Western Digital Corporation 2012 Annual Report Page 46

Changes in revenue by geography and channel generally reflect normal fluctuations in market demand and

competitive dynamics. However, during 2012, changes in revenue by geography and channel reflected our efforts to
allocate products to our customers as a result of the flooding in Thailand by balancing their immediate needs with
their prevailing inventory positions in order to maximize the availability of hard drive products to the end customer
within the shortest time horizon. In addition, as a result of our acquisition of HGST, our revenue by channel mix has
become more heavily weighted toward OEM.

In accordance 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 rev-
enue. For 2012, these programs represented 6% of gross revenues compared to 11% in 2011. This decrease was
mainly driven by the severe supply constraints brought about by the Thailand floods. These amounts generally vary
according to several factors including industry conditions, seasonal demand, competitor actions, channel mix and
overall availability of product.

Gross Margin.

Gross margin for 2012 was $3.6 billion, an increase of $1.8 billion, or 103%, from the prior

year. Gross margin as a percentage of net revenue increased to 29.2% in 2012 from 18.8% in 2011. This percentage
increase was primarily due to an increase in ASP brought about by the impact of the Thailand flooding, offset by $91
million for costs recognized upon the sale of inventory that was written-up to fair value and $48 million for amor-
tization of intangibles related to the Acquisition.

Operating Expenses.

Total research and development ("R&D") expense and selling, general and administrative

("SG&A") expense increased to 12.6% of net revenue in 2012 compared to 10.6% in 2011. R&D expense was
$1.1 billion in 2012, an increase of $352 million, or 50%, over the prior year. This increase in R&D expense was
primarily due to increased expense related to the business of HGST and the continued investment in product
development to support new programs. As a percentage of net revenue, R&D expense increased to 8.5% in 2012
compared to 7.4% in 2011. SG&A expense was $518 million in 2012, an increase of $211 million, or 69%, as com-
pared to 2011. This increase in SG&A expense was primarily due to increased expense related to the business of
HGST, the expansion of sales and marketing to support new products and growing markets, $37 million of
incremental expenses related to the acquisition of HGST and $15 million for amortization of intangibles related to the
Acquisition. SG&A expense as a percentage of net revenue increased to 4.2% in 2012 compared to 3.2% in 2011.

During 2012, we recorded $214 million of net charges related to the flooding in Thailand, including $119 mil-

lion of fixed asset impairments, $61 million of recovery charges, $28 million of write-downs of damaged inventory
and $27 million in wage continuation during the shutdown period of our facilities, offset by $21 million of insurance
recoveries and other cost reimbursements.

In addition, during the fourth quarter of 2012, we recorded $56 million of asset impairment charges, $16 mil-

lion of contract termination and other exit costs and $8 million of employee termination benefits.

Other Income (Expense).

Other expense, net was $14 million in 2012 compared to $1 million in 2011. Interest

expense increased from $10 million in 2011 to $26 million in 2012, primarily due to interest on a higher debt bal-
ance and a $5 million increase in debt commitment fees incurred prior to the closing of the Acquisition, offset by $4
million of gains on sales of our investments. Interest income increased from $9 million in 2011 to $12 million in
2012 due to higher average daily invested cash balances.

Income Tax Provision.

Income tax expense was $145 million in 2012 as compared to $54 million in 2011. Tax

expense as a percentage of income before taxes was 8.3% in 2012 compared to 6.9% for 2011. 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 through 2025 and the current year generation of income tax credits.

As of June 29, 2012, we had a recorded liability for unrecognized tax benefits of approximately $280 million,

which includes $39 million assumed in the Acquisition. Aside from the increase in the liability for unrecognized tax
benefits related to liabilities assumed in the Acquisition, we recognized a net decrease of $4 million in our liability for
unrecognized tax benefits during 2012. Interest and penalties recognized on such amounts were not material.

The Internal Revenue Service ("IRS") has completed its field examination of the federal income tax returns for

fiscal years 2006 and 2007 for us and calendar years 2005 and 2006 for Komag, Incorporated ("Komag"), which was