAAP basis, net income in the September quarter was $341 million dollars, or $1.18 per share. On a GAAP basis we had net loss of $366 million dollars, or $1.28 per share. The GAAP net loss for the period includes charges associated with our recent acquisitions, debt extinguishment charges related to our repricing and repayment of outstanding debt. Essentially, the entire net difference between our GAAP and non-GAAP net income is a result of non-cash charges.
In the September quarter we generated $440 million dollars in cash from operations with $210 million dollars spent on capital investments, resulting in free cash flow of $230 million dollars.
We also declared a dividend in the amount of $0.50 cents per share.
We closed the quarter with total cash and cash equivalents of $4.1 billion dollars compared to the June quarter end balance of $8.2 billion dollars. The decrease was primarily driven by repayment of $4.2 billion dollars of debt, consisting of the acquisition bridge loan, US Term Loan B and SanDisk convertible debt.
As Steve and Mike indicated, we have continued to make very good progress with respect to our integrations. From a synergy standpoint, we remain on track to achieve the $800 million dollars of annualized savings from the HGST integration by the end of calendar 2017 and expect to exit the December quarter of this year having achieved more than $175 million dollars of cost of revenue synergies and approximately $300 million dollars of operating expense synergies, each on an annual run-rate basis. With respect to the SanDisk integration, we expect to exit the December quarter having realized synergies of approximately $130 million dollars on an annual run-rate basis, toward our 18 month target of achieving $500 million dollars of total run-rate synergies on an annualized basis.
Now, I would like to describe a change we are implementing in our non-GAAP reporting beginning with our December quarter. To better reflect the performance of the underlying business operations in our results and to be more consistent with the majority of our technology peers, we will be excluding stock based compensation expense from our non-GAAP results. All future guidance, including today's for the December quarter, will be on this basis. The stock based compensation portion of our total operating expenses is typically between $75 and $85 million dollars per quarter. If we had made this change in our September quarter, our non-GAAP operating expenses would have declined $89 million dollars from $952 million dollars to $863 million dollars. Our non-GAAP cost of revenue would have also decreased $15 million dollars, and our non-GAAP tax expense would have been reduced $3 million dollars. The total stock based compensation expense impact would have increased non-GAAP net income by $107 million dollars to $448 million dollars. Non-GAAP EPS would have increased from $1.18 to $1.54. We are posting this data with some historical comparisons on the investor relations section of our website for your information.
With that, I will now provide our guidance for the December quarter on the new non-GAAP basis excluding stock based compensation expense.
While the September quarter is typically the high point of our revenue due to seasonality, we expect our December quarter revenue to be equally strong due to the continuation of favorable industry dynamics and the success of our broadened product portfolio. As such, we now expect revenue in our December quarter to be approximately flat to the September quarter.
On a non-GAAP basis:
- We expect gross margin to increase to approximately 35%, driven by improved product mix reflecting lower gaming volume and outperformance in other key areas. I would like to note that we have only included half a quarter of license and royalty revenue from our cross-license agreement with Samsung, which as you know, expired on August 14th and under which revenue is recognized one quarter in arrear. We remain in constructive negotiations with Samsung working toward a new agreement and will provide further updates as the situation changes.
- Turning to operating expenses, we expect those to total approximately $805 million dollars, which includes higher variable compensation expense given our outperformance of the targets set for the first 6 months of our fiscal year.
- Interest and other expense is expected to be approximately $205 million dollars reflecting a full quarter benefit from our lower interest expense and amortization of debt issuance costs from the debt repricing and pay down transactions.
- We expect an effective tax rate in the 14-16% range
- As a result, we expect non-GAAP earnings per share between $1.85 and $1.95 with an estimated share count of 293 million diluted shares. I would note, on our previous non-GAAP basis, including stock based compensation expense, the high end of our earnings per share guidance would have been approximately $1.60.
At our Investor Day on December 6th, we will provide a deeper dive into our strategy, business operations, technology capabilities and long-term financial model, which should give further clarity on what we expect to deliver across key financial metrics for the new Western Digital.
I will now turn the call over to the operator to begin the Q&A session. Operator?
I want to thank you for joining us today. We look forward to seeing many of you at our Investor Day on December 6.