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

Thank you. Good morning, everyone. Welcome to Day 2 of the Stifel Cross Sector Insight Virtual Conference. I'm Patrick Ho, semiconductor capital equipment and applied technologies analyst here at Stifel. I am pleased to introduce next in our agenda, Seagate Technology, and CEO, Dave Mosley. Seagate is one of the leaders in the hard disk drive marketplace, but it's one that's also growing overall in the storage segment. And today, in our fireside chat session, we'll go into a lot more detail. But first, maybe I'll toss it to you, Dave, to give a quick brief background of Seagate. I think most people know Seagate. But maybe if you can just start off with a quick background, and then toss it back to me, and we'll start the fireside chat session.

Great. Thanks, Patrick. Before starting, a quick reminder that I'll be making forward-looking statements today. And you can learn more about the risk factors associated with these statements in our SEC filings, which are on our web page. Patrick, thanks for the opportunity today. And I'll try to just keep my comments at the front very short. Seagate has been around for about 40 years. And the past decade for us has been a time of big transition. Client server peaked from a volume perspective in about 2012, so not ancient history. But because of the massive shift of data locality and mobile cloud architectures, we've had to change our operational and technology footprints to match. And so the drive types have changed, the drive quantities have changed, but our fundamental technology, which answers the call for data out there in the world, which is our heads and media technologies, that's actually ramping up because of the growth that we're in. We're seeing it -- we're in an era right now of strong secular growth with what we call mass capacity storage. Demand for these products and data centers and edge locations near to the end customers is all happening while data products themselves are becoming more valuable. Data itself is becoming more valuable. People are finding better ways to mine it, use it, not necessarily throw it all away. So exabyte demand is growing. That's the way we like to track things now, watching how many exabytes are required and which pieces of the architecture. As far as 2020 is concerned right now, we've seen lean times in the past, coming down off of client server, and we've developed a strong financial model with strong liquidity and levers we get to pull if we had to. But we do believe in these secular trends and we think that we're going to get through the period that we're in right now, and we're going to have to make very purposeful investment because the growth of data will, actually, probably be one of the main stories between 2020 and 2030. So with that -- that's the comments. I'll stick to -- keep it short. I'll open it up for question, Patrick.

Great, Dave. Thanks, again. Let's start off with some industry topics first, get those out of the way before we go into the Seagate story specifically. First off, can you discuss how Seagate responded to the recent COVID-19 crisis, particularly as it evolved from region to region? What steps did you take in order to ensure you could procure the necessary supply, provide the necessary precautions in your own manufacturing sites? And how much did you incur on the logistics end? On the call specifically, your recent earnings call, you noted you took extra efforts to ensure delivery of products to your customers and based on the results that happened. So can you just give a little bit of color on those items?

Sure. A few different points. I mean having factories in China, large supply chain in China, where the thing started, at least from an awareness perspective, that's where we had to lock things down the quickest, in the factories. And the priority immediately was the health and well-being of the employees and all the customers and suppliers that were feeding our factory at the time. It was pretty logistically disrupted, but we learned a lot of lessons there too about how to run a factory in these times. And we went into things that wouldn't surprise you, temperature monitoring, social distancing. Everybody is wearing masks anyway in the clean rooms. But then outside the logistics were as important, how people flow to and from the plants, how the parts flow to and from the plants, and where can people -- where have you been, and if you've been traveling or something like that, please don't come in. So we did a lot of that in the early days. And I think that's helped us maintain kind of operational integrity the way -- all the way through this. There have been times where various jurisdictions were getting hurt because of the pandemic, and we had to shut down factories or we had to slow down factories, but we think we're pretty much through those periods now. And so kudos to our team, our suppliers, our customers, everybody working together to kind of keep it together. To your point, we also incurred about $25 million worth of COVID-19 costs in the last quarter. That was about 100 basis points, I think, impact on gross margin. And we do expect some of those costs to go up in this current quarter, simply, and we talked about this on the earnings call, simply because the large part of the supply impact didn't really start until, I'll say, March, April time frame. It wasn't really January, February either. So we were able to do a lot of things with inventory positioning and making sure we had buffer stock to keep things flowing as much as we could. On the demand side, there's also disruption. And I think this is what you're alluding to in your question a little bit. We continue to see strong cloud and data center demand currently, but the consumer and desktop markets have remained weak. And surveillance, which I think everyone thinks long-term is going to grow, not just security and surveillance products, but also health care, smart cities, smart factories, smart hospitals now. I think all these things are going to grow, but that's pretty disrupted out in the world right now, particularly in China, which was actually first to open and back up for business. And so there's all that macro uncertainty. And a lot of that comes down to, how do people get parts? Maybe they can get hard drives from us, but they can't get all these other parts from other people. That's just led to an era of demand uncertainty that -- we think these market perturbations are temporary, and we continue to view the long-term data growth secular trends that we talked about as really positive, but we've got to get through the period, and that's what we're managing through.

Dave, maybe just as a quick follow-up to that. And I guess, it's something that really hit home for me on your last earnings call when you talked about you had to get products to your customers. One of the things I've learned from the semiconductor and capital equipment space is ensuring customers get their products and to do it maybe at all costs. I found that really telling that you mentioned it on your last call. I think I know what your answer to this, but can you talk about the priorities of, okay, we've got to get these products, we'll take some of the cost hits now, but longer term, that will benefit us.

Yes. I'm a little biased here, because I do hear people saying things like, I'll move the market or I'll do this or do that. I mean ultimately, we just serve the customers, and the customers are the ones that are fanning our products out there in the world. And then with their success, then we can turn around and share that back with our suppliers. So there's a sense of urgency in a disruptive time to make sure you keep all that balanced. Actual true customer demand when there's an end customer actually waving money and saying, I'm willing to spend on this. We all have to react to that and not get into this kind of parochial, this is what I have or I'll try to trim the portfolio this way, because that actually can impact the suppliers, it can impact the customers. It's not good for relationships. And if I've learned anything in my career over times of demand disruption, you really want to strengthen the relationships, not strain them. So that's how we think about it. It's all about customer service and then turning around and making sure our suppliers are ready for the next wave which will come for us.

Great. Moving on to the other industry topic that's on a lot of investors' minds is the U.S.-China trade war, the changes in the Commerce Department's rules and regulations. Now you're obviously seeing a pickup in business and you just mentioned that the supply chain is reopening up in China. Can you discuss some of these new rules and regulations and how it potentially affects Seagate, if any, at all? Again, it seems it's obviously more targeted towards semis and the equipment space, but I thought at the very least to ask you how it potentially impacts Seagate.

Yes. I think there's no direct impact to Seagate, but there are indirect impacts insofar as, if somebody can't -- to the earlier discussion, if somebody can't get a complete kit of parts for one reason, then maybe that demand can't be fulfilled by that customer. Maybe the demand shows up at another customer or something like that. It's also -- when things are temporary, you'll find people buying buffer stock, and they have to do that out of the same pot of money, so that can get a little bit disruptive. Maybe they go lean on one part. We've seen this in the buildup of the cloud over the last 10 years, where you get a shortage in one component, and it would basically affect all the other components temporarily. May have been responsible for what we call a digestion phase from time to time. So I think all these are watch items against the backdrop of the fact that data is growing. The data centers need to answer the call. There's all that demand still there. So I think some of this and some other things will tend to just elongate cycles where people may have wanted to build something now, and they can't, or they might -- because they might -- for another reason, they might actually pull something in just because they're worried about component availability. And to the earlier point, all we can do is stay nimble through it. It's not a direct impact to us.

Great. Let's go on to the specific Seagate story and the opportunities ahead for you. The first area I want to focus on is the industry shift to nearline drives, excuse me, where last quarter, you saw a very strong uptick in nearline drives as it made up of almost 60% of your total revenues. We're going to go into a little more details about some of your bigger term and big thesis about cloud to the edge and things of that nature. So you can hold off on that. But can you give us your take on the near-term demand environment and how sustainable it is maybe potentially over the next couple of quarters?

Yes. I think if I go to the long term, we believe the mass capacity, which includes nearline and the surveillance drives and some other just high capacity drives, say 10 terabytes and above, the demand will continue to be very steady for that, largely because the lead time is so long to manufacture and the qualification times are -- these are massive installs, so the qualifications are very important. People have to be very thoughtful, diligent through the qualification process. And because of that, we work with the customers really closely and understand their needs, then that gets into multi-quarter demand forecasts. Long term, we believe in that growth. So from a short-term perspective, there's been people calling digestion periods and things like that. My take is even the cloud, which I said at the outset has been fairly steady, is still reacting to demand changes and where data is located. I think some cloud customers have seen fairly large shifts to their products over these last few months, and they're going to have to react to that with infrastructure investments, not necessarily all just data storage investments, some of them are compute and networking investments, but I think those investments are coming.

Great. Another area of growth you've talked about in the past is the opportunity in the gaming market. And I was particularly interested when I saw you in Las Vegas for CES, how well versed you are in the gaming environment. My 12-year-old is quite versed in it, but I saw how much of an expert you are in that. First, can you discuss broadly the industry opportunity for storage and disk drives, and then specifically, how Seagate can capitalize on this opportunity?

Yes. It's an interesting market. It's changing very quickly. And I love the products, actually, to your point. We've been involved in console gaming for almost 2 decades now. So we know that market very well. We also make externally attached drives, which -- it depends on how many titles you actually play. If you play some of the bigger titles, the bigger map sizes, then you need a lot of capacity. You also need performance. And so what I find that is great about the gaming market is that there's this real push for edge performance, edge compute, edge storage, network into the cloud so that you can share the gaming experience. It's a great example, kind of a leading-edge example of where I think the edge is going to go with performance and capacity requirements. And that's one of the reasons why we're so excited about it. So we have a full range of products, from externally attached drives to internal drives, SSDs. The brand is actually doing pretty well. And from my perspective, our team has done a fantastic job really answering the call there. It's just an exciting space.

Great. Let's move to your market share and the opportunities still ahead for the company. So one of the key themes I've discussed recently are the share gain, I believe, the company has achieved over the past 6 to 9 months in the nearline drive market. This was obviously driven by the introduction of your 16-terabyte drive, which you have noted as being one of the fastest product ramps in the company's history. First, can you give some color on how this drive has driven share gains and allowed Seagate to outpace overall mass capacity drives segment growth overall? And secondly, you've been in the industry for a long time. Your competition is not going to sit idly by. How do you plan on maintaining these gains as you begin to roll out your 18-terabyte and 20-terabyte offerings?

Yes. Thanks. It's a little bit of ancient history now if you go back 1.5 years, but we were in a kind of a down cycle at the time. We had -- the whole industry had 12s and starting to get some 14s into the market, and the demand was just really not that strong. Seagate made a conscious decision to -- we've been changing our platform too frequently from -- we did from 4s to 6s to 8s to 10s to 12s. We changed it every time. And so we've been developing, which takes roundabout 3 years, the platform, that would take us 16, 18, 20, 24, maybe even beyond that, if we can continue to stretch the technology, with some subtle changes, but largely, most of the platform is the same. And so we made a conscious decision in the middle of that to say, let's take our resources off some of that prior build, and given the long lead times, let's start pivoting over to the 16 ramp. And it was the fast -- to your point, it was the fastest heads and media ramp that we'd ever done as a company. From my perspective, very successful. Now it's a matter of leveraging to the 18 and beyond. I don't expect the competition to stand still. I also think that when we're dealing with our individual customers, they deal with us kind of autonomously based on what they think we're capable of, what product we have, all the other attributes of our product. And it's not as much us versus the other person directly. So -- because the cycle times for qualification and procurement and manufacturing is so long, it doesn't come down to the end of a quarter kind of decision for them. So we're not really focused on market share. We're focused on getting predictable on this product family, getting it out there in front of the customers, letting them see that predictability and then to the extent that they have to go and insert it in data centers at mass scale, we need to be there for them.

Great. And maybe just as a quick follow-up to that. You did mention now it's on a common platform. Does that ease of use and the ability to transition from one product to another, is that going to help drive, I guess, greater stickiness with the existing customers? And how do you look at new customer adoptions off of the common platform?

Yes. I think so. I think there are so many different kinds of customers that there's not a one-size-fits-all cloud mass capacity. Sometimes the drives themselves even in one installer used in dramatically different ways, depending on what the business unit that they're servicing is. But I would say, in general, when people become more comfortable with the family, you can make targeted improvements, say for example, going from 16 to 18. And we slightly changed the heads in the media, a couple of pieces of electronics. People know exactly what to go qualified there. We can do it with confidence because we don't have -- it's not a new product family for us. They can also see that and watch certain items with more confidence and then ramp with more confidence as well. So that does help us to have a consistent product family.

Great. Let's go to the HAMR technology and the road map Seagate has developed based on this technology. So one of the other areas that I believe differentiates Seagate is the efforts on the HAMR technology front. You've noted in the past about the continued evolution of the HAMR technology and how it will eventually allow Seagate to move to 30 terabytes and beyond. First, can you give us an update on those efforts and why Seagate chose this technology versus alternative options? And secondly, why you believe this is the best road map for future product development.

Yes. I think there are other options, but most of the other options are what I would call, slight changes on the current perpendicular recording technologies. MAMR comes to mind. We were -- I remember in 2007, I've said this before publicly. We were pretty excited about MAMR. It's a gain that you can get in write-ability. But it really doesn't offer you -- afford you the opportunity to go change your media magnetics, if you will. What really needs to change to make the bit smaller is you need to go to a much stronger magnetic materials. And because they're smaller and stronger, they're harder and harder to write, and you can't get any closer. And we get into what's called the writing trilemma. And so the way to break out of that, to go to a new media material set, is to really introduce another energy assist, people have called it. The energy we happen to use comes from a laser. There's other kinds of energy you can put in. But you have to get through that new media material to get the bit sizes down. We -- as an industry, we've been stuck at grain sizes in our media that are 9 nanometers or thereabouts. We've been stuck there for a number of years. We can do it with the new media materials. It's hard. It's very, very difficult to do this because -- to put it into context for semiconductor people, the track width are on the order of 30 nanometers, give or take, the downtrack size of the bit is 7, 8, 9 nanometers. And in order to increase aerial density, we have to make those things even smaller. There's multiple layers in the media. You have to get it right. And the other thing is that we're not in a notebook drive of old where it was basically turned off and not writing most of the time. We're in data center drives today, which are going to -- which need to live for a long time with no pit stops in data centers. And so the requirements on all aspects of the drive are going up, up, up. And we have to answer the call, not only on aerial density, but on all those other metrics as well. So these are tough challenges that the industry is going through. We chose this because we really want to get onto a platform that will take us to 50 terabytes or 100 terabytes someday. There may -- we may need some other tricks to get to 100 terabytes, but I have no doubt that once we solve these problems, that there will be customers there. Nobody wants to build bigger and bigger data centers with the same capacities of drives. I mean that changes the economics dramatically. So for all of us, for those of us making the technology investments and then the end users, there's benefit to continuing the aerial density curve challenge that we've been on for 50 or 100 years.

That's great. Let's move to a topic that I think you'll certainly want to discuss, IT 4.0 and the migration of data from the cloud to the edge. But before we go there, for full disclosure, when I first started in the finance industry in the late '90s, one of my first sectors that I covered was the disk drive industry. And it's obviously evolved a lot from when I was there. When it started moving to the PC client market base, you -- the industry itself had a lot more players like Conner, Quantum, Maxtor and so many others. And your predecessor as CEO was a lot more flamboyant, Mr. Shugart. So with that in mind, we've seen the disk drive industry continue to evolve in recent years. You talked about industry IT 3.0 of the migration to the cloud. But you've also talked about the transition to 4.0, the shift to the edge that will drive further mass capacity drive growth. First, can you provide a little background on that thesis itself, the key market drivers, and why you believe this will be the next catalyst for the drive industry?

Yes. It is interesting, and it's interesting to reflect on the more ancient history. I've been at Seagate for 25 years, and that's upfront and personal with a lot of those people, and a lot of the changes that we've been through. I would say that when we were in client server, we were in a massively decentralized data mode, and then the cloud has centralized that data out of -- by putting forward a good value proposition. I think there's a coming push to really decentralize some of the data again. It's not necessarily at the expense of the cloud, but it's just because the size of the data set is growing so much. When you think about it, mobile cloud was designed as a kind of a push model to push data out to the edge. And what we're going to see in IoT and with a bunch of AI and ML, there's a lot of data being created on the edge. So there are pit stops that are needed many places as the data comes back into the cloud and then cycles back for learning. And we call this IT 4.0, the rise of the edge. What do the products look like? I think -- and who are the players? How do -- what are our routes to market? That's still developing. There are a lot of people that have tried to build business models around the old business models to try to address this, but it doesn't scale the same way, I think. Consumers now want to buy products, even IT professionals want to buy products that are very, very easy to use, don't require a whole lot of maintenance, very easy to procure, really flexible as a service model, for example. So there's a lot of uncertainty right now. I will say that one of the most powerful drivers that I don't think people talk about is lock in. I think people want -- not everyone, but a lot of people will want their data to be frictionlessly moved from platform to platform and they want to avoid lock in. We're at the very inception of this right now. We at Seagate, we believe that some data will actually physically be moved. I mean I'm not talking about moved over a network. I'm talking about picked up and moved. The concepts of data gravity apply. And sometimes, the easiest solution to that problem is to just move data. We see -- we still have a strong, healthy business in consumer products. You can buy them in retail outlets or on e-tail. And that's people that are running small business models that are generating data at the edge and moving the data around and owning the data themselves. And so I think these trends will continue to persist. And it's something that we're investing in. We're trying desperately to understand. We're communicating with a lot of businesses to have specific needs in their locations. And then we also run a lot of POCs on our own data, in our manufacturing sites and inside of our business to understand how the data is flowing. And I think there may be some opportunities for that, I'd point to the Lyve Drive platform that we announced at CES, if anybody is interested. But I think there's a lot of learning for many players in the ecosystem still yet.

Yes. Maybe as a follow-up to that. You brought it up. And one of the opportunities I see of Seagate capitalizing on this emerging trend is solutions like the Lyve Drive. It's a very modular platform. If you could give a little bit of color, one, of the capabilities of the Lyve Drive. And what else you can look at from a, I guess, market opportunity standpoint for Seagate to deliver storage capabilities to the edge?

Right. At a high level, if you think about external USB drives, which, like I said, we have a healthy business on, they're easy to procure. You can go down to your local retail outlet or get one on e-tail. And so what are they? They're data storage that is actually behind a fairly slow interface it's a USB cable. And it's not -- I'm not deriding USB. It's a sign of those times. But I think those interfaces need to be faster in the future in order to satisfy the extreme data workloads. I mean if you just put -- if you were to put, say, 20 or 30 terabytes with the USB interface on the front, it'll take you forever to write and read the entire thing. It's just not -- it's performance prohibitive. But I would also say that there are a lot of issues in the enterprise where you actually see data being shuttled around in much larger quantities. So we want to do that with the quality and reliability that comes from enterprise, with the speed that comes from enterprise, but we want to do it with the ease of use that comes from consumer. And that's what our Lyve Drive platform does. It basically takes it into tens or hundreds of terabytes worth of data that you can easily move around, and it doesn't really get you stuck in one place. We're not the only ones with models like this. There are other shuttles, I guess, you could say, in the world. And it wouldn't surprise you too much to say that, sometimes, these things end up stationary for a while. Just like the consumer products do, they're designed to be mobile, but a lot of times they end up stationary for a while. That's what we're thinking with that. It's allowed us to participate in some great discussions with a whole variety of people, from autonomous vehicles, to health care, to smart city applications, all kinds of different smart city applications, finance applications. So it's an exciting time for us. We're learning a lot from it, and I think it's going to be super relevant 5 years from now.

Great. Let's go to the operating model. At your Analyst Day in the last fall, you and the team laid out some new target model metrics, and most notably on, one, the operating model targets for the company, and two, the capital allocation strategy. On the operating model front, you set target model metrics of 13% to 16% pro forma operating margins. And admittedly, you're already at the high end of that range. What are some of the additional levers on the operating model front, whether it's gross margins, OpEx, that will allow you to hit the high end and possibly exceed this range over the long term?

Yes. Thanks. So the first thing is to get more efficient with our platform. So to the point of launching the 16-terabyte platform and being able to leverage it and things like that. That's an efficiency that allows us to operate at the high end of our range kind of temporarily. What I would say, if you think back historically, we had to do notebook drives and little 1-inch form factors that went into little MP3 players. And we did all kinds of different form factors. Now that world has consolidated for us quite a bit. So from an R&D perspective, we're a lot more efficient. If I think about it long term, then when you get into the right supply and demand balance, then you'll start to see the model, you can exercise the model north. And that -- calling what the right supply and demand balances is a tough thing because the world throws curveballs at you like we've all seen in the last 4 or 5 months. But I would say, in general, the secular growth that we're seeing in mass capacity storage and some of the other opportunities is growing heads and media, which is fundamentally our investment, allows us to -- if we're behind that demand curve with supply, then I think our model should stabilize.

Great. Moving on to the capital allocation side of things. You noted you wanted to return over 50% of your free cash flow to shareholders. You have a nice mix of right now dividends, buybacks and even M&A potential opportunities. Can you discuss how you'll manage this cash flow among those different tactics, and how you look at it relative to your repayment of debt or refinancing, which you've also recently announced?

Yes. I think it's exactly to your point, and all things balanced, the refinancing that we're talking about is really about getting into a smoothed over profile such that we can repay, and that's part of the allocation that we'll talk about. We're committed to 50% of free cash flow. That is largely right now dividends. Opportunistically, when we have more, we can do either M&A or buybacks. From our perspective, those are all things we think about fairly diligently. And also, reinvesting in ourselves, frankly, CapEx and OpEx. So -- and all things balanced is the way we look at it. The commitment to the shareholder return is important because I think it drives the kind of company that we want to be, a long-term company, long-term for employees, long-term for capital equipment and factories, long-term for customers and suppliers, long-term on all things. And it's very consistent with who we want to be, how we want to invest. There's obviously always near-term issues, problems. We'll get through those. But I'm pretty happy with how we balanced all these things out to -- amongst each other. And our job is to drive the absolute best returns. To your point earlier, is -- get the -- operate at the top of the range or go higher than the top of the range in operating income. And then we'll have more cash to be able to allocate to all these different objectives.

Great. With that, we are at our time limit. But Dave, first off, again, thank you very much and stay safe. And two, I'm really looking forward to the continued evolution of the disk drive industry as I do see the shift to nearline drives and mass capacity storage. I think we could be seeing a second wave of growth like we saw in the late '90s, early 2000s when the PC client market took off. So again, thank you very much.

Thanks, Patrick. Like you said, everybody, stay safe.