Hard-drive and flash memory manufacturer Western Digital (NASDAQ: WDC) missed estimates badly when it reported its fiscal third-quarter results on Monday. Revenue was down just a bit more than expected, but earnings missed by a mile due to inventory writedowns.
Western Digital saw some improvements in demand for capacity enterprise drives, but a rough market for flash memory overwhelmed that good news. The company sees demand for flash memory improving in the second half, but it also expects gross margin to continue to be pressured by slumping prices.
Image source: Western Digital.
Revenue tumbled in the third quarter, while the cost of revenue didn't budge thanks to a charge related to manufacturing underutilization. The company posted a loss on a GAAP basis, but it turned a small profit on an adjusted basis. The adjusted figure includes the impact from the inventory charge, but it excludes other charges.
Compared to Average Analyst Estimate
Missed by $10 million
GAAP earnings per share
Adjusted earnings per share
Missed by $0.29
Data source: Western Digital. YOY = year over year.
In the data-center devices and solutions segment, the company saw better-than-expected demand for capacity enterprise drives and began initial revenue shipments of enterprise NVMe solid-state drive solutions. Revenue rose 16% from the second quarter but was down 25% year over year.
Revenue in the client solutions segment declined both sequentially and year over year despite an expanding presence for Western Digital in external solid-state drives sold through retail. Average capacity for flash devices jumped 44% year over year, but crashing flash prices overwhelmed that capacity growth. Revenue was down 15% from the second quarter and down 23% from the prior-year period.
The client devices segment was hit hardest, with revenue declines driven by weak smartphone demand, seasonality in the PC market, and flash price declines. Revenue was down 26% sequentially and down 30% year over year.
Non-GAAP gross margin was 25.3%, down from 39.2% in the prior-year period. Western Digital managed to produce $204 million in operating cash flow during the quarter, but free cash flow was a loss of $110 million. That's down from a positive free cash flow of $616 million during the third quarter of last year.
Banking on a stronger second half
Western Digital's fiscal fourth-quarter earnings guidance was much worse than analysts were expecting, but the company remains confident that things will start to look better in the back half of the calendar year.
The company sees fourth-quarter revenue between $3.6 billion and $3.8 billion, in line with the average analyst estimate of $3.7 billion. But Western Digital expects adjusted earnings per share of just $0.10 to $0.30, well below the $0.49 analysts were expecting. On a GAAP basis, the company will lose about $1.14 per share based on its guidance.
Despite its worsening results, Western Digital expects demand to improve. CEO Stephen Milligan reiterated that during the earnings call: "Our expectation for the demand environment to further improve for both flash and hard drive products for the balance of calendar 2019 is largely unchanged."
The company does expect flash price declines to become less severe for a few reasons, according to President and COO Michael Cordano:
Flash pricing conditions remain challenging, but we anticipate the rate of price decline will moderate as the year progresses due to a slowing rate of industry supply growth, elasticity driving demand for higher capacity points, and seasonal strength in the back half of the calendar year.
Vice President of Investor Relations T. Peter Andrew made it clear, though, that there's still a lot of uncertainty around flash pricing:
Now, we don't know exactly what's going to happen to Flash gross margins because a lot of that is dependent upon other factors that are outside of our control. What do our competitors do, production levels, demand levels, and all that. So, we don't know exactly how it's going to play out, but from our standpoint it is safest to assume that we're going to continue to see our Flash gross margins remain under some degree of pressure as we move through the calendar year ...
It doesn't look like a bottom in the flash market is coming anytime soon, even with an expected demand recovery in the second half. Per-bit memory prices decline over time, but per-bit costs do as well. It's when prices decline much faster than costs that memory-chip manufacturers see slumping profits. That's what's happening to Western Digital right now.
This flash memory downturn will eventually end, but the timing remains a mystery. Western Digital's bottom line won't start to recover until that happens.
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