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EXCEL - IDEA: XBRL DOCUMENT - WESTERN DIGITAL CORPFinancial_Report.xls
EX-32.2 - EXHIBIT 32.2 - WESTERN DIGITAL CORPwdc-010215xexhibit322.htm
EX-32.1 - EXHIBIT 32.1 - WESTERN DIGITAL CORPwdc-010215xexhibit321.htm
EX-31.1 - EXHIBIT 31.1 - WESTERN DIGITAL CORPwdc-010215xexhibit311.htm
EX-31.2 - EXHIBIT 31.2 - WESTERN DIGITAL CORPwdc-010215xexhibit312.htm
EX-10.1 - EXHIBIT 10.1 - WESTERN DIGITAL CORPexecutiveseveranceplan-exh.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
FORM 10-Q
 
 
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended January 2, 2015
Or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
Commission file number: 1-8703
 
 

WESTERN DIGITAL CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
 
 
Delaware
33-0956711
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
 
 
3355 Michelson Drive, Suite 100
Irvine, California
92612
(Address of principal executive offices)
(Zip Code)
Registrant’s telephone number, including area code: (949) 672-7000
 
 
 
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  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
ý
Accelerated filer
¨
Non-accelerated filer
¨  (Do not check if a smaller reporting company)
Smaller reporting company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
As of the close of business on February 5, 2015, 231,031,533 shares of common stock, par value $.01 per share, were outstanding.



WESTERN DIGITAL CORPORATION
INDEX
 
 
PAGE NO.
 
 
 
 
Condensed Consolidated Balance Sheets — January 2, 2015 and June 27, 2014
 
 
Condensed Consolidated Statements of Income — Three and Six Months Ended January 2, 2015 and December 27, 2013
 
 
Condensed Consolidated Statements of Comprehensive Income — Three and Six Months Ended January 2, 2015 and December 27, 2013
 
 
Condensed Consolidated Statements of Cash Flows — Six Months Ended January 2, 2015 and December 27, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Our fiscal year ends on the Friday nearest to June 30 and typically consists of 52 weeks. Approximately every six years, we report a 53-week fiscal year to align our fiscal year with the foregoing policy. Our fiscal second quarters ended January 2, 2015 and December 27, 2013 both consisted of 13 weeks. Fiscal year 2014 was comprised of 52 weeks and ended on June 27, 2014. Fiscal year 2015 will be comprised of 53 weeks and will end on July 3, 2015. Fiscal year 2016 will be comprised of 52 weeks and will end on July 1, 2016. Unless otherwise indicated, references herein to specific years and quarters are to our fiscal years and fiscal quarters, and references to financial information are on a consolidated basis. As used herein, the terms “we,” “us,” “our,” the “Company,” “WDC” and “Western Digital” refer to Western Digital Corporation and its subsidiaries, unless we state, or the context indicates, otherwise.
WDC, a Delaware corporation, is the parent company of our storage business, which operates under two independent subsidiaries – HGST and WD. Our principal executive offices are located at 3355 Michelson Drive, Suite 100, Irvine, California 92612. Our telephone number is (949) 672-7000 and our website is www.westerndigital.com. The information on our website is not incorporated in this Quarterly Report on Form 10-Q.
Western Digital, WD and the WD logo are trademarks of Western Digital Technologies, Inc. and/or its affiliates. All other trademarks mentioned are the property of their respective owners.

2


PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
WESTERN DIGITAL CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in millions, except par values; unaudited)
 
 
January 2,
2015
 
June 27,
2014
ASSETS
Current assets:
 
 
 
Cash and cash equivalents
$
4,902

 
$
4,804

Short-term investments
241

 
284

Accounts receivable, net
1,880

 
1,989

Inventories
1,282

 
1,226

Other current assets
355

 
417

Total current assets
8,660

 
8,720

Property, plant and equipment, net
3,099

 
3,293

Goodwill
2,566

 
2,559

Other intangible assets, net
359

 
454

Other non-current assets
455

 
473

Total assets
$
15,139

 
$
15,499

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
 
 
 
Accounts payable
$
2,071

 
$
1,971

Accrued arbitration award

 
758

Accrued expenses
496

 
412

Accrued compensation
451

 
460

Accrued warranty
146

 
119

Current portion of long-term debt
125

 
125

Total current liabilities
3,289

 
3,845

Long-term debt
2,250

 
2,313

Other liabilities
518

 
499

Total liabilities
6,057

 
6,657

Commitments and contingencies (Notes 4 and 5)

 

Shareholders’ equity:
 
 
 
Preferred stock, $.01 par value; authorized — 5 shares; issued and outstanding — none

 

Common stock, $.01 par value; authorized — 450 shares; issued — 261 shares; outstanding — 232 and 234 shares, respectively
3

 
3

Additional paid-in capital
2,318

 
2,331

Accumulated other comprehensive income (loss)
(32
)
 
12

Retained earnings
8,738

 
8,066

Treasury stock — common shares at cost; 29 and 27 shares, respectively
(1,945
)
 
(1,570
)
Total shareholders’ equity
9,082

 
8,842

Total liabilities and shareholders’ equity
$
15,139

 
$
15,499

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

3


WESTERN DIGITAL CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in millions, except per share amounts; unaudited)
 
 
Three Months Ended
 
Six Months Ended
 
January 2,
2015
 
December 27,
2013
 
January 2,
2015
 
December 27,
2013
Revenue, net
$
3,888

 
$
3,972

 
$
7,831

 
$
7,776

Cost of revenue
2,778

 
2,816

 
5,572

 
5,521

Gross profit
1,110

 
1,156

 
2,259

 
2,255

Operating expenses:
 
 
 
 
 
 
 
Research and development
426

 
416

 
863

 
817

Selling, general and administrative
164

 
226

 
384

 
358

Charges related to arbitration award
1

 
13

 
15

 
26

Employee termination, asset impairment and other charges
53

 
23

 
62

 
34

Total operating expenses
644

 
678

 
1,324

 
1,235

Operating income
466

 
478

 
935

 
1,020

Other income (expense):
 
 
 
 
 
 
 
Interest income
4

 
3

 
8

 
6

Interest and other expense
(12
)
 
(14
)
 
(25
)
 
(27
)
Total other expense, net
(8
)
 
(11
)
 
(17
)
 
(21
)
Income before income taxes
458

 
467

 
918

 
999

Income tax provision
20

 
37

 
57

 
74

Net income
$
438

 
$
430

 
$
861

 
$
925

Income per common share:
 
 
 
 
 
 
 
Basic
$
1.88

 
$
1.82

 
$
3.70

 
$
3.92

Diluted
$
1.84

 
$
1.77

 
$
3.60

 
$
3.81

Weighted average shares outstanding:
 
 
 
 
 
 
 
Basic
233

 
236

 
233

 
236

Diluted
238

 
243

 
239

 
243

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


4


WESTERN DIGITAL CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions; unaudited)
 
 
Three Months Ended
 
Six Months Ended
 
January 2,
2015
 
December 27,
2013
 
January 2,
2015
 
December 27,
2013
Net income
$
438

 
$
430

 
$
861

 
$
925

Other comprehensive loss, net of tax:
 
 
 
 
 
 
 
Net unrealized loss on foreign exchange contracts
(18
)
 
(30
)
 
(44
)
 
(14
)
Other comprehensive loss
(18
)
 
(30
)
 
(44
)
 
(14
)
Total comprehensive income
$
420

 
$
400

 
$
817

 
$
911

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


5


WESTERN DIGITAL CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions; unaudited)
 
 
Six Months Ended
 
January 2,
2015
 
December 27,
2013
Cash flows from operating activities
 
 
 
Net income
$
861

 
$
925

Adjustments to reconcile net income to net cash provided by operations:
 
 
 
Depreciation and amortization
579

 
629

Stock-based compensation
80

 
84

Deferred income taxes
31

 
(39
)
Gain from insurance recovery
(37
)
 
(65
)
Loss on disposal of assets
12

 
29

Non-cash portion of employee termination, asset impairment and other charges
19

 
9

Changes in:
 
 
 
Accounts receivable, net
109

 
(145
)
Inventories
(56
)
 
(66
)
Accounts payable
94

 
86

Accrued arbitration award
(758
)
 
26

Accrued expenses
70

 
(36
)
Accrued compensation
(9
)
 
3

Other assets and liabilities
75

 
(34
)
Net cash provided by operating activities
1,070

 
1,406

Cash flows from investing activities
 
 
 
Purchases of property, plant and equipment
(306
)
 
(306
)
Proceeds from sale of property, plant and equipment
7

 

Proceeds from sales and maturities of investments
630

 

Purchases of investments
(595
)
 

Acquisitions, net of cash acquired
(6
)
 
(823
)
Other investing activities, net
16

 
4

Net cash used in investing activities
(254
)
 
(1,125
)
Cash flows from financing activities
 
 
 
Issuance of stock under employee stock plans
112

 
97

Taxes paid on vested stock awards under employee stock plans
(59
)
 
(24
)
Excess tax benefits from employee stock plans
11

 
25

Repurchases of common stock
(532
)
 
(300
)
Dividends paid to shareholders
(187
)
 
(118
)
Proceeds from debt

 
500

Repayment of debt
(63
)
 
(115
)
Net cash provided by (used in) financing activities
(718
)
 
65

Net increase in cash and cash equivalents
98

 
346

Cash and cash equivalents, beginning of period
4,804

 
4,309

Cash and cash equivalents, end of period
$
4,902

 
$
4,655

Supplemental disclosure of cash flow information:
 
 
 
Cash paid (received) for income taxes
$
(45
)
 
$
122

Cash paid for interest
$
23

 
$
24

Supplemental disclosure of non-cash financing activities:
 
 
 
Accrual of cash dividend declared
$
93

 
$
71

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


6


WESTERN DIGITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Basis of Presentation
The accounting policies followed by Western Digital Corporation (the “Company”) are set forth in Part II, Item 8, Note 1 of the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended June 27, 2014. 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 (“U.S. GAAP”) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). 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 for the year ended June 27, 2014. The results of operations for interim periods are not necessarily indicative of results to be expected for the full year. The Company's fiscal year ends on the Friday nearest to June 30 and typically consists of 52 weeks. Approximately every six years, the Company reports a 53-week fiscal year to align its fiscal year with the foregoing policy. The Company's fiscal second quarters ended January 2, 2015 and December 27, 2013 both consisted of 13 weeks. Fiscal year 2015 will be comprised of 53 weeks and will end on July 3, 2015.
Company management has made estimates and assumptions relating to the reporting of certain assets and liabilities in conformity with U.S. GAAP. These estimates and assumptions have been applied using methodologies that are consistent throughout the periods presented. However, actual results could differ materially from these estimates.
2. Supplemental Financial Statement Data
Inventories; Property, Plant and Equipment; and Other Intangible Assets
 
 
January 2,
2015
 
June 27,
2014
 
(in millions)
Inventories:
 
 
 
Raw materials and component parts
$
154

 
$
168

Work-in-process
510

 
493

Finished goods
618

 
565

Total inventories
$
1,282

 
$
1,226

Property, plant and equipment:
 
 
 
Property, plant and equipment
$
8,353

 
$
8,123

Accumulated depreciation
(5,254
)
 
(4,830
)
Property, plant and equipment, net
$
3,099

 
$
3,293

Other intangible assets:
 
 
 
Other intangible assets
$
983

 
$
984

Accumulated amortization
(624
)
 
(530
)
Other intangible assets, net
$
359

 
$
454


Warranty
The Company records an accrual for estimated warranty costs when revenue is recognized. The Company generally warrants its products for a period of one to five years. The warranty provision considers estimated product failure rates and trends, estimated replacement costs, estimated repair costs which include scrap costs, and estimated costs for customer compensatory claims related to product quality issues, if any. A statistical warranty tracking model is used to help prepare estimates and assist the Company in exercising judgment in determining the underlying estimates. The statistical tracking model captures specific detail on hard drive reliability, such as factory test data, historical field return rates, and costs to repair by product type. Management’s judgment is subject to a greater degree of subjectivity with respect to newly introduced products because of limited field experience with those products upon which to base warranty estimates. Management reviews the warranty accrual quarterly for products shipped in prior periods and which are still under warranty. Any changes in the estimates underlying the accrual may result in adjustments that impact current period gross profit and income. Such changes are generally a result of differences between forecasted and actual return rate experience and costs to repair. If actual product return trends, costs to repair

7


returned products or costs of customer compensatory claims differ significantly from estimates, future results of operations could be materially affected. Changes in the warranty accrual were as follows (in millions):
 
Three Months Ended
 
Six Months Ended
 
January 2,
2015
 
December 27,
2013
 
January 2,
2015
 
December 27, 2013
Warranty accrual, beginning of period
$
201

 
$
195

 
$
182

 
$
187

Warranty liability assumed as a result of acquisition

 
1

 

 
4

Charges to operations
50

 
44

 
99

 
84

Utilization
(44
)
 
(57
)
 
(93
)
 
(106
)
Changes in estimate related to pre-existing warranties
16

 
7

 
35

 
21

Warranty accrual, end of period
$
223

 
$
190

 
$
223

 
$
190

The long-term portion of the warranty accrual classified in other liabilities was $77 million as of January 2, 2015 and $63 million as of June 27, 2014.
Investments
The following table summarizes, by major type, the fair value and cost basis of the Company’s investments as of January 2, 2015 (in millions):
 
Cost Basis
 
Unrealized Gains (Losses)
 
Fair Value
Available-for-sale securities:
 
 
 
 
 
U.S. Treasury securities
$
159

 
$

 
$
159

U.S. Government agency securities
126

 

 
126

Commercial paper
154

 

 
154

Certificates of deposit
26

 

 
26

Total
$
465

 
$

 
$
465

 
 
 
 
 
 
Short-term investments
 
 
 
 
$
241

Included in other non-current assets
 
 
 
 
224

Total
 
 
 
 
$
465


The fair value of the Company’s investments classified as available-for-sale securities at January 2, 2015, by remaining contractual maturity, were as follows (in millions):
 
Cost Basis
 
Fair Value
Due in less than one year:
$
241

 
$
241

Due in one to five years:
224

 
224

Total
$
465

 
$
465



8


The following table summarizes, by major type, the fair value and cost basis of the Company’s investments as of June 27, 2014 (in millions):
 
Cost Basis
 
Unrealized Gains (Losses)
 
Fair Value
Available-for-sale securities:
 
 
 
 
 
U.S. Treasury securities
$
180

 
$

 
$
180

U.S. Government agency securities
88

 

 
88

Commercial paper
165

 

 
165

Certificates of deposit
66

 

 
66

Total
$
499

 
$

 
$
499

 
 
 
 
 
 
Short-term investments
 
 
 
 
$
284

Included in other non-current assets
 
 
 
 
215

Total
 
 
 
 
$
499


The fair value of the Company’s investments classified as available-for-sale securities as of June 27, 2014, by remaining contractual maturity, were as follows (in millions):
 
Cost Basis
 
Fair Value
Due in less than one year:
$
284

 
$
284

Due in one to five years:
215

 
215

Total
$
499

 
$
499


The Company determined no available-for-sale securities were other-than-temporarily impaired in the three and six months ended January 2, 2015. For more information on the Company's available-for-sale securities, see Note 7 below.

In addition, the Company enters into certain strategic investments for the promotion of business and strategic objectives. These strategic investments are recorded at cost within other non-current assets in the consolidated balance sheets and were not material to the condensed consolidated financial statements as of January 2, 2015 and June 27, 2014.
Other Comprehensive Income (Loss)
Other comprehensive income (loss) refers to revenue, expenses, gains and losses that are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income (loss) is comprised of unrealized gains and losses on foreign exchange contracts. There were no unrealized gains or losses on the Company's available-for-sale securities or actuarial gains and losses related to pensions in the six months ended January 2, 2015. In addition, the income tax impact on components of other comprehensive income (loss) is immaterial for all periods presented.
The following table illustrates the changes in the balances of each component of accumulated other comprehensive income (loss) for the six months ended January 2, 2015 (in millions):
 
Actuarial Pension Gain
 
Unrealized Gain (Loss) on Foreign Exchange Contracts
 
Accumulated Other Comprehensive Income (Loss)
Balance at June 27, 2014
$
7

 
$
5

 
$
12

Other comprehensive income (loss) before reclassifications

 
(57
)
 
(57
)
Amounts reclassified from accumulated other comprehensive income (loss)

 
13

 
13

Net current-period other comprehensive income (loss)

 
(44
)
 
(44
)
Balance at January 2, 2015
$
7

 
$
(39
)
 
$
(32
)

9


The following table illustrates the changes in the balances of each component of accumulated other comprehensive income (loss) for the six months ended December 27, 2013 (in millions):
 
Actuarial Pension Gain
 
Unrealized Gain (Loss) on Foreign Exchange Contracts
 
Accumulated Other Comprehensive Income (Loss)
Balance at June 28, 2013
$
11

 
$
(46
)
 
$
(35
)
Other comprehensive income (loss) before reclassifications

 
(11
)
 
(11
)
Amounts reclassified from accumulated other comprehensive income (loss)

 
(3
)
 
(3
)
Net current-period other comprehensive income (loss)

 
(14
)
 
(14
)
Balance at December 27, 2013
$
11

 
$
(60
)
 
$
(49
)
3. Income per Common Share
The Company computes basic income per common share using net income and the weighted average number of common shares outstanding during the period. Diluted income per common share is computed using net income and the weighted average number of common shares and potentially dilutive common shares outstanding during the period. Potentially dilutive common shares include certain dilutive outstanding employee stock options, rights to purchase shares of common stock under the Company’s Employee Stock Purchase Plan (“ESPP”) and restricted stock unit awards (“RSUs”).

The following table illustrates the computation of basic and diluted income per common share (in millions, except per share data):
 
Three Months
Ended
 
Six Months
Ended
 
January 2,
2015
 
December 27,
2013
 
January 2,
2015
 
December 27,
2013
Net income
$
438

 
$
430

 
$
861

 
$
925

Weighted average shares outstanding:
 
 
 
 

 

Basic
233

 
236

 
233

 
236

Employee stock options and other
5

 
7

 
6

 
7

Diluted
238

 
243

 
239

 
243

Income per common share:
 
 
 
 

 

Basic
$
1.88

 
$
1.82

 
$
3.70

 
$
3.92

Diluted
$
1.84

 
$
1.77

 
$
3.60

 
$
3.81

Anti-dilutive potential common shares excluded*
1

 
2

 
2

 
1

*
For purposes of computing diluted income per common share, certain potentially dilutive securities have been excluded from the calculation because their effect would have been anti-dilutive.
4. Debt
On January 9, 2014, Western Digital Ireland, Ltd. (“WDI”) used existing cash to repay the outstanding term loan balance of $1.8 billion under its previous credit agreement, dated March 8, 2012, and the Company, Western Digital Technologies, Inc. (“WDT”) and WDI entered into a new credit agreement with JPMorgan Chase Bank, N.A., as administrative agent, and the lenders party thereto (the "Credit Agreement"). The Credit Agreement provides for $4.0 billion of unsecured loan facilities consisting of a $2.5 billion term loan facility to WDT and a $1.5 billion revolving credit facility to WDT and WDI (the “Borrowers”). The revolving credit facility includes a $100 million sublimit for letters of credit and a $50 million sublimit for swing line loans. Subject to certain conditions, a Borrower may elect to expand the credit facilities by, or obtain incremental term loans of, up to $1.0 billion if existing or new lenders provide additional term or revolving commitments. The loans under the Credit Agreement have a five-year term. The obligations of the Borrowers under the Credit Agreement are guaranteed by the Company and its material domestic subsidiaries, and the obligations of WDI under the Credit Agreement are also guaranteed by WDT.
As of January 2, 2015, no amounts were outstanding under the revolving credit facility and the term loan facility had an outstanding balance of $2.4 billion and a variable interest rate of 1.66%. The Company is required to make quarterly principal

10


payments on the term loan facility totaling $63 million for the remainder of fiscal 2015, $156 million in fiscal 2016, $219 million in fiscal 2017, $250 million in fiscal 2018 and the remaining balance of $1.7 billion in fiscal 2019.
The Credit Agreement requires the Company to comply with a leverage ratio and an interest coverage ratio calculated on a consolidated basis for the Company and its subsidiaries. In addition, the Credit Agreement contains customary covenants, including covenants that limit or restrict the Company’s and its subsidiaries’ ability to incur liens, incur indebtedness, make certain restricted payments, merge or consolidate and enter into certain speculative hedging arrangements, and customary events of default. As of January 2, 2015, the Company was in compliance with all covenants.
5. Legal Proceedings
When the Company becomes aware of a claim or potential claim, the Company assesses the likelihood of any loss or exposure. The Company discloses information regarding each material claim where the likelihood of a loss contingency is probable or reasonably possible. If a loss contingency is probable and the amount of the loss can be reasonably estimated, the Company records an accrual for the loss. In such cases, there may be an exposure to potential loss in excess of the amount accrued. Where a loss is not probable but is reasonably possible or where a loss in excess of the amount accrued is reasonably possible, the Company discloses an estimate of the amount of the loss or range of possible losses for the claim if a reasonable estimate can be made, unless the amount of such reasonably possible losses is not material to the Company’s financial position, results of operations or cash flows. Unless otherwise stated below, for each of the matters described below, the Company has either recorded an accrual for losses that are probable and reasonably estimable or has determined that, while a loss is reasonably possible (including potential losses in excess of the amounts accrued by the Company), a reasonable estimate of the amount of loss or range of possible losses with respect to the claim or in excess of amounts already accrued by the Company cannot be made. The ability to predict the ultimate outcome of such matters involves judgments, estimates and inherent uncertainties. The actual outcome of such matters could differ materially from management’s estimates.
Solely for purposes of this note, “WD” refers to Western Digital Corporation or one or more of its subsidiaries excluding HGST prior to the HGST Closing Date. HGST refers to Hitachi Global Storage Technologies Holdings Pte. Ltd. or one or more of its subsidiaries as of the HGST Closing Date, and “the Company” refers to Western Digital Corporation and all of its subsidiaries on a consolidated basis including HGST.
Intellectual Property Litigation
On June 20, 2008, plaintiff Convolve, Inc. (“Convolve”) filed a complaint in the Eastern District of Texas against WD, HGST, and one other company alleging infringement of U.S. Patent Nos. 6,314,473 and 4,916,635. The complaint sought unspecified monetary damages and injunctive relief. On October 10, 2008, Convolve amended its complaint to allege infringement of only the ‘473 patent. The ‘473 patent allegedly relates to interface technology to select between certain modes of a disk drive’s operations relating to speed and noise. A trial in the matter began on July 18, 2011 and concluded on July 26, 2011 with a verdict against WD and HGST in an amount that is not material to the Company’s financial position, results of operations or cash flows, for which the Company previously recorded an accrual. WD and HGST have filed post-trial motions challenging the verdict. On January 17, 2014, the Court denied the Company’s motion for judgment as a matter of law on invalidity. On May 20, 2014, the Court ordered supplemental briefing on post-trial motions related to infringement. Convolve and the Company filed their supplemental briefs on May 30, 2014 and June 6, 2014, respectively. Additional post-trial motions are pending, and the Company will evaluate its options for appeal after the Court rules on the remaining post-trial motions. The Company intends to continue to defend itself vigorously in this matter.
On August 1, 2011, plaintiff Guzik Technical Enterprises (“Guzik”) filed a complaint in the Northern District of California against WD and various of its subsidiaries alleging infringement of U.S. Patent Nos. 6,023,145 and 6,785,085, breach of contract and misappropriation of trade secrets. The complaint seeks injunctive relief and unspecified monetary damages, fees and costs. The patents asserted by Guzik allegedly relate to devices used to test hard disk drive heads and media. On November 30, 2013, WD entered into a settlement agreement for an amount that is not material to the Company’s financial position, results of operations or cash flows, for which the Company recorded an accrual. Guzik is disputing the enforceability of the agreement and on December 27, 2013, WD filed a motion to enforce the agreement. The Court heard oral argument on WD’s motion on January 23, 2014. The Court granted WD’s motion to enforce the settlement agreement on March 21, 2014. On April 14, 2014, Guzik filed a Notice of Appeal to the Federal Circuit. On June 17, 2014, Guzik filed its opening appellate brief. WD filed its appellate brief on August 14, 2014. On September 11, 2014, Guzik filed its reply brief in support of its opening appellate brief. On January 7, 2015, the Federal Circuit heard oral argument on Guzik’ s appeal and on January 9, 2015, the Federal Circuit affirmed the Court’s decision granting WD’s motion to enforce the settlement agreement. WD intends to continue to defend itself vigorously in this matter.


11


On March 24, 2014, plaintiff Steven F. Reiber (“Reiber”) filed a complaint in the Eastern District of California against the Company, alleging infringement of U.S. Patent Nos. 7,124,927 and 7,389,905. On September 16, 2014, Reiber filed an amended complaint in the Eastern District of California against the Company alleging infringement of three additional patents-U.S. Patent Nos. 6,935,548, 6,651,864, and 6,354,479. Reiber alleges that WD products (including hard disk drive heads, head gimbal assemblies, head stack assemblies and SSDs) infringe these patents based on the allegation that the manufacturing of these products involves the use of certain bonding tools (e.g., wire-bonding tips, capillary tips, and flip-chip handling tools) that have electrically “dissipative” properties, and which are used when bonding components, such as leads, wires and flip chips. The complaint seeks an injunction, unspecified monetary damages, interests, fees and costs. On September 30, 2014, the Company filed a motion to dismiss Reiber’s claims for induced infringement and contributory infringement. Oral argument on the Company’s motion to dismiss occurred on January 16, 2015. The parties' initial case management conference is set for April 16, 2015. The Company intends to defend itself vigorously in this matter.
On October 20, 2014, plaintiff SOTA Semiconductor LLC (“SOTA”) filed a complaint in the Central District of California against the Company, Marvell Semiconductor, Inc., Belkin International, Inc., Dell Inc., Hewlett-Packard Company, Hisense USA Corp., Konica Minolta Business Solutions U.S.A., Inc., Lenovo (United States) Inc., Netgear, Inc., Samsung Electronics America, Inc., and Seagate Technology LLC, alleging infringement of U.S. Patent No. 5,991,545 (“’545 patent”). SOTA alleges that the Company’s devices that incorporate Marvell Thumb Processors, including WD’s My Cloud EX2 network attached storage devices, which include model numbers WDBVKW0080JCH, WDBVKW0060JCH, WDBVKW0040JCH and WDBVKW0000NCH, infringe the ’545 patent. The complaint seeks unspecified monetary damages, interests, fees, costs and expenses. On December 12, 2014, the Company filed an answer and counterclaims to SOTA’s complaint. The Company intends to defend itself vigorously in this matter.
Seagate Matter
On October 4, 2006, plaintiff Seagate Technology LLC ("Seagate") filed an action in the District Court of Hennepin County, Minnesota, naming as defendants WD and one of its now former employees previously employed by Seagate. The complaint in the action alleged claims based on misappropriation of trade secrets and sought injunctive relief and unspecified monetary damages, interest, fees and costs. On June 19, 2007, WD’s former employee filed a demand for arbitration with the American Arbitration Association.
On January 23, 2012, the arbitrator issued a total final award, including pre-award interest of $630.4 million. On January 23, 2012, WD filed a petition in the District Court of Hennepin County, Minnesota to have the final arbitration award vacated, and, on October 12, 2012, the District Court of Hennepin County, Minnesota vacated, in full, the $630.4 million final arbitration award, ordering that a rehearing be held concerning the alleged trade secret claims before a new arbitrator.
Seagate appealed the District Court decision to the Minnesota Court of Appeals. On July 22, 2013, the Minnesota Court of Appeals reversed the District Court’s decision and remanded for entry of an order and judgment confirming the arbitration award. On August 20, 2013, the Company filed a petition for review with the Minnesota Supreme Court and, on October 15, 2013, the Minnesota Supreme Court granted the Company’s petition. On October 8, 2014, the Minnesota Supreme Court affirmed the decision of the Minnesota Court of Appeals. Because the Minnesota Supreme Court’s decision is not subject to appeal, on October 14, 2014, the Company paid Seagate $773.4 million to satisfy the full amount of the final arbitration award plus interest accrued through October 13, 2014. This amount was paid during the quarter ended January 2, 2015 by one of the Company’s foreign subsidiaries using cash held outside of the United States.
Seagate disputes the method the Company used for calculating post-award interest and contends that the Company owes Seagate approximately $28.9 million in additional interest. The Company denies Seagate’s contention and believes it calculated interest properly in accordance with the arbitration award. On November 12, 2014, the Company filed a motion with the District Court seeking an order declaring that WD has paid to Seagate all amounts due under the arbitration award, including all pre-award and post-award interest, and all costs and disbursements assessed by the Minnesota Court of Appeals and the Minnesota Supreme Court. On December 23, 2014, Seagate filed a cross-motion seeking entry of judgment in the amount of $28.9 million, plus daily interest from October 15, 2014 until the date any judgment is paid. Both parties’ motions were fully briefed and, on January 9, 2015, the Court heard oral argument on both motions. The Court has not yet ruled on the matter.
Other Matters
On December 22, 2011, the German Central Organization for Private Copying Rights (Zentralstelle für private Überspielungsrechte), (“ZPÜ”), an organization consisting of several levy collecting societies, instituted arbitration proceedings against Western Digital's German subsidiary ("WD Germany") before to the Copyright Arbitration Board (“CAB”) claiming copyright levies for multimedia hard drives, external hard drives and network hard drives sold or introduced into commerce in Germany from January 2008 through December 2010.  The CAB, which was required to issue a settlement proposal within one year

12


of the initiation of the action, failed to do so and requested the parties consent to continue the deadline.  WD Germany declined to provide consent and, on February 1, 2013, WD Germany filed a declaratory relief action against ZPÜ in the Higher Regional Court of Munich (the “Higher Court”), seeking an order from the court to determine the copyright levy issue.  On May 21, 2013, ZPÜ filed a counter-claim against WD Germany with the Higher Court, seeking copyright levies for multimedia hard drives, external hard drives and network hard drives (collectively, "Covered Products") sold or introduced into commerce from January 2008 through December 2010 based on tariffs published by ZPÜ on November 3, 2011. On May 22, 2014, oral argument on the pleadings occurred.  On January 15, 2015, the Higher Court ruled in favor of ZPÜ. In its ruling, the Higher Court declared that WD Germany must pay certain levies on certain WD products which it sold in Germany between January 1, 2008 and December 31, 2010. The judgment specifies levy amounts on certain WD products sold from 2008 to 2010 and directs WD Germany to provide applicable sales data to the ZPÜ. The exact amount of the judgment has not been determined. WD Germany intends to appeal this decision to the German Federal Court of Justice and defend itself vigorously in this matter.
On December 11, 2014, ZPÜ submitted a pleading to the CAB seeking copyright levies for Covered Products sold by WD or introduced into commerce in Germany from January 1, 2012 to December 31, 2013. WD Germany intends to defend itself vigorously in this matter.  
In the three months ended January 2, 2015, the Company recorded an accrual for German copyright levies in an amount that is not material to the Company’s financial position, results of operations or cash flows.  It is reasonably possible that the Company may incur losses totaling up to $90 million, including the amount accrued.
In the normal course of business, the Company is subject to other legal proceedings, lawsuits and other claims. Although the ultimate aggregate amount of probable monetary liability or financial impact with respect to these other 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 other matters, individually and in the aggregate, would not be material to the Company’s financial condition, results of operations or cash flows. However, there can be no assurance with respect to such result, and monetary liability or financial impact to the Company from these other matters could differ materially from those projected.

6. Income Taxes
The Company’s income tax provision for the three and six months ended January 2, 2015 was $20 million and $57 million, respectively, as compared to $37 million and $74 million in the respective prior-year periods. The Company's tax provision for both the three and six months ended January 2, 2015 reflects a tax benefit of $16 million as a result of the retroactive extension of the U.S. Federal R&D tax credit that was signed into law on December 19, 2014. The differences between the effective tax rate and the U.S. Federal statutory rate are primarily due to tax holidays in Malaysia, the Philippines, Singapore and Thailand that expire at various dates from 2015 through 2025 and the current year generation of income tax credits.
In the three months ended January 2, 2015, the Company recorded a net increase of $9 million in its liability for unrecognized tax benefits. In the six months ended January 2, 2015, the Company recorded a net increase of $16 million in its liability for unrecognized tax benefits. As of January 2, 2015, the Company's liability for unrecognized tax benefits was approximately $316 million. Interest and penalties recognized on such amounts were not material to the condensed consolidated financial statements during the three months and six months ended January 2, 2015.

The Internal Revenue Service (“IRS”) previously completed its field examination of the Company's federal income tax returns for fiscal years 2006 and 2007, and the Company and the IRS reached agreement with respect to all matters except on the proposed adjustments to income before income taxes relating to intercompany payable balances. The proposed adjustments relating to intercompany payable balances for fiscal years 2006 and 2007 will be addressed in conjunction with the IRS’s examination of the Company’s fiscal years 2008 and 2009, which commenced in January 2012. In addition, in January 2012, the IRS commenced an examination of the 2007 fiscal period ended September 5, 2007 of Komag, Incorporated, which was acquired by the Company on September 5, 2007.  The Company anticipates that the IRS fieldwork will be completed in the fourth quarter of fiscal year 2015.  With respect to the 2008 and 2009 audit, the Company received a notice of proposed adjustment from the IRS relating to intercompany payable balances. The proposed adjustments to income before income taxes relating to intercompany payable balances for fiscal years 2006, 2007, 2008 and 2009 total approximately $200 million. The Company disagrees with the proposed adjustments, believes that its tax position is properly supported and will vigorously contest the position taken by the IRS. The IRS examined calendar years 2010 and 2011 of HGST, which was acquired by the Company on March 8, 2012, and completed the examination with no material adjustments.
The Company believes that adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. As of January 2, 2015, it was not possible to estimate the amount of change, if any, in the unrecognized tax benefits that is reasonably possible within the next twelve months. Any significant change in the

13


amount of the Company’s liability for unrecognized tax benefits would most likely result from additional information or settlements relating to the examination of the Company’s tax returns.
7. Fair Value Measurements
Financial assets and liabilities that are remeasured and reported at fair value at each reporting period are classified and disclosed in one of the following three levels:
Level 1. Quoted prices in active markets for identical assets or liabilities.
Level 2. Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3. Inputs that are unobservable for the asset or liability and that are significant to the fair value of the assets or liabilities.

The following table presents information about the Company’s financial assets and liabilities that are measured at fair value on a recurring basis as of January 2, 2015, and indicates the fair value hierarchy of the valuation techniques utilized to determine such value (in millions): 
 
Fair Value Measurements at
Reporting Date Using
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
1,677

 
$

 
$

 
$
1,677

U.S. Government agency securities

 
15

 

 
15

Commercial paper

 
20

 

 
20

Total cash equivalents
1,677

 
35

 

 
1,712

Short-term investments:
 
 
 
 
 
 
 
U.S. Government agency securities

 
61

 

 
61

Commercial paper

 
154

 

 
154

Certificates of deposit

 
26

 

 
26

Total short-term investments

 
241

 

 
241

Long-term investments:
 
 
 
 
 
 
 
U.S. Treasury securities

 
159

 

 
159

U.S. Government agency securities

 
65

 

 
65

Total long-term investments

 
224

 

 
224

Total assets at fair value
$
1,677

 
$
500

 
$

 
$
2,177

Liabilities:

 

 

 

Foreign exchange contracts
$

 
$
45

 
$

 
$
45

Total liabilities at fair value
$

 
$
45

 
$

 
$
45


14


The following table presents information about the Company’s financial assets and liabilities that are measured at fair value on a recurring basis as of June 27, 2014, and indicates the fair value hierarchy of the valuation techniques utilized to determine such value (in millions): 
 
Fair Value Measurements at
Reporting Date Using
 
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
756

 
$

 
$

 
$
756

Bank acceptances

 
1

 

 
1

Total cash equivalents
756

 
1

 

 
757

Short-term investments:
 
 
 
 
 
 
 
U.S. Government agency securities

 
53

 

 
53

Commercial paper

 
165

 

 
165

Certificates of deposit

 
66

 

 
66

Total short-term investments

 
284

 

 
284

Long-term investments:
 
 
 
 
 
 
 
U.S. Treasury securities

 
180

 

 
180

U.S. Government agency securities

 
35

 

 
35

Total long-term investments

 
215

 

 
215

Foreign exchange contracts

 
7

 

 
7

Total assets at fair value
$
756

 
$
507

 
$

 
$
1,263

Liabilities:
 
 
 
 
 
 
 
Foreign exchange contracts
$

 
$
2

 
$

 
$
2

Total liabilities at fair value
$

 
$
2

 
$

 
$
2

Money Market Funds. The Company’s money market funds are funds that invest in U.S. Treasury and U.S. Government Agency securities and are recorded within cash and cash equivalents in the condensed consolidated balance sheets. Money market funds are valued based on quoted market prices.
Certificates of Deposit. The Company’s certificates of deposit are investments which are held in custody by a third party and recorded within short-term investments in the condensed consolidated balance sheets. Certificates of deposit are valued using fixed interest rates.
Commercial Paper. The Company’s commercial paper securities are investment grade debt issued by corporations which are held in custody by a third party with original maturities of twelve months or less and are recorded within cash and cash equivalents or short-term investments in the condensed consolidated balance sheets depending on their original maturities. Commercial paper securities are valued using a market approach which is based on observable inputs including market interest rates from multiple pricing sources.
U.S. Government Agency Securities. The Company’s U.S. Government agency securities are investments in fixed income securities sponsored by the U.S. Government and are held in custody by a third party and recorded within cash and cash equivalents, short-term investments or other non-current assets in the condensed consolidated balance sheets depending on their original maturities. U.S. Government agency securities are valued using a market approach which is based on observable inputs including market interest rates from multiple pricing sources.
U.S. Treasury Securities. The Company’s U.S. Treasury securities are direct obligations of the U.S. federal government, are held in custody by a third party and are recorded within other non-current assets in the condensed consolidated balance sheets. U.S. Treasury securities are valued using a market approach which is based on observable inputs including market interest rates from multiple pricing sources.
Bank Acceptances. The Company’s bank acceptances are held in custody by a third party and recorded within cash and cash equivalents in the condensed consolidated balance sheets. Bank acceptances are valued using a market approach which is based on observable inputs including market interest rates from multiple pricing sources.
Foreign Exchange Contracts. The Company’s foreign exchange contracts are short-term contracts to hedge the Company’s foreign currency risk. Foreign exchange contracts are classified within other current assets and liabilities in the condensed consolidated balance sheets. For contracts that have a right of offset by its individual counterparties under master netting

15


arrangements, the Company presents its foreign exchange contracts on a net basis by counterparty in the condensed consolidated balance sheets. For more information on the Company's foreign exchange contracts, see Note 8. Foreign exchange contracts are valued using an income approach that is based on a present value of future cash flows model. The market-based observable inputs for the model include forward rates and credit default swap rates.
The carrying amounts of cash, accounts receivable, accounts payable and accrued expenses approximate fair value for all periods presented because of the short-term maturity of these assets and liabilities. The carrying amount of debt approximates fair value because of its variable interest rate.
8. Foreign 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, foreign exchange contracts to hedge the impact of foreign currency exchange fluctuations on certain underlying assets, liabilities and commitments for operating expenses and product costs denominated in foreign currencies. The purpose of entering into these hedging transactions is to minimize the impact of foreign currency fluctuations on the Company’s results of operations. These contract maturity dates do not exceed 12 months. All foreign exchange contracts are for risk management purposes only. The Company does not purchase foreign exchange contracts for trading purposes. As of January 2, 2015, the Company had outstanding foreign exchange contracts with commercial banks for British Pound Sterling, Euro, Japanese Yen, Malaysian Ringgit, Philippine Peso, Singapore Dollar and Thai Baht, which were designated as either cash flow or fair value hedges.
If the derivative is designated as a cash flow hedge, the effective portion of the change in fair value of the derivative is initially deferred in other comprehensive income (loss), net of tax. These amounts are subsequently recognized into earnings when the underlying cash flow being hedged is recognized into earnings. Recognized gains and losses on foreign exchange contracts entered into for manufacturing-related activities are reported in cost of revenue and presented within cash flow from operations. Hedge effectiveness is measured by comparing the hedging instrument’s cumulative change in fair value from inception to maturity to the underlying exposure’s terminal value. The Company determined the ineffectiveness associated with its cash flow hedges to be immaterial to the condensed consolidated financial statements for the three and six months ended January 2, 2015 and December 27, 2013.
A change in the fair value of fair value hedges is recognized in earnings in the period incurred and is reported as a component of operating expenses. All fair value hedges were determined to be effective as of January 2, 2015 and June 27, 2014. The changes in fair value on these contracts were immaterial to the condensed consolidated financial statements during the three and six months ended January 2, 2015 and December 27, 2013.
As of January 2, 2015, the net amount of unrealized losses with respect to the Company’s foreign exchange contracts that is expected to be reclassified into earnings within the next 12 months was $39 million. In addition, as of January 2, 2015, the Company did not have any foreign exchange contracts with credit-risk-related contingent features. The Company opened $1.0 billion and $2.0 billion, and closed $1.1 billion and $2.1 billion, in foreign exchange contracts in the three and six months ended January 2, 2015, respectively. In addition, the Company opened $1.7 billion and $2.7 billion and closed $1.3 billion and $2.7 billion, in foreign exchange contracts in the three and six months ended December 27, 2013, respectively. The fair value and balance sheet location of the Company's foreign exchange contracts as of January 2, 2015 and June 27, 2014 were as follows (in millions): 
 
Asset Derivatives
Liability Derivatives
  
January 2, 2015
June 27, 2014
January 2, 2015
June 27, 2014
Derivatives Designated as
Hedging Instruments
Balance Sheet
Location
Fair
Value
Balance Sheet
Location
Fair
Value
Balance Sheet
Location
Fair
Value
Balance Sheet
Location
Fair
Value
Foreign exchange contracts
Other current assets
$

Other current assets
$
7

Accrued expenses
$
45

Accrued expenses
$
2

The following table presents the gross amounts of the Company's derivative instruments, amounts offset due to master netting arrangements with the Company's various counterparties, and the net amounts recognized in the condensed consolidated balance sheet as of January 2, 2015 (in millions):
Derivatives Designated as
Hedging Instruments
Gross Amounts of Recognized Assets (Liabilities)
 
Gross Amounts Offset in the Balance Sheet
 
Net Amounts of Assets (Liabilities) Presented in the Balance Sheet
Foreign exchange contracts
 
 
 
 
 
  Financial assets
$
1

 
$
(1
)
 
$

  Financial liabilities
(46
)
 
1

 
(45
)
    Total derivative instruments
$
(45
)
 
$

 
$
(45
)

16


    
The following table presents the gross amounts of the Company's derivative instruments, amounts offset due to master netting arrangements with the Company's various counterparties, and the net amounts recognized in the condensed consolidated balance sheet as of June 27, 2014 (in millions):    
Derivatives Designated as
Hedging Instruments
Gross Amounts of Recognized Assets (Liabilities)
 
Gross Amounts Offset in the Balance Sheet
 
Net Amounts of Assets (Liabilities) Presented in the Balance Sheet
Foreign exchange contracts
 
 
 
 
 
  Financial assets
$
9

 
$
(2
)
 
$
7

  Financial liabilities
(4
)
 
2

 
(2
)
    Total derivative instruments
$
5

 
$

 
$
5

The impact on the condensed consolidated financial statements was as follows (in millions):
 
Amount of Loss Recognized in
Accumulated OCI on Derivatives
Location of
(Gain) Loss
Reclassified
from
Accumulated
OCI into
Income
Amount of (Gain) Loss Reclassified
From Accumulated OCI into Income
Derivatives in Cash
Flow Hedging Relationships
Three
Months
Ended
 
Six Months Ended
 
Three
Months
Ended
 
Six Months Ended
Three
Months
Ended
 
Six Months Ended
 
Three
Months
Ended
 
Six Months Ended
January 2,
2015
 
December 27,
2013
January 2,
2015
 
December 27,
2013
Foreign exchange contracts
$
(35
)
 
$
(57
)
 
$

 
$
(11
)
Cost of revenue
$
(17
)
 
$
(13
)
 
$
30

 
$
3

The total net realized transaction and foreign exchange contract currency gains and losses were not material to the condensed consolidated financial statements during the three and six months ended January 2, 2015 and December 27, 2013.

9. Stock-Based Compensation

Stock-Based Compensation Expense
During the three and six months ended January 2, 2015, the Company recognized in expense $18 million and $37 million, respectively, for stock-based compensation related to the vesting of options issued under the Company’s stock plans and the ESPP, as compared to $24 million and $45 million in the respective prior-year periods. The tax benefit realized as a result of the aforementioned stock-based compensation expense was $7 million and $12 million in the three and six months ended January 2, 2015, respectively, as compared to $6 million and $11 million in the three and six months ended December 27, 2013, respectively. As of January 2, 2015, total compensation cost related to unvested stock options and ESPP rights issued to employees but not yet recognized was $129 million and will be amortized on a straight-line basis over a weighted average service period of approximately 2.2 years.
During the three and six months ended January 2, 2015, the Company recognized in expense $23 million and $43 million, respectively, for stock-based compensation related to the vesting of awards of RSUs issued under the Company's stock plans, as compared to $18 million and $39 million in the respective prior-year periods. The tax benefit realized as a result of the aforementioned stock-based compensation expense was $6 million and $11 million in the three and six months ended January 2, 2015, respectively, as compared to $5 million and $9 million in the three and six months ended December 27, 2013, respectively. As of January 2, 2015, the aggregate unamortized fair value of all unvested RSUs was $157 million, which will be recognized on a straight-line basis over a weighted average vesting period of approximately 1.7 years. RSUs include performance stock unit awards (“PSUs”). The effect of PSUs was immaterial to the condensed consolidated financial statements in the three and six months ended January 2, 2015 and December 27, 2013.
During the three and six months ended January 2, 2015, the Company recognized in expense $8 million and $12 million, respectively, related to adjustments to market value as well as the vesting of stock appreciation rights (“SARs”), as compared to $20 million and $24 million in the respective prior-year periods. The tax benefit realized as a result of the aforementioned SARs expense was $2 million and $3 million in the three and six months ended January 2, 2015, respectively, as compared to $4 million and $5 million in the three and six months ended December 27, 2013, respectively. The SARs will be settled in cash upon exercise. As a result, the Company had a total liability of $63 million related to SARs included in accrued expenses in the condensed consolidated balance sheet as of January 2, 2015. As of January 2, 2015, total compensation cost related to unvested SARs issued to employees but not yet recognized was not material to the Company's consolidated statement of income.

17


Stock Option Activity
The following table summarizes stock option activity under the Company’s stock option plans (in millions, except per share amounts and remaining contractual lives): 
 
Number
of
Shares
 
Weighted
Average
Exercise
Price
Per
Share
 
Weighted
Average
Remaining
Contractual
Life
(in years)
 
Aggregate
Intrinsic
Value
Options outstanding at June 27, 2014
10.1

 
$
37.03

 
 
 
 
Granted
1.2

 
100.06

 
 
 
 
Exercised
(1.3
)
 
31.04

 
 
 
 
Options outstanding at October 3, 2014
10.0

 
45.16

 
 
 
 
Exercised
(1.1
)
 
32.14

 
 
 
 
Canceled or expired
(0.1
)
 
32.53

 
 
 
 
Options outstanding at January 2, 2015
8.8

 
$
47.01

 
4.4
 
$
564

Exercisable at January 2, 2015
4.0

 
$
32.98

 
3.1
 
$
314

Vested and expected to vest after January 2, 2015
8.6

 
$
46.41

 
4.4
 
$
558

If an option has an exercise price that is less than the quoted price of the Company’s common stock at the particular time, the aggregate intrinsic value of that option at that time is calculated based on the difference between the exercise price of the underlying options and the quoted price of the Company’s common stock at that time. As of January 2, 2015, the Company had options outstanding to purchase an aggregate of 8.8 million shares with an exercise price below the quoted price of the Company’s stock on that date resulting in an aggregate intrinsic value of $564 million at that date. During the three and six months ended January 2, 2015, the aggregate intrinsic value of options exercised under the Company’s stock option plans was $76 million and $163 million, respectively, determined as of the date of exercise, as compared to $80 million and $107 million in the respective prior-year periods.
RSU Activity
The following table summarizes RSU activity under the Company's stock plans (in millions, except weighted average grant date fair value):
 
Number
of Shares
 
Weighted Average
Grant-Date
Fair Value
RSUs outstanding at June 27, 2014
3.7

 
$
49.77

Granted
1.1

 
100.07

Vested
(1.5
)
 
40.57

RSUs outstanding at October 3, 2014
3.3

 
70.88

Granted*

 
101.27

Vested
(0.1
)
 
48.25

RSUs outstanding at January 2, 2015
3.2

 
72.15

Expected to vest after January 2, 2015
3.0

 
$
71.69

*
Shares granted were immaterial for rounding purposes.
The fair value of each RSU is the market price of the Company’s stock at the date of grant. RSUs are generally payable in an equal number of shares of the Company’s common stock at the time of vesting of the units. The grant-date fair value of the shares underlying the RSU awards at the date of grant was $3 million and $116 million in the three and six months ended January 2, 2015, respectively. These amounts are being recognized to expense over the corresponding vesting periods. The Company has assumed a forfeiture rate of 4.3% and 4.4% for the three and six months ended January 2, 2015, respectively, based on a historical analysis indicating forfeitures for these types of awards.

18


SARs Activity
The share-based compensation liability for SARs is recognized for the portion of fair value for which service has been rendered at the reporting date. The share-based liability is remeasured at each reporting date, using a binomial option-pricing model, through the requisite service period. As of January 2, 2015, 0.6 million SARs were outstanding with a weighted average exercise price of $8.11. There were no SARs granted and all other SARs activity was immaterial to the condensed consolidated financial statements for the three and six months ended January 2, 2015.

Fair Value Disclosure — Binomial Model
The fair value of stock options granted is estimated using a binomial option-pricing model. The binomial model requires the input of highly subjective assumptions. The Company uses historical data to estimate exercise, employee termination, and expected stock price volatility within the binomial model. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The fair value of stock options granted was estimated using the following weighted average assumptions: 
 
Three Months Ended
 
Six Months Ended
 
January 2,
2015
 
December 27,
2013
 
January 2,
2015
 
December 27,
2013
Suboptimal exercise factor
2.59
 
2.20
 
2.51
 
2.06
Range of risk-free interest rates
0.25% to 1.92%
 
0.12% to 2.44%
 
0.11% to 2.16%
 
0.10% to 2.44%
Range of expected stock price volatility
0.23 to 0.46
 
0.29 to 0.49
 
0.23 to 0.47
 
0.29 to 0.50
Weighted average expected volatility
0.35
 
0.41
 
0.36
 
0.43
Post-vesting termination rate
1.69%
 
3.18%
 
1.25%
 
3.09%
Dividend yield
1.45%
 
1.45%
 
1.68%
 
1.58%
Fair value
$31.96
 
$25.29
 
$32.29
 
$24.03
The weighted average expected term of the Company’s stock options granted during the three and six months ended January 2, 2015 was 6.0 years and 5.8 years, respectively, compared to 5.4 years and 5.0 years in the respective prior-year periods.
Fair Value Disclosure — Black-Scholes-Merton Model
The fair value of ESPP purchase rights issued is estimated at the date of grant of the purchase rights using the Black-Scholes-Merton option-pricing model. The Black-Scholes-Merton option-pricing model requires the input of highly subjective assumptions such as the expected stock price volatility and the expected period until options are exercised. Purchase rights under the current ESPP are granted on either June 1 or December 1 of each year. ESPP activity was immaterial to the condensed consolidated financial statements for the three and six months ended January 2, 2015 and December 27, 2013.
Stock Repurchase Program
Since May 21, 2012, the Company's Board of Directors has authorized $3.0 billion for the repurchase of its common stock. The Company repurchased 3.2 million and 5.4 million shares for a total cost of $309 million and $532 million during the three and six months ended January 2, 2015. The remaining amount available to be purchased under the Company’s stock repurchase program as of January 2, 2015 was $622 million. On February 3, 2015, the Company's Board of Directors authorized an additional $2.0 billion for the repurchase of its common stock and approved the extension of its stock repurchase program to February 3, 2020, resulting in a cumulative authorized repurchase amount of $5.0 billion since the inception of the repurchase program. The Company may continue to repurchase its stock as it deems appropriate and market conditions allow. Repurchases under the stock repurchase program may be made in the open market or in privately negotiated transactions and may be made under a Rule 10b5-1 plan. The Company expects stock repurchases to be funded principally by operating cash flows and borrowings under the Company's Credit Agreement.

19


Dividends to Shareholders
On September 13, 2012, the Company announced that its Board of Directors had authorized the adoption of a quarterly cash dividend policy. Under the cash dividend policy, holders of the Company’s common stock receive dividends when and as declared by the Company’s Board of Directors. In the three months ended January 2, 2015, the Company declared a cash dividend of $0.40 per share of the Company’s common stock to shareholders of record as of January 2, 2015, totaling $93 million, which was paid on January 15, 2015. In addition, in the three months ended October 3, 2014, the Company declared a cash dividend of $0.40 per share of the Company’s common stock to shareholders of record as of October 3, 2014, totaling $94 million, which was paid on October 15, 2014. On February 3, 2015, the Company declared a cash dividend of $0.50 per share of the Company's common stock to shareholders of record as of April 3, 2015, which will be paid on April 16, 2015. The Company may modify, suspend or cancel its cash dividend policy in any manner and at any time.
10. Pensions and Other Post-retirement Benefit Plans
The Company’s principal pension and other post-retirement benefit plans are in Japan. All pension and other post-retirement benefit plans outside of the Company’s Japanese plans were immaterial to the Company’s condensed consolidated financial statements for the three and six months ended January 2, 2015 and December 27, 2013. The expected long-term rate of return on the Japanese plan assets is 3.5%.
The following table presents the unfunded status of the benefit obligations and Japanese plan assets (in millions): 
 
January 2,
2015
 
June 27,
2014
Benefit obligation
$
220

 
$
255

Fair value of plan assets
(168
)
 
(191
)
Unfunded status
$
52

 
$
64

The following table presents the unfunded amounts as recognized on the Company’s condensed consolidated balance sheets (in millions): 
 
January 2,
2015
 
June 27,
2014
Current liabilities
$
1

 
$
1

Non-current liabilities
51

 
63

Net amount recognized
$
52

 
$
64


The net periodic benefit cost of the Company’s pension plans was not material to the condensed consolidated financial statements for the three and six months ended January 2, 2015 and December 27, 2013. The Company’s expected employer contribution for its Japanese defined benefit pension plans is $11 million in fiscal 2015.
11. Acquisitions
The condensed consolidated financial statements include the results of operations of acquired companies commencing after their respective acquisition dates. Disclosed below are those acquisitions which have a significant impact to these condensed consolidated financial statements.
Acquisition of Virident
On October 17, 2013, the Company acquired Virident, a provider of server-side flash storage solutions for virtualization, database, cloud computing and webscale applications. As a result of the acquisition, Virident has been fully integrated into the Company's HGST subsidiary and became a wholly-owned indirect subsidiary of the Company. The acquisition furthered HGST's strategy to address the rapidly changing needs of enterprise customers by delivering intelligent storage solutions that maximize application performance by leveraging the tightly coupled server, storage and network resources of today’s converged datacenter infrastructures.

20


The values assigned to the acquired assets and liabilities were finalized during the three months ended June 27, 2014, and the final purchase price allocation for Virident was as follows (in millions):
Tangible assets acquired and liabilities assumed
$
58

Intangible assets
49

Goodwill
506

     Total
$
613

Acquisition of sTec
On September 12, 2013, the Company completed its acquisition of sTec, a provider of enterprise solid-state drives. As a result of the acquisition, sTec has been fully integrated into the Company's HGST subsidiary and became a wholly-owned indirect subsidiary of the Company. The acquisition augmented HGST's existing solid-state storage capabilities.
The values assigned to the acquired assets and liabilities were finalized during the three months ended October 3, 2014, and the final purchase price allocation for sTec was as follows (in millions):
Tangible assets acquired and liabilities assumed
$
189

Intangible assets
58

Goodwill
89

     Total
$
336

12. Employee Termination, Asset Impairment and Other Charges
The Company periodically incurs charges to realign its operations with anticipated market demand. The following table summarizes the Company's employee termination, asset impairment and other charges over fiscal year 2015 (in millions):
 
Employee
Termination
Benefits
 
Impairment
of Assets
 
Total
Accrual at June 27, 2014
$

 
$

 
$

Charges
8

 
1

 
9

Non-cash charges

 
(1
)
 
(1
)
Accrual at October 3, 2014
$
8

 
$

 
$
8

Charges
34

 
19

 
53

Cash payments
(9
)
 

 
(9
)
Non-cash charges

 
(19
)
 
(19
)
Accrual at January 2, 2015
$
33

 
$

 
$
33

13. Thailand Flooding
In October 2011, severe flooding in Thailand inundated all of the Company’s Thailand manufacturing facilities and submerged certain equipment located there. The Company maintains insurance coverage that provides property and business interruption coverage in the event of losses arising from flooding. As a result, the Company received a total of $50 million of insurance recoveries, of which $13 million was received previously and $37 million was received in the three months ended January 2, 2015 and recorded within the "Selling, general and administrative" line item on the Company's condensed consolidated statements of income. As a result, all claims submitted by the Company to its insurers have been closed as of January 2, 2015.
14. Recent Accounting Pronouncements    
In July 2013, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2013-11, "Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists" ("ASU 2013-11"). The new standard requires the presentation of certain unrecognized tax benefits as reductions to deferred tax assets rather than as liabilities in the consolidated balance sheets when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The new standard is effective for fiscal years and interim periods within those fiscal years, beginning after December 15, 2013, which for the Company was the first quarter of fiscal 2015. The Company adopted this pronouncement in the first quarter of fiscal 2015, and it did not have a material effect on its condensed consolidated financial statements.

21


In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers" ("ASU 2014-09"), which amends the guidance in former Accounting Standards Codification Topic 605, "Revenue Recognition," to provide a single, comprehensive revenue recognition model for all contracts with customers. The new standard requires an entity to recognize revenue in a manner that depicts the transfer of promised goods or services to customers in amounts that reflect the consideration to which an entity expects to be entitled in exchange for those goods or services. The new standard also requires entities to enhance disclosures about the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The new standard allows for either a full retrospective or a modified retrospective transition method and is effective for fiscal years beginning after December 15, 2016, which for the Company is the first quarter of fiscal 2018. The Company has not yet selected a transition method and is currently evaluating the impact ASU 2014-09 will have on its consolidated financial statements and related disclosures.
Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read this information 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 Part II, Item 7, contained in our Annual Report on Form 10-K for the year ended June 27, 2014.
Unless otherwise indicated, references herein to specific years and quarters are to our fiscal years and fiscal quarters. As used herein, the terms “we,” “us,” “our,” and the “Company” refer to Western Digital Corporation and its subsidiaries.
Forward-Looking Statements
This document contains forward-looking statements within the meaning of the federal securities laws. Any statements that do not relate to historical or current facts or matters are forward-looking statements. You can identify some of the forward-looking statements by the use of forward-looking words, such as “may,” “will,” “could,” “would,” “project,” “believe,” “anticipate,” “expect,” “estimate,” “continue,” “potential,” “plan,” “forecast,” and the like, or the use of future tense. Statements concerning current conditions may also be forward-looking if they imply a continuation of current conditions. Examples of forward-looking statements include, but are not limited to, statements concerning:
expectations regarding industry demand and shipments in the quarter ending April 3, 2015 and the expected impact on our revenue;
expectations concerning the anticipated benefits of our acquisitions;
demand for our products in the various markets and factors contributing to such demand;
our position in the industry;
our belief regarding our ability to capitalize on the expansion in, and our expectations regarding the growth and demand of, digital data;
our plans to continue to develop new products and expand into new storage markets and into emerging economic markets;
emergence of new storage markets for our products;
emergence of competing storage technologies;
our quarterly cash dividend policy;
our share repurchase plans;
our stock price volatility;
our belief regarding our compliance with environmental laws and regulations;
expectations regarding our external and internal supply base;
our belief regarding component availability;
expectations regarding the outcome of legal proceedings in which we are involved;
our beliefs regarding tax benefits and the timing of future payments, if any, relating to the unrecognized tax benefits, and the adequacy of our tax provisions;
contributions to our pension plans in fiscal 2015; and
our beliefs regarding the sufficiency of our cash and cash equivalents to meet our working capital, capital expenditure and other cash needs.
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. We urge you to carefully review the disclosures we make concerning risks and other factors that may affect our business and operating results, including those made in Part I, Item 1A of this Quarterly

22


Report on Form 10-Q, and any of those made in our other reports filed with the SEC. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this document. We do not intend, and undertake no obligation, to publish revised forward-looking statements to reflect events or circumstances after the date of this document or to reflect the occurrence of unanticipated events.
Our Company

We are a leading developer, manufacturer and provider of data storage solutions that enable consumers, businesses, governments and other organizations to create, manage, experience and preserve digital content. Our product portfolio includes hard disk drives (“HDDs”) and solid-state drives ("SSDs"), direct attached storage solutions, personal cloud network attached storage solutions, and public and private cloud data center storage solutions. HDDs are our principal products and are today’s primary storage medium for digital content, with the use of solid-state storage products growing rapidly. Our products are marketed under the HGST, WD and G-Technology brand names.  We currently operate our global business through two independent subsidiaries due to regulatory requirements - HGST and WD.
Second Quarter Overview
In accordance with accounting principles generally accepted in the United States (“U.S. GAAP”), we include the operating results for acquired companies commencing after their respective acquisition dates. Accordingly, Virident and sTec have been included in our results of operations since their acquisition dates of October 17, 2013, and September 12, 2013, respectively.
Our fiscal year ends on the Friday nearest to June 30 and typically consists of 52 weeks. Approximately every six years, we report a 53-week fiscal year to align our fiscal year with the foregoing policy. Our fiscal second quarters ended January 2, 2015 and December 27, 2013 both consisted of 13 weeks. Fiscal year 2015 will be comprised of 53 weeks and will end on July 3, 2015.
For the quarter ended January 2, 2015, we believe that overall hard drive industry shipments totaled approximately 141 million units, down 1% from the prior-year period and down 4% from the first fiscal quarter.
The following table sets forth, for the periods presented, selected summary information from our condensed consolidated statements of income by dollars (in millions) and percentage of net revenue:
 
 
Three Months Ended
 
Six Months Ended
 
January 2,
2015
 
December 27,
2013
 
January 2,
2015
 
December 27,
2013
Net revenue
$
3,888


100.0
%

$
3,972


100.0
%

$
7,831


100.0
%

$
7,776


100.0
%
Gross profit
1,110


28.5


1,156


29.1


2,259


28.8


2,255


29.0

Total operating expenses
644


16.6


678


17.1


1,324


16.9


1,235


15.9

Operating income
466


12.0


478


12.0


935


11.9


1,020


13.1

Net income
438


11.3


430


10.8


861


11.0


925


11.9

The following is a summary of our financial performance for the second quarter of fiscal 2015:
Consolidated net revenue totaled $3.9 billion.
Net revenue derived from enterprise SSDs was $187 million as compared to $155 million in the prior-year period.
Hard drive unit shipments decreased 3% from the prior-year period to 61.0 million units.
Gross margin decreased to 28.5%, compared to 29.1% for the prior-year period.
Operating income was $466 million, a decrease of $12 million from the prior-year period.
We generated $243 million in cash flow from operations and we ended the quarter with $4.9 billion in cash and cash equivalents.


23


Results of Operations
Net Revenue 
 
Three Months
Ended
 
 
 
Six Months
Ended
 
 
(in millions, except percentages and
average selling price)
January 2,
2015
 
December 27,
2013
 
Percentage Change
 
January 2,
2015
 
December 27,
2013
 
Percentage
Change
Net revenue
$
3,888


$
3,972

 
(2
)%
 
$
7,831


$
7,776

 
1
%
Average selling price (per unit)*
$
60

 
$
60

 
 %
 
$
59

 
$
59

 
%
Revenues by Geography (%)
 
 
 
 
 
 
 
 
 
 
 
Americas
27
%
 
25
%
 
 
 
27
%
 
26
%
 
 
Europe, Middle East and Africa
24

 
23

 
 
 
23

 
21

 
 
Asia
49

 
52

 
 
 
50

 
53

 
 
Revenues by Channel (%)
 
 
 
 
 
 
 
 
 
 
 
OEM
63
%
 
62
%
 
 
 
63
%
 
63
%
 
 
Distributors
23

 
24

 
 
 
24

 
24

 
 
Retailers
14

 
14

 
 
 
13

 
13

 
 
Unit Shipments*
 
 
 
 
 
 
 
 
 
 
 
PC
36.6

 
39.5

 
 
 
76.3

 
79.7

 
 
Non-PC
24.4

 
23.6

 
 
 
49.5

 
46.0

 
 
            Total units shipped
61.0

 
63.1

 
(3
)%
 
125.8

 
125.7

 
%
*
Based on sales of hard drive units only.
For the quarter ended January 2, 2015, net revenue was $3.9 billion, a decrease of 2% from the prior-year period. This decrease in revenue was primarily due to a decrease in total hard drive shipments, offset by changes in product mix. Total hard drive shipments decreased to 61.0 million units for the quarter ended January 2, 2015 as compared to 63.1 million units in the prior-year period. For the six months ended January 2, 2015, net revenue was $7.8 billion, an increase of 1% from the prior year period. Total hard drive shipments increased to 125.8 million units for the six months ended January 2, 2015 as compared to 125.7 million units in the prior-year period. For the quarter ended January 2, 2015, average selling price ("ASP") remained flat with the prior-year period at $60. For the six months ended January 2, 2015, ASP remained flat with the prior-year period at $59.
Changes in revenue by geography and channel generally reflect normal fluctuations in market demand and competitive dynamics. For both the three and six months ended January 2, 2015, Hewlett-Packard Company accounted for approximately 11% of our net revenue. For the three and six months ended December 27, 2013, Hewlett-Packard Company accounted for approximately 11% and 12% of our net revenue, respectively.
Consistent with standard industry practice, we have sales incentive and marketing programs that provide customers with price protection and other incentives or reimbursements that are recorded as a reduction to gross revenue. Generally, total sales incentive and marketing programs range from 7% to 10% of gross revenues per quarter. For the three and six months ended January 2, 2015, these programs represented 10% and 9% of gross revenues, respectively, as compared to 7% in both respective prior-year periods. These amounts generally vary according to several factors, including industry conditions, seasonal demand, competitor actions, channel mix and overall availability of product. Changes in future customer demand and market conditions may require us to adjust our incentive programs as a percentage of gross revenue from the current range. Adjustments to revenues due to changes in accruals for these programs related to revenues reported in prior periods have averaged 0.6% of quarterly gross revenue since the first quarter of fiscal 2013.

Gross Margin 
 
Three Months
Ended

 

Six Months
Ended

 
(in millions, except percentages)
January 2,
2015

December 27,
2013

Percentage Change

January 2,
2015

December 27,
2013

Percentage
Change
Net revenue
$
3,888


$
3,972


(2
)%

$
7,831


$
7,776


1
%
Gross profit
1,110


1,156


(4
)%

2,259


2,255


%
Gross margin
28.5
%

29.1
%



28.8
%

29.0
%



24


For the three months ended January 2, 2015, gross margin decreased to 28.5% as compared to 29.1% for the prior-year period. For the six months ended January 2, 2015, gross margin decreased to 28.8% as compared to 29.0% for the prior-year period.
Operating Expenses 
 
Three Months
Ended
 
 
 
Six Months
Ended
 
 
(in millions, except percentages)
January 2,
2015
 
December 27,
2013
 
Percentage Change
 
January 2,
2015
 
December 27,
2013
 
Percentage
Change
R&D expense
$
426


$
416


2
 %

$
863


$
817


6
 %
SG&A expense
164


226


(27
)%

384


358


7
 %
Charges related to arbitration award
1


13


(92
)%

15


26


(42
)%
Employee termination, asset impairment and other charges
53


23


130
 %

62


34


82
 %
Total operating expenses
$
644


$
678




$
1,324


$
1,235



Research and development (“R&D”) expense was $426 million for the three months ended January 2, 2015, an increase of $10 million from the prior-year period. This increase was primarily due to additional investment in our enterprise SSD business. For the six months ended January 2, 2015, R&D expense was $863 million, an increase of $46 million from the prior-year period. This increase was primarily due to additional investment in our enterprise SSD business and the inclusion of a full six month period of Virident and sTec's R&D expenses, as opposed to a partial six month period of such expenses in the comparative prior-year period, and an additional week of operating expenses due to a 14-week quarter in our first fiscal quarter in the current period. As a percentage of net revenue, R&D expense increased to 11.0% in both the three and six months ended January 2, 2015, as compared to 10.5% in both the respective prior-year periods.
Selling, general and administrative (“SG&A”) expense was $164 million for the three months ended January 2, 2015, a decrease of $62 million from the prior-year period. This decrease was primarily due to a $37 million flood-related insurance recovery during the period, as well as ongoing efforts to reduce our operating expenses. For the six months ended January 2, 2015, SG&A expense was $384 million, an increase of $26 million from the prior-year period. This increase was primarily due to the inclusion of a full six month period of Virident and sTec's SG&A expenses, as opposed to a partial six month period of such expenses in the comparative prior-year period, and an additional week of operating expenses due to a 14-week quarter in our first fiscal quarter in the current period. Additionally, this increase is a result of a $37 million flood-related insurance recovery in the current period compared to a $65 million flood-related insurance recovery in the prior-year period. SG&A expense as a percentage of net revenue was 4.2% and 4.9% in the three and six months ended January 2, 2015, respectively, as compared to 5.7% and 4.6% in the respective prior-year periods.
During the three and six months ended January 2, 2015, we recorded $1 million and $15 million, respectively, of interest charges related to an arbitration award for claims brought against us and a now former employee of ours by Seagate Technology LLC ("Seagate") as compared to $13 million and $26 million in the respective prior-year periods. For additional information, refer to Part I, Item 1, Note 5 of the Notes to Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q.
During the three and six months ended January 2, 2015, we recorded employee termination, asset impairment and other charges of $53 million and $62 million, respectively, in order to realign our operations with anticipated market demand as compared to $23 million and $34 million in the respective prior-year periods. For additional information, refer to Part I, Item 1, Note 12 of the Notes to Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q.

Other Income (Expense)
Interest income for the three and six months ended January 2, 2015 increased $1 million and $2 million, respectively, as compared to the prior-year periods primarily due to a higher average daily invested cash balance for the periods. Interest and other expense for both the three and six months ended January 2, 2015 decreased $2 million when compared to the respective prior-year periods primarily due to interest on a lower debt balance.
Income Tax Provision
Our income tax provision for the three months ended January 2, 2015 was $20 million, as compared to $37 million in the prior-year period. Our income tax provision for the six months ended January 2, 2015 was $57 million, as compared to $74 million in the prior-year period. Our tax provision for the three and six months ended January 2, 2015 reflects a tax benefit of $16

25


million as a result of the retroactive extension of the U.S. Federal R&D tax credit that was signed into law on December 19, 2014. The differences between the effective tax rate and the U.S. Federal statutory rate are primarily due to tax holidays in Malaysia, the Philippines, Singapore and Thailand that expire at various dates from 2015 through 2025 and the current year generation of income tax credits. For additional information, refer to Part I, Item 1, Note 6 of the Notes to Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q.
Arbitration Award

In relation to our litigation matter with Seagate, on October 8, 2014, the Minnesota Supreme Court affirmed the decision of the Minnesota Court of Appeals, and as a result, on October 14, 2014, we paid Seagate $773.4 million to satisfy the full amount of the final arbitration award plus interest accrued through October 13, 2014. This amount was paid by one of our foreign subsidiaries using cash held outside the United States. For additional information, refer to Part I, Item 1, Note 5 of the Notes to Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q.
Liquidity and Capital Resources
We ended the second quarter of fiscal 2015 with total cash and cash equivalents of $4.9 billion. The following table summarizes our statements of cash flows (in millions): 
 
Six Months Ended
 
January 2,
2015
 
December 27,
2013
Net cash flow provided by (used in):
 
 
 
Operating activities
$
1,070

 
$
1,406

Investing activities
(254
)
 
(1,125
)
Financing activities
(718
)
 
65

Net increase in cash and cash equivalents
$
98

 
$
346

Our investment policy is to manage our investment portfolio to preserve principal and liquidity while maximizing return through the full investment of available funds. We believe our current cash, cash equivalents and cash generated from operations as well as our available credit facilities will be sufficient to meet our working capital, debt, dividend, stock repurchase and capital expenditure needs for at least the next twelve months. Our ability to sustain our working capital position is subject to a number of risks that we discuss in Part II, Item 1A of this Quarterly Report on Form 10-Q.
A total of $3.5 billion of our cash and cash equivalents was held outside of the United States at both January 2, 2015 and June 27, 2014. Substantially all of the amounts held outside of the United States are intended to be indefinitely reinvested in foreign operations. As described in the section "Arbitration Award" above, the amount of $773.4 million was paid on October 14, 2014 from one of our foreign subsidiaries using cash held outside the United States. On September 13, 2012, our Board of Directors approved a capital allocation plan which includes repurchases of our common stock and the adoption of a quarterly cash dividend policy. Our current plans do not anticipate that we will need funds generated from foreign operations to fund our domestic operations or capital allocation plan. In the event funds from foreign operations are needed in the United States, any repatriation could result in the accrual and payment of additional U.S. income tax.
Operating Activities
Net cash provided by operating activities was $1.1 billion during the six months ended January 2, 2015. Cash flow from operating activities consists of net income, adjusted for non-cash charges, plus or minus working capital changes. This represents our principal source of cash. Net cash used in working capital changes was $475 million for the six months ended January 2, 2015 as compared to $166 million used by working capital changes in the prior-year period.

26


Our working capital requirements primarily depend on the effective management of our cash conversion cycle, which measures how quickly we can convert our products into cash through sales. The cash conversion cycles were as follows: 
 
Three Months Ended
 
January 2,
2015
 
December 27,
2013
Days sales outstanding
44

 
45

Days in inventory
42

 
42

Days payables outstanding
(68
)
 
(68
)
Cash conversion cycle
18

 
19

For the three months ended January 2, 2015, our average days sales outstanding (“DSOs”) decreased by 1 day, days in inventory (“DIOs”) remained flat, and days payable outstanding (“DPOs”) remained flat compared to the prior year period. Changes in average DSOs and DIOs are generally related to linearity of shipments and the timing of inventory builds, respectively. Changes in DPOs are generally related to production volume and the timing of purchases during the period. From time to time, we modify the timing of payments to our vendors. We make modifications primarily to manage our vendor relationships and to manage our cash flows, including our cash balances. Generally, we make the payment modifications through negotiations with our vendors or by granting to, or receiving from, our vendors’ payment term accommodations.
Investing Activities
Cash used in investing activities for the six months ended January 2, 2015 was $254 million and consisted of $595 million related to the purchase of investments, $306 million of capital expenditures and $6 million related to an immaterial acquisition, net of cash acquired, partially offset by $630 million of proceeds from sales and maturities of investments, $7 million of proceeds from the sale of property, plant and equipment and $16 million, net for other investing activities. Cash used in investing activities for the six months ended December 27, 2013 was $1.1 billion and consisted of $823 million related to acquisitions, net of cash acquired, and $306 million of capital expenditures, partially offset by a net $4 million for other investing activities.
Financing Activities
Net cash used in financing activities for the six months ended January 2, 2015 was $718 million as compared to $65 million provided by financing activities in the prior-year period. Net cash used in financing activities for the six months ended January 2, 2015 consisted of $532 million used to repurchase shares of our common stock, $187 million used to pay dividends on our common stock and $63 million used to make principal payments on the Credit Agreement, partially offset by a net $64 million provided by employee stock plans. Net cash provided by financing activities for the six months ended December 27, 2013 consisted of $500 million of debt proceeds under the revolving credit facility and a net $98 million provided by employee stock plans, partially offset by $300 million used to repurchase shares of our common stock, $118 million used to pay dividends on our common stock and $115 million used to repay long-term debt.
Off-Balance Sheet Arrangements
Other than facility lease commitments incurred in the normal course of business and certain indemnification provisions (see “Contractual Obligations and Commitments” below), we do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets, or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not included in our condensed consolidated financial statements. Additionally, we do not have an interest in, or relationships with, any special-purpose entities.
Contractual Obligations and Commitments
Long-Term Debt — On January 9, 2014, Western Digital Ireland, Ltd. (“WDI”) used existing cash to repay the outstanding term loan balance of $1.8 billion under our previous credit agreement dated March 8, 2012, and we, in our capacity as the parent entity and guarantor, and the Borrowers, entered into a new credit agreement (the "Credit Agreement").
As of January 2, 2015, no amounts were outstanding under the revolving credit facility of the Credit Agreement and the term loan facility had an outstanding balance of $2.4 billion with a variable interest rate of 1.66%. We are required to make quarterly principal payments on the term loan facility totaling $63 million for the remainder of fiscal 2015, $156 million in fiscal 2016, $219 million in fiscal 2017, $250 million in fiscal 2018 and the remaining balance of $1.7 billion in fiscal 2019. For additional information, refer to Part I, Item 1, Note 4 of the Notes to Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.

27


Purchase Orders — In the normal course of business, we enter into purchase orders with suppliers for the purchase of components used to manufacture our products. These purchase orders generally cover forecasted component supplies needed for production during the next quarter, are recorded as a liability upon receipt of the components, and generally may be changed or canceled at any time prior to shipment of the components. We also enter into purchase orders with suppliers for capital equipment that are recorded as a liability upon receipt of the equipment. Our ability to change or cancel a capital equipment purchase order without penalty depends on the nature of the equipment being ordered. In some cases, we may be obligated to pay for certain costs related to changes to, or cancellation of, a purchase order, such as costs incurred for raw materials or work in process of components or capital equipment.
We have entered into long-term purchase agreements with various component suppliers, containing minimum quantity requirements. However, the dollar amount of the purchases may depend on the specific products ordered, achievement of pre-defined quantity or quality specifications or future price negotiations. We have also entered into long-term purchase agreements with various component suppliers that carry fixed volumes and pricing which obligate us to make certain future purchases, contingent on certain conditions of performance, quality and technology of the vendor’s components.
We enter into, from time to time, other long-term purchase agreements for components with certain vendors. Generally, future purchases under these agreements are not fixed and determinable as they depend on our overall unit volume requirements and are contingent upon the prices, technology and quality of the supplier’s products remaining competitive.
Refer to Part II, Item 7 of our Annual Report on Form 10-K for the year ended June 27, 2014, for further discussion of our purchase orders and purchase agreements and the associated dollar amounts. See Part II, Item 1A of this Quarterly Report on Form 10-Q for a discussion of the risks associated with these commitments.
Foreign Exchange Contracts — We purchase short-term, foreign exchange contracts to hedge the impact of foreign currency fluctuations on certain underlying assets, liabilities and commitments for operating expenses and product costs denominated in foreign currencies. See Part I, Item 3, of this Quarterly Report on Form 10-Q under the heading “Disclosure About Foreign Currency Risk,” for a description of our current foreign exchange contract commitments and Part I, Item 1, Note 8 of the Notes to Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.
Indemnifications — In the ordinary course of business, we may provide indemnifications of varying scope and terms to customers, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of our breach of agreements, products or services to be provided by us, or from intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and certain of our officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. We maintain director and officer insurance, which may cover certain liabilities arising from our obligation to indemnify our directors and officers in certain circumstances.
It is not possible to determine the maximum potential amount under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Such indemnification agreements may not be subject to maximum loss clauses. Historically, we have not incurred material costs as a result of obligations under these agreements.
Unrecognized Tax Benefits — As of January 2, 2015, the cash portion of our total recorded liability for unrecognized tax benefits was $259 million. We estimate the timing of the future payments of these liabilities to be within the next one to eight years. For additional information, refer to Part I, Item 1, Note 6 of the Notes to Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.
Stock Repurchase Program — Since May 21, 2012, our Board of Directors has authorized $3.0 billion for the repurchase of our common stock. We repurchased 3.2 million and 5.4 million shares of our common stock for a total cost of $309 million and $532 million during the three and six months ended January 2, 2015, respectively. On February 3, 2015, our Board of Directors authorized an additional $2.0 billion for the repurchase of our common stock and approved the extension of our stock repurchase program to February 3, 2020, resulting in a cumulative authorized repurchase amount of $5.0 billion since the inception of the repurchase program. Subsequent to January 2, 2015 and through February 5, 2015, we repurchased an additional 2.2 million shares of our common stock for a total cost of $240 million. For additional information, refer to Part I, Item 1, Note 9 of the Notes to Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q.
Cash Dividend Policy — During the three months ended January 2, 2015, we declared a cash dividend of $0.40 per share of our common stock to our shareholders of record as of January 2, 2015, totaling $93 million, which we paid on January 15, 2015. In addition, in the three months ended October 3, 2014, we declared a cash dividend of $0.40 per share of our common stock to our shareholders of record as of October 3, 2014, totaling $94 million, which we paid on October 15, 2014. On February 3, 2015, we declared a cash dividend of $0.50 per share of our common stock to shareholders of record as of April 3, 2015, which will be

28


paid on April 16, 2015. For additional information, refer to Part I, Item 1, Note 9 of the Notes to Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q.
Critical Accounting Policies and Estimates
We have prepared the unaudited condensed consolidated financial statements in accordance with U.S. GAAP. The preparation of the financial statements requires the use of judgments and estimates that affect the reported amounts of revenues, expenses, assets, liabilities and shareholders’ equity. We have adopted accounting policies and practices that are generally accepted in the industry in which we operate. If these estimates differ significantly from actual results, the impact to the condensed consolidated financial statements may be material. There have been no material changes in our critical accounting policies and estimates from those disclosed in our Annual Report on Form 10-K for the year ended June 27, 2014. Please refer to Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended June 27, 2014 for a discussion of our critical accounting policies and estimates.
Recent Accounting Pronouncements
For a description of recently issued and adopted accounting pronouncements, including the respective dates of adoption and expected effects on our results of operations and financial condition, refer to Part I, Item 1, Note 14 of the Notes to Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Disclosure About Foreign Currency Risk
Although the majority of our transactions are in U.S. dollars, some transactions are based in various foreign currencies. We purchase short-term, foreign exchange contracts to hedge the impact of foreign currency exchange fluctuations on certain underlying assets, liabilities and commitments for operating expenses and product costs denominated in foreign currencies. The purpose of entering into these hedge transactions is to minimize the impact of foreign currency fluctuations on our results of operations. The contract maturity dates do not exceed 12 months. We do not purchase foreign exchange contracts for trading purposes. For additional information, refer to Part I, Item 1, Note 8 of the Notes to Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.
As of January 2, 2015, we had outstanding the following purchased foreign exchange contracts (in millions, except weighted average contract rate):
 
Contract
Amount
 
Weighted Average
Contract Rate*
 
Unrealized
Losses
Foreign exchange contracts:
 
 
 
 
 
Cash flow hedges:
 
 
 
 
 
Japanese Yen
$
213

 
$
108.67

 
$
(16
)
Malaysian Ringgit
$
193

 
$
3.30

 
$
(12
)
Philippine Peso
$
32

 
$
44.33

 
$

Singapore Dollar
$
44

 
$
1.27

 
$
(2
)
Thai Baht
$
528

 
$
32.72