UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549________________
FORM 10-Q
Commission file number 1-8703
WESTERN DIGITAL CORPORATION
(Exact name of Registrant as specified in its charter)
REGISTRANT’S TELEPHONE NUMBER INCLUDING AREA CODE: (949) 672-7000REGISTRANT’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 October 25, 2002, is 193,535,008.
TABLE OF CONTENTS
WESTERN DIGITAL CORPORATIONINDEX
Western Digital Corporation (the “Company” or “Western Digital”) has a 52 or 53-week fiscal year and each fiscal month ends on the Friday nearest to the last day of the calendar month. Unless otherwise indicated, references herein to specific years and quarters are to the Company’s fiscal years and fiscal quarters, and references to financial information are on a consolidated basis.
The information in the Company’s website referenced herein is not incorporated by reference in this Quarterly Report on Form 10-Q.
2
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts; unaudited)
The accompanying notes are an integral part of these condensed consolidated financial statements.
3
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except par values)
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands; unaudited)
5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
6
7
8
9
Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This information should be read in conjunction with the unaudited condensed interim consolidated financial statements and the notes thereto included in this Quarterly Report on Form 10-Q, and the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in Western Digital Corporation’s (the “Company’s” or “Western Digital’s”) Annual Report on Form 10-K as of and for the year ended June 28, 2002.
Unless otherwise indicated, references herein to specific years and quarters are to the Company’s fiscal years and fiscal quarters.
Forward-Looking Statements
This report contains forward-looking statements within the meaning of the federal securities laws. The statements that are not purely historical should be considered forward-looking statements. Often they can be identified by the use of forward-looking words, such as “may,” “will,” “could,” “project,” “believe,” “anticipate,” “expect,” “estimate,” “continue,” “potential,” “plan,” “forecasts,” and the like. Statements concerning current conditions may also be forward-looking if they imply a continuation of current conditions. These statements appear in a number of places in this report and include statements regarding the intentions, plans, strategies, beliefs or current expectations of the Company with respect to, among other things:
Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. Readers are urged to carefully review the disclosures made by the Company concerning risks and other factors that may affect the Company’s business and operating results, including those made in this report under the caption “Risk Factors That May Affect Future Results”, 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.
Critical Accounting Policies
The Company has prepared the accompanying unaudited condensed interim consolidated financial statements in conformity with accounting principles generally accepted in the United States for interim financial information. The preparation of the financial statements requires the use of estimates and judgment that affect the reported amounts of revenues, expenses, assets and liabilities. The Company has adopted accounting policies and practices that are generally accepted in the industry in which it operates. The Company believes the following are its most critical accounting policies that affect significant areas and involve management’s judgment and estimates. If these estimates differ materially from actual results, the impact to the consolidated financial statements may be material.
Revenue and Accounts Receivable
In accordance with standard industry practice, the Company has agreements with resellers that provide limited price protection for inventories held by resellers at the time of published list price reductions. In addition the Company may have agreements with resellers that provide for stock rotation on slow-moving items and other incentive programs. In accordance with current accounting standards, the Company recognizes revenue upon shipment or delivery to resellers and records a corresponding adjustment for estimated price protection and other programs in effect until the resellers sell such inventory to their customers. Adjustments are based on anticipated price decreases during the reseller holding period, estimated amounts to be reimbursed to qualifying customers as well as historical pricing information.
10
The Company establishes an allowance for doubtful accounts by analyzing specific customer accounts and assessing the risk of uncollectibility based on insolvency, disputes or other collection issues. In addition, the Company routinely analyzes the different receivable aging categories and establishes reserves based on the length of time receivables are past due.
The Company records provisions against revenue and cost of revenue for estimated sales returns in the same period that the related revenues are recognized. The Company bases these provisions on existing product return notifications as well as historical returns by product type (see “Warranty”).
Warranty
The Company records an accrual for estimated warranty costs when revenue is recognized. Warranty covers cost of repair or replacement of the hard drive over the warranty period which ranges from one to three years. The Company has comprehensive processes with which to estimate accruals for warranty, which include specific detail on hard drives in the field by product type, historical field return rates and costs to repair.
Inventory
Inventories are valued at the lower of cost (first-in, first-out basis) or net realizable value. Inventory write-downs are recorded for the valuation of inventory at the lower of cost or net realizable value by analyzing market conditions, estimates of future sales prices, inventory costs and inventory balances.
The Company evaluates inventory balances for excess quantities and obsolescence on a regular basis by analyzing backlog, estimated demand, inventory on hand, sales levels and other information. The Company writes down inventory balances for excess and obsolete inventory based on the analysis.
Litigation and Other Contingencies
The Company applies Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies” to determine when and how much to accrue for and disclose related to legal and other contingencies. Accordingly, the Company accrues loss contingencies when management, in consultation with its legal advisors, concludes that a loss is probable and is able to be reasonably estimated.
Deferred Tax Assets
The Company’s deferred tax assets, which consist primarily of net operating loss and tax credit carryforwards, are fully reserved due to management’s determination that it is “more likely than not” that these assets will not be realized. This determination is based on the weight of available evidence, the most significant of which is the Company’s loss history in the related tax jurisdictions. Should this determination change in the future, some amount of deferred tax assets could be recognized, resulting in a tax benefit or a reduction of future tax expense.
Results of Operations
Summary Comparison
The following table sets forth, for the periods indicated, summary information from the Company’s statements of income expressed as a percentage of net revenue. This table and the following discussion exclude the results of discontinued operations.
11
Net Revenue
Net revenue was $582.9 million for the three months ended September 27, 2002, an increase of 32%, or $142.0 million, from the three months ended September 28, 2001 and an increase of 8%, or $42.2 million, from the immediately preceding quarter. The increase in net revenue as compared to the corresponding period of the prior year was due to a 59% increase in unit shipments, partially offset by a 17% decrease in average selling prices (“ASP’s”). The increase in net revenue as compared to the immediately preceding quarter was due to an 8% increase in unit shipments.
Gross Margin
Gross margin totaled $83.6 million, or 14.3% of net revenue for the three months ended September 27, 2002. This compares to a gross margin of $56.0 million, or 12.7% of net revenue, for the three months ended September 28, 2001 and gross margin of $74.0 million, or 13.7% of net revenue, for the immediately preceding quarter. The increase in gross margin over the corresponding period of the prior year was primarily the result of higher unit shipments, manufacturing efficiencies and cost reduction efforts, partially offset by lower ASP’s. The increase over the immediately preceding quarter was primarily the result of higher unit shipments, stable ASP’s and manufacturing efficiencies.
Operating Expenses
Research and development (“R&D”) expense was $31.9 million for the three months ended September 27, 2002, an increase of 10.6%, or $3.1 million, from the three months ended September 28, 2001 and an increase of 4.2%, or $1.3 million, from the immediately preceding quarter. The increase in R&D expense from the corresponding period of the prior year was primarily due to higher employee incentive payments resulting from improved operating results. The increase from the immediately preceding quarter was due to increases in new development programs and higher employee incentive payments.
Selling, general and administrative (“SG&A”) expense was $26.4 million for the three months ended September 27, 2002, a decrease of 3.4%, or $0.9 million, from the three months ended September 28, 2001 and an increase of 1.1% or $0.3 million, from the immediately preceding quarter. The decrease in SG&A expense from the corresponding period of the prior year was due to expense reduction efforts, which was partially offset by higher employee incentive payments.
Income Tax Provision
Income tax provision was $1.8 million for the three months ended September 27, 2002 compared to $0.5 million for the immediately preceding quarter. The Company did not record an income tax benefit in the three months ended September 28, 2001 as no additional loss carrybacks were available at that time and management deemed it “more likely than not” that the deferred tax benefits generated would not be realized.
Discontinued Operations
During the three months ended September 28, 2001, the Company decided to terminate the operations of Connex, Inc. (“Connex”) and SANavigator, Inc. (“SANavigator”) and sold substantially all of the assets of these two businesses for a net gain of $24.5 million. In addition, during the three months ended June 28, 2002, the Company terminated its Keen Personal Media, Inc. (“Keen”) operations. Accordingly, the operating results of Connex, SANavigator and Keen for the periods reported, and the net gain recognized on the sale of substantially all of the assets of Connex and SANavigator during the three months ended September 28, 2001, have been segregated from continuing operations and reported separately on the unaudited condensed consolidated statements of income as discontinued operations.
12
Liquidity and Capital Resources
The Company had cash and cash equivalents of $244.4 million at September 27, 2002 and $223.7 million at June 28, 2002. Net cash provided by continuing operations was $45.0 million during the three months ended September 27, 2002 as compared to net cash provided by continuing operations of $11.4 million during the three months ended September 28, 2001. This $33.6 million improvement in cash provided by continuing operations consists of a $20.8 million improvement in the Company’s net income, net of non-cash items, and a $12.8 million decrease in cash used to fund working capital requirements. These improvements are due to significantly better operating performance by the Company, including increased revenue and gross margin, improved cost management and improved asset management.
The Company’s working capital requirements depend upon the effective management of its cash conversion cycle. The cash conversion cycle, which represents the sum of the number of days sales outstanding (“DSO”) and days inventory outstanding (“DIO”) less days payable outstanding (“DPO”), was negative 10 days for the three months ended September 27, 2002, a 4 day deterioration over the corresponding period of the prior year. The increase in the cash conversion cycle was due primarily to a decrease in DPO, which was significantly higher in the three months ended September 28, 2001 as a result of the Company’s temporary extension of its payment terms with certain key vendors in order to better manage cash resources during the period. This decrease in DPO was partially offset by a reduction in both DIO and DSO for the three months ended September 27, 2002 over the corresponding period of the prior year.
Uses of cash during the three months ended September 27, 2002 included net capital expenditures of $12.4 million, primarily to upgrade the Company’s desktop hard drive production capabilities and for the normal replacement of existing assets, $14.3 million for the extinguishment of a portion of the 5.25% zero coupon convertible subordinated debentures due February 18, 2018 (the “Debentures”) and $1.0 million for discontinued operations. Other sources of cash during the period included $3.4 million received in connection with stock option exercises and employee stock purchase plan purchases.
The Debentures are subordinated to all senior debt; are redeemable at the option of the Company any time after February 18, 2003 at the issue price plus accrued original issue discount to the date of redemption; and at the holder’s option, will be redeemed by the Company, as of February 18, 2003, February 18, 2008 or February 18, 2013, or if there is a Fundamental Change (as defined in the Debenture documents), at the issue price plus accrued original issue discount to the date of 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 Debentures are convertible into shares of the Company’s common stock at the rate of 14.935 shares per $1,000 principal amount at maturity. As of September 27, 2002, the remaining book value of the Debentures was $72.6 million, the aggregate principal amount at maturity was $160.9 million and the market value was $72.4 million. Based on current forecasts that show the Company continuing to generate positive cash flow from operations, the Company intends to satisfy the majority, if not all, of its put obligations in cash instead of common stock. Accordingly, the Debentures have been classified as a current liability. Debentures not put to the Company by February 2003, if any, will be reclassified as long-term debt.
The Company has a three-year senior credit facility that provides up to $125 million in revolving credit (subject to outstanding letters of credit and a borrowing base calculation), matures on September 20, 2003 and is secured by the Company’s accounts receivable, inventory, 65% of its stock in its foreign subsidiaries and other assets (the “Senior Credit Facility”). At the option of the Company, borrowings bear interest at either LIBOR (with option periods of one to three months) or a base rate, plus a margin determined by the borrowing base. The Senior Credit Facility requires the Company to maintain certain amounts of tangible net worth, prohibits the payment of cash dividends on common stock and contains a number of other covenants. As of the date hereof, there were no borrowings under the facility. However, the availability under the Senior Credit Facility has been reduced by $25.2 million for an outstanding letter of credit (refer to Note 7 “Legal Proceedings” of the Notes to Condensed Consolidated Financial Statements).
At September 27, 2002, the Company had a cash and cash equivalent balance of $244.4 million and working capital of $45.1 million. In addition, the Senior Credit Facility provides up to $125 million in revolving credit (subject to outstanding letters of credit and a borrowing base calculation). The Company believes its current cash and cash equivalents and the Senior Credit Facility will be sufficient to meet its working capital needs through the foreseeable future. There can be no assurance that the Senior Credit Facility will continue to be available to the Company. Also, the Company’s ability to sustain its working capital position is dependent upon a number of factors that are discussed below under the heading “Risk Factors That May Affect Future Results”.
13
Commitments
Except as otherwise disclosed, the Company does not have any commercial commitments with terms greater than one year that would significantly impact liquidity. The following is a summary of the Company’s significant contractual cash obligations and commercial commitments at September 27, 2002:
Convertible Debentures
The Company has Debentures due February 18, 2018. For a description of the Debentures, see the discussion under “Liquidity and Capital Resources”.
Operating Leases
The Company leases certain facilities and equipment under long-term, non-cancelable operating leases which expire at various dates through 2010. The following table summarizes the future payments of these leases (in thousands):
Purchase Orders
In the normal course of business, to reduce the risk of component shortages, the Company enters into purchase commitments with suppliers for the purchase of hard drive components used to manufacture the Company’s products. These commitments generally cover forecasted component supplies needed for production during the next quarter, become payable upon receipt of the components and may be non-cancelable (cancellation charges may be significant). The Company’s relationship with suppliers allows for some flexibility within these commitments and quantities are subject to change as a quarter progresses and the Company’s needs change.
Forward Exchange Contracts
Although the majority of the Company’s transactions are in U.S. Dollars, some transactions are based in various foreign currencies. 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 Company does not purchase short-term forward exchange contracts for trading purposes. As of September 27, 2002, the Company had $12.0 million outstanding of purchased foreign currency forward exchange contracts. The contracts have maturity dates that do not exceed three months. At September 27, 2002, the carrying value of the contracts approximated fair value.
New Accounting Pronouncements
Refer to Note 8 “New Accounting Pronouncements” of the Notes to Condensed Consolidated Financial Statements of this Quarterly Report on Form 10-Q for a discussion of new accounting pronouncements affecting the Company for the quarter ended September 27, 2002.
14
Risk Factors That May Affect Future Results
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 at a low cost.
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:
our operating results could be adversely affected.
Product life cycles require continuous technical innovation associated with higher areal densities.
New products require higher areal densities (the gigabyte of storage per disk) than previous product generations, posing formidable technical challenges. Higher areal densities require fewer heads and disks to achieve a given drive capacity, which means that existing head technology must be improved or new technology developed to accommodate more data on a single disk. Our failure to bring these new products to market on time and at acceptable costs could put us at a competitive disadvantage to companies that achieve these results.
Short product life cycles make it difficult to recover the cost of development.
Product life cycles have extended during the past twelve months due to a decrease in the rate of hard drive areal density growth. However, there can be no assurance that this trend will continue. Historically, more rapid increases in areal density resulted in shorter product life cycles, with each generation of hard drives being more cost effective than the previous one. Shorter product life cycles make it more difficult to recover the cost of product development before the product becomes obsolete. While we believe that the current rate of growth in areal density is lower than in the past several years, we expect that areal density will continue to increase. Our failure to recover the cost of product development in the future could adversely affect our operating results.
Short product life cycles and new products force us to continually qualify new products with our customers.
Short product life cycles and continuously changing products require us to 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 personal computer (“PC”) market. If product life cycles continue to be extended due to a decrease in the rate of areal density growth, we may have a significantly longer period to wait before we have an opportunity to qualify a new product with a customer, which could harm our competitive position. These risks are increased because we expect cost improvements and competitive pressures to result in declining sales and gross margins on our current generation products.
Increasing product life cycles may require us to reduce our costs to remain competitive.
Longer product life cycles have resulted from a decrease in the rate of areal density growth in the past twelve months. If longer product life cycles continue, we may need to develop new technologies or programs to reduce our costs on any particular product in
15
order to maintain competitive pricing for such product. This may result in an increase in our overall expenses, which could adversely affect our operating results.
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 that permits greater storage of data on a disk, it could put us at a competitive disadvantage and harm our operating results.
Advances in magnetic, optical, semiconductor or other data storage technologies could result in competitive products that have better performance or lower cost per unit of capacity than our products. If these products prove to be superior in performance or cost per unit of capacity, we could be at a competitive disadvantage to the companies offering those products.
Our average selling prices are declining.
We expect that our average selling prices for hard drives will continue to decline. Increases in areal density mean that the average drive we sell has fewer heads and disks, and therefore lower component 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 as a result of decreased costs or to absorb excess capacity, liquidate excess inventories, restructure or attempt to gain market share.
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 attempting to 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 the first quarter of 2000, the Company lost market share as a result of a product recall. Similar losses in market share could adversely affect our operating results.
Our prices and margins are subject to declines due to unpredictable end-user demand and periodic oversupply of hard drives.
Demand for our hard drives depends on the demand for systems manufactured by our customers and on storage upgrades to existing systems. The demand for systems has been volatile in the past and often has had an exaggerated effect on the demand for hard drives in any given period. As a result, the hard drive market tends to experience periods of excess capacity, which typically lead to intense price competition. During calendar year 2001 and the first half of calendar year 2002, the industry experienced weak PC demand in the U.S. and other markets due in part to general economic conditions worldwide. If intense price competition occurs as a result of weak demand, we may be forced to lower prices sooner and more than expected, which could result in lower revenues and gross margins.
Changes in the markets for hard drives require us to develop new products.
Over the past few years the consumer market for desktop computers has shifted significantly towards lower priced systems, especially those systems priced below $1,000. Although we were late to market with a value line hard drive to serve the low-cost PC market, we are now offering such value line products at prices that we view as competitive. However, if we are not able to continue to offer a competitively priced value line hard drive for the low-cost PC market, our share of that market will likely fall, which could harm our operating results.
The PC market is fragmenting into a variety of computing devices and products. Some of these products, such as Internet appliances, may not contain a hard drive. On the other hand, many industry analysts expect, as do we, that as broadcasting and communications are increasingly converted to digital technology from the older, analog technology, the technology of computers and consumer electronics and communication devices will converge, and hard drives will be found in many consumer products other than computers. For the quarter ended September 27, 2002, approximately 7% of our unit sales were for consumer products other than computers, primarily gaming devices. If we are not successful in using our hard drive technology and expertise to develop new products for these emerging markets, it will likely harm our operating results.
16
The market acceptance for hard disk drives in game consoles continues to be uncertain.
The use of hard disk drives in the game console market is a fairly recent trend. Due to the price competitive nature of the hard disk drive industry, with selling prices of personal computers being substantially higher than game consoles, game manufacturers may not have the ability to either incorporate or continue to incorporate hard disk drives into their overall architecture. In addition, current price reduction demands from either current or future game console customers may not make hard disk drive integration an attractive market for us or other hard drive manufacturers.
We depend on our key personnel and skilled employees.
Our success depends upon the continued contributions of our key personnel and skilled employees, many of whom would be extremely difficult to replace. Worldwide competition for skilled employees in the hard drive industry is intense. Volatility or lack of positive performance in our stock price may adversely affect our ability to retain key personnel or skilled employees who have been granted stock options. If we are unable to retain our existing key personnel or skilled employees or hire and integrate new key personnel or skilled employees, our operating results would likely be harmed.
Risk factors relating to Western Digital particularly
Loss of market share with a key customer could harm our operating results.
A majority of our revenue comes from a few customers. For example, during 2002, sales to our top 10 customers accounted for approximately 58% of revenue. These customers have a variety of suppliers to choose from and therefore can make substantial demands on us. Even if we successfully qualify a product with a customer, the customer generally is not obligated to purchase any minimum volume of products from us and is able to terminate its relationship with us at any time. Our ability to maintain strong relationships with our principal customers is essential to our future performance. If we lose a key customer, or if any of our key customers reduce their orders of our products or require us to reduce our prices before we are able to reduce costs, our operating results would likely be harmed. For example, this occurred with our enterprise hard drive product line early in the third quarter of 2000 and is one of the factors which led to our decision to exit the enterprise hard drive market.
Dependence on a limited number of qualified suppliers of components could lead to delays, lost revenue or increased costs.
Because we do not manufacture any of the basic 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, and could significantly harm our operating results. 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. In addition, if a component becomes unavailable, we could suffer significant loss of revenue. For example, we lost revenue in September 1999 when we had to shut down our Caviar product line production for approximately two weeks as a result of a faulty power driver chip that was sole-sourced from a third party supplier.
To reduce the risk of component shortages, we attempt to provide significant lead times when buying these components. As a result, we may have to pay significant cancellation charges to suppliers if we cancel orders, as we did in 1998 when we accelerated our transition to magnetoresistive recording head technology, and as we did in 2000 as a result of our decision to exit the enterprise hard drive market.
In April 1999, we entered into a three-year volume purchase agreement with Komag under which we buy a substantial portion of our media components from Komag. In October 2001, we amended the Komag volume purchase agreement to extend the initial term to six years. Similarly, in February 2001, we entered into a two-year volume purchase agreement with IBM under which we buy a substantial portion of our read channel chips from IBM. Effective June 2002, we amended the IBM volume purchase agreement to extend the initial term through December 31, 2003. These strategic relationships have increased our dependence on each of Komag and IBM as a supplier. Our future operating results may depend substantially on Komag’s ability to timely qualify its media components in our new development programs, and each of Komag’s and IBM’s ability to supply us with these components or chips, as the case may be, in sufficient volume to meet our production requirements. A significant disruption in Komag’s ability to manufacture and supply us with media components or IBM’s ability to manufacture and supply us with read channel chips could harm our operating results.
17
To develop new products we must maintain effective partner relationships with our strategic component suppliers.
Under our business model, we do not manufacture any of the component 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, each of which employs variations on technology which can impact, for example, feasible combinations of heads and media components. We are currently engaged in litigation with Cirrus, a supplier who previously was the sole source of read channel chips for our hard drives. As a result of the disputes that gave rise to the litigation, our business operations were at risk until another supplier’s read channel chips could be designed into our products. Similar disputes with other strategic component suppliers could adversely affect our operating results.
We have only one primary high-volume manufacturing facility, and a secondary smaller facility, which subjects us to the risk of damage or loss of either facility.
The majority of our manufacturing volume comes from one facility in Malaysia. During 2002, we acquired a second, smaller manufacturing facility in Thailand. A fire, flood, earthquake or other disaster, condition or event that adversely affects either our Malaysia or Thailand facility or ability to manufacture could result in a loss of sales and revenue and harm our operating results.
Terrorist attacks may adversely affect our business and operating results.
The terrorist attacks on the United States on September 11, 2001, the United States-led military response to counter terrorism and the continued threat of terrorist activity and other acts of war or hostility have created uncertainty in the financial and insurance markets and have significantly increased the political, economic and social instability in some of the geographic areas in which the Company operates. Further acts of terrorism, either domestically or abroad, could create further uncertainties and instability. To the extent this results in disruption or delays of our manufacturing capabilities or shipments of our products, our business, operating results and financial condition could be adversely affected.
Manufacturing our products abroad subjects us to numerous risks.
We are subject to risks associated with our foreign manufacturing operations, including:
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, which 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. Currently, we hedge the Thai Baht and British Pound Sterling.
18
The nature of our business and our reliance on intellectual property and other proprietary information subjects us to the risk of significant litigation.
The hard drive industry has been characterized by significant litigation. This includes litigation relating to patent and other intellectual property rights, product liability claims and other types of litigation. We are currently evaluating notices of alleged patent infringement or notices of patents from patent holders. We also are a party to several judicial and other proceedings relating to patent and other intellectual property rights. If we conclude that a claim of infringement is valid, we may be required to obtain a license or cross-license, modify our existing technology or design a new non-infringing technology. Such licenses or design modifications can be extremely costly. We may also be liable for any past infringement. If there is an adverse ruling against us in an infringement lawsuit, an injunction could be issued barring production or sale of any infringing product. It could also result in a damage award equal to a reasonable royalty or lost profits or, if there is a finding of willful infringement, treble damages. Any of these results would likely increase our costs and harm our operating results.
Our reliance on intellectual property and other proprietary information subjects us to the risk that these key ingredients of our business could be copied by competitors.
Our success depends, in significant part, on the proprietary nature of our technology, including non-patentable intellectual property such as our process technology. Despite safeguards, to the extent that a competitor is able to reproduce or otherwise capitalize on our technology, it may be difficult, expensive or impossible for us to obtain necessary legal protection. Also, the laws of some foreign countries may not protect our intellectual property to the same extent as do the laws of the United States. In addition to patent protection of intellectual property rights, we consider elements of our product designs and processes to be proprietary and confidential. We rely upon employee, consultant and vendor non-disclosure agreements and contractual provisions and a system of internal safeguards to protect our proprietary information. However, any of our registered or unregistered intellectual property rights may be challenged or exploited by others in the industry, which might harm our operating results.
Inaccurate projections of demand for our product can cause large fluctuations in our quarterly results.
We typically book and ship a high percentage (at times in excess of 50%) of our total quarterly sales in the third month of the quarter, which makes it difficult for us to forecast our financial results prior to the end of the quarter. In addition, our quarterly projections and results may be subject to significant fluctuations as a result of a number of other factors including:
If we do not forecast total quarterly demand accurately, it can have a material adverse effect on our quarterly results.
19
Rapidly changing market conditions in the hard drive industry make it difficult to estimate actual results.
We have made and continue to make a number of estimates and assumptions relating to our consolidated financial reporting. The rapidly changing market conditions with which we deal means that actual results may differ significantly from our estimates and assumptions. Key estimates and assumptions for us include:
The market price of our common stock is volatile.
The market price of our common stock has been, and may continue to be, extremely volatile. Factors such as the following may significantly affect the market price of our common stock:
In addition, general economic conditions may cause the stock market to experience extreme price and volume fluctuations from time to time that particularly affect the stock prices of many high technology companies. These fluctuations often appear to be 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 should any new lawsuits be filed, such matters could result in substantial costs and a diversion of resources and management’s attention.
We may be unable to raise future capital through debt or equity financing.
Due to the risks described herein, in the future we may be unable to maintain adequate financial resources for capital expenditures, expansion or acquisition activity, working capital and research and development. We have a credit facility, which matures on September 20, 2003. If we decide to increase or accelerate our capital expenditures or research and development efforts, or if results of operations do not meet our expectations, we could require additional debt or equity financing. However, we cannot ensure that additional financing will be available to us or available on acceptable terms. An equity financing could also be dilutive to our existing stockholders.
20
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. The Company purchases short-term, forward exchange contracts to hedge the impact of foreign currency fluctuations on certain underlying assets, liabilities and commitments for operating expenses denominated in foreign currencies. The purpose for entering into these hedge transactions is to minimize the impact of foreign currency fluctuations on the results of operations. 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 three months. The Company does not purchase short-term forward exchange contracts for trading purposes. Currently, the Company focuses on hedging its foreign currency risk related to the British Pound Sterling and the Thai Baht.
As of September 27, 2002, the Company had outstanding the following purchased foreign currency forward exchange contracts (in millions, except average contract rate):
During the three months ended September 27, 2002 and September 28, 2001 total realized transaction and forward exchange contract currency gains and losses were not material to the condensed consolidated financial statements. At September 27, 2002 and September 28, 2001 the carrying value of the contracts approximated fair value. Based on historical experience, the Company does not expect that a significant change in foreign exchange rates would materially affect the Company’s condensed consolidated financial statements.
Disclosure About Other Market Risks
Fixed Interest Rate Risk
At September 27, 2002, the market value of the Debentures was approximately $72.4 million, compared to the related book value of $72.6 million. At the option of the holder, the Debentures will be repurchased by the Company, as of February 18, 2003, February 18, 2008, or February 18, 2013, or if there is a Fundamental Change (as defined in the Debenture documents), at the issue price plus accrued original issue discount to the date of 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.
Variable Interest Rate Risk
At the option of the Company, borrowings under the Senior Credit Facility would bear interest at either LIBOR (with option periods of one to three months) or a base rate, plus a margin determined by the borrowing base. This is the only Company debt which does not have a fixed rate of interest. At September 27, 2002, there were no borrowings outstanding under the Senior Credit Facility.
Fair Value Risk
The Company owns approximately 1.0 million shares of Vixel Corporation common stock (the “Vixel Stock”). As of September 27, 2002, the market value of the Vixel Stock was approximately $1.2 million. Changes in the market value of the Vixel Stock are recorded as unrealized gains or losses in other comprehensive income (shareholders’ equity). As of September 27, 2002, a $1.2 million total accumulated unrealized gain has been recorded in accumulated other comprehensive income related to the Vixel Stock. If the Company sells any portion of the Vixel Stock, the related unrealized gain or loss on the date of sale will become realized and reflected as a gain or loss in the Company’s statement of income. As a result of market conditions, the market value of the Vixel Stock had increased from approximately $1.2 million as of September 27, 2002 to approximately $1.7 million as of October 25, 2002. Due to market fluctuations, a decline in the Vixel Stock’s fair market value could occur in future periods.
21
Item 4. CONTROLS AND PROCEDURES
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
Refer to Part I, Item 1, Notes to Condensed Consolidated Financial Statements, Note 7 “Legal Proceedings” of this Quarterly Report on Form 10-Q.
Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
During the three months ended September 27, 2002, the Company engaged in transactions pursuant to which it exchanged an aggregate principal amount at maturity of $32.6 million of the Debentures for an aggregate of 49,900 shares of the Company’s common stock and $14,345,150 in cash. These transactions were undertaken in reliance upon the exemption from the registration requirements of the Securities Act afforded by Section 3(a)(9) thereof, as exchanges of securities by the Company with its existing security holders. No commission or other remuneration was paid or given directly or indirectly for soliciting such exchanges. These exchanges were consummated in private, individually negotiated transactions with institutional investors.
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
22
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.
23
CERTIFICATIONS
Certification of Chief Executive Officer
I, Matthew E. Massengill, certify that:
24
Certification of Chief Financial Officer
I, D. Scott Mercer, certify that:
25
EXHIBIT INDEX
26