WESTERN DIGITAL SECOND QUARTER ENDED DECEMBER 31, 2010 CONFERENCE CALL REMARKS, 01/18/11

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 total available market for hard drives in the March quarter and in 2011; industry capital expenditures for 2011; our growth rate and growth plan for 2011; our growth opportunities in the medium to long term; our position within the storage industry; our inventory holding and supply demand balancing in the March quarter; our expected capital expenditures, depreciation and amortization and tax rate for fiscal 2011; our share repurchase plans; our financial results expectations for the March quarter, including revenue, gross margin, 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-Q filed with the SEC on October 29, 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.

 

John Coyne - President & Chief Executive Officer

Good afternoon and thank you for joining us. With me on our Q2 call are Tim Leyden our chief operating officer and Wolfgang Nickl our chief financial officer.

Calendar 2010 was a year of tremendous opportunity for the hard drive industry with 651 million drives shipped, that's 330 million terabytes of storage capacity sold into a broadening set of applications and markets. At 16 percent, this was the industry’s strongest full year unit growth in five years. Rotating magnetic storage remains the dominant technology solution for high volume, mass storage of digital content in both the consumer and commercial markets. Full-year revenue for the industry expanded by some 13 percent to $34 billion.

However, it was also a year of significant missed opportunity as the industry’s supply/demand dynamic deteriorated as the year progressed, resulting in sharply declining ASPs, with the final quarter demonstrating a year-over-year decline in industry revenue of 7 percent on a unit increase of 4 percent, and  an even sharper decline in profitability.

WD again outperformed the industry in calendar 2010—we grew units 23 percent, revenues by 19 percent and operating income by 12 percent.  The operating income number reflected the significant challenge of the industry’s ASP deterioration that emerged in mid year. While we improved our financial performance sequentially in the December quarter, we are far from happy that we failed to monetize our growth throughout the year and generate the kind of return needed to sustain robust investment in technologies and products to improve our customers’ future experience.

In the coming year, we expect the hard drive volume opportunity to approach 700 million units, representing a storage capacity of approximately 440 million terabytes.  Our estimate of the investment required by the hard drive community, including our component suppliers,  to support this growth is approximately $5 billion. So the need for the industry to perform well enough to sustain its critical role in the digital ecosystem should be clear—to us, to our customers and to their customers.

In reviewing how we can improve our future performance, we have identified a misalignment in how our industry typically begins the calendar year from a production standpoint, in contrast with the underlying demand trend of PCs, our largest served market. We are determined to start this year with the benefit of lessons learned from this analysis and Tim and Wolfgang will elaborate on this approach later in this call.

In addressing the calendar year 2011 market opportunity, we expect to continue to grow faster than the overall market by providing greater customer value and satisfaction than competition. We will continue to leverage our cost advantage and our relentless focus on high quality, reliability and availability of product, especially in the industry’s fastest growing market segments.  We believe we can achieve this growth plan while at the same time improving the way in which we approach the supply/demand dynamic from the outset of the year.

In the medium to long term, we are focused on multiple growth opportunities in both our core business and beyond: 

  • First,  as I have said, we intend to continue to grow in our existing hard drive segments by providing superior availability, quality, reliability and value—a proven approach that has established us as a leading supplier in each of our served markets today.
  • Second, we will leverage that same approach into the underpenetrated markets for WD of gaming and traditional enterprise. We have recently introduced our second generation SAS product for the traditional enterprise market along with our first SAS offering for the high capacity near-line storage market and we believe our commitment and measured approach to these important markets will earn significant share as we deliver a succession of outstanding products to customers in the years ahead.
  • Third, we are focused on growing our storage presence beyond rotating magnetic media through our leadership in the embedded SSD space and our planned entry into the tier zero enterprise segment for SSD, when that market evolves into a significant and profitable market opportunity. In the context of solid state technology, we also continue to evaluate the opportunity to combine rotating magnetic storage with flash into hybrid solutions.
  • Fourth, as highlighted earlier this month at our analyst briefing at the Consumer Electronics Show, we are expanding our TAM [Total Available Market] by addressing the connected digital home market with products that integrate and bring to life consumers’ personal and premium digital content.  The acceleration of digital content-creation offers almost unlimited opportunities for those smart enough to feel the pulse of the consumer and provide solutions to address the need to safely store, share and experience this growing mass of content both private and public. This growth is being driven by relentless innovation in hardware and software which in turn is enabling and encouraging new usage models, such as social media, which all compound to proliferate content and copies of content throughout the world.

At WD we view every device or system which enables and encourages content creation or consumption—including tablets—as a potential opportunity for expanded market participation--either directly or indirectly. Since fiscal 2004, WD has been at the forefront of the still nascent market for branded storage and connected home products, with 85 million WD branded products sold to consumers, including 2.5 million WD TV® media players. We believe this market has the potential to generate significant growth for WD in the years ahead.

We will continue to review opportunities to invest in, and expand our presence in these and additional aligned markets in the months ahead as part of our strategic evaluation of how to best create value for our shareholders.

We're excited about the changing landscape  of the digital ecosystem, which we see filled with opportunity for WD.  Managing through changing times is in our DNA at WD. We would like to remind investors that we are entering the fourth decade in the  storage solutions  marketplace, with some valuable experiences and lessons learned along the way. Very early on, we were one of the world’s leading suppliers of specialized semiconductors to the calculator industry. Beginning in the early 80s, we were the leading maker of stand-alone storage controllers for the original PC, before we entered the hard drive business in 1988. Today, we are the world’s unit volume leader in hard drives, having evolved from an exclusively desktop player to a broad-based, vertically integrated supplier to multiple market segments, with an established consumer brand.  So we have seen change and successfully embraced it throughout our history.

We believe there is no one better-positioned in the storage industry today than WD. We have a track record of good, crisp decision-making and execution, a healthy balance sheet to enable prudent and smart investments and a business model that has generated sustained and consistently profitable growth. We remain focused on extending this trend. 

Tim Leyden will now cover the operational developments and highlights of the December quarter.

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. We look forward to seeing you again in another quarter.

 

Tim Leyden - Chief Operating Officer

The December quarter industry TAM came in at 167.5 million units compared with the 165 million units that we had forecast.  Demand was reasonably linear and our expectation that industry participants would be cautious about carrying excess inventory out of the December quarter proved correct as we saw a moderation of the over-weighting of work-week 13 shipments that had occurred in both the June and September quarters.

Looking at our served markets in the December quarter, in the compute space units increased from 114 to 118 million.  Commercial demand remained strong and while overall consumer demand was below expectations, demand for hard drives was further tempered by inventory reductions both in the system supply chain and in the distribution channel.  While OEM PC shipments increased by nearly 4 percent sequentially, HDD shipments increased by only 2 percent leading to a reduction in inventory within the PC manufacturers pipeline.  We also saw better matching of build to true demand in the industry as a whole, which resulted in more linear shipments throughout the quarter and less pressure to ship higher volumes later in the quarter.

The near-line enterprise market was down sequentially from 6.1 to 5.7 million units.  We believe this was a reflection of the fact that this segment’s demand is driven by large discrete project expenditures  which drives lumpier demand patterns. On a full year basis this segment grew by 50 percent in calendar year 2010, and now accounts for around 40 percent of enterprise shipments and will continue to be a high growth area for the industry.

After a  three year period below its’ previous demand highpoint, the traditional enterprise market – at 8.3 million units - returned close to its pre-recession level of 8.5 million, reflecting a continuing recovery in the commercial market.  For the first time, shipments of the 2.5-inch platform exceeded shipments of the 3.5-inch form factor validating our decision to direct our traditional enterprise investments towards 2.5-inch SAS.

The HDD manufacturer’s TAM [Total Available Market] in the branded product segment was at 14.7 million units, up from 11.6 million units in the September quarter and 11.3 million units in the year-ago quarter, presenting further evidence of continuing strong consumer demand for personal storage.

In the DVR market segment, TAM was 12.1 million units, down sequentially from 13.2 million and up year-on-year from 11.3 million units.

The balance of the TAM is represented by gaming, automotive and 1.8-inch drives.

We shipped 52.2 million units in the December quarter, up 5.5 percent from the year-ago period and 3 percent sequentially, while the overall market grew by 4.4 percent and 2.1 percent respectively. Revenues totaled $2.475 billion, we expanded gross margin by 19.2 percent and we remained solidly profitable with net income of $225 million. Importantly, we continued to generate strong cash flow from operations of $505 million.

We are pleased that the moderating steps that we started in the September quarter relative to pricing, production builds, inventory alignment, and capital expenditure achieved the desired result of keeping us within our business model parameters in the December quarter.  Combined with a heightened emphasis on cost management, those actions contributed to our results being significantly better than we had guided in our October earnings call.  We continue to focus on satisfying customer needs, staying on the industry areal density curve, and providing competitive products while at the same time maintaining industry cost leadership.

Consistent with the plans that we laid out in our October call, we optimized our profitable participation in the market in the December quarter while continuing to satisfy customer requirements.  The adaptability of our business model enabled us to optimize mix and that together with pricing discipline, and tight cost management including accelerated cost improvements from our recently acquired Singapore media facility, contributed to our better than expected gross margin.  Despite this, we still fell short of the profitability levels that we would normally have expected to achieve in what has traditionally been ours and the industry’s most profitable quarter of the year.  This is a direct result of the cumulative impact of higher price declines than normal in both the June and September quarters.  As a reminder, based on historical achievements in past December quarters, ordinarily we would expect that the gross margin percentage would be above the mid-point of our margin model range of 18 to 23 percent and we are not happy that our fiscal Q2 gross margin performance at 19.2 percent is well below the mid-point of that range as we head into the more seasonally challenging quarters of the year.

While inventories in the HDD supply chain exiting the quarter were well controlled in each segment, we still believe that despite a reduction of approximately 2 to 3 million HDDs in the PC supply chain there is still an inventory excess of some 6 to 8 million HDD units in the PC manufacturers  pipeline and this will place additional downward pressure on the HDD TAM in the March quarter.

Bearing that in mind, we intend to depart from what has been the industry’s typical approach to inventory holding and supply demand balancing in the March quarter.  Historically, over the last decade, PC volumes have shown an average unit volume decline of around 9 percent sequentially when March quarters are compared to the immediately preceding December quarters. Despite that PC industry historical demand trend, the HDD industry has typically shipped volumes that were down approximately 4 percent sequentially during the same period as HDD producers attempted to utilize the capacity that had already been put in place to service the seasonally stronger December quarter volumes.  The consequence of this mismatch in unit volume trends between the PC and HDD industries has been to put pressure on March quarter pricing, contribute to an inventory overhang exiting the March quarter, and consequently exert further pricing pressure in the June quarter which has repeatedly seen the weakest seasonal demand profile.  Consequently, although we believe that end-user demand will be around 160 million units, we are forecasting an HDD TAM of 155 million units for the March quarter as we anticipate some further flushing of excess inventory in the PC pipeline.

Additionally, we expect volumes in DVR, Branded Products and Enterprise segments to be seasonally flat to down sequentially.

Despite the slower start to the calendar year, we expect to see mid to high single digit HDD volume growth in calendar 2011.

Now turning to our product line–up, we continue to focus on opportunities in the fastest-growing market segments which remains a key strategy for WD. Since our last report, we introduced new products and software that enable consumers to easily move data and content into, around, and outside the home and experience their collections of movies, photos and music, as well as premium content on the Internet.

  • We launched the new flagship of our popular WD TV® media player family of products, the WD TV® Live Hub, which centralizes and streams movies, photos and music to any connected screen in the home with its 1 TB capacity, media server capability, and seamless connection to premium content services such as Netflix, Blockbuster OnDemand and Facebook.
  • We updated our other WD TV products with premium online services first introduced on WD TV Live Hub.
  • With an update to our WD Photos™ application, we enabled Android smartphone users with the ability to access all their photos residing on My Book® Live™, My Book® World Edition™, and WD ShareSpace™ network drives, from anywhere in the world that they can connect to the Internet – a feature also available for the iPad, iPhone, and iPod touch.
  • In our core hard-drive business, we began shipping the WD Scorpio® Black™ mobile drive in 750 GB capacity for the road warrior who needs  its 7,200 RPM high performance and the capacity to carry an entire media collection while traveling.

Earlier today we underscored our long-term commitment to the enterprise segment by bolstering our product portfolio with two new drive families:

  • Our second-generation 2.5-inch, 10,000 RPM WD S25 SAS drive for mission critical, high-performance server and storage applications, available in both 450 GB and 600 GB capacities; and
  • The new 7,200 RPM WD RE SAS 3.5-inch drive, available in 1 TB and 2 TB capacities, for nearline applications – a large and expanding market serving IT data centers and cloud computing applications.

I will now turn the call over to Wolfgang Nickl for a review of our Q2 financial performance and our outlook for the third quarter.

 

Wolfgang Nickl - Senior VP Finance & Chief Financial Officer

I would like to remind you that a summary of financial information has been posted to the Investor Relations section of our website, which will be updated with our Q3 guidance after this call.  

Revenue for the second fiscal quarter was $2.475 billion, down 5 percent from the prior year and up 3 percent sequentially. Hard drive shipments totaled 52.2 million units, up 5 percent from the prior-year period and 3 percent sequentially. Revenue from sales of WD TV® Media Players, WD Livewire™ Network Kits and solid-state drives totaled approximately $57 million, up 21 percent from the prior year and up 54 percent from the September quarter.

Average hard drive selling price was approximately $47 per unit, down $5 from the year-ago quarter and up $1 from the September quarter.

Revenue from sales of our branded products, including WD TV® and WD Livewire™ products, was $546 million, down 4 percent from the year-ago quarter and up 28 percent sequentially.

There were no customers that comprised 10 percent or more of our total revenue.

Geographically, all regions contributed revenue gains, with Europe showing the best comparative improvement on a sequential basis.

From a channel perspective, OEM declined as a percentage of revenue as we actively managed shipments and inventory, and the retail channel increased along seasonal expectations.

We exceeded the upper end of our revenue guidance by $75 million, which was achieved through a combination of re-mixing our product and business segments, improved pricing discipline resulting in lower like-for-like price declines, higher volume due to a slightly higher TAM [Total Available Market], and moderate market share gains.

Our gross margin for the quarter was 19.2 percent, down from 26.2 percent in the year-ago quarter and up from 18.2 percent in the September quarter.  December’s gross margin exceeded our implied guidance by about 320 basis points.  There were three main reasons for this.  First, our like-for-like price declines were better than we had modeled.  Second, we actively drove changes in our product and segment mix.  Last but not least, our relentless effort to optimize our product cost yielded larger than anticipated like-for-like cost improvements, with one factor being that our recently acquired Singapore media facility achieved accretion more quickly than anticipated.  We had modeled a 50 basis point dilution for the quarter, but we are now experiencing the 50 basis point accretion that we had built into our acquisition models. 

Total R&D and SG&A spending was $235 million, or 9.5 percent of revenue. This compares with $214 million, or 8.2 percent of revenue in the year-ago quarter, and $226 million, or 9.4 percent of revenue in the September quarter. The quarter-over-quarter increase is primarily a function of increased investments in our branded products business.

Operating income was $240 million, or 9.7 percent of revenue.  This compares with $473 million, or 18.1 percent of revenue in the year-ago quarter, and $211 million, or 8.8 percent of revenue in the September quarter.

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

Tax expense for the December quarter was $14 million, or 5.9 percent of pre-tax income.  The rate for the quarter reflects the retroactive extension of the R&D Tax Credit that was signed into law during the December quarter.

Our net income totaled $225 million, or $0.96 per share.  This compares with $429 million, or $1.85 per share, and $197 million, or $0.84 per share in the year-ago and September quarters, respectively. Turning to the balance sheet, our cash conversion cycle for the second quarter was a negative 2 days. This consisted of 46 days of receivables, 26 days of inventory or 14 turns, and 74 days of payables.  We generated $505 million in cash flow from operations during the December quarter, and our free cash flow totaled $255 million.

Capital additions for the December quarter totaled $250 million. Depreciation and amortization expense for the second quarter totaled $151 million.

We continue to expect our capital expenditures for fiscal 2011 to be between 7 and 8 percent of revenue, plus up to $200 million for our 6 to 8-inch wafer conversion and some smaller expenditure to optimize the output from our recently acquired media facility in Singapore. Depreciation and amortization is expected to be about $620 million for the fiscal year.

We made $25 million of debt repayment installments during the second quarter, and thereby reduced our debt balance to $350 million.

We exited fiscal Q2 with cash and cash equivalents of $3.1 billion, an increase of $252 million from the September quarter. 

Let me now turn to our expectations for fiscal Q3.

As Tim indicated, over the last 10 years, PC shipments have declined on average 9 percent from the December to March quarters, yet hard-drive industry shipments have historically decreased by only 4 percent. This systematically creates a supply/demand dynamic that leads to significant price declines in this and subsequent quarters as we have experienced this past calendar year.

Furthermore, despite the fact that the industry made progress towards balancing supply and demand in the December quarter, we believe that there still remains an excess inventory of 6 to 8 million units within the PC manufacturers’ pipeline.

Also, our sense of the market indicates higher than usual PC inventory levels in both the Distribution and Retail channels.

With the objective of entering the June quarter with more balanced inventory, we estimate that the hard-drive industry TAM for the March quarter is unlikely to exceed 155 million units.

We strongly believe that the effects from fixed cost under-absorption are of much lesser impact to the bottom line than subjecting the entire volume to significant price declines. Having said that, since we operate in a highly competitive market, we have modeled like-for-like price declines of five percent in line with pricing trends in prior March quarters.

We believe our value proposition will continue to resonate with our customers and we will maintain focus on ROI through product and segment mix management.   We continue to strengthen our investments in R&D and market development to support the significant opportunities in our medium and long term future.

Accordingly, our guidance for fiscal Q3 is as follows:

We expect revenue to be in the range from $2.2 billion to $2.25 billion. 

R&D and SG&A spending is expected to total approximately $240 million. 

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

We expect our tax rate to be at the upper end of our business model of 6 to 9 percent.

We anticipate our share count to be approximately 236 million.

We estimate earnings per share of between $0.55 and $0.65 for the March quarter.