1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------- FORM 10-Q (Mark One) [X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended March 31, 2000. OR [ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from to Commission file number 1-8703 WESTERN DIGITAL CORPORATION ------------------------------------------------------ (Exact name of Registrant as specified in its charter) Delaware 95-2647125 - ------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 8105 Irvine Center Drive Irvine, California 92618 ------------------------ ---------- (Address of principal executive offices) (Zip Code) REGISTRANT'S TELEPHONE NUMBER INCLUDING AREA CODE: (949) 932-5000 REGISTRANT'S WEB SITE: http://www.westerndigital.com N/A ----------------------------------------------------- Former name, former address and former fiscal year if changed since last report. 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 April 28, 2000, is 139,340,111.
2 WESTERN DIGITAL CORPORATION INDEX PAGE NO. -------- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Statements of Operations - Three-Month Periods Ended March 27, 1999 and March 31, 2000.............. 3 Condensed Consolidated Statements of Operations - Nine-Month Periods Ended March 27, 1999 and March 31, 2000.............. 4 Condensed Consolidated Balance Sheets - July 3, 1999 and March 31, 2000............................................... 5 Condensed Consolidated Statements of Cash Flows - Three-Month Periods Ended March 27, 1999 and March 31, 2000.............. 6 Condensed Consolidated Statements of Cash Flows - Nine-Month Periods Ended March 27, 1999 and March 31, 2000.............. 7 Notes to Condensed Consolidated Financial Statements......... 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations......................... 14 Item 3. Quantitative and Qualitative Disclosures About Market Risk.. 24 PART II. OTHER INFORMATION Item 1. Legal Proceedings........................................... 27 Item 6. Exhibits and Reports on Form 8-K............................ 28 Signatures.......................................................... 29 2
3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS WESTERN DIGITAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED) <TABLE> <CAPTION> THREE-MONTH PERIOD ENDED ---------------------------- MAR. 27, MAR. 31, 1999 2000 --------- ---------- <S> <C> <C> Revenues, net........................................ $ 668,456 $ 516,587 Costs and expenses: Cost of revenues............................... 628,592 505,003 Research and development....................... 62,699 33,770 Selling, general and administrative............ 46,210 33,970 Restructuring charges.......................... 41,000 28,002 --------- --------- Total costs and expenses.................. 778,501 600,745 --------- --------- Operating loss....................................... (110,045) (84,158) Net interest and other income (expense).............. (4,248) 13,489 --------- --------- Net loss............................................. $(114,293) $ (70,669) ========= ========= Basic and diluted loss per common share: Loss per common share.......................... $ (1.27) $ (.53) ========= ========= Common shares used in computing per share amounts: Basic..................................... 89,883 133,903 ========= ========= Diluted................................... 89,883 133,903 ========= ========= </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 3
4 WESTERN DIGITAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED) <TABLE> <CAPTION> NINE-MONTH PERIOD ENDED ----------------------------- MAR. 27, MAR. 31, 1999 2000 ----------- ----------- <S> <C> <C> Revenues, net............................................ $ 2,057,904 $ 1,483,718 Costs and expenses: Cost of revenues................................... 2,081,625 1,517,235 Research and development........................... 164,983 127,996 Selling, general and administrative................ 151,361 116,862 Restructuring charges.............................. 41,000 85,837 ----------- ----------- Total costs and expenses...................... 2,438,969 1,847,930 ----------- ----------- Operating loss........................................... (381,065) (364,212) Net interest and other income (expense).................. (10,139) 5,132 ----------- ----------- Loss before extraordinary item........................... (391,204) (359,080) Extraordinary gain from redemption of convertible debentures........................................ -- 166,899 ----------- ----------- Net loss................................................. $ (391,204) $ (192,181) =========== =========== Basic and diluted loss per common share: Loss per common share before extraordinary item.... $ (4.39) $ (3.07) Extraordinary gain................................. -- 1.43 ----------- ----------- Loss per common share.............................. $ (4.39) $ (1.64) =========== =========== Common shares used in computing per share amounts: Basic......................................... 89,105 116,983 =========== =========== Diluted....................................... 89,105 116,983 =========== =========== </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 4
5 WESTERN DIGITAL CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) <TABLE> <CAPTION> JULY 3, MAR. 31, 1999 2000 ---------- --------- (UNAUDITED) ASSETS <S> <C> <C> Current assets: Cash and cash equivalents........................... $ 226,147 $202,087 Accounts receivable, less allowance for doubtful accounts of $18,537 at July 3, 1999 and $15,069 at March 31, 2000...................... 273,435 177,455 Inventories......................................... 144,093 98,208 Prepaid expenses & other current assets............. 81,853 56,068 ---------- -------- Total current assets........................... 725,528 533,818 Property and equipment at cost, net....................... 237,939 108,886 Intangible and other assets, net.......................... 58,935 47,491 ---------- -------- Total assets................................... $1,022,402 $690,195 ========== ======== LIABILITIES AND SHAREHOLDERS' DEFICIENCY Current liabilities: Accounts payable.................................... $ 335,907 $ 290,330 Accrued expenses.................................... 252,791 234,713 Current portion of long-term debt................... 10,000 -- ----------- --------- Total current liabilities...................... 598,698 525,043 Long-term debt............................................ 40,000 -- Convertible debentures.................................... 494,144 222,562 Other liabilities......................................... 43,350 51,393 Shareholders' deficiency: Preferred stock, $.01 par value; Authorized: 5,000 shares Outstanding: None............................. -- -- Common stock, $.01 par value; Authorized: 225,000 shares Outstanding: 101,908 shares at July 3, 1999 and 149,175 at March 31, 2000.................. 1,019 1,492 Additional paid-in capital.......................... 335,197 532,476 Accumulated deficit................................. (294,841) (487,022) Accumulated other comprehensive income (loss)....... (2,123) 25,287 Treasury stock-common stock at cost; 11,297 shares at July 3, 1999 and 9,852 shares at March 31, 2000....................... (193,042) (181,036) ----------- --------- Total shareholders' deficiency................. (153,790) (108,803) ----------- --------- Total liabilities and shareholders' deficiency. $ 1,022,402 $ 690,195 =========== ========= </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 5
6 WESTERN DIGITAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) <TABLE> <CAPTION> THREE-MONTH PERIOD ENDED ---------------------------- MAR. 27, MAR. 31, 1999 2000 --------- ---------- <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net loss................................................ $(114,293) $ (70,669) Adjustments to reconcile net loss to net cash used for operating activities: Non-Cash Items: Depreciation and amortization................... 34,554 17,726 Interest on convertible debentures.............. 6,279 2,896 Non-cash portion of restructuring charges....... 25,603 27,497 In-process research and development charge...... 7,471 -- Investment gains (Note 2)....................... -- (14,767) Changes in assets and liabilities: Accounts receivable............................. 60,498 20,905 Inventories..................................... (2,439) 3,520 Prepaid expenses................................ (9,630) (490) Accounts payable................................ (36,407) 32,917 Accrued expenses................................ (18,335) (42,497) Restructuring and special charge accruals....... 7,850 (2,387) Other........................................... (74) 5,804 --------- --------- Net cash used for operating activities...... (38,923) (19,545) --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sales of property and equipment........... -- 29,737 Capital expenditures, net............................... (27,666) (3,258) Other investments....................................... 1,500 -- --------- --------- Net cash provided by (used for) investing activities.................................. (26,166) 26,479 --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Repayment of bank debt (Note 5)......................... -- (16,625) Common stock issued for cash............................ 8,524 48,103 --------- --------- Net cash provided by financing activities... 8,524 31,478 --------- --------- Net increase (decrease) in cash and cash equivalents..... (56,565) 38,412 Cash and cash equivalents, beginning of period........... 353,660 163,675 --------- --------- Cash and cash equivalents, end of period................. $ 297,095 $ 202,087 ========= ========= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for income taxes................. $ 763 $ 3,225 Cash paid during the period for interest..................... 1,418 166 </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 6
7 WESTERN DIGITAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) <TABLE> <CAPTION> NINE-MONTH PERIOD ENDED --------------------------- MAR. 27, MAR. 31, 1999 2000 ---------- --------- <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net loss................................................. $(391,204) $(192,181) Adjustments to reconcile net loss to net cash used for operating activities: Non-Cash Items: Depreciation and amortization.................... 101,841 64,949 Interest on convertible debentures............... 18,596 12,513 Non-cash portion of restructuring charges........ 25,603 56,301 In-process research and development charge....... 7,471 -- Extraordinary gain from redemption of convertible debentures......................... -- (166,899) Investment gains (Note 2)........................ -- (14,767) Changes in assets and liabilities: Accounts receivable.............................. 57,551 95,980 Inventories...................................... 23,103 45,885 Prepaid expenses................................. 2,158 6,203 Accounts payable................................. 19,467 (18,837) Accrued expenses................................. 37,987 (65,947) Restructuring and special charge accruals........ 7,850 47,542 Other............................................ 2,322 8,474 --------- --------- Net cash used for operating activities....... (87,255) (120,784) --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sales of property and equipment............ -- 66,756 Capital expenditures, net................................ (87,763) (17,101) Other investments........................................ -- (2,200) --------- --------- Net cash provided by (used for) investing activities................................... (87,763) 47,455 --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Repayment of bank debt (Note 5).......................... -- (50,000) Common stock issued for cash............................. 15,208 99,269 Costs relating to credit facility........................ (2,925) -- --------- --------- Net cash provided by financing activities.... 12,283 49,269 --------- --------- Net decrease in cash and cash equivalents................. (162,735) (24,060) Cash and cash equivalents, beginning of period............ 459,830 226,147 --------- --------- Cash and cash equivalents, end of period.................. $ 297,095 $ 202,087 ========= ========= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for income taxes.................. $ 4,080 $ 4,307 Cash paid during the period for interest...................... 3,554 2,094 </TABLE> The accompanying notes are an integral part of these condensed consolidated financial statements. 7
8 WESTERN DIGITAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. Basis of Presentation The accounting policies followed by the Company are set forth in Note 1 of Notes to Consolidated Financial Statements included in the Company's Annual Report on Form 10-K as of and for the year ended July 3, 1999. In the opinion of management, all adjustments necessary to fairly state the condensed consolidated financial statements have been made. All such adjustments are of a normal recurring nature. Certain information and footnote disclosures normally included in the consolidated financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company's Annual Report on Form 10-K as of and for the year ended July 3, 1999. The Company has a 52 or 53-week fiscal year. In order to align its manufacturing and financial calendars, effective during the three months ended December 31, 1999, the Company changed its fiscal calendar so that each fiscal month ends on the Friday nearest to the last day of the calendar month. Prior to this change, the Company's fiscal month ended on the Saturday nearest to the last day of the calendar month. The change did not have a material impact on the Company's results of operations or financial position. All general references to years relate to fiscal years unless otherwise noted. Certain prior periods' amounts have been reclassified to conform to the current period presentation. 2. Supplemental Financial Statement Data (in thousands) JULY 3, MAR. 31, 1999 2000 -------- -------- Inventories: Finished goods....................... $101,828 $72,027 Work in process...................... 26,307 13,907 Raw materials and component parts.... 15,958 12,274 -------- ------- $144,093 $98,208 ======== ======= <TABLE> <CAPTION> THREE-MONTH PERIOD ENDED NINE-MONTH PERIOD ENDED --------------------------------------------------------- MAR. 27, MAR. 31, MAR. 27, MAR. 31, 1999 2000 1999 2000 --------- ------- --------- --------- Net Interest and Other Income (Expense): <S> <C> <C> <C> <C> Interest income.................................. $ 4,187 $ 1,939 $ 14,303 $ 6,425 Investment gains................................. -- 14,767 -- 14,767 Interest expense................................. (8,435) (3,217) (24,442) (16,060) --------- ------- --------- -------- $ (4,248) $13,489 $ (10,139) $ 5,132 ========= ======= ========= ======== </TABLE> 8
9 <TABLE> <CAPTION> NINE-MONTH PERIOD ENDED ---------------------------- MAR. 27, MAR. 31, 1999 2000 -------------- ------------ <S> <C> <C> Supplemental disclosure of non-cash investing and financing activities: Common stock issued for redemption of convertible debentures.............................................. $ -- $ 110,109 ============== ============ Redemption of convertible debentures for Company common stock, net of capitalized issuance costs................. $ -- $ 277,008 ============== ============ Settlement of accounts payable by transfer of cost method investments....................................... $ -- $ 26,242 ============== ============ </TABLE> 3. Loss per Share As of March 27, 1999 and March 31, 2000, 16.6 and 21.3 million shares, respectively, relating to the possible exercise of outstanding stock options were not included in the computation of diluted loss per share. As of March 27, 1999 and March 31, 2000, an additional 19.4 and 8.4 million shares, respectively, issuable upon conversion of the convertible debentures were excluded from the computation of diluted loss per share. The effects of these items were not included in the computation of diluted loss per share as their effect would have been anti-dilutive. 4. Common Stock Transactions On September 30, 1999, the Company's Board of Directors approved a "Broad-Based" Stock Incentive Plan (the "Broad-Based Plan") under which options to purchase shares of common stock may be granted to employees of the Company and others. On October 20, 1999, the Board of Directors approved a grant to its regular, non-direct labor employees of approximately 2.4 million shares under the Broad-Based Plan and the Company's Employee Stock Option Plan, at $3.31 per share, the fair market value of the Company's common stock on the date of the grant. The options granted vest 100% one year from the date of grant. On September 10, 1998, the Company's Board of Directors authorized and declared a dividend distribution of one Right for each share of common stock of the Company outstanding at the close of business on November 30, 1998. In addition, the Company's Board of Directors authorized the issuance of one Right for each share of common stock of the Company issued from the record date until certain dates as specified in the Company's rights agreement dated as of October 15, 1998, pursuant to which the Company's then existing shareholders rights plan was replaced by a successor ten year plan. The Rights issued become exercisable for common stock at a discount from market value upon certain events related to a change in control. During the nine-month period ended March 31, 2000, the Company issued approximately 1,236,000 shares of its common stock in connection with Employee Stock Purchase Plan ("ESPP") purchases and 210,000 shares of its common stock in connection with common stock option exercises, for aggregate cash proceeds of approximately $5.5 million. During the corresponding period of the prior year, the Company issued approximately 1,002,000 shares of its common stock in connection with ESPP purchases and 709,000 shares of its common stock in connection with common stock option exercises, for aggregate cash proceeds of $15.2 million. Under an existing equity facility, the Company may issue for cash, shares of common stock to institutional investors in monthly increments of $12.5 million. The equity facility provides for up to $150.0 million in cash proceeds of which $93.8 million had been utilized during the nine month period ended March 31, 2000. Shares sold under the equity facility are at the market price of the Company's common stock less a discount ranging from 2.75% to 4.25%. During the nine months ended March 31, 2000, the Company 9
10 issued 20.5 million shares of common stock under the equity facility for net cash proceeds of approximately $93.8 million. During the nine-month period ended March 31, 2000, the Company issued 26.7 million shares of common stock to redeem a portion of its 5.25% zero coupon convertible subordinated debentures (the "Debentures") with a book value of $284.1 million and an aggregate principal amount at maturity of $735.6 million. These redemptions were private, individually negotiated transactions with certain institutional investors. The redemptions resulted in extraordinary gains of $166.9 million during the nine months ended March 31, 2000. As of March 31, 2000, the book value of the remaining outstanding Debentures was $222.6 million and the aggregate principal amount at maturity was $561.6 million. 5. Credit Facility The Company's credit facility matured on March 31, 2000. The remaining balance on the term loan was repaid using the proceeds from the equity facility during the three months ended March 31, 2000. The Company has a commitment for a new Senior Credit Facility that will provide up to a $150 million revolving credit line (depending on a borrowing base calculation). The new Senior Credit Facility will be secured by the Company's accounts receivable, inventory, 65% of its stock in its foreign subsidiaries and other assets of the Company, excluding the Company's Connex and Sagetree subsidiaries. At the option of the Company, borrowings 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. The Company anticipates that the new Senior Credit Facility will be completed by June 30, 2000. 6. Sales of Real Property On August 9, 1999, the Company sold approximately 34 acres of land in Irvine, California, upon which it had previously planned to build a new corporate headquarters, for $26 million (the approximate cost of the land). The Company has extended the current lease of its worldwide headquarters in Irvine, California, through January 2001. During December 1999, the Company received an $11.0 million deposit on the sale of its enterprise drive manufacturing facility in Tuas, Singapore. The total sales proceeds were $11.0 million and the sale was recognized during the three months ended March 31, 2000. The corresponding gain on the sale of $3.1 million is included in net restructuring charges for the three months ended March 31, 2000. During the three months ended March 31, 2000, the Company sold its Rochester, Minnesota enterprise research and development facility for $29.7 million. The resulting loss of $1.9 million is included in net restructuring charges for the three months ended March 31, 2000. 7. Restructuring Activities CONSOLIDATION OF ASIA MANUFACTURING FACILITIES During the first half of 2000, the Company initiated a restructuring program directed at improving operational effectiveness and efficiency and reducing operational expenses worldwide. Charges related to these restructuring actions were accrued in the periods in which executive management committed to execute such actions. Committed actions for the six months ended December 31, 1999 included reorganization of operational and management responsibilities, transfer of hard drive production from Singapore to the Company's manufacturing facility in Malaysia, closure of the Company's Singapore operations, and taking property and equipment out of service and holding it for disposal. These actions resulted in a net reduction of worldwide headcount of approximately 1,600, of which approximately 140 were management, professional and administrative personnel and the remainder were manufacturing employees. In Asia, approximately 3,800 employees were reduced from the Company's Singapore operation and approximately 2,900 were added in Malaysia in connection with the transfer of production. The restructuring charges originally recorded during the six months ended December 31, 1999, as well as third-quarter changes to the original restructuring accruals are summarized in the table below. No additional 10
11 restructuring charges for the Desktop product line were recorded during the quarter ended March 31, 2000. ENTERPRISE DRIVE MARKET On January 19, 2000, the Company announced its plans to exit the enterprise hard drive market and shift its strategic focus and resources in the enterprise storage market to Internet-related data content management systems and management software. In connection with this decision, the Company closed its Rochester, Minnesota enterprise hard drive design center and approximately 402 employees in the design center were laid off and given legally required notification and outplacement services. The exit from the enterprise market resulted in a restructuring charge of $38.1 million during the three months ended March 31, 2000. The restructuring charge consisted of $27.4 million for property and equipment write-offs (equipment taken out of service and held for disposal) including the loss on the sale of the Rochester facility, and $10.7 million for severance, outplacement and other incremental costs associated with the closure. Reducing these charges is the gain realized on the sale of the Tuas facility of $3.1 million, the favorable settlement of lease commitments in Singapore of $5.3 million and favorable settlement of 1999 restructuring accruals of $1.7 million. Below is a summary of the restructuring charges, the amounts paid and the ending accrual balance (in thousands) for the nine months ended March 31, 2000. The Company estimates that these restructuring efforts will be substantially completed by June 30, 2000. <TABLE> <CAPTION> Nine Month Period Ended March 31, 2000 ------------------------------------------ Non-Cash Total Accruals Charges Charges --------- -------- --------- <S> <C> <C> <C> Consolidation of Asian Operation: Fixed asset write-offs $ -- $ 28,804 $ 28,804 Severance and outplacement 18,028 -- 18,028 Lease cancellation and other (net of favorable lease settlement of $5,252 recorded in third quarter) 5,733 -- 5,733 --------- -------- --------- 23,761 28,804 52,565 Closure of enterprise drive business: Fixed asset write-offs 27,497 27,497 Severance, outplacement and other 10,651 -- 10,651 --------- -------- --------- 10,651 27,497 38,148 --------- -------- --------- 34,412 56,301 90,713 Cash Payments: (26,364) -- --------- -------- $ 8,048 $ 56,301 ========= ======== Changes to 1999 restructuring estimates: Gain on sale of Tuas building (3,100) Favorable settlement of 1999 restructuring accruals (1,776) --------- $ 85,837 ========= </TABLE> 8. Product Recall On September 27, 1999, the Company announced a recall of its 6.8GB per platter series of WD Caviar(R) desktop hard drives because of a reliability problem resulting from a faulty power driver chip manufactured by a third-party supplier. Approximately 1.2 million units were manufactured with the faulty chip. Replacement of the chips involved rework of the printed circuit board assembly. Revenues of approximately $100 million related to the products that were recalled were reversed in the three months ended October 2, 1999. In addition, the Caviar product line was shut down for approximately two weeks, eliminating approximately $70 million of forecasted revenue during the three months ended October 2, 1999. Cost of revenues for the three months ended October 2, 1999 included charges totaling $37.7 million for estimated costs to recall and repair the affected drives, consisting of $23.1 million for repair and retrieval, $4.5 million for freight and other, and $10.1 million for write-downs of related inventory. By March 31, 2000, the Company had completed rework on approximately 83% of the 1.2 million units and had resolved its claims against third parties resulting from the recall. 11
12 9. Investments in Marketable Securities The Company owns approximately 10.8 million shares of Komag common stock, which when acquired on April 8, 1999, had a fair market value of $34.9 million. The stock is restricted as to the number of shares which can be sold in a given time period. The restrictions lapse over a three and one-half year period. As of March 31, 2000, approximately 60% of these shares may be sold within twelve months. Because the Company has identified these shares as "available for sale" under the provisions of Statement of Financial Accounting Standards No. 115, "Investments in Certain Debt and Equity Securities" ("SFAS 115"), the amount sellable within twelve months has been marked to market value using published closing prices of Komag stock as of March 31, 2000. Accordingly, a total accumulated unrealized gain of $3.6 million is included in accumulated other comprehensive income (loss). The aggregate carrying value of the shares was $38.5 million (market value of approximately $40.9 million) as of March 31, 2000, of which $24.6 million relates to shares sellable within twelve months and is classified as current. Due to market conditions, as of April 28, 2000 the market value of all Komag shares held by the Company had declined to $31.7 million, of which $19.0 million relates to shares sellable within twelve months. The Company owns approximately 1.3 million shares of Vixel Corporation ("Vixel") common stock. The Company has identified these shares as "available for sale" under the provisions of SFAS 115. During the three months ended October 2, 1999, Vixel completed an initial public offering and the shares were marked to market value. At March 31, 2000 a total accumulated unrealized gain of $21.7 million is included in accumulated other comprehensive income (loss). The investment in Vixel common stock is classified as current. The aggregate carrying value of the shares, which approximates market value, is $21.7 million as of March 31, 2000. As of April 28, 2000 the market value had declined to $9.4 million, due to market conditions. 10. Other Comprehensive Income (Loss) The Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"), beginning with the Company's fourth quarter of 1999. Prior to the fourth quarter of 1999, the Company did not possess any components of other comprehensive income as defined by SFAS 130. SFAS 130 separates comprehensive income into two components: net income and other comprehensive income (loss). Other comprehensive income (loss) refers to revenue, expenses, gains and losses that are recorded as an element of shareholders' equity (deficiency) but are excluded from net income (loss). While SFAS 130 establishes new rules for the reporting and display of comprehensive income (loss), SFAS 130 has no impact on the Company's net loss or total shareholders' deficiency. The Company's other comprehensive income (loss) is comprised of unrealized gains and losses on marketable securities categorized as "available for sale" under SFAS 115. The components of total comprehensive loss for the three and nine-month periods ended March 31, 2000 were as follows (in millions): THREE-MONTH NINE-MONTH PERIOD ENDED PERIOD ENDED MAR. 31, 2000 MAR. 31, 2000 -------------- ------------- Net loss $ (70.7) $ (192.2) Other comprehensive income: Unrealized gain on available for sale investments, net 1.8 27.4 ------- -------- Total comprehensive loss $ (68.9) $ (164.8) ======= ======== 12
13 11. Legal Proceedings The Company was sued by Amstrad PLC ("Amstrad") in December 1992 in Orange County Superior Court. The complaint alleged that hard drives supplied by the Company in calendar 1988 and 1989 were defective and caused damages to Amstrad of $186.0 million in out-of-pocket expenses, lost profits, injury to Amstrad's reputation and loss of goodwill. The Company filed a counterclaim for $3.0 million in actual damages in addition to exemplary damages in an unspecified amount. The first trial of this case ended in a mistrial, with the jury deadlocked on the issue of liability. The case was retried, and on June 9, 1999, the jury returned a verdict against Amstrad and in favor of Western Digital. Amstrad has filed a notice of appeal from the judgment, and the Company has filed motions seeking recovery of a portion of its legal and other costs of defense. The Company does not believe that the ultimate resolution of this matter will have a material adverse effect on the financial position, results of operations or liquidity of the Company. However, should the judgment be reversed on appeal, and if in a retrial of the case Amstrad were to prevail, the Company may be required to pay damages and other expenses, which may have a material adverse effect on the Company's financial position, results of operations and/or liquidity. In addition, the costs of defending a retrial of the case may be material, regardless of the outcome. In 1994 Papst Licensing ("Papst") brought suit against the Company in the U.S. District Court for the Central District of California alleging infringement by the Company of five of its patents relating to disk drive motors that the Company purchases 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 agree to 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 ultimate resolution of this matter will have a material adverse effect on the financial position, results of operations or liquidity of the Company. However, because of the nature and inherent uncertainties of litigation, should the outcome of this action be unfavorable, the Company may be required to pay damages and other expenses, which may have a material adverse effect on the Company's financial position, results of operations and/or liquidity. In addition, the costs of defending such litigation may be material, regardless of the outcome. The Company and Censtor Corporation ("Censtor") have had discussions concerning royalties, if any, that might be due Censtor under a licensing agreement. Censtor has initiated arbitration procedures under the agreement seeking payment of royalties. In response, the Company has filed a complaint in federal court seeking a determination that the patents at issue are invalid. The Federal Court action has been stayed pending completion of the arbitration procedures. The Company does not believe that the outcome of this dispute will have a material adverse effect on its financial position, results of operations and/or liquidity. In the normal course of business, the Company receives and makes inquiry 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 a license will be offered or that the terms of any license offered will be acceptable to the Company. Several such matters are currently pending. The Company does not believe that the ultimate resolution of these matters will have a material adverse effect on the financial position, results of operations or liquidity of the Company. 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 believes that the final disposition of such matters will not have a material adverse effect on the Company's financial position, results of operations or liquidity. 13
14 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: o the financial prospects of the Company o the Company's financing plans o litigation and other contingencies potentially affecting the Company's financial position, operating results, or liquidity o trends affecting the Company's financial condition or operating results o the Company's strategies for growth, operations, product development and commercialization o conditions or trends in or factors affecting the computer, data storage, home entertainment or hard drive industry. 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. RECENT DEVELOPMENTS During the first half of 2000, the Company initiated a restructuring program directed at improving operational effectiveness and efficiency and reducing operational expenses worldwide. Charges related to these restructuring actions were accrued in the periods in which executive management committed to execute such actions. Committed actions for the six months ended December 31, 1999 included reorganization of operational and management responsibilities, transfer of hard drive production from Singapore to the Company's manufacturing facility in Malaysia, closure of the Company's Singapore operations, and taking property and equipment out of service and holding it for disposal. These actions resulted in a net reduction of worldwide headcount of approximately 1,600, of which approximately 140 were management, professional and administrative personnel and the remainder were manufacturing employees. In Asia, approximately 3,800 employees were reduced from the Company's Singapore operation and approximately 2,900 were added in Malaysia in connection with the transfer of production. Restructuring charges recorded in connection with these actions totaled $57.8 million for the six-month period ended December 31, 1999. No additional restructuring charges for the Desktop product line were recorded during the third quarter ended March 31, 2000. On August 9, 1999, the Company sold approximately 34 acres of land in Irvine, California, upon which it had previously planned to build a new corporate headquarters, for $26 million (the approximate cost of the land). The Company has extended the current lease of its worldwide headquarters in Irvine, California, through January 2001, and has an option to extend the lease for an additional five-month period. On September 27, 1999, the Company announced a recall of its 6.8GB per platter series of WD Caviar(R) desktop hard drives because of a reliability problem resulting from a faulty power driver chip manufactured by a third-party supplier. Approximately 1.2 million units were manufactured with the faulty chip. Replacement of the chips involved rework of the printed circuit board assembly. Revenues of approximately $100 million 14
15 related to the products that were recalled were reversed in the three months ended October 2, 1999. In addition, the Caviar product line was shut down for approximately two weeks, eliminating approximately $70 million of forecasted revenue during the three months ended October 2, 1999. Cost of revenues for the three months ended October 2, 1999 included charges totaling $37.7 million for estimated costs to recall and repair the affected drives, consisting of $23.1 million for repair and retrieval, $4.5 million for freight and other, and $10.1 million for write-downs of related inventory. By March 31, 2000, the Company had completed rework on approximately 83% of the 1.2 million units and had resolved its claims against third parties resulting from the recall. In December 1999, the Company agreed to sell a manufacturing facility in Tuas, Singapore for cash proceeds of $11.0 million. In January 2000, the Company also agreed to sell its Rochester, Minnesota facility for cash proceeds of approximately $29.7 million. The sales were recognized during the third quarter and the corresponding gain of $3.1 million on the Tuas facility and the loss of $1.9 million on the Rochester facility are included in the net restructuring charge for the third quarter ended March 31, 2000. On January 19, 2000, the Company announced its plans to exit the enterprise hard drive market and shift its strategic focus and resources in the enterprise storage market to Internet-related data content management systems and management software. In connection with this decision, the Company closed its Rochester, Minnesota enterprise hard drive design center, and approximately 402 employees in the design center were laid off and given legally required notification and outplacement services. The exit from the enterprise market resulted in a restructuring charge of $38.1 million during the three months ended March 31, 2000. The restructuring charge consisted of $27.4 million for equipment write-offs (equipment taken out of service and held for disposal) including the loss on the sale of the Rochester facility, and $10.7 million for severance, outplacement and other incremental costs associated with the closure. Reducing these charges is the gain realized on the sale of the Tuas facility of $3.1 million, the favorable settlement of lease commitments in Singapore of $5.3 million and favorable settlement of 1999 restructuring accruals of $1.7 million. The Company estimates that the restructuring effort will be substantially completed by June 30, 2000. Also, as a direct result of the exit from the enterprise drive market, the Company had nonrecurring "special" charges of $34.8 million during the three months ended March 31, 2000. These charges are included in costs of revenues and consist of vendor settlements, incremental warranty accruals and inventory write-downs resulting from the immediate termination of operations. RESULTS OF OPERATIONS Consolidated revenues were $516.6 million for the three months ended March 31, 2000, a decrease of 23%, or $151.9 million, from the three months ended March 27, 1999 and a decrease of 8%, or $43.6 million, from the immediately preceding quarter. The lower revenues during the three months ended March 31, 2000 as compared to the corresponding period of the prior year and the immediately preceding quarter, resulted from the Company's decision in the third quarter of 2000 to exit the high end enterprise hard drive market and a decline in the average selling prices (ASP's) of hard drive products due to an intensely competitive hard drive market, partially offset by slight increases in desktop unit shipments. Consolidated revenues were $1.5 billion for the nine months ended March 31, 2000, down 28% from the nine months ended March 27, 1999. The lower revenues resulted from the exit from the enterprise hard drive market combined with lower ASPs and a decline in unit shipments of approximately 8%, which was largely due to the product recall in the three months ended October 2, 1999. The gross profit for the three months ended March 31, 2000, totaled $11.6 million, or 2% of revenue. This compares to a gross profit of $39.9 million, or 6% of revenue, for the three months ended March 27, 1999, and $20.2 million, or 4% of revenue, for the immediately preceding quarter. The gross profit for the current quarter included $34.8 million of special charges directly relating to the exit from the enterprise hard drive market, as discussed above. Excluding the special charges, consolidated gross profit for the current quarter was $46.4 million, or 9% of revenue. The increase in gross profit (excluding special charges) over the three months ended March 27, 1999 and the immediately preceding quarter was primarily the result of lower manufacturing costs due to recent restructurings and the transfer of all desktop production to a single, highly utilized facility in Malaysia. The consolidated gross profit for the nine months ended March 31, 2000 totaled $39.0 million, or 3% of revenue (excluding special charges of $72.5 million). This compares to a gross profit for the nine months ended March 27, 1999 of $53.3 million, or 3% of revenue (excluding special charges of $77 million). The decline in gross 15
16 profit for the current nine-month period was the result of lower volumes due to the product recall and lower ASPs, offset by the Company's restructuring and cost-cutting efforts. Research and development ("R&D") expense for the three months ended March 31, 2000 was $33.8 million, a decrease of $28.9 million from the three months ended March 27, 1999 and a decrease of $10.3 million from the immediately preceding quarter. R&D expense for the nine months ended March 31, 2000 was $128.0 million, a decrease of $37.0 million from the nine months ended March 27, 1999. The decrease in R&D expenses was primarily due to the Company's exit from the enterprise hard drive market and its expense reduction efforts, particularly expenses associated with hard disk drive development, partially offset by increased spending at Connex and Sagetree, the Company's subsidiaries, and other new venture development efforts. Also included in R&D spending for the three and nine-months ended March 27, 1999 was $12 million of special charges associated with the acquisition of in process R&D. Selling, general and administrative ("SG&A") expense in the three months ended March 31, 2000, was $34.0 million, a decrease of $12.2 million from the three months ended March 27, 1999 and a decrease of $5.1 million from the immediately preceding quarter. The decrease in SG&A expense for the three months ended March 31, 2000 compared to the three months ended March 27, 1999 and the immediately preceding quarter was primarily due to the Company's exit from the enterprise hard drive market and its expense reduction efforts, particularly SG&A expenses associated with the Company's hard disk drive business. The decrease was partially offset by increased spending at Connex, Sagetree and other of the Company's developing ventures. SG&A expense was $116.9 million for the nine months ended March 31, 2000, a decrease of $34.5 million from the nine months ended March 27, 1999. The decrease was the result of the exit from the enterprise hard drive market, expense reduction efforts, and the nonrecurrence of a $7.5 million special charge on terminated hedging contracts recorded in SG&A expense during the nine months ended March 27, 1999. Net interest and other income for the three months ended March 27, 2000 was $13.5 million, compared to net interest expense of $4.2 million for the three months ended March 27, 1999 and net interest expense of $3.0 million in the immediately preceding quarter. The increase in net interest and other income for the three months ended March 31, 2000 was due to a $14.7 million gain on disposition of certain investment securities and lower interest expense on the Company's convertible debentures (the average carrying value of the Company's convertible debentures was lower due to the debenture redemptions which occurred during the immediately preceding quarter). Net interest and other income was $5.1 million for the nine months ended March 31, 2000 as compared to net interest expense of $10.1 million for the nine months ended March 27, 1999. The increase in net interest and other income was due to the $14.7 million gain and a decrease in interest expense on the Company's convertible debentures. The Company initiated significant restructuring efforts during the nine months ended March 31, 2000. As a result, net restructuring charges of approximately $28.0 million and $85.8 million were recorded during the three and nine months ended March 31, 2000, respectively. The charges related to severance and outplacement, the write-off of fixed assets taken out of service and to be disposed of, lease cancellation and other charges, as discussed above. During the nine months ended March 31, 2000, the Company issued common stock in exchange for its convertible debentures which were retired in non-cash transactions. These redemptions were private, individually negotiated transactions with certain institutional investors. The redemptions resulted in extraordinary gains of $166.9 million during the six months ended December 31, 1999. There were no redemptions during the three months ended March 31, 2000. The Company did not record an income tax benefit in any periods presented as no additional loss carrybacks were available and management deemed it "more likely than not" that the deferred tax benefits generated would not be realized. LIQUIDITY AND CAPITAL RESOURCES At March 31, 2000, the Company had cash and cash equivalents of $202.1 million as compared to $226.1 million at July 3, 1999 and $163.7 million at December 31, 1999. Net cash used in operations was $19.5 million and $120.8 million for the three and nine months ended March 31, 2000 respectively, as compared to $38.9 million and $87.3 million for the comparable periods of the prior year. Net cash used in operations for 16
17 the nine months ended March 31, 2000 increased by $33.5 million as compared to the nine months ended March 27,1999, due to higher expenditures for restructuring activities and the product recall. Operating cash flows provided by changes in working capital amounted to $6.2 million and $119.3 million for the three and nine months ended March 31, 2000, respectively and reflect the Company's management of operating assets and liabilities during the periods. For the three months ended March 31, 2000, the Company's days of sales outstanding ("DSO") was 31 days, inventory turned 21 times and days of payables outstanding was 52 days. Excluding charges and cash used for restructuring and other nonrecurring activities, operations provided net cash of $18.2 million for the three months ended March 31, 2000 as compared to usage of $8.0 million for the three months ended December 31, 1999. Cash used for restructuring and other nonrecurring activities was $37.7 million for the three months ended March 31, 2000 and consisted of expenditures for severance and outplacement, lease cancellations and product recall costs. Other uses of cash during the nine months ended March 31, 2000 included the repayment of bank debt of $50.0 million and net capital expenditures of $17.1 million, primarily to upgrade the Company's desktop hard drive production capabilities and for normal replacement of existing assets. Other sources of cash during the period included proceeds of $93.8 million received upon issuance of 20.5 million shares of the Company's stock under the Company's equity facility, and $66.8 million received on sales of real property during the period. The Company anticipates that capital expenditures for the remainder of 2000 will not be more than $15 million and will relate to accommodating new technologies and new product lines, normal replacement of existing assets and expansion of production capabilities in Malaysia. The Company also anticipates cash expenditures of approximately $10.0 million to be paid in the remaining three months of 2000 related to the Company's restructuring programs, primarily for severance and outplacement costs, lease cancellation and other costs of vacating leased properties, and settlements with vendors on existing purchase orders related to the Company's exit from its enterprise hard drive market. The Company's credit facility matured on March 31, 2000. The remaining balance on the term loan was repaid using the proceeds from the equity facility during the three months ended March 31, 2000. The Company has a commitment for a new Senior Credit Facility that will provide up to a $150 million revolving credit line (depending on a borrowing base calculation). The new Senior Credit Facility will be secured by the Company's accounts receivable, inventory, 65% of its stock in its foreign subsidiaries and other assets of the Company, excluding the Company's Connex and Sagetree subsidiaries. At the option of the Company, borrowings 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. The Company anticipates that the new Senior Credit Facility will be completed by June 30, 2000. Under an existing equity facility, the Company may issue shares of common stock to institutional investors for cash, in monthly increments of $12.5 million. The facility provides for up to $150.0 million in cash proceeds of which $93.8 million had been utilized as of March 31, 2000. Shares sold under the facility are at the market price of the Company's common stock less a discount ranging from 2.75% to 4.25. During the six months ended December 31, 1999, the Company issued 26.7 million shares of common stock in exchange for Debentures with a book value of $284.1 million, and an aggregate principal amount at maturity of $735.6 million. These redemptions were private, individually negotiated transactions with certain institutional investors. The redemptions resulted in extraordinary gains of $166.9 million during the six months ended December 31, 1999. There were no redemptions during the three months ended March 31, 2000. As of March 31, 2000, the book value of the remaining outstanding Debentures was $222.6 million and the aggregate principal amount at maturity was $561.6 million. The Company expects to continue to incur operating losses in 2000. The Company had a shareholders' deficiency of $108.8 million as of March 31, 2000. However, the Company had cash balances of $202.1 million and working capital of $8.8 million as of March 31, 2000. In addition, the Company has significantly restructured its operations and has other sources of liquidity available. In light of these conditions, the company has the following plans and other options: 17
18 o The Company's ongoing operating expenses and capital expenditures have been reduced substantially as compared to historical levels due to: -- Recent restructurings; -- Reduced general and administrative spending; and -- Lower fixed spending resulting from the closure of its Santa Clara, California disk media operations, its disk drive manufacturing facilities in Tuas and Chai Chee, Singapore, and its enterprise hard drive design center in Rochester, Minnesota. o The Company has the following additional sources of liquidity available to it: -- $56.2 million remaining available under the Equity Facility; -- Other equity investments that may be disposed of during the next twelve months, including 6.5 million shares of Komag common stock and 1.3 million shares of Vixel common stock with a combined market value of approximately $28.4 million as of April 28, 2000. -- The Company has a commitment for a new Senior Credit Facility that will provide up to a $150 million revolving credit line (depending on a borrowing base calculation). The Company anticipates that the new Senior Credit Facility will be completed by June 30, 2000. -- The Company is also pursuing other sources of private equity financing for its developing subsidiaries. Based on the above factors, the Company believes its current cash balances, its existing equity facility, and other liquidity sources currently available to it, will be sufficient to meet its working capital needs through the next twelve months. There can be no assurance that a new bank facility will be obtained or the equity 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 heading "Risk factors relating to Western Digital particularly." NEW ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 was effective for all fiscal quarters for fiscal years beginning after June 15, 1999. In August 1999, the FASB issued Statement of Financial Accounting Standards No. 137, "Accounting for Derivative Instruments and Hedging Activities -- Deferral of the Effective Date of FASB Statement No. 133, An Amendment of FASB Statement No. 133" ("SFAS 137"), which defers the effective date of SFAS 133 to all fiscal quarters for fiscal years beginning after June 15, 2000. SFAS 133 establishes accounting and reporting standards for derivative instruments embedded in other contracts and for hedging activities. Application of SFAS 133 is not expected to have a material impact on the Company's consolidated financial position, results of operations or liquidity. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin 101 ("SAB101") "Revenue Recognition in Financial Statements". This Staff Accounting Bulletin summarizes certain of the staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. The Company does not expect the adoption of SAB101 to have a material impact on the Company's consolidated results of operations. YEAR 2000 On January 1, 2000, the Company incurred nominal impact on its products, equipment, computer systems and applications as a result of the Year 2000 issue. The Company attributes this to its Year 2000 readiness efforts. As of December 31, 1999, systems remediation and integration testing and development of the Company's contingency plans had been completed. Supplier management is an ongoing process, and no material impact was felt from lack of supplier readiness at January 1, 2000. Although the Company did not experience any material problems related to the Year 2000 issue, there can be no assurances that problems 18
19 relating to the Year 2000 issue will not manifest themselves in the future. Expenditures related to the Year 2000 project, excluding normal replacement of existing capital assets, totaled approximately $12.2 million. 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: o consistently maintain or improve our time-to-market performance with our new products o produce these products in sufficient volume within our rapid product cycle o qualify these products with key customers on a timely basis by meeting our customers' performance and quality specifications, or o achieve acceptable manufacturing yields and costs with these products 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, and we expect this trend to continue. 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. Our average selling prices and our revenue are declining. We expect that our average selling prices for hard disk 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. 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. Some of our competitors are developing hybrid storage devices that combine magnetic and optical technologies, but 19
20 we have decided not to pursue this technology at this time. 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. 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 1997, we significantly increased our share of the desktop market, but these gains were lost during 1998 and 1999. If our market share erodes further, it would likely harm our operating results. Our prices and margins are subject to declines due to unpredictable end-user demand and oversupply of hard disk 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. If intense price competition occurs, we may be forced to lower prices sooner and more than expected and transition to new products sooner than expected. For example, in the second half of 1998 and throughout 1999, as a result of excess inventory in the desktop hard drive market, aggressive pricing and corresponding margin reductions materially adversely affected our operating results. 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. If we do not develop lower cost hard drives that can successfully compete in this market, our market share will likely fall, which could harm our operating results. Furthermore, 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. While we are investing development resources in designing hard drive products for new audio-visual applications, it is too early to assess the impact of these new applications on future demand for hard drive products. 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, for the nine-month period ended March 31, 2000, sales to our top 10 customers accounted for approximately 58% of revenues. These customers have a wide variety of suppliers to choose from and therefore can make substantial demands on 20
21 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 early in the third quarter of 2000 in our enterprise hard drive market and is one of the factors which led to the Company's decision to exit the enterprise hard drive market and close its Rochester, Minnesota facility. 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 which 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 are doing 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. This strategic relationship has reduced our media component costs; however, it has increased our dependence on Komag as a supplier. Our future operating results will 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. Any disruption in Komag's ability to manufacture and supply us with media would likely harm our operating results. 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. We have only one manufacturing facility, which subjects us to the risk of damage or loss of the facility. Our volume manufacturing operations currently are based in one facility in Malaysia. A fire, flood, earthquake or other disaster or condition affecting our facility would almost certainly result in a loss of substantial 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: o obtaining requisite United States and foreign governmental permits and approvals o currency exchange rate fluctuations or restrictions o political instability and civil unrest 21
22 o transportation delays or higher freight rates o labor problems o trade restrictions or higher tariffs o exchange, currency and tax controls and reallocations o loss or non-renewal of favorable tax treatment under agreements or treaties with foreign tax authorities. 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 in data and content management, storage and communication takes us into new markets. We have recently entered the storage subsystem market through our Connex subsidiary. In this market we are facing the challenges of building volume and market share in a market which is new to us but which has several established and well-funded competitors. There is already significant competition for skilled engineers, both in the hardware and software areas, in this market. Our success will depend on Connex's ability to develop, introduce and achieve market acceptance of new products, applications and product enhancements, and to attract and retain skilled engineers. Additionally, our competitors in this market have established intellectual property portfolios. Our success will also depend on our ability to license existing intellectual property or create new innovations. Moreover, our competitors' established intellectual property portfolios increase our risk of intellectual property litigation. We are also developing hard drives and storage devices for the emerging audio-visual market. 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 which have also entered this emerging market, and there is no assurance that the market for digital storage devices for audio-visual content will materialize or support all of these competitors. We have recently 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. 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 several 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. 22
23 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 not 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 is 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: o the timing of orders from and shipment of products to major customers o our product mix o changes in the prices of our products o manufacturing delays or interruptions o acceptance by customers of competing products in lieu of our products o variations in the cost of components for our products o limited access to components that we obtain from a single or a limited number of suppliers, such as Komag o competition and consolidation in the data storage industry o seasonal and other fluctuations in demand for computers often due to technological advances. 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: o accruals for warranty against product defects o price protection adjustments on products sold to resellers and distributors o inventory adjustments for write-down of inventories to fair value o reserves for doubtful accounts o accruals for product returns. 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: 23
24 o actual or anticipated fluctuations in our operating results o announcements of technological innovations by us or our competitors which may decrease the volume and profitability of sales of our existing products and increase the risk of inventory obsolescence o new products introduced by us or our competitors o periods of severe pricing pressures due to oversupply or price erosion resulting from competitive pressures o developments with respect to patents or proprietary rights o conditions and trends in the hard drive, data and content management, storage and communication industries o changes in financial estimates by securities analysts relating specifically to us or the hard drive industry in general. In addition, the stock market in recent months has experienced extreme price and volume fluctuations that have particularly affected the stock price of many high technology companies. These fluctuations are often unrelated to the operating performance of the companies. 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 our recent financial performance and 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. Our prior borrowing agreement with our banks matured on March 31, 2000, and we have received a commitment letter for a new credit facility. As of the date hereof, the definitive agreement for the new credit facility has not been finalized. 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 insure that additional financing will be available to us or available on favorable terms. An equity financing could also be dilutive to our existing stockholders. 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 of entering into these hedge transactions is to minimize the impact of foreign currency fluctuations on the results of operations. 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 unrealized gains and losses on these contracts are deferred and recognized in the results of operations in the period in which the hedged transaction is consummated. 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 has discontinued hedging its Malaysian Ringgit currency risk. Future hedging of this currency will depend on currency conditions in Malaysia. The imposition of exchange controls by the Malaysian government resulted in a $7.5 million realized loss on terminated hedging contracts in the first quarter of 1999. As a result of the closure of the 24
25 Company's Singapore operations in 2000, the Company has also discontinued its hedging program related to the Singapore Dollar. As of March 31, 2000, the Company had outstanding the following purchased foreign currency forward exchange contract (in millions, except average contract rate): <TABLE> <CAPTION> MARCH 31, 2000 -------------------------------------------- WEIGHTED CONTRACT AVERAGE UNREALIZED AMOUNT CONTRACT RATE GAIN* ------------- ------------- ---------- (U.S. DOLLAR EQUIVALENT AMOUNTS) <S> <C> <C> <C> Foreign currency forward contracts: British Pound Sterling.............. $ 3.1 1.60 -- </TABLE> - ------------ * Unrealized gains on contracts are deferred and recognized in the results of operations in the period in which the hedged transactions are consummated, at which time the gain is offset by the increased U.S. Dollar value of the local currency operating expense. During the three and nine months ended March 31, 2000 and March 27, 1999 total realized transaction and forward exchange contract currency gains and losses (excluding the $7.5 million realized loss on the Malaysian Ringgit realized in the first quarter of 1999), were immaterial to the consolidated financial statements. Based on historical experience, the Company does not expect that a significant change in foreign exchange rates (up to approximately 25%) would materially affect the Company's consolidated financial statements. DISCLOSURE ABOUT OTHER MARKET RISKS Fixed Interest Rate Risk At March 31, 2000, the market value of the Company's 5.25% zero coupon convertible subordinated debentures due in 2018 was approximately $85.6 million, compared to the related book value of $222.6 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 various note receivables from other companies. All of the notes carry a fixed rate of interest. Therefore a significant change in interest rates would not impact the Company's consolidated financial statements. Variable Interest Rate Risk The Company's credit facility matured on March 31, 2000 and the Company has a commitment for a new Senior Credit Facility. The Company anticipates that the new Senior Credit Facility will be completed by June 30, 2000. The Company will not be able to borrow under the new credit facility until its completion. The Company currently has no variable interest rate risk. Fair Value Risk The Company owns approximately 10.8 million shares of Komag, Inc. common stock. The stock is restricted as to the percentage of total shares which can be sold in a given time period. The unrestricted portion of the total Komag shares acquired represents the shares which can be sold within one year. The Company determines, on a quarterly basis, the fair market value of the unrestricted Komag shares and records an unrealized gain or loss resulting from the difference in the fair market value of the unrestricted shares as of the previous quarter end and the fair market value of the unrestricted shares on the measurement date. As of March 31, 2000, a $3.6 million total accumulated unrealized gain has been recorded in accumulated other 25
26 comprehensive income (loss). If the Company sells all or a portion of this 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 of March 31, 2000, the quoted market value of the Company's Komag common stock holdings, without regard to discounts due to sales restrictions, was $40.9 million. As a result of market conditions, the market value had declined to $31.7 million as of April 28, 2000. Due to market fluctuations, an additional decline in the stock's fair market value could occur. A significant decline (50% or more) could materially adversely impact the Company's consolidated financial statements. The Company owns approximately 1.3 million shares of Vixel common stock. The shares were restricted as to sale until March 28, 2000 pursuant to an agreement with Vixel's underwriters. 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 March 31, 2000, a $21.7 million total accumulated unrealized gain has been recorded in accumulated other comprehensive income (loss). 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 declined from $21.7 million as of March 31, 2000 to $9.4 million as of April 28, 2000. Due to market fluctuations, an additional decline in the stock's fair market value could occur. 26
27 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. Litigation is inherently uncertain and may result in adverse rulings or decisions. Additionally, the Company may enter into settlements or be subject to judgments that may, individually or in the aggregate, have a material adverse effect on the Company's financial position, results of operations and/or liquidity. Accordingly, actual results could differ materially from those projected in the forward-looking statements. The Company was sued by Amstrad PLC ("Amstrad") in December 1992 in Orange County Superior Court. The complaint alleged that hard drives supplied by the Company in calendar 1988 and 1989 were defective and caused damages to Amstrad of $186.0 million in out-of-pocket expenses, lost profits, injury to Amstrad's reputation and loss of goodwill. The Company filed a counterclaim for $3.0 million in actual damages in addition to exemplary damages in an unspecified amount. The first trial of this case ended in a mistrial, with the jury deadlocked on the issue of liability. The case was retried, and on June 9, 1999, the jury returned a verdict against Amstrad and in favor of Western Digital. Amstrad has filed a notice of appeal from the judgment, and the Company has filed motions seeking recovery of a portion of its legal and other costs of defense. The Company does not believe that the ultimate resolution of this matter will have a material adverse effect on the financial position, results of operations or liquidity of the Company. However, should the judgment be reversed on appeal, and if in a retrial of the case Amstrad were to prevail, the Company may be required to pay damages and other expenses, which may have a material adverse effect on the Company's financial position, results of operations and/or liquidity. In addition, the costs of defending a retrial of the case may be material, regardless of the outcome. In 1994 Papst Licensing ("Papst") brought suit against the Company in the U.S. District Court for the Central District of California alleging infringement by the Company of five of its patents relating to disk drive motors that the Company purchases 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 agree to 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 ultimate resolution of this matter will have a material adverse effect on the financial position, results of operations or liquidity of the Company. However, because of the nature and inherent uncertainties of litigation, should the outcome of this action be unfavorable, the Company may be required to pay damages and other expenses, which may have a material adverse effect on the Company's financial position, results of operations and/or liquidity. In addition, the costs of defending such litigation may be material, regardless of the outcome. The Company and Censtor Corporation ("Censtor") have had discussions concerning royalties, if any, that might be due Censtor under a licensing agreement. Censtor has initiated arbitration procedures under the agreement seeking payment of royalties. In response, the Company has filed a complaint in federal court seeking a determination that the patents at issue are invalid. The Federal Court action has been stayed pending completion of the arbitration procedures. The Company does not believe that the outcome of this dispute will have a material adverse effect on its financial position, results of operations and/or liquidity. In the normal course of business, the Company receives and makes inquiry 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 a license will be offered or that the terms of any license offered will be acceptable to the Company. Several such matters are currently pending. The Company does not believe that the ultimate resolution of these matters will have a material adverse effect on the consolidated financial position, results of operations and/or liquidity of the Company. 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 believes that the final disposition of such matters will not have a material adverse effect on the Company's consolidated financial position, results of operations and/or liquidity. 27
28 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS: 10.19 Retention Agreement effective September 21, 1998 between registrant and Teresa A. Hopp 10.32.4 Sixth Amendment to the Company's Retirement Savings and Profit Sharing Plan 10.32.5 Seventh Amendment to the Company's Retirement Savings and Profit Sharing Plan 10.34 Western Digital Broad-Based Stock Incentive Plan 10.44 Amended and Restated Purchase Agreement dated February 23, 2000, by and between Western Digital Corporation and Mayo Foundation 27 Financial Data Schedule - ------------------------------- (b) REPORTS ON FORM 8-K: On January 19, 2000, the Company filed a current report on Form 8-K to file its press release dated January 13, 2000, announcing the appointment of Matthew E. Massengill as President and Chief Executive Officer and to file its press release dated January 19, 2000, announcing its decision to exit the enterprise hard drive market. On January 21, 2000, the Company filed a current report on Form 8-K to file its press release dated January 20, 2000, announcing the expected range of the net loss and loss per share for its second quarter. On January 31, 2000, the Company filed a current report on Form 8-K to file its press release dated January 25, 2000, announcing its second quarter results. 28
29 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. WESTERN DIGITAL CORPORATION Registrant /s/ Teresa Hopp --------------------------------------------- Teresa Hopp Senior Vice President and Chief Financial Officer Date: May 15, 2000 29
30 EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION - ------- ----------- 10.19 Retention Agreement effective September 21, 1998 between registrant and Teresa A. Hopp 10.32.4 Sixth Amendment to the Company's Retirement Savings and Profit Sharing Plan 10.32.5 Seventh Amendment to the Company's Retirement Savings and Profit Sharing Plan 10.34 Western Digital Broad-Based Stock Incentive Plan 10.44 Amended and Restated Purchase Agreement dated February 23, 2000, by and between Western Digital Corporation and Mayo Foundation 27 Financial Data Schedule