Why did Western Digital swing from a profit to a large loss in fiscal 1998?

Revenue fell 15% on lower average selling prices and a roughly 6% drop in unit shipments, amid unusually severe desktop price competition and industry oversupply. Gross margin collapsed to 2.8% from 15.6%, reflecting $148 million of second-quarter special charges (inventory and component cancellations and thin-film wind-down costs) and yield problems during the transition to MR heads. Higher R&D of $203.7 million, including $22 million of IBM start-up costs, added to the loss.

Is Western Digital at risk of violating its debt agreements?

Possibly. The filing states that it is uncertain whether the company will meet certain financial covenants under its Senior Bank Facility at the end of the first quarter of fiscal 1999, and that borrowing availability has already been reduced. The company has signed a non-binding term sheet for a replacement facility, but there is no assurance it will be completed or that the existing facility will remain available. Management believes current cash and operating cash flow are sufficient for working capital needs through 1999.

What is the IBM agreement and why does it matter to investors?

In June 1998, Western Digital entered a minimum three-year technology license and component supply agreement with IBM. IBM will supply heads for Western Digital's desktop drives incorporating GMR technology, with the first products expected in the first six months of calendar 1999. The agreement is non-exclusive, makes IBM the sole head supplier for those products, and does not extend to enterprise drives. It is intended to restore time-to-market leadership in desktop drives, but execution and IBM supply risks remain.

How is the company's capital structure different after the 1998 financing?

In February 1998, Western Digital issued 5.25% zero-coupon convertible subordinated debentures due 2018 for gross proceeds of $460.1 million, with a principal amount at maturity of $1.3 billion. They are convertible into about 19.4 million shares and holders can require repurchase in 2003, 2008 and 2013. The company also has a $50 million funded term loan and a $200 million revolver, both secured by receivables, inventory and 66% of its foreign subsidiary stock. The debentures' fair value was about $335 million against a carrying value of $469.2 million at year end.

What are the key legal and business risks highlighted in the filing?

The Amstrad PLC lawsuit alleging $186 million in damages for defective 1988-1989 drives was scheduled for trial in September 1998, though management believes the outcome will not materially harm its financial condition. Papst has threatened to reinstate a motor patent suit unless the company licenses its patents. Eight securities class actions were dismissed with prejudice. Other key risks include customer concentration (Compaq at 14% of 1998 revenue), the shift to build-to-order and channel assembly models, possible erosion of the desktop business if network computers gain share, and continued reliance on Singapore and Malaysia manufacturing.

WDC 10-K FY1998 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed September 1, 1998. Cited figures are marked; the original filing is the authoritative source.

Western Digital's fiscal 1998 10-K (year ended June 27, 1998) shows a sharp deterioration in operating performance.

Revenues fell 15% to $3.54 billion^a from $4.18 billion, and gross margin collapsed from 15.6% to 2.8%. The company posted a net loss of $290.2 million ($3.32 per share), versus net income of $267.6 million the prior year. Management attributes the decline to unusually severe desktop pricing pressure, lost market share, a costly accelerated transition from thin-film to MR head technology, and $148 million of second-quarter special charges, plus $22 million of R&D start-up costs tied to the IBM Agreement.

Balance sheet and liquidity are the main investor concerns. Cash rose to $459.8 million^b, but that was driven by $460 million of 5.25% zero-coupon convertible debentures due 2018 (principal at maturity $1.3 billion) and a $50 million term loan. Shareholders' equity fell to $317.8 million from $620.0 million, and long-term debt stands at $519.2 million.

Operating cash flow was negative $39.0 million^c, and capital expenditures of $198.6 million are expected to fall to about $135 million in 1999. The company says its current cash and cash flow will suffice through 1999, but it may not comply with financial covenants on its Senior Bank Facility at the end of the first quarter of 1999 and is negotiating a replacement facility under a non-binding term sheet. The strategic bet is the June 1998 IBM technology license and component supply agreement, which is intended to deliver GMR-head desktop drives in the first half of calendar 1999.

Management also plans a significant R&D increase to build a full enterprise drive line by mid-2000, where the company holds roughly 8%^d share. Investors should weigh that upside against near-term risks: continued oversupply, expected pricing pressure through at least the first half of 1999, customer concentration (Compaq at 14% of revenue), a pending Amstrad trial scheduled for September 1998, and a Papst patent claim.

02—Key points

Key Highlights

Revenue declined 15% to $3.54 billion, and gross margin fell from 15.6% to 2.8%, driven by severe desktop price competition and manufacturing yield problems in the MR head transition.
Net loss of $290.2 million ($3.32 per share) compared with net income of $267.6 million in fiscal 1997; results include $148 million in Q2 special charges and $22 million of IBM-related R&D costs.
Shareholders' equity dropped to $317.8 million from $620.0 million, while long-term debt rose to $519.2 million after the February 1998 convertible debenture offering and bank term loan.
Operating cash flow was negative $39.0 million, but year-end cash of $459.8 million was boosted by $491 million of debt financing, which is a key liquidity dependency.
The June 1998 IBM agreement gives access to IBM's GMR head technology for desktop drives expected in H1 1999, but it is non-exclusive and makes IBM the sole head supplier for those products.
Covenant risk is elevated: the company may not meet Senior Bank Facility financial ratios at the end of Q1 1999 and has only a non-binding term sheet for a replacement credit facility.
Market share eroded in 1998 and competitors Maxtor, Fujitsu and Samsung gained share, while the company plans a major enterprise R&D push to reach full-line enterprise coverage by mid-2000.

03—Questions

Frequently Asked Questions

Why did Western Digital swing from a profit to a large loss in fiscal 1998?
Revenue fell 15% on lower average selling prices and a roughly 6% drop in unit shipments, amid unusually severe desktop price competition and industry oversupply. Gross margin collapsed to 2.8% from 15.6%, reflecting $148 million of second-quarter special charges (inventory and component cancellations and thin-film wind-down costs) and yield problems during the transition to MR heads. Higher R&D of $203.7 million, including $22 million of IBM start-up costs, added to the loss.
Is Western Digital at risk of violating its debt agreements?
Possibly. The filing states that it is uncertain whether the company will meet certain financial covenants under its Senior Bank Facility at the end of the first quarter of fiscal 1999, and that borrowing availability has already been reduced. The company has signed a non-binding term sheet for a replacement facility, but there is no assurance it will be completed or that the existing facility will remain available. Management believes current cash and operating cash flow are sufficient for working capital needs through 1999.
What is the IBM agreement and why does it matter to investors?
In June 1998, Western Digital entered a minimum three-year technology license and component supply agreement with IBM. IBM will supply heads for Western Digital's desktop drives incorporating GMR technology, with the first products expected in the first six months of calendar 1999. The agreement is non-exclusive, makes IBM the sole head supplier for those products, and does not extend to enterprise drives. It is intended to restore time-to-market leadership in desktop drives, but execution and IBM supply risks remain.
How is the company's capital structure different after the 1998 financing?
In February 1998, Western Digital issued 5.25% zero-coupon convertible subordinated debentures due 2018 for gross proceeds of $460.1 million, with a principal amount at maturity of $1.3 billion. They are convertible into about 19.4 million shares and holders can require repurchase in 2003, 2008 and 2013. The company also has a $50 million funded term loan and a $200 million revolver, both secured by receivables, inventory and 66% of its foreign subsidiary stock. The debentures' fair value was about $335 million against a carrying value of $469.2 million at year end.
What are the key legal and business risks highlighted in the filing?
The Amstrad PLC lawsuit alleging $186 million in damages for defective 1988-1989 drives was scheduled for trial in September 1998, though management believes the outcome will not materially harm its financial condition. Papst has threatened to reinstate a motor patent suit unless the company licenses its patents. Eight securities class actions were dismissed with prejudice. Other key risks include customer concentration (Compaq at 14% of 1998 revenue), the shift to build-to-order and channel assembly models, possible erosion of the desktop business if network computers gain share, and continued reliance on Singapore and Malaysia manufacturing.

04—Continue

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