Seagate Q3'16 Earnings Conference Call: Full Transcript

Operator:

Good morning and welcome to the Seagate Technology Fiscal Third Quarter 2016 Financial Results Conference Call. My name is Christy and I will be your coordinator for today. At this time, all participants are in a listen-only mode. Following the prepared remarks, there will be a question-and-answer session at the end of the call. As a reminder, this conference is being recorded for replay purposes.

At this time, I would like to turn the call over to Kate Scolnick, Senior Vice President, Investor Relations. Please proceed, Kate.

 

Kate Scolnick: Vice President, Investor Relations:

Thank you. Good morning, everyone and welcome to today’s call. Joining me today from Seagate’s executive team are Steve Luczo, Chairman and CEO; Dave Morton, Executive Vice President and CFO; Dave Mosley, President, Operations and Technology; and Phil Brace, President, Cloud Systems and Silicon Group. We posted our press release and detailed supplemental information about our third fiscal quarter 2016 on our Investor Relations site at seagate.com. During today’s call, we will review the highlights for the quarter, provide the company outlook for the fourth fiscal quarter 2016 and then open the call for questions.

We will refer to non-GAAP measures on this call, which are reconciled to GAAP figures on our supplemental information available on the Investors section of our website. We are planning for the call today to go approximately half an hour and we will do our best to accommodate your questions following our prepared remarks as time permits.

As a reminder this conference call contains forward-looking statements about the company’s anticipated future operating and financial performance, customer demand and general market conditions. These forward-looking statements are based on management’s current views and assumptions and should not be relied upon as of any subsequent date. Actual results may vary materially from today’s statements. Information concerning risks, uncertainties and other factors that could cause results to differ from these forward-looking statements are contained in the company’s SEC filings and supplemental information posted on the Investors section of the company’s website at seagate.com.

I would now like to turn the call over to Steve Luczo. Please go ahead, Steve.

 

Steve J. Luczo: Chairman and CEO:

Thanks Kate. Good morning everyone and thanks for joining us today. In addition to my usual commentary, I have extended the prepared remarks for today’s call and I have asked the management team to cover a few important aspects of our business as it relates to the March quarter and the position of the company moving forward. We will discuss some of the actions we are taking to align with near-term market realities and to improve the company’s profitability and cash flow.

First I will cover the higher level trends I have seen from customers and provide information as the direction we will be taking with the company with respect structure and focus. Dave Morton will then walk through certain financial metrics, Dave Mosley will cover the HDD business particularly with respect to our evolving product portfolio, and I’ll close the call with our guidance for the June quarter and our general expectations for the second half of calendar 2016.

For the March quarter, Seagate achieved revenues of $2.6 billion and on a non-GAAP basis gross margin of 23%, net income of $66 million, and diluted earnings per share of $0.22. Non-GAAP operating expenses in the March quarter were $439 million reflecting cost controls on lower variable compensation. Overall inventory levels were down 11% sequentially and ended at the lowest level of finished goods excluding the floods since June 2010. Capital Expenditures of $95 million were in line with our expectations.

We believe Seagate’s March quarter results are reflective of a generally weak macroeconomic environment as well as accelerating usage shifts of technologies and architectures by end users. Our HDD shipments for the March quarter were 39.2 million units and 55.6 exabytes reflecting a seasonally lower TAM than expected overall. In the March quarter we initiated targeted pricing increases across our product line and we were successful in some areas and unsuccessful in others. We continue to believe the industry needs a stable pricing environment to deliver the higher level of requirements being placed on our products and to realize the value we are providing to the market. As a result we will continue to pursue a pricing strategy that reduces and properly reflects the investment in technology the market requires.

We experienced particular weakness in the client desktop markets as well as the enterprise legacy market with offsetting strength in the enterprise nearline cloud markets. Overall average capacity per drive was 1.4 Terabytes up 30% year-over-year and within this nearline cloud average capacity per drive was 3.9 Terabytes up 25% year-over-year. On a year-over-year basis, unit shipments were down 22% while total exabytes shipped were up 2%. The decrease in the unit TAM in our markets presents challenges for Seagate that will require alignment through operational footprint and it pressures the overall HDD supply chain especially for suppliers that are supplying one part per drive. However, we are encouraged by the trend towards significantly higher average capacity per drive applications which results in great absorption and heads and disk and favor HDD over any other storage device now and in the foreseeable future in terms of costs as a function of required performance.

The continued advancement and adaptation of mobile and cloud based computing architectures is reflected in the revenue shifts we are seeing in our portfolio. Our long term business thesis continues to be that there will be a significant transition in HDD from a historical revenue split of 60% client and 40% enterprise revenue, to 40% client and 60% enterprise revenue over the next several years. We also expect that the average capacity per drive will increase in all markets.

Most important to our product positioning and related investments is not just the mix between client and enterprise and the mix shift within these markets. In the client space, we expect to continue decline PC shipments that we anticipate to moderate in the next year. PC HDDs now represent about 56% of Seagate’s client revenue and approximately 30% of the total company revenue. While overall PC client HDD revenue is declining, the remaining share is dominated by high capacity products which will continue to increase with the new product offerings that we have started to introduce in the June quarter.

We are starting to see our client business shift to consumer, surveillance, gaming, and DVR markets which are all high capacity user environments. We I believe over the next several quarters, this growth will result in these combined markets being greater than the traditional PC compute market today. As an example, our consumer business revenues as a percentage of total client revenues have grown 6% in the last 12 months whereas PC revenues as a percentage of total client revenues have declined 6%. This is consistent with our belief that reducing the amount of storage on certain client devices propagates it to another location.

In the enterprise market, revenue mix continues to trend from the legacy mission-critical market to the nearline car market. In the March quarter we experienced unexpected weakness for a legacy mission critical HDDs which were approximately 700,000 units below our forecast. While it’s difficult to attribute the weakness in enterprise mission-critical between macroeconomic factors and architectural shifts, we expect further declines in the mission-critical market in June quarter and then declines should moderate over the quarters thereafter. This mission critical market weakness in the March quarter was offset by nearline cloud upside demand of more than 500,000 units of which we could only deliver 350,000 additional units due to the long lead times required to fulfill demand. Importantly in the March quarter, the average capacity per drive for the mission critical HDDs that came out of our forecast, versus the average capacity of ATB 8 Terabytes of the nearline HDD upside demand we saw, reflected a shift in exabytes of almost 6 to 1.

Demand signals from our nearline customers has improved over the last few weeks and we are planning for our fourth consecutive quarter of growth with high demand for 8 terabyte portfolio and initial volume shipments of our 10 terabyte Helium HDD product. As a result of these trends as well as input from our major cloud customers, we believe that these shifts from legacy to cloud enterprise applications has accelerated in the last 6 months and is now complementing the demand for cloud storage generated by consumer applications. As we manage the shifts in our product portfolio demand and changing nature of our customer base, we are aligning the operating model of our HDD business to optimize our manufacturing footprint and we are reducing our capital expenditures to maintenance capital requirement levels. Through these actions Seagate will be operating at or very near full capacity in our operating philosophy to our shift to chasing demand upside versus managing excess capacity.

In the March quarter, we began the process of reducing our HDD manufacturing capacity from approximately 55 million to 60 million drives per quarter to approximately 35 million to 40 million drives per quarter. The actions required will be completed within the next 6 to 9 months. At the same time, we are continuing to accelerate the utilization of our own drive factories, internal head, and media facilities.

For fiscal ‘16 total capital expenditures are expected to be approximately $535 million, down approximately 28% over fiscal year ‘15. For fiscal year ‘17 assuming current outlook on demand, we are targeting an additional reduction in spending reflecting a very low maintenance capital plan of approximately $400 million. In addition, we will continue operating expense management actions across the company that aligns with the market trends. We believe that given the shifts in our product revenues as well as recognizing the full impact in the significant changes in our manufacturing footprint and operating expenses, the company will see revenue growth, product gross margin improvements, and improved profitability, assuming a relatively stable macro environment.

Dave Morton and Dave Mosley will go into more detail on these activities and I will turn the call over to Dave Morton now.

 

C:David H. Morton, Jr.:

Executive Vice President and Chief Financial Officer:

Thanks Steve. With the shifts taking place in Seagate’s business, there are a few specific areas of our financial model that were impacted in Q3. I would like to provide some detail to these conditions to provide further context to Steve’s earlier discussion around the actions we are taking in manufacturing and operating expense levels. For the March quarter, the addressable HDD and cloud storage systems markets were lower than forecast, impacting our revenue results for the quarter. Within this, there were specific HDD product areas where demand fell short of our expectations, including traditional mission critical HDD enterprise products and desktop client products primarily in China. In addition, we made strategic decisions to not aggressively participate in certain areas of the low capacity notebook market.

In our systems and silicon business we experienced weaker than expected demand across most of the product lines. The lowered than forecasted HDD demand impacted our production levels and increased our factory absorption costs. We also aggressively managed our finished goods in the quarter and improved our inventory levels by approximately $180 million. This reduction in inventory negatively impacted our factory utilization.

Combined, these factors were the primary reasons for our product gross margins declining approximately 290 basis points sequentially to approximately 23% with 80 basis points impact from the HDD revenue shortfall, 70 basis points from the systems and silicon business revenue shortfall, and 140 basis points from factory underutilization. While we are disappointed we did not anticipate the weaker demand in the March quarter, the company is evaluating and implementing a variety of actions to reduce the company’s cost structure which will result in financial improvements over the next several months. Towards our infrastructure cost alignment in fiscal Q3 alone, we implemented certain cost reduction activities and recognized approximately $90 million in onetime restructuring charges right off of certain fixed assets, certain terminated contracts, and discontinued inventory. We are currently sizing future non-reoccurring restructuring cash charges that we are estimating will be approximately $150 million over the next several quarters. We anticipate having more detailed actions identified within 60 days and we will expect that the financial benefit of these actions will begin to have a positive impact in the September quarter with the full benefit occurring in calendar 2017.

As we formalize the specific actions and timing of cost savings, we will continue to provide updates to this framework. While we are still formulating all of the actions we will take to address gross margins and operating profits, we believe the overall cost alignment activities we will implement will benefit our product gross margins and overall profitability of our business with the goal of achieving a minimum of $2.50 in non-GAAP earnings per share in calendar 2017. For the March quarter, non-GAAP operating expenses were approximately $439 million, slightly lower than forecasted. Looking ahead, our expenses in the June quarter will be relatively flat with additional cost reductions in plan for FY ‘17. Cash flow from operations in the March quarter was $205 million and free cash flow was $110 million. Fiscal year to-date we have generated $1.4 billion in cash flow from operations. Our balance sheet remains healthy and we ended the quarter with $1.2 billion in cash and cash equivalents and 298 million shares outstanding. Our debt structure and level of interest expense s manageable. As announced today, our Board has approved our quarterly dividend payment of $0.63. There has been no change to our dividend policy and our dividend payout of $188 million a quarter is supported by our cash flow generation forecast albeit at a higher payout ratio than previously stated as our objective.

I will turn over the call to Dave Mosley to cover our HDD business in more detail.

 

Dr. Dave Mosley: President, Operations and Technology:

Thanks Dave. Beginning with the nearline product lines, our 8 terabyte business critical product continues its aggressive volume ramp and we have been essentially sold out for the months of March and April. We’ve had over 200% volume growth of 8 terabyte in the March quarter and we anticipate continued growth in the June quarter. In addition, our 10 terabyte product lines shipped a large volume of qualification units in the March quarter and the volume growth is accelerating in the June quarter as well. We believe our 10 terabyte product to be leading in all performance and power metrics and we are very happy with the feedback from our customers and our qualifications.

In the client space, as Steve said, the PC market continued to decline in Q3 and we began end of life activities on some of the older 500 gigabyte and below products that have very low margins. Most of the margin cost benefits of these products exits will be realized over the next few quarters. In the March quarter, we began the ramp of our 1 and 2 terabyte 7 mm 2.5 inch product line for our consumer, notebook, and DVR customers. This new product line allows us to address those target markets with lower costs and improve value propositions for our customers. Qualifications have gone well with customer interest high and we anticipate shipping several million units in the June quarter. Initially the product will be a consumer offering moving to OEM offerings in September and December and we believe we will have competitive technology leadership through the end of the calendar year. We are also accelerating the application of these same technologies into our 3.5 inch product lines for surveillance, NAS, and DVR, at the end of the calendar year.

The mission critical market served by our 10,000 and 15,000 RPM products has been declining over the last few quarters and we have seen traditional TAM of approximately 8 million to 8.5 million units per quarter decline to approximately 6.5 million to 7 million units in the March quarter. Within the mission critical market, approximately 25% of the volumes are 15,000 RPM HDDs. This is the primary area where we are seeing a shift in low end servers moving to lower capacity flash SSDs and we expect this trend to continue. In 10,000 RPM HDD, there has been some technology shifts happening as well however we believe the 10,000 RPM HDD market will have a much longer transition horizon. Our goal over the coming months is to manage our forecasting conservatively with mission critical TAM declines in the June quarter potentially leveling to modest declines in the back half of the year. Over the long term, we believe the technology shifts in this market support our complimentary investment thesis of flash per performance and driving HDD for capacity architecture. Shifting our HDD build volumes to our higher capacity offerings will allow us to simplify our wafer requirements and optimize our product portfolio which will not need further product refreshes for some time. Coupled with this, improved utilization of our own factories, sized properly for the market demand will improve our costs considerably.

We realize our non-depreciation related fixed costs are high competitively and also too high for current demands. These cost items will be addressed sooner than those related to the manufacturing footprint. There are also many costs related to the product transitions that while temporarily driving a higher cost profile, will also us to improve our cost footprint in FY ‘17. With respect to the shift to higher capacity products, we do need to be mindful of longer lead times and supply chain management requirements for these products. By engaging directly with a broader customer base and establishing deeper channel partnerships, we believe we will improve our sales operations’ efficiency and forecast.

Thanks now I will turn the call back over to Steve.

 

Steve J. Luczo:

Thanks Dave. Given the recent published earning results and related conservative guidance from a broad base of large corporations that serve the global technology and industrial markets, we are planning for seasonal declines in revenue in the June quarter from most of the markets we serve with the exception of the nearline markets. Based on these factors as well as our decision not to participate in the low capacity PC client market, we expect to achieve revenues of approximately $2.3 billion in the June quarter with relatively flat gross margins and operating expenses. We continue to expect that demand in the second half of calendar year 2016 will be stronger than the first half with positive seasonal trends and continued growth in nearline demand offset somewhat by macroeconomic pressures. With this anticipated revenue growth as well as the actions we are taking to align our manufacturing footprint and operating expense investments, gross margins and profitability will improve in the second half of the calendar year 2016. Should there be improvement in the overall macroeconomic conditions, we would expect to see improved HDD unit demand across all markets with commensurate benefits to the company’s performance.

Thank you for joining us on the call today and we can now open it up for questions and answers.

 

Question & Answer

 

 

Operator:

Thank you. Our first question is from the line of Rich Kugele of Needham & Company. Your line is open.

 

Rich Kugele: Needham & Company:

Thank you. Good morning. Just a couple of questions. In terms of the restructuring Steve you talked about getting to something around $2.50. So should we assume something revenue wise lower first before it can start to grow again as you realign those lines, I mean to get to 35 million to 40 million units of capacity that it assumes you are probably exiting quite a few categories.

 

Steve J. Luczo:

I think the capacity issue also relates to the amount of outsourced drives we have Rich. So again I think in the second half of the year we expect revenue growth off of the guide for June and we would expect that to continue through the calendar 17 year. So the adjustments in manufacturing are both where we take our internal capacity right which was under-absorbed and taking production inside which was basically if you can think of it as additional under absorption whether or not that was the non-operating fixed cost or the cost of the factories themselves. So there is kind of a double effect of what happens once we bring the drives inside as well as we so our overall footprint. But we would expect that the calendar year 17 revenues other than may be seasonal decline from December to March should continue to grow assuming the macro condition that’s stable in part because also the portfolio gets a lot stronger with the 1 TB and the 2.5 and the 2 TB and the desktop which are then products that are highly competitive we believe at least six months ahead of the competition and capacity clinch that are much more relevant to us in the client space.

 

Rich Kugele:

Okay and then as a follow up just to understand the difference in moving from mission critical to high capacity, can you just expand the gross margin dollar impact and the technology investments required to go and do that. Is it similar R&D investments, any thoughts on just that shift?

 

Steve J. Luczo:

Let me just give a general answer and then Mosley can talk about the R&D side. In general the gross profit dollars are about the same which is why losing 700,000 units but picking up 350,000 hurt us. The gross margin percentages are about the same so as the shift continues once you’ve kind of reached the crossover point where we can either meet that upside demand or naturally exceeds whatever erosion continues in mission critical than you get growth there and like I said, it’s really hard to understanding what’s happening in mission critical right now, is it being driven by macro or is it encouraging by flash or certain segments of that. I think the answer is it’s a little of both and maybe the macro’s even accelerating the incursion of flash and it doesn’t really matter because ones that happens it’s not like it’s going to reverse itself. So we are preparing for the continued decline of the 15K segment but as Dave indicated the 10K segment from our customer input probably remain intact for a number of quarters if not for a number of years so I think it’s more about managing our investment in the portfolio going forward which clearly means continue to emphasize the nearline and then obviously again just adjusting the manufacturing footprint so you are basically keeping pace and are a little bit ahead of the decline so you’re always sold out versus having excess capacity. Dave talk to it in more detail.

 

David H. Morton, Jr.:

From a R&D perspective Rich it’s fairly applicable you can move the technologies or there is ahead, media technologies over from one market segment to the other. As Steve commented and I won’t elaborate too much, the speed of the shift that we saw last quarter was really high demand for the cloud products and then the falling demand for the mission critical products were more a factory reaction than time issue than anything.

 

Rich Kugele:

Okay. Thank you.

 

Operator:

Thank you. Our next question is from Sherri Scribner of Deutsche Bank. Your line is open.

 

Sherri Scribner : Deutsche Bank:

Hi. Thank you. The cash flow number came in a little bit this quarter obviously with the gross margins coming down I wanted to get your sense of how you are thinking about your uses of cash going forward? How will the cash costs related to some of these restructuring actions impact you? Are you still committed to the dividend? Is there a plan to buy back shares considering shares have come back and do you have plans to buyback any of your debt which is trading at a discount to par? Thank you.

 

Dr. Dave Mosley:

Hi Sherri, this is Dave. As we think about heading into the back half of the year obviously first and foremost we are going to continue to invest in our business ourselves. As we stated as we look at some of these onetime costs, restructuring cash charge specifically around the $150 million we think that is very manageable over a generation and what we are able to yield here again over the next 6 to 9 months and then as far as the dividend we think that is well manageable albeit at the higher end of those levels of a payout ratio and obviously up to the Board of Directors but with that said, we feel that it’s very defendable against what we are able to generate moving forward.

 

Steve J. Luczo:

I think in the near future Sherri meaning the next 6 to 12 months, the considerations clearly go invest in the business because we do feel we have technology and product leads across the portfolio that we really want to execute to. As long as the macro environment stays I won’t say decent because I can’t call today decent but it is going to stay like it is today with that product execution. We feel pretty good about the company’s position competitively and then in terms of what we would do with that cash flow, I think defending the dividend is the first we would do and certainly like to keep the dividend level where it is. Initially obviously these are payout ratios above the 30% and 50% that we had indicated but as the company is growing into that with improving revenues and margins, certainly we’d put the company in a position where the Board least of easier decision to make or the other way around. I think in terms of buy backs whether or not it’s debt or equity, for the near term that’s probably not reduce the cash or probably if there is excess cash we would keep it on the balance sheet, just in case the macro situation turns on us as we had more confidence about 2017 outlook and again the success of our products we would evaluate that in terms of best use of it beyond dividend or going on balance sheet.

 

Sherri Scribner:

Thank you.

 

Operator:

Thank you. Our next question is from the line of Aaron Rakers of Stifel. Your line is open.

 

Aaron Rakers: Stifel:

Thank you for taking the questions. Steve I was just curious in the past you have talked about returning to that 27% plus gross margin, the Analyst Day you even talked about 27% to 32% and then on top of that you talked about 13% to 15% operating expense to revenue. Understanding there is a lot of things going on in terms of the realignment and stuff I am just curious when do you think you are able to get back into that target model at this point?

 

Steve J. Luczo:

Yes, we talked about was it worth guessing right now to provide you some guidance and I think I would prefer just for us to get through this next 60 days of really understanding the changes we are going to be making to the operational footprint related OpEx investments because the reality is depending on which decisions we make, there is different timing locations. Some of the things we can get after right away is mostly mentioned but others they are really a function of product transitions, customer issues, regulatory issues et cetera so I think it’s just probably not worth guessing at this point and I think as we get more clarity on that specific actions we’re taking we will get back to you. The question is do we think though that we still get back in to that range in a reasonable period of time, the answer is yes. We think we can work ourselves back into the range. But we want to get a little more work done before we kind of give you an idea of when that’s going to happen in terms of ‘in this quarter’. Our world does not work in the crisp 90 days that the calendar provides so we’d rather do a little more work before we lay that out for you.

 

Aaron Rakers:

And Steve what gives you confidence that the mission critical business declined in the June quarter but then seems to stabilize into the back half of the year and going forward. It seems like there’s not that much visibility there given the moving parts be it macro and obviously the element of flash.

 

Steve J. Luczo:

Yes I think our feeling based on customer input is that and I was mostly talking to the application shift Aaron so mean the macro stuff I am not going to speculate on. If it gets worse than obviously all these markets will be under pressure. If it gets better all get a little bit of reprieve. But it feels to us like the trend of where mission critical 15K is being taken out is the point of exposure in the 10K piece isn’t at least for now and maybe not for quite a while based on customer inputs. So, our only point is that as a transition to some point it stabilizes and we feel like that probably happens in the second half of this calendar year.

 

Aaron Rakers:

Okay. Thank you.

 

Steve J. Luczo:

Great. Everyone, thanks for taking the time today and we look forward to talking next quarter and thanks for all your support as well to our customers and our suppliers and most importantly, our employees. Thanks very much.

 

Operator:

Ladies and gentlemen, thank you for participating in today’s program. This concludes today’s program and you can disconnect. Everyone have a great day.

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