Seagate Technology Holdings plc (STX) Earnings Call Transcript & Summary

Everyone, thanks for joining today's meeting. I'm pleased to present to you Gianluca Romano, CFO of Seagate, along with Shanye Hudson, VP of IR. My name is Karl Ackerman. I'm at Cowen. I cover semiconductors along with the entire storage supply chain. Very happy to have Gianluca and Shanye with us today. The format of today's meeting will be a fireside chat, and please e-mail me with any questions you'd like to have asked in that content box that you'll see next to your screen.

Maybe Gianluca, I'd like to just begin by discussing the current environment. It's been a couple of weeks since you last reported. And when you did, you mentioned some manufacturing challenges due to the COVID restrictions. Have you seen a systematic improvement in your manufacturing operations? And are you still capacity constrained on these high capacity nearline drives? And maybe just generally, do you think demand continues to improve from here?

Yes, Karl, and thank you for organizing this video call. In general, I would say we are operating in all our locations. So we don't have any location that is shut down. But we have a couple of locations where we are not yet 100%. So for sure, we have a little bit of underutilization and underutilization charges that we will have towards the quarter. You also know that the freight charges are actually very high starting mid of last quarter. So there are additional costs related to COVID that we are experiencing is similar to what we said at our earnings release. In the prior quarter, we had about $25 million of additional cost. And we said for the June quarter, we're expecting even a little bit higher. And we see this actually happening. So on the supply chain side, we say more cost. However, in term of production, I don't see at this point any constraint in order to meet our customers' demands.

Got it. That's helpful. Gianluca, I think we're actually entering a new phase for the industry where high capacity nearline drives are actually exceeding revenue and profitability of all other hard drive subcategories for the first time in history. Even with the compression-based technologies leveraging NAND flash, it seems like you just simply can't beat the economic value this portion of the market. How do you see your hard drive mix evolving over the next 2 or 3 years between high capacity surveillance and enterprise drives relative to legacy consumer markets? And would a dramatic shift in high capacity allow you to see sustained low single-digit growth from here? Or is that dependent upon some level of stability in the legacy businesses?

Yes. I would say the trend is very clear. You have a mass capacity storage part of the business that is growing very rapidly. We have seen, in particular, for Seagate last quarter was a very high increase in volume and revenue sequentially and year-over-year. In general, this is a part that we expect to continue to grow with the cloud business, the edge business, the video and image applications businesses. So all those applications, like artificial intelligence, Internet of Things, autonomous driving, smart cities, smart factories are all fairly new applications that are just now starting to generate a lot of data. And that will be stored in a hard disk in the near future. And that is the part of the business that will continue to grow very rapidly. On the other side, the legacy part of the business is declining. Will continue to decline, we think, until a certain point where it will be a fairly small volume. And for that small volume, probably will not be a benefit from a financial standpoint to continue to convert to other technologies. So that tail will probably stay for a long period of time. We already see that in the mission-critical part of the business where Seagate has a very high market share. And for the volume that we move in the mission-critical, we don't really see a lot of transition to the new technology. The volume was very stable between the December quarter and the March quarter, despite the March quarter is usually a seasonally low quarter for mission-critical. And even if I look at last year or even in the last 2 or 3 years, that volumes is actually fairly stable, slightly up in the last couple of quarters. So probably, this could also happen in other part of the legacy applications. So the compute, the consumer, the DVR, all those application probably know they continue to decline at certain points. They keep the long take. For us, as you know, we get a higher gross margin from the mass capacity storage part of the business. On the legacy, we focus a lot on [ freight look ] when the gross margin is lower than what we generate in the mass capacity storage, but we also spend very little in OpEx. We spend almost nothing in CapEx except for the maintenance CapEx. So in terms of contribution to our free cash flow, it's a good business. And so this is where we focus basically on the legacy part. And then until we have the volume, that is good. And when the volume will continue to decline, we'll convert that capacity to the other part of the business. So we don't need to spend a lot of CapEx to create more and more capacity. But we need to do anyway, but not to that extent. And we will focus more and more on what is the future, that is the mass capacity storage with this secular growth.

That's helpful. You obviously sell more than just high-capacity nearline drives. You not only have a very broad hard drive portfolio, but you also have an enterprise systems business and a solid-state drive portfolio through your partnerships with these flash vendors. As your business mix shifts toward higher capacity drives that include up to 9x more heads and disks than a consumer drive, does it make sense to bring more of that IP in-house? How do you think about your manufacturing footprint and internal capability as nearline becomes a much larger piece of your business?

Yes. In terms of IP, the important part are the IP that's related to edge and media, so the disk. And we are -- as you know, we are producing in-house the vast majority of our edge and media. So we don't think we have a lot of new IPs that we need to bring in-house. I think we are at a very good level right now already. So probably not much for us to do in that part of the business.

Got it. I guess do you see -- maybe an extension of that in a way. Do you see longer-term opportunities for Seagate to participate in the NAND flash market, particularly in the systems area that would extend your reach across cloud, edge and enterprise customers? Your existing NAND supply agreements appear sufficient for your business and limits the capital investment in a wholly owned fab. But I guess how strategic do you see partnering with a system vendor to add balance to your enterprise offering?

I would say that Seagate's focus is for sure on the R&D space, less into the SSD. System is very important for us, we think will be very important in the future. It is a way to give a total solution to our customers. On the SSD, in particular, we focus on certain SSD and only for a certain customers. Basically, we do what the customer want, to have a single solution from us, and there are some SSD and some of the hard disk and maybe some of the system solutions. But just know that is another part of the business that we want to develop in term of volume. It's more a small part of our service to our customer and a good customer partnership, but it's not where we really want to grow. Right now, there are so many NAND competitors already in the business. I think there are at least 7 very big competitors that now, it doesn't really make sense for us to be the number 8 to enter into this arena.

Sure. No. That makes sense. I guess pivoting a little bit to nearline again. You're currently in the lead on 16-terabyte, but you're obviously not stopping there. At your Analyst Day last year, you indicated that you would have 18 and 20-terabyte out this year. As we think about the pace of your nearline technology road map, where do you see the primary capacity point exiting calendar 2021? Is it 20 terabytes? Is it less? Is it more? How do we just think about the node scaling of your nearline business?

Yes. As you know, we are in the full ramp of our 16-terabyte. We sold more than 2 million units in the March quarter. We are still ramping our volume. 16-terabyte is a big success for us. We have already sold some 18-terabyte, in particular, in our system solution business in during the March quarter. As you have seen with our 16 terabytes, it takes a few quarters to ramp high volume in the hard disk. It's not as fast as maybe in the memory business when you move from one tech node towards the next tech node and then you ramp the fab very quickly. And that just takes more time. So we think for the calendar '20, the high volume will be in the 16-terabyte, not only for us but we think for the industry. 16-terabyte will be the high-capacity drive with high volume. We will start seeing more and more of the 18-terabyte through the end of the calendar year. At the same time, in November or December of this calendar year, we will have our 20-terabyte HAMR. That is now the big technology development. And hopefully, our technology success is a first drive, HAMR drive. It is not optimized in term of capacity. To be in HAMR technology, it's still a small drive. We have discussed this during our Analyst Day. HAMR is the technology that will drive the capacity for hard disk up to 30, 40 and 50, and we gave already the road map. And by 2026, we expect to have 50-terabyte at this drive. So given chance in 5 or 6 year, we go from 16 today to 50-terabyte. So in a very short period of time, there will be a major, major increase in the capacity of the hard disk. So this is where we are really focusing is developing HAMR and be successful. So the first generation of HAMR, the 20-terabyte, will be used to qualify our customer and to ramp some volume and to generate. But really, the focus will shift very quickly to the second generation. And with the second generation, will be a 22 or a 24-terabyte, and that will be sold probably by the end of the calendar '21. So I would say now answering to your question, probably 20 is a capacity drive that you would see at the end of calendar '21. And then again, we will progress to 30-terabyte and the 40 and the 50 as per our road map.

That's helpful. I guess as we think about the long-term tech road map for the industry and yourselves, where edge computing should, I think, further catalyze demand for high-capacity drives. Could you discuss tactically how leveraging HAMR, which you just briefly touched upon, will push capacity points to 20 terabytes and beyond? And I guess specifically, could you talk about any qualification hurdles and timing differences for your ramp beyond the 16 terabytes today?

Yes. I would say for Seagate, the very good news is the platform that we have developed for the 16-terabyte, so the one that we are selling today, will also be the platform to support the 18-terabyte and the first -- at least the first 2 generations of HAMR. So this will make our qualification a little bit easier than usual. In the past, every new capacity had a new platform. So this time, we have a little bit simplified it. Now our engineering team was able to develop this very good platform that will be able to support at least the 3 generation for the future hard disk. And of course, we expect for that part of the business, the nearline part of the business, but even other parts like -- sorry, video and image applications, moving more and more into the high-capacity drive, and that is where HAMR is a real benefit. It is giving us a benefit in term of capacity increase and internal cost decrease. With increasing capacity, especially when you go into the 24-terabyte and higher, you start optimizing your cost. Our 16-terabyte, 18-terabyte, 20-terabyte HAMR, probably even the 24-terabyte HAMR, they will all use 9 disk and 18 heads. And there are many common parts in a hard disk. So the cost per terabyte will continue to decline, continuing for -- on our side to increase the capacity, but not increasing some of the components. Now we need to keep in mind that the edge will be more expensive because the HAMR include a laser. So the cost of edge will be higher, but of course, will be spread on a much higher capacity. So this is why HAMR is so important. First of all, we think we are the only company that is so advanced with HAMR technology and are ready to start really shipping real drives. This will give us a technology advantage, and therefore, a competitive advantage. We expect through the better product to continue to increase our market share in that part of the business. And because this will also generate a good cost decrease, we will pass some of this cost decrease to our customers in order to improve their TCO, but we also want to keep some of it for Seagate and continue to optimize our profitability and our free cash.

That's helpful. Shanye, you're on mute right now.

Sorry. Let's try that again. Before we move on, one additional sort of benefit we have with the transition to HAMR, which most of the capacity increase that we'll garner, as Gianluca was mentioning, is from areal density increases. And so we always sort of focus on the highest capacity drive, the 20 to -- the 30 to 50 terabytes. But really, another benefit is being able to produce mid-capacity drives using fewer disks and fewer heads, so sort of an optimized cost. So it really is -- it's a common platform that's beneficial and that has sort of a [indiscernible] capacity and [indiscernible] capacity and new capacity in motion.

That's helpful. Maybe if I could just pivot to the ASP. Even in Western Europe, Western Europe has seen a substantial increase in blended hard drive prices with your ASPs up nearly 30% year-over-year in March, thanks to better mix of these high-capacity nearline drives. Yet, I guess when we look at it from a price per terabyte perspective, that's also declined, I think, around 20% over the last quarter or 2, more than would be normally expected. I guess given the oligopolistic nature of the market, why should we see -- continue to see these sizable price per terabyte? Is that something that changes with a new technology like HAMR? Or does it have to do with pricing of the legacy business? Just hoping trying to think about the trajectory on a price per terabyte because you are certainly adding a lot more value in these high-capacity drives.

Yes. There are many different drivers for the pricing in the quarter. And of course, one is the mix. So when you scale up into the mix, so with higher capacity drive, the price per terabyte tend to decrease. Of course, the cost per terabyte tend to decrease too. So the gross margin that you usually get from high-capacity drive is, in general, better than low-capacity drive. But here, you have that dynamic of the price. And when the mix is changing, like for us, for example, in the March quarter, we increased a lot into the 16-terabyte and in the nearline and as a legacy part where you have the low capacity was still declining, so you have a mix impact that can distort a little bit the pricing. If you look at internal price per terabyte, you should -- internally, we look, of course, at price per terabyte. But more than that, we look at the price per terabyte on the like-for-like drive. And now when you normalize for the mix, the story is a bit different. However, I would say, there was a lot of pricing pressure in the prior quarters until probably the December quarter. And the March quarter was better, then pricing environment was better. We see that situation now continuing into the June quarter. So I would say it's a bit different right now. My opinion is the main reason why you have a different pricing environment is a better balance between supply and demand. But there was maybe a little bit of oversupply in the hard disk industry a few quarters ago, and then it has been absorbed. And now there is a fairly good balance, and now you know that the nearline demand is very strong, and that is what also is driving a lower pressure on pricing.

Got it. Thanks for that. I guess as an extension of that, how do you feel about your hard drive margins in the back half of the year and into kind of next year? Perhaps near term, there is maybe some puts and takes between your legacy branded and consumer hard drive businesses being particularly strong over the next 2 quarters. But your mix is clearly shifting toward enterprise and you're leading today on the highest capacity point. Maybe gross margins, they aren't 40% anymore, but they're certainly margin accretive. And I know you've kind of eschewed gross margins over operating margins, but perhaps could you tie in the 2 on whether there's room to increase your operating margin target of 13% to 16% as nearline becomes a larger part of your portfolio?

Yes. Starting from the near-term that you were asking, which I said during our earnings release that we expect that the mix for the June quarter to be fairly similar to the March quarter. So this means savings still a fairly strong nearline business, at the same time, maybe an also strong legacy part of the business. If you remember, in the March quarter, consumer was lower than what we were expecting. Compute and desktop, in particular, also was lower than what we were expecting, and that was offset by a little bit stronger nearline. In the June quarter, I would say if I look at April and May, what we shipped in April and May, it's probably a similar situation to what we had in January and February. So the level of shipments is not very strong in the first part of the quarter. And then we were expecting -- and we had a very strong March, now we expect to have a busy June, but we will know more in the next couple of weeks. But there is this dynamic in the quarter that is even less linear than maybe what was in the past. When you go a little bit in the longer term, of course, now all those applications that we were discussing before, those will continue to drive a major increase in the volume, that of the data that will be created, the data that will need to be stored. And some will be in the cloud, some will be in the edge. And it's not one or the other, can be a duplication. It can be -- actually, as you included in your report, that was the most very good. I actually read that in the last 2 days. It was really good. And now you can see also within your report how the data will be used differently in the different storage space. You have the cloud with more analytics, more computing. You have the edge where the important is the latencies more than -- so the speed more than the analytics and the compute. And then very importantly is the end user more than humans will be other machines. That's why -- this is why the speed is so important. And this is why you need to have several edge storage closer to the end user than what is a cloud storage location today. So all this new environment will continue to drive the future that we said is with secular growth into the mass capacity part of the business. And the legacy will decline, will continue to decline until a certain point. And in general, if you look at the gross margin percentage, we're assuming an increase in the gross margin percentage because of the mix. But what I would really like is to improve our profitability and our free cash flow because we have the best product. And hopefully, the best product is our HAMR product, and that will drive higher market share and higher profitability instead of trying to gain few point of market share through pricing as maybe was done in the past in this environment.

Yes. That's helpful. Maybe just as to round that out, you talked about investing in nearline and you talked about generating a fair amount of free cash flow. I guess if I want to -- if I focus on the OpEx side of the equation for a moment, you've done a tremendous job at optimizing the model. I think you've taken out about $250 million of OpEx in the last 2 years. I guess how much room do you see on the fixed cost side to continue to drive margin upside? At the same time, how should we think about your R&D, specifically as you drive capacity with these new technologies, as you mentioned in your nearline technology road map going to 24 terabytes and beyond?

Seagate was very successful in the last probably 2 years in optimizing the cost structure. And now we look at opportunities every quarter. Right now, I'm fairly happy with the level of OpEx we have. I think we are very competitive. However, there are always opportunities, and we want to take those opportunities. One could come, for example, from the common platform that we have developed. So not needing to develop a new platform for the 18-terabyte, another new platform for HAMR, et cetera, et cetera. Now that would maybe give us an opportunity to continue to see where we can optimize our cost, where we can reduce, where we should invest. So it's not only a total cost discussion. It's also where we spend the money and how we spend the money. But whenever there is a good opportunity, we take it as we have done in the past.

Got it. That's helpful. I know we're bumping up on time here. Perhaps maybe 1 or 2 questions left. Just on kind of -- I guess coming out of the March earnings, you had gross leverage a little over 2x, more or less in line with your long-term average. In line with the current environment, how should investors expect you to utilize your cash balance in the near term? Is deleveraging a greater priority for you? Or are you prioritizing cash build as only a fraction of your debt is due in the next 2 years? And then thirdly, maybe just touch on the dividend. You obviously have one of the highest dividend yields across, well, frankly, I think all of tech. Can you just discuss the sustainability of that and perhaps the ability to raise that over time as you continue to drive free cash flow margin improvement?

Well, in term of leverage, we are investment-grade. And to be investment-grade, usually, you need to be around the 2 in term of gross leverage. So we want to be at least at that level. We have a total of $4 billion in debt, slightly more than that. We generate more than $0.5 billion of EBITDA every quarter. So we are close to that level. We are happy with that level. If we can do more, we will do it. But in term of capital allocation strategy, we didn't change our strategy because of COVID. So our first priority is always support the business, especially now right now, where we see an opportunity to becoming even a bigger leader in the industry. So our CapEx, our OpEx, when it's needed. And then dividend, of course, it's very important for us to return to our shareholders. And so dividend, for sure. We actually said last year at the Analyst Day that we were going to review our dividend amount on a yearly basis. So fairly soon, we will review also what we want to do for the near future. And then there is a share buyback. And on the share buyback, we have always been more opportunistic. And so it depends from the share price and depend also from the general macroeconomic situation. So I would say maybe this is where you will see a little bit of a difference compared to the recent past where we are -- we have done share buyback in the March quarter, about $200 million, so not small. I'm not saying we are not doing anything this quarter. But for sure, we want also to be a little bit prudent until we see the end of the COVID situation. So we will do something, but maybe a little bit at a lower extent.

Perfect. Well, with that, we're out of time. But Gianluca and Shanye, I really appreciate your time this afternoon and thanks again.

Thank you very much.

Yes. Take care.