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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 28, 2003

OR

For the transition period from            to

Commission file number 1-8703

WESTERN DIGITAL CORPORATION

(Exact name of registrant as specified in its charter)

(949) 672-7000
(Registrant’s telephone number, including area code)

http://www.westerndigital.com
(Registrant’s Web Site)

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 [   ]

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [   ] No [   ]

     As of the close of business on April 25, 2003, 198,095,885 shares of common stock, par value $.01 per share, were outstanding.

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WESTERN DIGITAL CORPORATION
INDEX

     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.

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PART I. FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

WESTERN DIGITAL CORPORATION

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.

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WESTERN DIGITAL CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except par values; unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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WESTERN DIGITAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands; unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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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 the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K as of and for the year ended June 28, 2002. In the opinion of management, all adjustments necessary to fairly state the unaudited 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 accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. These unaudited 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 June 28, 2002. The results of operations for interim periods are not necessarily indicative of results to be expected for the full year.
		Certain prior period amounts have been reclassified to conform to the current period presentation as a result of the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections” (“SFAS 145”) and the termination of certain of the Company’s new business ventures.
2.		Supplemental Financial Statement Data (in thousands)

The Company records a provision for estimated warranty costs as products are sold to cover the cost of repair or replacement of the hard drive during the warranty period. This provision is based on estimated future returns within the warranty period and costs to repair, using historical field return rates by product type and current average repair costs. Changes in the warranty provision for the nine months ended March 28, 2003 were as follows (in thousands):

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3.		Income per Share
		The following table illustrates the computation of basic and diluted income per common share from continuing operations (in thousands, except per share data):

		For purposes of computing diluted income per share, antidilutive common share equivalents have been excluded from the calculation. These include employee stock options with an exercise price which exceeded the average fair market value of the common stock for the period and common shares issuable upon conversion of the 5.25% zero coupon convertible subordinated debentures due February 18, 2018 (the “Debentures”). These antidilutive common share equivalents totaled 20.1 million and 24.4 million shares for the three months ended March 28, 2003 and March 29, 2002, respectively, and 24.1 million and 28.7 million shares for the nine months ended March 28, 2003 and March 29, 2002, respectively.
4.		Common Stock and Convertible Debenture Transactions
		During the nine months ended March 28, 2003, the Company issued approximately 2,064,000 shares of its common stock in connection with Employee Stock Purchase Plan (“ESPP”) purchases and approximately 3,528,000 shares of its common stock in connection with common stock option exercises, for aggregate cash proceeds of $21.0 million. During the nine months ended March 29, 2002, the Company issued approximately 1,343,000 shares of its common stock in connection with ESPP purchases and approximately 1,204,000 shares of its common stock in connection with common stock option exercises, for aggregate cash proceeds of $8.8 million.
		During the nine months ended March 28, 2003, the Company issued approximately 50,000 shares of common stock and paid $88.0 million in cash to redeem its remaining Debentures. The book value of Debentures redeemed was $88.4 million, and the aggregate principal amount at maturity was $192.9 million. The net gain from redemptions of the Debentures was not material.
5.		Comprehensive Income
		Comprehensive income includes net income as well as the components of other comprehensive income which include all revenue, expense, gain and loss items that are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income is comprised of unrealized gains on marketable securities categorized as “available for sale” under SFAS No. 115 “Accounting for Certain Investments in Debt and Equity Securities”. The components of comprehensive income for the three and nine months ended March 28, 2003 and March 29, 2002 were as follows (in thousands):

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6.

Stock Based Compensation

     The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations (“APB Opinion No. 25”) in accounting for its stock options (including shares issued under the Stock Option Plans and the ESPP, collectively called “Options”) and, accordingly, no compensation expense has been recognized for the Options in the consolidated financial statements. Pro forma information for interim financial statements regarding net income and income per share is required by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123” (“SFAS 148”). This information is required to be determined as if the Company had accounted for its Options granted subsequent to July 1, 1995, under the fair value method of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”).

     The fair value of Options granted during the nine months ended March 28, 2003 and March 29, 2002 has been estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions:

     The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. This model also requires the input of highly subjective assumptions including the expected stock price volatility and expected period until options are exercised. The pro forma impact of applying SFAS 123 in the three and nine months ended March 28, 2003 is not necessarily representative of future periods.

     Had the Company determined compensation expense based on the Black-Scholes fair value model at the grant date for its Options under SFAS 123, the Company’s net income and net income per share would have been as indicated below (amounts in thousands except per share data):

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7.		Business Segment and Discontinued Operations
		The Company operates in one segment, the hard drive business.
		During 2002, the Company terminated the operations of all new business ventures, including Connex, Inc. (“Connex”), SANavigator, Inc. (“SANavigator”), Keen Personal Media, Inc. (“Keen”) and other smaller businesses. In conjunction with these business terminations, substantially all of the operating assets of Connex were sold to Quantum Corporation in August 2001 for cash proceeds of $11.0 million, and substantially all of the operating assets of SANavigator were sold to McData Corporation in September 2001 for cash proceeds of $29.8 million. These transactions generated a one-time gain of $24.5 million, net of costs incurred from the measurement date of July 1, 2001 through the end of the period to shutdown the businesses. Accordingly, the operating results of Connex, SANavigator and Keen, and the net gain recognized on the sale of substantially all of the assets of Connex and SANavigator for the periods reported, have been segregated from continuing operations and reported separately on the unaudited condensed consolidated statements of income as discontinued operations.
8.		Legal Proceedings
		In June 1994, Papst Licensing (“Papst”) brought suit against the Company in the United States District Court for the Central District of California, alleging infringement by the Company of five disk drive motor patents owned by Papst. In December 1994, Papst dismissed its case without prejudice. In July 2002, Papst filed a new complaint against the Company and several other defendants. The suit alleges infringement by the Company of seventeen of Papst’s patents related to disk drive motors that the Company purchased from motor vendors. Papst is seeking an injunction and damages. The Company filed an answer on September 4, 2002, denying Papst’s complaint. On December 11, 2002, the lawsuit was transferred to the United States District Court for the Eastern District of Louisiana and included in the consolidated pre-trial proceedings occurring there. The lawsuit was stayed pending the outcome of certain other related litigation. A potential loss, if any, cannot presently be reasonably estimated. The Company intends to vigorously defend the suit.
		On July 5, 2001, the Company’s Western Digital Technologies, Inc. subsidiary (“WDT”) and its Malaysian subsidiary (“WDM”) filed suit (the “complaint”) against Cirrus Logic, Inc. (“Cirrus”) for breach of contract and other claims resulting from Cirrus’ role as a strategic supplier of read channel chips for the Company’s hard disk drives. WDM also stopped making payments to Cirrus for past deliveries of chips and terminated all outstanding purchase orders from Cirrus for such chips. The complaint alleges that Cirrus’ unlawful conduct caused damages in excess of any amounts that may be owing on outstanding invoices or arising out of any alleged breach of the outstanding purchase orders. On August 20, 2001, Cirrus filed an answer and cross-complaint denying the allegations contained in the complaint and asserting counterclaims against the plaintiffs for, among other things, the amount of the outstanding invoices and the plaintiffs’ alleged breach of the outstanding purchase orders. The disputed payable, which is included in the Company’s balance sheet in accounts payable, is approximately $27 million. Cirrus claims that the canceled purchase orders, which are not reflected in the Company’s financial statements, total approximately $26 million. On November 2, 2001, Cirrus filed Applications for Right to Attach Orders and for Writs of Attachment against WDT and WDM in the amount of $25.2 million as security for the approximately $27 million allegedly owed for read-channel chips purchased from Cirrus that is disputed by WDT and WDM. On December 20, 2001, the Court granted Cirrus’ Applications. Pursuant to agreement with Cirrus, the Company has posted a letter of credit in the amount of $25.2 million in satisfaction of the Writs of Attachment.
		On November 26, 2002, WDT and WDM filed a motion for summary adjudication as to Cirrus’ second and third causes of action. The parties fully briefed the motion which was scheduled to be heard on December 24, 2002. On December 24, 2002, the Court continued the summary judgment motion until February 4, 2003, and then, on February 4, 2003, further continued the motion until April 1, 2003, to allow Cirrus to conduct additional discovery. On December 3, 2002, Cirrus filed a motion for summary adjudication as to WDT and WDM’s first, second, third, fourth, fifth and seventh causes of action. The parties fully briefed the motion which was scheduled to be heard on December 31, 2002. On December 31, 2002, after hearing arguments from both sides, the Court granted Cirrus’ motion as to the first, second, fourth, fifth and seventh causes of action, and denied Cirrus’ motion as to the third cause of action. On January 30, 2003, Cirrus filed another motion for summary adjudication as to the third cause of action. The parties completed briefing on the motion and the motion was scheduled to be heard on April 15, 2003.

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		On March 4, 2003, WDT filed a motion for leave to amend its second amended complaint, seeking to add causes of action for intentional and fraudulent misrepresentation and negligent misrepresentation. The Court granted WDT’s motion on March 25, 2003. On March 18, 2003, WDT filed a motion to continue the trial date from May 19, 2003. On April 8, 2003, the Court granted Western Digital’s motion and moved the trial date to December 1, 2003. As a result of its ruling to continue the trial date, the Court continued the mandatory settlement conference originally scheduled for April 25, 2003, and continued indefinitely the hearings on WDT’s motion for summary judgment and Cirrus’ motion for summary judgment originally scheduled for April 1, 2003 and April 15, 2003 respectively. Discovery in this matter, originally scheduled to conclude by April 18, 2003, will continue into September 2003.
		On April 22, 2003, Cirrus filed a demurrer to WDT’s claims for promissory estoppel, intentional and fraudulent misrepresentation and negligent misrepresentation. The Court has scheduled a hearing on the demurrer for May 13, 2003. A potential loss, if any, cannot presently be reasonably estimated. The Company intends to prosecute this matter and defend the cross-complaint vigorously.
		In the normal course of business, the Company is subject to other legal proceedings, lawsuits and other claims. Although the ultimate aggregate amount of monetary liability or financial impact with respect to these matters is subject to many uncertainties and is therefore not predictable with assurance, management believes that any monetary liability or financial impact to the Company from these matters, individually and in the aggregate, beyond that provided at March 28, 2003, would not be material to the Company’s financial condition. However, there can be no assurance with respect to such result and results could differ materially from those projected.
9.		New Accounting Pronouncements
		In November 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 45 “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. FIN 45 also clarifies that a guarantor is required to recognize a liability for the fair value, or market value, of the obligation undertaken in issuing a guarantee at the inception of the guarantee. The provisions of FIN 45 relating to liability recognition does not apply to certain obligations such as product warranties and guarantees accounted for as derivatives. The initial recognition and measurement provisions apply on a prospective basis to guarantees issued or modified subsequent to December 31, 2002. The disclosure requirements of FIN 45 are effective for interim or annual financial statement periods ending after December 15, 2002. The Company adopted the provisions of FIN 45 relating to footnote disclosure of warranty obligations during the quarter ended December 27, 2002. This information is included in Note 2 “Supplemental Financial Statement Data” of the Notes to Condensed Consolidated Financial Statements. The Company’s adoption of the recognition and measurement provisions of FIN 45 had no impact on its consolidated financial position or results of operations.

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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 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.

     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 (the “SEC”). 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.

Results of Operations

Summary Comparison

     The following table sets forth, for the periods indicated, summary information from the Company’s statements of income. This table excludes the results of discontinued operations (dollars in thousands):

Net Revenue

     Net revenue was $705.8 million for the three months ended March 28, 2003, an increase of 19%, or $111.0 million, from the three months ended March 29, 2002. Total unit shipments increased to 10.3 million for the quarter as compared to 8.1 million for the corresponding period in the prior year as a result of the Company’s improved competitive position and an increase in demand for hard drives in the personal computer (“PC”) market. Average selling prices (“ASP’s”) decreased to $68 per unit for the quarter from $74 in the corresponding period in the prior year. Historically, ASP’s in the desktop hard drive industry have generally declined annually in the 10-20% range. However, those price declines have moderated over the past few quarters given longer product life cycles, improved supply/demand management and fewer component cost reduction opportunities. Specifically, ASP’s for the three months ended March 28, 2003 represent the fourth consecutive quarter of flat-to-higher ASP’s.

     Revenue by geographic region for the three months ended March 28, 2003 was 48% from the Americas, 31% from Europe and 21% from Asia compared to 52%, 33% and 15%, respectively, for the corresponding prior period.

     Revenue by sales channel for the three months ended March 28, 2003 was 53% from original equipment manufacturers, 39% from distributors and 8% from the retail channel compared to 57%, 36% and 7%, respectively, for the corresponding prior period.

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     For the nine months ended March 28, 2003, net revenue was $2,038.2 million, an increase of 27%, or $427.8 million, from the nine months ended March 29, 2002. During this period, total unit shipments increased to 29.2 million from 21.1 million from the corresponding prior period while ASP’s decreased to $70 per unit from $76.

Gross Margin

     For the three months ended March 28, 2003, gross margin percentage increased to 17.3% from 13.6% for the corresponding period of the prior year. For the nine months ended March 28, 2003, gross margin percentage increased to 17.2% from 12.9% for the corresponding period of the prior year. The increase in gross margin percentage over the prior year periods was primarily the result of a more moderate pricing environment, manufacturing efficiencies associated with higher unit volume and continuing cost reduction efforts.

Operating Expenses

     Total operating expenses, consisting of research and development (“R&D”) and selling, general and administrative (“SG&A”), decreased to 9.2% of net revenue for the three months ended March 28, 2003 as compared to 10.1% of net revenue for the corresponding period of the prior year. For the nine months ended March 28, 2003, total operating expenses decreased to 9.4% of net revenue from 10.8% for the corresponding period of the prior year. The Company’s operating expense structure is highly leveraged. Absolute dollar increases in operating expenses over the prior year are primarily due to higher pay-for-performance and retention plan expenses, resulting from improved Company performance.

     R&D expense was $34.7 million for the three months ended March 28, 2003, an increase of 10.4%, or $3.3 million, from the three months ended March 29, 2002. R&D expense for the nine months ended March 28, 2003 was $101.1 million, an increase of 12.9%, or $11.6 million, from the corresponding period of the prior year. The increase in R&D expense from the corresponding periods of the prior year was primarily due to higher employee incentive payments resulting from improved operating results.

     SG&A expense was $30.2 million for the three months ended March 28, 2003, an increase of 5.0%, or $1.4 million, from the three months ended March 29, 2002. SG&A expense for the nine months ended March 28, 2003 was $90.3 million, an increase of 6.7%, or $5.6 million, from the corresponding period of the prior year. The increase in SG&A expense from the corresponding periods of the prior year was due to higher employee incentive payments resulting from improved operating results and higher retention plan expenses.

Income Tax Provision

     Income tax provision was $2.3 million and $6.3 million for the three and nine months ended March 28, 2003, respectively. The increase in the income tax provision for the three and nine months ended March 28, 2003 is primarily related to an increase in earnings within certain tax jurisdictions. Differences between the effective tax rate estimated for 2003 of 4%, as compared to the U.S. federal statutory rate, are primarily due to earnings of certain subsidiaries which are taxed at substantially lower tax rates as compared with U.S. statutory rates.

Liquidity and Capital Resources

     The Company had cash and cash equivalents of $347.1 million at March 28, 2003 and $223.7 million at June 28, 2002. Net cash provided by continuing operations was $236.5 million during the nine months ended March 28, 2003 as compared to net cash provided by continuing operations of $72.2 million during the nine months ended March 29, 2002. This $164.3 million improvement in cash provided by continuing operations consists of a $115.6 million improvement in the Company’s net income, net of non-cash items, and a $48.7 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 efficient 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 ten days for the nine months ended March 28, 2003, the same as the corresponding period of the prior year. The cash conversion cycle for the nine months ended March 28, 2003 consists of 30 DSO, 16 DIO less 56 DPO.

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     Uses of cash during the nine months ended March 28, 2003 included net capital expenditures of $43.6 million, primarily to upgrade the Company’s desktop hard drive production capabilities and for the normal replacement of existing assets, $88.0 million for the extinguishment or redemption of its remaining 5.25% zero coupon convertible subordinated debentures due February 18, 2018 (the “Debentures”) and $2.6 million for discontinued operations. Other sources of cash during the period included $21.0 million received in connection with stock option exercises and Employee Stock Purchase Plan purchases.

     The Company has a 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 March 28, 2003, 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 Part I, Item 1, Notes to Condensed Consolidated Financial Statements, Note 8 “Legal Proceedings” included in this Quarterly Report on Form 10-Q).

     The Company believes its current cash and cash equivalents 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”.

Critical Accounting Policies

     The Company has prepared the accompanying unaudited condensed 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 judgment and estimates 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 significantly 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 reduction to revenue 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. If end-market demand for hard drives declines significantly, the Company may have to increase sell-through incentive payments to resellers, resulting in an increase in price protection allowances, which could adversely impact operating results.

     The Company establishes an allowance for doubtful accounts by analyzing specific customer accounts and assessing its risk of loss 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. If the financial condition of a significant customer deteriorates resulting in their inability to pay their accounts when due, an increase in our allowance for doubtful accounts would be required, which could negatively affect operating results.

     The Company records provisions against revenue and cost of revenue for estimated sales returns in the same period that the related revenue is recognized. The Company bases these provisions on existing product return notifications as well as historical returns by product type (see “Warranty”). If actual sales returns exceed expectations, an increase in the sales return provisions would be required, which could negatively affect operating results.

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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 five 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. If actual product return rates or costs to repair returned products increase above expectations, an increase to the warranty provision would be required, which could negatively affect operating results.

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 and estimates of future sales prices as compared to 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. Unanticipated changes in technology or customer demand could result in a decrease in demand for one or more of our products, which may require an increase in inventory write-downs, which could negatively affect operating results.

Litigation and Other Contingencies

     The Company applies Statement of Financial Accounting Standards 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 (refer to Part I, Item 1, Notes to Condensed Consolidated Financial Statements, Note 8 “Legal Proceedings” included in this Quarterly Report on Form 10-Q).

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.

New Accounting Pronouncements

     Refer to Part I, Item 1, Notes to Condensed Consolidated Financial Statements, Note 9 “New Accounting Pronouncements” included in this Quarterly Report on Form 10-Q.

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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, first-to-volume and first-to-quality 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:

	•		develop new products with features required by our customers,
	•		consistently maintain or improve our time-to-market performance with our new products,
	•		produce these products in sufficient volume within our rapid product cycle,
	•		qualify these products with key customers on a timely basis by meeting our customers’ performance and quality specifications,
	•		achieve acceptable manufacturing yields and costs with these products, or
	•		consistently meet stated quality requirements on delivered products,

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. In addition, our introduction of new products during a technology transition increases the likelihood of unexpected quality concerns. Our failure to bring high quality new products to market on time and at acceptable costs could put us at a competitive disadvantage to companies that achieve these results.

Increases in areal density may outpace customers’ demand for storage capacity.

     The rate of increase in areal density may be greater than the increase in our customers’ demand for aggregate storage capacity. This could lead to our customers’ storage capacity needs being satisfied with fewer hard disk drives or with more lower-cost single-surface drives, thereby decreasing our sales. As a result, even with increasing aggregate demand for storage capacity, our unit volumes and/or ASP’s could decline, which could adversely affect our results of operations.

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. Although we believe that the current rate of growth in areal density is lower than in the past several years and will continue to decrease in the near term, 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

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number of high volume computer manufacturers, most of which continue to consolidate their share of the 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, such as system-on-a-chip, to reduce our costs on any particular product in order to maintain competitive pricing for such product. This may result in an increase in our overall expenses and a decrease in our gross margins, both of 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.

The decline of ASP’s in the hard disk drive industry could adversely affect our operating results.

     The hard disk drive industry has experienced declining ASP’s in recent years. Although the rate of decline has decreased in recent quarters, there can be no assurance that this trend will continue. Increases in areal density mean that the average drive we sell has fewer heads and disks for the same capacity, 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 ASP’s 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. A continued decline in ASP’s could cause our operating results to suffer.

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 has experienced periods of excess capacity, which has led 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. According to data released by International Data Corporation Tracker in December 2002, systems priced below $599 currently

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comprise the fastest growing segment of the consumer market for desktop computers. 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, consumer electronics and communication devices will converge, and hard drives will be found in many consumer products other than computers. For the quarter ended March 28, 2003, approximately 3% 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.

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 PC’s 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. Also, the success of specific game consoles such as Microsoft’s Xbox™, which uses a hard disk drive for game use, remains uncertain.

If we do not successfully expand into new hard drive market segments, our business may suffer.

     To remain a significant supplier of hard disk drives, we will need to offer a broad range of disk drive products to our customers. We currently offer a variety of 3.5-inch form factor hard disk drives for the desktop computer market. However, demand for desktop hard drives may shift to products in smaller form factors, which we do not currently offer, but which some of our competitors offer. The desktop PC industry is transitioning to higher speed interfaces such as Serial ATA to handle higher data transfer rates and 80 gigabyte (“GB”) per platter technology for increased capacity. The Company currently offers Serial ATA and 80 GB per platter products, however, the transition of technology and the introduction of new products is challenging and creates risks. While we continue to develop new products and look to expand into non-desktop applications such as consumer electronics and game consoles, the success of our new product introductions is dependent on a number of factors, including difficulties faced in manufacturing ramp, market acceptance, effective management of inventory levels in line with anticipated product demand, and the risk that our new products will have quality problems or other defects in the early stages of introduction that were not anticipated in the design of those products. If we fail to successfully develop and manufacture new products, customers may decrease the amounts of our products that they purchase, and we may lose business to our competitors who offer these products or who use their dominance in the enterprise or mobile market to encourage sales of desktop hard drives.

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 the nine months ended March 28, 2003, sales to our top 10 customers accounted for approximately 52% 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,

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