Western Digital 2004 Annual Report Download - page 22

Fiscal 2004 Overview
According to quarterly reports for 2004 and calendar year 2003 from Gartner, the desktop hard disk drive market
increased by approximately 17% based on unit shipments. Based on quarterly reports published by Gartner in 2004 and
calendar 2003, the Company believes that its market share in desktop hard disk drives increased to 24% from 23% in
2003. While Western Digital's unit shipments grew by 22% in 2004, the average selling price of its hard disk drives
declined by 8% due to aggressive pricing pressures and mix of products.
In 2004, Western Digital's net revenue increased by 12%, to $3.0 billion, on unit shipments of 48.3 million.
However, in 2004, gross margin decreased to 15.2% from 16.3% in 2003 primarily as a result of aggressive pricing
pressures. In addition, the Company incurred approximately $50 million of start-up expenses and other charges related to
the acquisition of substantially all the assets of Read-Rite Corporation (""Read-Rite'') in July 2003. These factors oÅset
the ongoing positive contribution of the Company's newly acquired head manufacturing operations. As a result, operating
income decreased by $31.9 million, to $154.9 million, and operating margins decreased to 5.1% as a percentage of net
revenue, compared with 6.9% in 2003. For 2005, the Company expects incremental beneÑts from its integrated head
operations; however, it is not clear whether this will be enough to oÅset any continued downward pressure on gross
margin caused by competitive pricing. Western Digital generated $190.0 million in cash Öow from operations in 2004
and Ñnished the year with $377.8 million in cash and cash equivalents, a decrease of $15.4 million from the prior year's
balance.
Read Rite Asset Acquisition
In June 2003, Read-Rite, then one of the Company's suppliers of magnetic recording heads, commenced voluntary
Chapter 7 bankruptcy proceedings. On July 31, 2003, Western Digital purchased substantially all of the assets of Read-
Rite, including its wafer fabrication equipment in Fremont, California and manufacturing facility in Bang Pa-In,
Thailand. The cost of the acquisition was $172.0 million and consisted of cash consideration of $94.8 million, assumed
debt obligations of the Thailand operations of approximately $60.2 million, direct costs of the acquisition and other
miscellaneous assumed obligations totaling $17.0 million. Proceeds from a $50 million term loan were used to repay
obligations assumed as a result of the acquired head manufacturing operations in Thailand.
Western Digital's acquisition of the head manufacturing operations represented a fundamental change in the
Company's operating structure as the Company is now manufacturing heads for use in its hard disk drives. Previously,
the Company purchased all of its recording head requirements from external suppliers, including Read-Rite. The
Company acquired the Read-Rite assets for the following reasons:
‚ to enhance its Ñnancial business model,
‚ to gain better control of head technology as the Company's business grows,
‚ to improve Öexibility, product planning and quality, and
‚ to improve its cost structure and tighten its supply chain through better operational integration.
Taking the asset acquisition into consideration, the Company expects its long-term Ñnancial business model to
beneÑt from a higher gross margin percentage, oÅset by higher research and development expenses, than it otherwise
would have had without the acquisition. The gross margin percentage improvement will result from lower cost of sales, as
the Company develops the ability to manufacture heads at a lower cost than what it would have otherwise paid external
suppliers. This is expected to result in higher operating income than it otherwise would have had without the acquisition.
The Company began realizing these net Ñnancial beneÑts in 2004. However, these beneÑts were oÅset by downward
pressures on gross margins caused by an aggressive pricing environment. The incremental beneÑts from an integrated
head manufacturing operation are expected to increase as the Company continues to ramp its head manufacturing
capability. The Company is currently satisfying a substantial portion of its head requirements through its own head
manufacturing operations.
As a result of integrating the head manufacturing operations, the Company carries a higher percentage of Ñxed costs
than assumed in its prior Ñnancial business model. For example, depreciation expense for the head manufacturing
operations is expected to be between $15 million and $20 million per quarter by the end of 2005.
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