Large Cap Watch List (Track at Marketocracy) member Western Digital Corp. (WDC) reported its financial results for its fiscal year 2007 and fourth quarter ended June 29, 2007. The company’s results for the fiscal year reflected strong year-over-year performance, with revenue of $5.5 billion compared to consensus estimates of $5.43 billion. Net income was $585 million, or $2.59 per share, compared to $395 million, or $1.76 per share for the prior year. The 2007 and 2006 net income amounts included income tax benefits of $147 million and $22 million, respectively, related to adjustments to the value of the company’s deferred tax assets. Adjusted net income of $1.93 narrowly edged the $1.92 consensus.

Part of the success reflected efforts to focus on more profitable lines of business. On a year-over-year basis, the company
expanded its share of revenue from newer markets from 29 percent to 43 percent. The company’s newer market revenue includes hard drives for notebook PCs, consumer electronics, enterprise applications and WD branded products.

Despite the impact of tax benefits, the company was able to control working capital. This resulted in full year cash flow from operating activities rising from $368 million to $618 million.

The company also announced that the acquisition of Komag (KOMG) is progressing on schedule.

Western Digital Corporation (WDC), and Komag, Incorporated (KOMG) announced today that the two companies have entered into a definitive agreement for WD to acquire Komag for $32.25 in cash per share for a value of approximately $1 billion.

Komag is currently a member of the Mid Cap Watch List (Track at Marketocracy), but is due to be replaced at today’s market close. Meanwhile, Western Digital is scheduled to join the Large Cap Watch List (Track at Marketocracy). The deal’s timing is perfect in that the Watch List will participate in the announcement-related rise in KOMG shares while avoiding any losses Western Digital might suffer today as the acquiror.

From a longer-term perspective, it is unclear whether the merger will reduce the bloody disk drive supply chain environment.

Mid Cap Watch List (Track at Marketocracy) member Komag, Incorporated (KOMG), a leading independent supplier of thin-film media for disk drives, announced revenue of $264.7 million and diluted earnings per share of $0.99 for the first quarter of 2007. Analysts had expected the $0.99 to be delivered on just $255 million in sales. According to the release:

Revenue in the first quarter included sales of precious metals inventory totaling $11.2 million. Gross margin for the first quarter was negatively impacted by the high cost of precious metals primarily used in the production of PMR media and an unfavorable Malaysian Ringgit currency rate change.

That would account for the higher revenue not contributing to net income. Guidance was disappointing:

“We expect that revenue in the second quarter of 2007 will be down approximately 8% to 10%, excluding the $11.2 million sale of precious metals inventory in the first quarter of 2007. While we normally plan for a seasonal decline in the second quarter, we started the second quarter more slowly than normal as some customers readjusted their plans to the current demand environment.

With our expected revenue level, the mix of finished media and substrate sales and lower capacity utilization, our net margin is expected to be in the range of 8% to 10% in the second quarter of 2007.

If we can do the math, that suggests approximately $232 million in sales and $0.62 in earnings per share, compared with analyst estimates of $0.97 on $248 million. Looking at the balance sheet, it is easy to spot the big issue: inventory was up 60% sequentially despite flat sales and predictions for a decline next quarter. As a result, cash flows from operating activities were negative to the tune of $11 million, compared with $59 million in positive cash flow last year.

Worse, the negotiating power is firmly in the hands of Komag’s customers:

Sales to Western Digital (WDC), Seagate (STX - Annual Report) and Hitachi (HIT) Global Storage Technologies accounted for 37%, 37% and 21% of disk product (media and substrates) revenue in the first quarter of 2007, respectively.

The three buyers who account for 95% of Komag’s sales can all see that Komag is stuffed with inventory. And they will all try to negotiate very favorable terms to relieve Komag of it.