UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
OR
Commission file number 1-8703
WESTERN DIGITAL CORPORATION
REGISTRANT’S TELEPHONE NUMBER INCLUDING AREA CODE: (949) 672-7000REGISTRANT’S WEB SITE: http://www.westerndigital.com
N/A
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]
Number of shares outstanding of Common Stock, as of January 25, 2002, is 189,437,385.
TABLE OF CONTENTS
WESTERN DIGITAL CORPORATIONINDEX
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PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
The accompanying notes are an integral part of these condensed consolidated financial statements.
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The accompanying notes are an integral part of these condensed consolidatedfinancial statements.
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CONDENSED CONSOLIDATED BALANCE SHEETS
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)(UNAUDITED)
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED)
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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-Looking Statements
This report contains forward-looking statements within the meaning of federal securities laws. The statements that are not purely historical should be considered forward-looking statements. Often they can be identified by the use of forward-looking words, such as “may,” “will,” “could,” “project,” “believe,” “anticipate,” “expect,” “estimate,” “continue,” “potential,” “plan,” “forecasts,” and the like. Statements concerning current conditions may also be forward-looking if they imply a continuation of current conditions. These statements appear in a number of places in this report and include statements regarding the intentions, plans, strategies, beliefs or current expectations of the Company with respect to, among other things:
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. Readers are urged to carefully review the disclosures made by the Company concerning risks and other factors that may affect the Company’s business and operating results, including those made under the captions “Risk factors related to the hard drive industry in which we operate” and “Risk factors relating to Western Digital particularly”, in this report, as well as the Company’s other reports filed with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to publish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
Unless otherwise indicated, references herein to specific years and quarters are to the Company’s fiscal years and fiscal quarters.
Overview
Western Digital is a longtime leader and one of the pioneers of the data storage industry. Through significant reorganization of its hard drive business in 1999 and 2000 the Company has become one of the most cost-effective producers of hard drives in the industry. During that time, the Company also established a framework to apply its data storage core competencies to emerging markets and expand beyond the traditional market for hard drives through new business ventures and market areas, while maintaining its core business.
The hard drive industry, the Company’s core and primary business, is intensely competitive and has experienced a great deal of growth, entry and exit of competitors, and technological change over recent years. This industry is characterized by short product life cycles, dependence upon highly skilled engineering and other personnel, significant expenditures for product development and recurring periods of oversupply.
The Company continuously evaluates opportunities to apply its data storage core competencies to emerging markets and to expand beyond traditional markets for hard drives through new business ventures meeting certain predefined criteria. The Company’s new business ventures have included Connex, Inc. (“Connex”), SANavigator, Inc. (“SANavigator”), SageTree, Inc. (“SageTree”), Keen Personal Media, Inc. (“Keen PM”) and Cameo Technologies, Inc. (“Cameo”). During the three months ended September 28, 2001, the Company discontinued the operations of both Connex and SANavigator, selling substantially all the assets of the two
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companies. The Company’s other new businesses have not yet generated significant revenue and the Company continues to evaluate their progress.
The following discussion of the Company’s results of operations includes the results of its continuing new ventures (see also footnote 8 to the condensed consolidated financial statements). The operating losses of the new ventures consist principally of research and development and selling, general and administrative costs. These operating losses have decreased from $10.0 million for the three months ended December 29, 2000 to $5.8 million for the three months ended December 28, 2001 due to expense reduction efforts. The operating losses of the new ventures have decreased from $18.0 million for the six months ended December 29, 2000 to $13.9 million for the six months ended December 28, 2001, also due to expense reduction efforts.
Results of Operations
Summary Comparison
The following table sets forth, for the periods indicated, items in the Company’s statements of operations expressed as a percentage of total revenue. This table and the following discussion exclude the results of the discontinued Connex and SANavigator businesses.
The Company’s income from continuing operations of $12.7 million for the three months ended December 28, 2001 increased by $9.9 million from the three months ended December 29, 2000 and $16.7 million from the immediately preceding quarter. The increase in income from continuing operations as compared to the corresponding period of the prior year was due to a $3.4 million increase in operating income in the hard drive business, a $4.2 million decrease in operating losses from new business ventures and a $2.3 million increase in interest and other income. The increase as compared to the immediately preceding quarter was due to an $11.4 million increase in operating income in the hard drive business, a $2.4 million decrease in operating losses from new business ventures and a $2.9 million increase in interest and other income. The Company’s income from continuing operations of $8.7 million for the six months ended December 28, 2001 increased by $43.1 million, or 125%, from the six months ended December 29, 2000. The increase was due to a $34.9 million increase in operating income in the hard drive business, a $4.1 million decrease in operating losses from new business ventures and a $4.1 million increase in interest and other income.
Consolidated revenues were $574.7 million for the three months ended December 28, 2001, an increase of 2%, or $13.1 million, from the three months ended December 29, 2000 and an increase of 30%, or $133.7 million, from the immediately preceding quarter. The increase in consolidated revenues as compared to the corresponding period of the prior year resulted from a 25% increase in unit shipments, partially offset by an 18% decrease in average selling prices (ASP’s). The increase in consolidated revenues as compared to the immediately preceding quarter resulted from a 43% increase in unit shipments, partially offset by a 9% decrease in ASP’s. Consolidated revenues were $1,015.6 million for the six months ended December 28, 2001, an increase of 3%, or $29.7 million, from the six months ended December 29, 2000. The increase in consolidated revenues resulted from a 16% increase in unit shipments, partially offset by an 11% decrease in ASP’s. Revenues from new business ventures were not material for all periods presented.
Gross profit for the three months ended December 28, 2001 totaled $70.6 million, or 12.3% of revenue. This compares to a gross profit of $67.5 million, or 12.0% of revenue, for the three months ended December 29, 2000 and gross profit of $56.0 million, or 12.7% of revenue, for the immediately preceding quarter. Gross profit for the six months ended December 28, 2001 totaled $126.6 million, or 12.5% of revenue. This compares to a gross profit of $93.5 million, or 9.5% of revenue, for the six months ended December 29, 2000. The increase in the gross profit over the corresponding three and six-month periods of the prior year was primarily the result of cost reduction efforts and higher volume in the hard drive business, partially offset by lower ASP’s. The
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decrease in gross margin percentage over the immediately preceding quarter was primarily the result of a change in the mix of products shipped.
Research and development (“R&D”) expense for the three months ended December 28, 2001 was $31.3 million, a decrease of $2.3 million from the three months ended December 29, 2000 and a decrease of $0.2 million from the immediately preceding quarter. The decrease in R&D expense from the corresponding period of the prior year was primarily due to expense reduction efforts in the new business ventures. The decrease in R&D expense from the immediately preceding quarter was primarily due to expense reduction efforts in the new business ventures, partially offset by an increase in expense in the hard drive business directly related to the increase in volume and revenues. R&D expense for the six months ended December 28, 2001 was $62.8 million, a decrease of $2.8 million from the corresponding period of the prior year. The decrease was primarily due to expense reduction efforts, partially offset by an increase in expense directly related the increase in volume and revenues.
Selling, general and administrative (“SG&A”) expense for the three months ended December 28, 2001 was $29.7 million, a decrease of $2.3 million from the three months ended December 29, 2000 and an increase of $1.0 million from the immediately preceding quarter. SG&A expense for the six months ended December 28, 2001 was $58.3 million, a decrease of $3.1 million from the corresponding period of the prior year. The decrease in SG&A expense from the corresponding three and six-month periods of the prior year was primarily due to expense reduction efforts in the hard drive business and the new business ventures. The increase in SG&A expense from the immediately preceding quarter was primarily due to an increase in expense in the hard drive business directly related to the increase in volume and revenues, partially offset by expense reduction efforts in the new business ventures.
Net interest and other income (expense) for the three months ended December 28, 2001 was $3.1 million, compared to $0.8 million for the three months ended December 29, 2000 and $0.2 million for the immediately preceding quarter. The increase in income from the corresponding period of the prior year and the immediately preceding quarter was primarily the result of net investment gains of $3.5 million, consisting of a $9.0 million cash recovery from its Komag note receivable and a $5.5 million write-down of certain cost-method investments which were determined to be impaired, offset by a decrease in net interest income due to lower interest rates. Net interest and other income (expense) for the six months ended December 28, 2001 was $3.3 million, compared to ($0.8) million for the six months ended December 29, 2000. The increase in income was primarily the result of an increase in net investment gains and minority interests in losses of consolidated subsidiaries, partially offset by lower net interest income.
During the three months ended September 28, 2001, the Company decided to discontinue the operations of Connex and SANavigator and sold substantially all of the assets of these two businesses for a net gain of $24.5 million. Accordingly, the operating results of Connex and SANavigator for the periods reported and the net gain recognized on the sale of the businesses during the six months ended December 28, 2001 have been segregated from continuing operations and reported separately on the statements of operations as discontinued operations.
During the six months ended December 28, 2001, the Company issued 1.5 million shares of common stock and $6.3 million in cash in exchange for $30.0 million in face value of the Debentures (with a book value of $13.0 million). During the corresponding period of the prior year, the Company issued 15.4 million shares of common stock in exchange for $286.9 million in face value of the Debentures (with a book value of $116.6 million). These redemptions were private, individually negotiated transactions with certain institutional investors. As a result of the redemptions, the Company recognized an extraordinary loss of $0.1 million for the three and six months ended December 28, 2001 and extraordinary gains of $10.6 million and $21.8 million for the three and six months ended December 29, 2000, respectively.
Liquidity and Capital Resources
At December 28, 2001, the Company had cash and cash equivalents of $193.3 million as compared to $167.6 million at June 29, 2001. Net cash provided by continuing operations was $14.2 million during the six months ended December 28, 2001, as compared to net cash used for continuing operations of $57.4 million during the six months ended December 29, 2000. This $71.6 million improvement in cash provided by continuing operations consists of a $37.0 million improvement in the Company’s operating results, net of non-cash items, and a $34.6 million decrease in cash used to fund working capital requirements. The improvement in operating results is due to significantly better performance by the Company’s hard drive business as a result of higher sales volume and improved cost management. The decrease in cash used to fund working capital requirements is primarily due to a decrease in cash used to settle restructuring and other special charge accruals resulting from transactions during 2000. In addition, the Company’s cash conversion cycle, which represents the sum of the number of days sales outstanding (“DSO”) and days inventory outstanding (“DIO”) less days payable outstanding (“DPO”), was reduced by 2 days for the six months ended December 28, 2001 compared to the corresponding period of the prior year.
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Other uses of cash during the six months ended December 28, 2001 included net capital expenditures of $26.0 million, primarily to upgrade the Company’s desktop hard drive production capabilities and for normal replacement of existing assets, and $6.3 million for debenture redemptions. Other sources of cash during the period included $9.0 million received from the sale of remaining Komag assets, $3.0 million received by the Company’s subsidiaries from minority investors and $2.6 million received in connection with stock option exercises and Employee Stock Purchase Plan purchases.
During the six months ended December 29, 2000, other uses of cash included net capital expenditures of $26.8 million. Other sources of cash during that period included proceeds of $15.0 million received upon the sale of marketable equity securities, $72.7 million received upon issuance of 14.5 million shares of the Company’s stock under the Company’s equity facility, $5.0 million received from a third-party bridge loan to one of the Company’s subsidiaries and $3.5 million received in connection with stock option exercises and Employee Stock Purchase Plan purchases.
The Company has a three-year Senior Credit Facility for its hard drive business, Western Digital Technologies, Inc. (“WDT”), which provides up to $125 million in revolving credit (subject to a borrowing base calculation), matures on September 20, 2003 and is secured by WDT’s accounts receivable, inventory, 65% of the stock in its foreign subsidiaries and other assets. At the option of WDT, borrowings bear interest at either LIBOR (with option periods of one to three months) or a base rate, plus a margin determined by the borrowing base. The Senior Credit Facility requires WDT to maintain certain amounts of tangible net worth, prohibits the payment of cash dividends on common stock and contains a number of other covenants. As of the date hereof, there were no borrowings under the facility. The Company is in discussions with Cirrus Logic, Inc. (“Cirrus”) concerning a negotiated posting of $25 million security for accounts payable to Cirrus, which are included in the Company’s balance sheet, that the Company is disputing in its litigation against Cirrus (See Part II, Item 1 — Legal Proceedings). If the Company decides to issue a letter of credit in favor of Cirrus to secure this payable, the availability under the Senior Credit Facility would be reduced by a corresponding amount.
During the six months ended December 29, 2000, the Company issued 14.5 million shares of common stock under preexisting shelf registrations for net cash proceeds of $72.7 million. During the six months ended December 28, 2001, no common stock was issued under the shelf registrations. Subsequent to December 28, 2001, the Company withdrew these shelf registrations as management determined they would not be utilized in the foreseeable future.
At December 28, 2001, the Company had cash and cash equivalents of $193.3 million, working capital of $80.8 million and shareholders’ equity of $48.9 million. In addition, the Company has a Senior Credit Facility providing up to $125 million in revolving credit. Furthermore, the Company has achieved significant reductions in manufacturing labor and overhead and operating expenses resulting from the sale in late 1999 of the Company’s media operations, the closure in 2000 of the Company’s two Singapore based manufacturing facilities and its Rochester design center, the disposal of its Connex and SANavigator businesses, and an overall reduction in worldwide headcount.
Based on the above factors, the Company believes its current cash and cash equivalents and its existing credit facility will be sufficient to meet its working capital needs through the foreseeable future. There can be no assurance that the Senior Credit Facility will continue to be available to the Company. Also, the Company’s ability to sustain its working capital position is dependent upon a number of factors that are discussed below under the headings “Risk factors related to the hard drive industry in which we operate” and “Risk factors relating to Western Digital particularly.”
New Accounting Pronouncements
During July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 141, “Business Combinations” (“SFAS 141”) and Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). Effective June 30, 2001, the Company adopted SFAS 141. SFAS 141 addresses financial accounting and reporting for business combinations and requires that all business combinations initiated after June 30, 2001 be accounted for using the purchase method. The adoption of SFAS 141 did not have a material impact on the Company’s financial position or results of operations.
SFAS 142 requires that goodwill and intangible assets that have indefinite useful lives not be amortized but rather be tested at least annually for impairment. The Company is required to adopt SFAS 142 on June 29, 2002. However, goodwill and intangible assets acquired after June 30, 2001 are subject to the amortization provisions of SFAS 142. The Company does not expect the adoption of SFAS 142 to have a material impact on the Company’s financial position or results of operations.
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During October 2001 the FASB issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). SFAS 144 is effective for fiscal years beginning after December 15, 2001. The Company does not expect the adoption of SFAS 144 to have a material impact on its consolidated financial position, results of operations or liquidity.
Risk factors related to the hard drive industry in which we operate
Our operating results depend on our being among the first-to-market and first-to-volume with our new products.
To achieve consistent success with computer manufacturer customers we must be an early provider of next generation hard drives featuring leading technology and high quality. If we fail to:
then our market share would be adversely affected, which would harm our operating results.
Short product life cycles make it difficult to recover the cost of development.
Over the past few years hard drive areal density (the gigabytes of storage per disk) has increased at a much more rapid pace than previously experienced. The technical challenges of maintaining this pace are becoming more formidable, and the risk of not achieving the targets for each new generation of drives increases, which could adversely impact product manufacturing yields and schedules, among other impacts. Higher areal densities mean that fewer heads and disks are required to achieve a given drive capacity. This has significantly shortened product life cycles, since each generation of drives is more cost effective than the previous one. Shorter product cycles make it more difficult to recover the cost of product development.
Short product life cycles force us to continually qualify new products with our customers.
Due to short product life cycles, we must regularly engage in new product qualification with our customers. To be considered for qualification we must be among the leaders in time-to-market with our new products. Once a product is accepted for qualification testing, any failure or delay in the qualification process can result in our losing sales to that customer until the next generation of products is introduced. The effect of missing a product qualification opportunity is magnified by the limited number of high volume computer manufacturers, most of which continue to consolidate their share of the PC market. These risks are magnified because we expect cost improvements and competitive pressures to result in declining sales and gross margins on our current generation products.
Unexpected technology advances in the hard drive industry could harm our competitive position.
If one of our competitors were able to implement a significant advance in head or disk drive technology that enables a step-change increase in areal density allowing greater storage of data on a disk, it would harm our operating results.
Advances in magnetic, optical, semiconductor or other data storage technologies could result in competitive products that have better performance or lower cost per unit of capacity than our products. If these products prove to be superior in performance or cost per unit of capacity, we could be at a competitive disadvantage to the companies offering those products.
Our average selling prices are declining.
We expect that our average selling prices for hard drives will continue to decline. Rapid increases in areal density mean that the average drive we sell has fewer heads and disks, and is therefore lower cost. Because of the competitiveness of the hard drive industry, lower costs generally mean lower prices. This is true even for those products that are competitive and introduced into the market in a timely manner. Our average selling prices decline even further when competitors lower prices to absorb excess capacity, liquidate excess inventories, restructure or attempt to gain market share.
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The hard drive industry is highly competitive and characterized by rapid shifts in market share among the major competitors.
The price of hard drives has fallen over time due to increases in supply, cost reductions, technological advances and price reductions by competitors seeking to liquidate excess inventories or gain market share. In addition, rapid technological changes often reduce the volume and profitability of sales of existing products and increase the risk of inventory obsolescence. These factors, taken together, result in significant and rapid shifts in market share among the industry’s major participants. For example, during 1998 and 1999, we lost significant share of the desktop market. During the first quarter of 2000, the Company lost market share as a result of a previously announced product recall; since then we have recovered significant market share, although our share is still significantly below its 1997 level.
Our prices and margins are subject to declines due to unpredictable end-user demand and oversupply of hard drives.
Demand for our hard drives depends on the demand for computer systems manufactured by our customers and on storage upgrades to existing systems. The demand for computer systems has been volatile in the past and often has had an exaggerated effect on the demand for hard drives in any given period. As a result, the hard drive market tends to experience periods of excess capacity, which typically lead to intense price competition. During calendar year 2001, the industry experienced weak PC demand in the U.S. and other markets, and forecasts for calendar year 2002 are cautious. If intense price competition occurs as a result of weak demand, we may be forced to lower prices sooner and more than expected, which could result in lower revenues.
Changes in the markets for hard drives require us to develop new products.
Over the past few years the consumer market for desktop computers has shifted significantly towards lower priced systems, especially those systems priced below $1,000. Although we were late to market with a value line hard drive to serve the low-cost PC market, we are now offering such value line products at prices that we view as competitive. However, if we are not able to continue to offer a competitively priced value line hard drive for the low-cost PC market, our share of that market will likely fall, which could harm our operating results.
The PC market is fragmenting into a variety of computing devices and products. Some of these products, such as Internet appliances, may not contain a hard drive. On the other hand, many industry analysts expect, as do we, that as broadcasting and communications are increasingly converted to digital technology from the older, analog technology, the technology of computers and consumer electronics and communication devices will converge, and hard drives will be found in many consumer products other than computers. For the quarter ended December 28, 2001 more than 10% of our unit sales were for consumer products other than computers, primarily gaming devices. If we are not successful in using our hard drive technology and expertise to develop new products for these emerging markets, it will likely harm our operating results.
We depend on our key personnel.
Our success depends upon the continued contributions of our key employees, many of whom would be extremely difficult to replace. Worldwide competition for skilled employees in the hard drive industry is intense. We have lost a number of experienced hard drive engineers over the past two years as a result of the loss of retention value of their employee stock options (because of the decrease in price of our common stock) and aggressive recruiting of our employees. If we are unable to retain our existing employees or hire and integrate new employees, our operating results would likely be harmed.
Risk factors relating to Western Digital particularly
Loss of market share with a key customer could harm our operating results.
A majority of our revenue comes from a few customers. For example, during 2001, sales to our top 10 customers accounted for approximately 60% of revenues. These customers have a variety of suppliers to choose from and therefore can make substantial demands on us. Even if we successfully qualify a product with a customer, the customer generally is not obligated to purchase any minimum volume of products from us and is able to terminate its relationship with us at any time. Our ability to maintain strong relationships with our principal customers is essential to our future performance. If we lose a key customer, or if any of our key customers reduce their orders of our products or require us to reduce our prices before we are able to reduce costs, our operating results would likely be harmed. For example, this occurred with our enterprise hard drive product line early in the third quarter of 2000 and is one of the factors which led to our decision to exit the enterprise hard drive market.
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Dependence on a limited number of qualified suppliers of components could lead to delays or increased costs.
Because we do not manufacture any of the components in our hard drives, an extended shortage of required components or the failure of key suppliers to remain in business, adjust to market conditions, or to meet our quality, yield or production requirements could harm us more severely than our competitors, some of whom manufacture certain of the components for their hard drives. A number of the components used by us are available from only a single or limited number of qualified outside suppliers. If a component is in short supply, or a supplier fails to qualify or has a quality issue with a component, we may experience delays or increased costs in obtaining that component. This occurred in September 1999 when we had to shut down our Caviar product line production for approximately two weeks as a result of a faulty power driver chip that was sole-sourced from a third-party supplier.
To reduce the risk of component shortages, we attempt to provide significant lead times when buying these components. As a result, we may have to pay significant cancellation charges to suppliers if we cancel orders, as we did in 1998 when we accelerated our transition to magnetoresistive recording head technology, and as we did in 2000 as a result of our decision to exit the enterprise hard drive market.
In April 1999, we entered into a three-year volume purchase agreement with Komag under which we buy a substantial portion of our media components from Komag. In October 2001, we amended the volume purchase agreement to extend the initial term to six years. This strategic relationship has reduced our media component costs; however, it has increased our dependence on Komag as a supplier. Our future operating results may depend substantially on Komag’s ability to timely qualify its media components in our new development programs and to supply us with these components in sufficient volume to meet our production requirements. A significant disruption in Komag’s ability to manufacture and supply us with media could harm our operating results. Komag is currently in Chapter 11 reorganization proceedings, during which it is continuing its operations.
To develop new products we must maintain effective partner relationships with our strategic component suppliers.
Under our “virtual vertical integration” business model, we do not manufacture any of the parts used in our hard drives. As a result, the success of our products depends on our ability to gain access to and integrate parts that are “best in class” from reliable component suppliers. To do so we must effectively manage our relationships with our strategic component suppliers. We must also effectively integrate different products from a variety of suppliers and manage difficult scheduling and delivery problems. Although we believe that our relationships with our current strategic suppliers are good, we are currently engaged in litigation with Cirrus, which until this year was the sole source of read-channel chips for our hard drives. As a result of the disputes that gave rise to the litigation, our business operations were at risk until another supplier could be designed into our products.
We have only one high-volume manufacturing facility, which subjects us to the risk of damage or loss of the facility.
Most of our manufacturing volume comes from one facility in Malaysia. We have recently acquired a second, smaller manufacturing facility in Thailand. A fire, flood, earthquake or other disaster or condition affecting our Malaysian facility would result in a loss of sales and revenue and harm our operating results.
Manufacturing our products abroad subjects us to numerous risks.
We are subject to risks associated with our foreign manufacturing operations, including:
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We have attempted to manage the impact of foreign currency exchange rate changes by, among other things, entering into short-term, forward exchange contracts. However, those contracts do not cover our full exposure and can be canceled by the issuer if currency controls are put in place, as occurred in Malaysia during the first quarter of 1999. As a result of the Malaysian currency controls, we are no longer hedging the Malaysian currency risk.
Our plan to broaden our business takes us into new markets.
We are developing storage devices and content management software for the emerging broadband television market through our Keen PM subsidiary. We will be facing the challenge of developing products for a market that is still evolving and subject to rapid changes and shifting consumer preferences. There are several competitors that have also entered this emerging market, and there is no assurance that the market for digital storage devices for television and other audio-visual content will materialize or support all of these competitors.
We have entered the data warehouse software and services market through our SageTree subsidiary and are considering other initiatives related to data and content management, storage and communication. In any of these initiatives we will be facing the challenge of developing products and services for markets that are still evolving and which have many current and potential competitors. If we are not successful in these new initiatives it will likely harm our operating results.
Our reliance on intellectual property and other proprietary information subjects us to the risk of significant litigation.
The hard drive industry has been characterized by significant litigation. This includes litigation relating to patent and other intellectual property rights, product liability claims and other types of litigation. We are currently evaluating notices of alleged patent infringement or notices of patents from patent holders. We also are a party to several judicial and other proceedings relating to patent and other intellectual property rights. If we conclude that a claim of infringement is valid, we may be required to obtain a license or cross-license or modify our existing technology or design a new non-infringing technology. Such licenses or design modifications can be extremely costly. We may also be liable for any past infringement. If there is an adverse ruling against us in an infringement lawsuit, an injunction could be issued barring production or sale of any infringing product. It could also result in a damage award equal to a reasonable royalty or lost profits or, if there is a finding of willful infringement, treble damages. Any of these results would likely increase our costs and harm our operating results.
Our reliance on intellectual property and other proprietary information subjects us to the risk that these key ingredients of our business could be copied by competitors.
Our success depends, in significant part, on the proprietary nature of our technology, including non-patentable intellectual property such as our process technology. Despite safeguards, to the extent that a competitor is able to reproduce or otherwise capitalize on our technology, it may be difficult, expensive or impossible for us to obtain necessary legal protection. Also, the laws of some foreign countries may not protect our intellectual property to the same extent as do the laws of the United States. In addition to patent protection of intellectual property rights, we consider elements of our product designs and processes to be proprietary and confidential. We rely upon employee, consultant and vendor non-disclosure agreements and a system of internal safeguards to protect our proprietary information. However, any of our registered or unregistered intellectual property rights may be challenged or exploited by others in the industry, which might harm our operating results.
Inaccurate projections of demand for our product can cause large fluctuations in our quarterly results.
If we do not forecast total quarterly demand accurately, it can have a material adverse effect on our quarterly results. We typically book and ship a high percentage of our total quarterly sales in the third month of the quarter, which makes it difficult for us to match our production plans to customer demands. In addition, our quarterly projections and results may be subject to significant fluctuations as a result of a number of other factors including:
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Rapidly changing market conditions in the hard drive industry make it difficult to estimate actual results.
We have made and continue to make a number of estimates and assumptions relating to our consolidated financial reporting. The rapidly changing market conditions with which we deal means that actual results may differ significantly from our estimates and assumptions. Key estimates and assumptions for us include:
The market price of our common stock is volatile.
The market price of our common stock has been, and may continue to be, extremely volatile. Factors such as the following may significantly affect the market price of our common stock:
In addition, the stock market from time to time experiences extreme price and volume fluctuations that particularly affect the stock prices of many high technology companies. These fluctuations are often unrelated to the operating performance of the companies.
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Securities class action lawsuits are often brought against companies after periods of volatility in the market price of their securities. A number of such suits have been filed against us in the past, and any of these litigation matters could result in substantial costs and a diversion of resources and management’s attention.
We may be unable to raise future capital through debt or equity financing.
Due to the risks described in this Report, in the future we may be unable to maintain adequate financial resources for capital expenditures, working capital and research and development. We have a credit facility for our WDT subsidiary, which matures on September 20, 2003. If we decide to increase or accelerate our capital expenditures or research and development efforts, or if results of operations do not meet our expectations, we could require additional debt or equity financing. However, we cannot ensure that additional financing will be available to us or available on favorable terms. An equity financing could also be dilutive to our existing stockholders.
We have zero coupon convertible subordinated debentures due February 18, 2018 (the “Debentures”) that, at the holder’s option, will be repurchased by the Company, as of February 18, 2003, February 18, 2008 or February 18, 2013, or if there is a Fundamental Change (as defined in the Debenture documents), at the issue price plus accrued original issue discount to the date of repurchase. The payment on those dates, with the exception of a Fundamental Change, can be in cash, stock or any combination, at the Company’s option. The issuance of stock to redeem the bonds could be dilutive to the existing stockholders.
Power outages resulting from energy shortages in California may have an adverse impact on our facilities located in California.
We conduct substantial operations at our headquarters located in Lake Forest, California and at our facilities located in San Jose, California and Irvine, California. We rely on a continuous power supply in order to conduct those operations. California’s current energy crisis could disrupt our operations and increase our expenses. In the event of an acute power shortage, that is, when energy reserves for the state fall below 1.5%, California has on some occasions implemented, and may in the future implement, rolling blackouts across the state. Although the Governor and state legislators are working to prevent them in the future, and although the Company has back-up energy reserves to last a short period, rolling blackouts could interrupt our power supply and might temporarily render us unable to continue operations at our California facilities. Any such interruption in our ability to continue our operations at our California facilities could delay the development of products or disrupt communications with our customers, suppliers or manufacturing operations, either of which could harm our business and results of operations. In addition, if wholesale prices for electricity continue to increase, our operating expenses would likely increase which might negatively affect our operating results.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Disclosure About Foreign Currency Risk
Although the majority of the Company’s transactions are in U.S. Dollars, some transactions are based in various foreign currencies. From time to time, the Company purchases short-term, forward exchange contracts to hedge the impact of foreign currency fluctuations on certain underlying assets, liabilities and commitments for operating expenses denominated in foreign currencies. The purpose for entering into these hedge transactions is to minimize the impact of foreign currency fluctuations on the results of operations. To date, a majority of the increases or decreases in the Company’s local currency operating expenses are offset by gains and losses on the hedges. The contracts have maturity dates that do not exceed twelve months. The Company does not purchase short-term forward exchange contracts for trading purposes.
Historically, the Company has focused on hedging its foreign currency risk related to the Singapore Dollar, the British Pound and the Malaysian Ringgit. With the establishment of currency controls and the prohibition of purchases or sales of the Malaysian Ringgit by offshore companies, the Company discontinued hedging its Malaysian Ringgit currency risk in 1999. Future hedging of this currency will depend on currency conditions in Malaysia. As a result of the closure of the Company’s Singapore operations in 2000, the Company has also discontinued its hedging program related to the Singapore Dollar.
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As of December 28, 2001, the Company had outstanding the following purchased foreign currency forward exchange contracts (in millions, except average contract rate):
During the three and six months ended December 29, 2000 and December 28, 2001, total realized transaction and forward exchange contract currency gains and losses were not material to the consolidated financial statements. Based on historical experience, the Company does not expect that a significant change in foreign exchange rates would materially affect the Company’s consolidated financial statements.
Disclosure About Other Market Risks
Fixed Interest Rate Risk
At December 28, 2001, the market value of the Company’s 5.25% zero coupon convertible subordinated debentures due in 2018 was approximately $102.6 million, compared to the related book value of $102.4 million. The convertible debentures will be repurchased by the Company, at the option of the holder, as of February 18, 2003, February 18, 2008, or February 18, 2013, or if there is a Fundamental Change (as defined in the Debenture documents), at the issue price plus accrued original issue discount to the date of redemption. The payment on those dates, with the exception of a Fundamental Change, can be in cash, stock or any combination, at the Company’s option.
The Company has a note receivable from another company that carries a fixed rate of interest. Therefore, a significant change in interest rates would not cause this note to impact the Company’s consolidated financial statements.
Variable Interest Rate Risk
At the option of WDT, borrowings under the Senior Credit Facility would bear interest at either LIBOR (with option periods of one to three months) or a base rate, plus a margin determined by the borrowing base. This is the only borrowing facility that does not have a fixed-rate of interest. The Senior Credit Facility requires WDT to maintain certain amounts of tangible net worth, prohibits the payment of cash dividends on common stock and contains a number of other covenants. As of the date hereof, there were no borrowings under the Senior Credit Facility.
Fair Value Risk
The Company owns approximately 1.2 million shares of Vixel common stock. As of December 28, 2001, the market value of the Vixel shares was $2.2 million. The Company determines, on a quarterly basis, the fair market value of the Vixel shares and records an unrealized gain or loss resulting from the difference in the fair market value of the shares as of the previous quarter end and the fair market value of the shares on the measurement date. As of December 28, 2001, a $2.2 million total accumulated unrealized gain has been recorded in accumulated other comprehensive income. If the Company sells all or a portion of this common stock, any unrealized gain or loss on the date of sale will be recorded as a realized gain or loss in the Company’s results of operations. As a result of market conditions, the market value of the shares had increased from $2.2 million as of December 28, 2001 to $4.4 million as of January 25, 2002. Due to market fluctuations, a decline in the stock’s fair market value could occur.
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PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
The following discussion contains forward-looking statements within the meaning of the federal securities laws. These statements relate to the Company’s legal proceedings described below. The “Company”, as used in this discussion, includes the Company’s operating subsidiary Western Digital Technologies, Inc. Litigation is inherently uncertain and may result in adverse rulings or judgments, or lead to settlements, that may, individually or in the aggregate, have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity. In addition, the costs of defending such litigation, individually or in the aggregate, may be material, regardless of the outcome. Accordingly, actual results could differ materially from those projected in the forward-looking statements.
In 1992 Amstrad plc (“Amstrad”) brought suit against the Company in California State Superior Court, County of Orange, alleging that disk drives supplied to Amstrad by the Company in 1988 and 1989 were defective and caused damages to Amstrad of not less than $186 million. The suit also sought punitive damages. The Company denied the material allegations of the complaint and filed cross-claims against Amstrad. The case was tried, and in June 1999 the jury returned a verdict in favor of Western Digital. Amstrad has appealed the judgment. The Company does not believe that the outcome of this matter will have a material adverse effect on its consolidated financial position, results of operations or liquidity.
In 1994 Papst Licensing (“Papst”) brought suit against the Company in federal court in California alleging infringement by the Company of five of its patents relating to disk drive motors that the Company purchased from motor vendors. Later that year Papst dismissed its case without prejudice, but it has notified the Company that it intends to reinstate the suit if the Company does not enter into a license agreement with Papst. Papst has also put the Company on notice with respect to several additional patents. The Company does not believe that the outcome of this matter will have a material adverse effect on its consolidated financial position, results of operations or liquidity.
In June 2000 Discovision Associates (“Discovision”) notified the Company in writing that it believes certain of the Company’s hard disk drive products may infringe certain of Discovision’s patents. Discovision has offered to provide the Company with a license under its patent portfolio. The Company is in discussion with Discovision regarding its claims. There is no litigation pending. The Company does not believe that the outcome of this matter will have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.
On May 22, 2001, Cambrian Consultants, Inc. (“Cambrian”) filed a complaint against the Company in the United States District Court, Central District of California. The suit alleges infringement by the Company of a Cambrian patent. On July 20, 2001, the Company filed an answer denying the allegations contained in Cambrian’s complaint and a counter claim asserting that Cambrian’s patent was invalid. The Court ordered an accelerated discovery schedule and scheduled the case for trial on March 26, 2002. On January 4, 2002, the Company entered into a settlement agreement with Cambrian, settling all claims in the litigation, and on January 7, 2002 the Court entered a dismissal of the action. The settlement was not material to the Company’s consolidated financial position, results of operations or liquidity.
On July 5, 2001, the Company (and its Malaysian subsidiary) filed suit against Cirrus Logic, Inc. (“Cirrus”) in California Superior Court for the County of Orange for breach of contract and other claims resulting from Cirrus’ role as a strategic supplier of read channel chips for the Company’s hard drives. The Company also stopped making payments to Cirrus for past deliveries of chips and terminated all outstanding purchase orders from Cirrus for such chips. The Company’s complaint alleges that Cirrus’ unlawful conduct caused damages in excess of any amounts that may be owing on outstanding invoices or arising out of any alleged breach of the outstanding purchase orders. On August 20, 2001, Cirrus filed an answer and cross-complaint. Cirrus denied the allegations contained in the Company’s complaint and asserted counterclaims against the Company for, among other things, the amount of the outstanding invoices and the Company’s alleged breach of the outstanding purchase orders. The disputed payable, which is included in the Company’s balance sheet in accounts payable, is approximately $27 million. Cirrus claims that the canceled purchase orders, which are not reflected in the Company’s financial statements, total approximately $26 million. On October 9, 2001, the Court granted Cirrus’ Motion for Judgment on the Pleadings, with leave to amend, and on November 8, 2001, the Company filed its First Amended Complaint. Cirrus demurred to the First Amended Complaint, and on December 18, 2001, the Court denied Cirrus’ demurrer. On November 2, 2001, Cirrus filed Applications for Right to Attach Orders and for Writs of Attachment against the Company and its Malaysian subsidiary in the amount of $25.2 million as security for the approximately $27 million allegedly owed for read-channel chips purchased from Cirrus that is disputed by the Company. On December 20, 2001, the Court granted Cirrus’
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Applications but required Cirrus to post undertakings in the amount of $0.5 million on each Writ before issuance. Neither the Right to Attach Orders nor the Writs of Attachment have been filed by Cirrus or issued by the Court as the Company and its Malaysian subsidiary are in discussions with Cirrus concerning a negotiated posting of security in satisfaction of Cirrus’ Writs. If the parties are unable to reach agreement, the Company and its Malaysian subsidiary will comply with the Court’s final order. The parties have begun discovery and expect that such discovery will continue for the next several months. Based on its initial investigation and the limited discovery done to date, the Company does not believe that the ultimate resolution of this matter will have a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.
In November 2001, Dynacore Holding Corporation (“Dynacore”) filed suit against the Company and several other defendants in the United States District Court for the Southern District of New York. The suit alleges that the Company’s 1394 external hard drives fall within the scope of the subject matter of Dynacore’s patent covering communication between nodes within a network, wherein nodes have both enhanced and common capabilities. During January 2002, the Company filed an answer denying Dynacore’s complaint and alleged counterclaims. The Company does not believe that the outcome of this matter will have a material adverse effect on its consolidated financial position, results of operations or liquidity.
In the normal course of business, the Company receives and makes inquiries regarding possible intellectual property matters, including alleged patent infringement. Where deemed advisable, the Company may seek or extend licenses or negotiate settlements. Although patent holders often offer such licenses, no assurance can be given that in a particular case a license will be offered or that the offered terms will be acceptable to the Company. The Company does not believe that the ultimate resolution of these matters will have a material adverse effect on its consolidated financial position, results of operations or liquidity.
From time to time the Company receives claims and is a party to suits and other judicial and administrative proceedings incidental to its business. Although occasional adverse decisions (or settlements) may occur, the Company does not believe that the ultimate resolution of these matters will have a material adverse effect on its consolidated financial position, results of operations or liquidity.
Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
During the three months ended December 28, 2001, the Company engaged in transactions pursuant to which it exchanged an aggregate principal amount at maturity of $30.0 million of the Company’s Zero Coupon Convertible Subordinated Debentures due 2018, for an aggregate of 1,546,296 shares of the Company’s common stock and $6,262,500 in cash. These transactions were undertaken in reliance upon the exemption from the registration requirements of the Securities Act afforded by Section 3(a)(9) thereof, as exchanges of securities by the Company with its existing security holders. No commission or other remuneration was paid or given directly or indirectly for soliciting such exchanges. These exchanges were consummated in private, individually negotiated transactions with institutional investors.
Item 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
The annual meeting of shareholders was held on November 29, 2001. The shareholders elected the following seven directors to hold office until the next annual meeting and until their successors are elected and qualified:
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In addition, the shareholders approved the following proposals:
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: February 8, 2002
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EXHIBIT INDEX