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

Hi, good morning, and welcome again to our next session at the BofA Tech conference. We're delighted that you could join us today. It's been amazing to see the participation levels virtual creep up last year. And this year, again, these sessions are hitting record levels of interest, so delighted that you could all join us today. Today, we're welcoming Seagate Technology's CFO, Gianluca Romano. Gianluca, thank you so much for joining us today. We really appreciate your time. We are excited to have you, particularly because you shared some great news this morning.

So maybe to kick it off, Gianluca, can you talk about what the preannouncement? What drove sort of the preannouncement?

Thank you, Wamsi, for inviting us here today. Before I start, let me quickly remind that I will be making forward-looking statements today. And you can learn more about the risks associated with those statements on our SEC filing that are posted on our website. So talking about our preannouncement, of course, very good news. We discussed at our last earnings release that entering into the quarter, we were expecting a very strong nearline market demand, both on the cloud and enterprise OEM side. And we see that happening, so really good. We also discussed about a pickup in demand in the VR market, and surveillance in particular. And this is also happening, so very, very good. On the legacy side, I would say, mission-critical consumer are also performing well. And on top of all this, we added something that we actually were not fully expecting that was an increase in the crypto farming demand. This is helping us in utilizing some of the capacity now that we discussed in the last 6 to 9 months, but was not fully utilized. We had the industry added too much capacity for a few years. And this increase in demand is actually helping a better -- to achieve a better alignment between supply and demand. And as you know, when you have a better alignment supply and demand, you go into a much better pricing environment. So this is happening a little bit before what we were expecting. We discussed at our Analyst Day that we were expecting that we need them to be achieved around Q4 '22, so in the June quarter next year. Now because of this new demand, we see a strong acceleration. We don't know if this will last for a long time or not. But it's important for us to be in a situation where we can use that capacity, and much earlier than what we were expecting. We are not changing our CapEx plan. So we are still aligning our core business, mass capacity between supply and demand as we were thinking before. And if the cryptocurrency demand stay with us for long, good, is all upside, is all an opportunity that, of course, we want to take benefit of in the next few quarters or longer if it will stay long.

Okay. That's great context.

Yes. So we really expect a strong calendar '21 at this point. As I said, we are accelerating through the achieving the targets we discussed in our long-term model. We will discuss even more about the calendar '21, and more importantly, the fiscal year '22 at our next earnings release.

Okay. No, that's great context, Gianluca, I appreciate that. So if we can dig in a little bit, I mean if we look at just sort of your updated guide, right, from your prior guide, on that $100 million of incremental revenues, there's very strong conversion margins. I mean this is coming down to EPS pretty heftily and nicely. So when we think about that, it usually means that you're tracking very well both on gross margins, which I guess makes sense given your utilization comment, and basically better pricing. So are you seeing that better pricing across the board? Are you seeing that better pricing in certain pockets? Like how should we think about that?

I'll say in general in both the mass capacity segments. So we have a good or a better pricing environment. I will not say it's still where we think it should be, but is going in the right direction. And as you said, a big part of the increase in revenue is flowing to EPS. So this is helping our gross margin, it's increasing our operating income. And is going in the direction that we discussed a few months ago at the Analyst Day. We are still not there, but we are getting close, and we think we can accelerate through the achievement of those objectives few quarters before what we were expecting before.

Okay. A few quarters is quite material given that there were just a few quarters. Okay. Well, that's great. So when you think about this demand, that incremental demand driver that you saw around the crypto market, you said you're not changing CapEx plans. But when we look at externally whatever we can track like [ chiaexplorer.com ], we look at Netspace. I looked this morning, I think it's exceeded like 23 petabytes. I don't even know where they're getting -- exabytes, sorry, not petabytes. Yes, 23 exabytes. So I don't even know where they could be getting that level of capacity. So what do you think is sort of happening in that market? Do you see any inventory build or was there a prior inventory build that's being utilized? How would you characterize that?

No, I think they are using a lot of the distribution channel market, so they take from there. So I expect at quarter end to see a very low inventory level at [ DC ]. That's good. We don't change our CapEx plan, first of all, because it's not a small plan. We always said our new target is before between 4% and 6% of revenue. So it's not a small number. It's a big number. We want to see if this increase in the crypto demand is going to stay and how much it will be. So I do not exclude that in the future, we could upsize the CapEx. But for the time being, we don't see the need. And again, our revenue is going to grow. So our CapEx as a percentage of revenue in dollars is going to grow. So it's -- I think it's a good way to realign supply and demand faster than what we were expecting, and then we need to be good enough in keeping that alignment for the future.

Would you say, Gianluca, that the pricing environment for the entire industry is getting better? Are there some Seagate-specific actions that you're taking versus what maybe the industry is doing?

No, I think it's more an industry situation. So again, it's not Seagate supply-demand, I think it's more an industry supply-demand. So we see our pricing going into that direction for the segment, not for just Seagate. So I think it's a good news, an improvement for the full industry.

So Gianluca, when we look at sort of what is happening in the channel, right, like I mean HDDs are essentially sold out at mass capacity, different capacity points. And the pricing has spiked in some significant fashion. So given that, are you making any active choices to reorient like drives from like place A to place B? Is there -- are they -- are you being very tactical about that? Or is that something that is not possible given the demand that exists from your overall committed customers, large hyperscalers for instance?

Yes. The demand in the nearline space is strong. So of course, we have a lot of volume that is linked to that segment that, of course, we want to continue to serve. As you know, we have LTAs with some of our big customers. And of course, we are respecting all our commitments and agreements, there are opportunities for some tactical improvements. And of course, when we can, we do it. But again, our focus is customer partnership and be sure that we work with our customers in the mutual interest and get a win-win situation for both. And then when we have additional volume available, of course, we have to sell where we can get the best financial result.

Okay. That makes sense. So when you think about this market and the lead times that are associated with nearline drives, I mean obviously, these drives are getting larger and larger, testing time is taking longer and longer. Cloud demand looks like it's here to stay. You said VIA market is recovering. So if let's say, crypto demand exists strong for another quarter, is that the point where you would say we need to like to go back and relook at capacity? Or does it need to be like 2 quarters or 3 quarters? Like what's going to make your decision around like making -- around understanding whether you need more capacity or not because this might be structural, not just sort of a cyclical thing?

Yes, it will take a little bit of time, of course. And when you look at the volume, for example, what we were discussing that before starting the conference, but it's one specific cryptocurrency that is now around 20 exabytes. So 20 exabytes is a big volume. But when you look at the overall exabytes that we shipped in a quarter or in a year as an industry not just at Seagate is still a fairly small percentage. It's very important because is consuming that additional capacity that otherwise was going to stay underutilized. So that last 10% is very important. But it's not the volume that you see in the cloud or in other segments. So let's see how that new market will develop. And of course, we will try to take all the benefit for the new opportunities. We see that as an upside to our plan. So if it stays, we have opportunity, we will take benefit. If it doesn't, we still have a plan. We are now utilizing that capacity for hopefully at least 2 or 3 quarters so that we will be fully aligned by Q3, Q4, as we were discussing before. And if it happens even earlier is good.

So Gianluca, when you guys reported results here for the June quarter, are we going to see this upside in the systems business as well?

Yes. So yes, the short answer is yes, but a part of the system business, which is actually supporting the grid. So already on the last quarter that we reported, we show an increase, especially in the system business volume, and I think is going in the same direction in the current quarter and hopefully in the next 2 or 3 quarters.

Yes. No, that's great. So the way I understood your comment was, look, if crypto demand remains strong, you see upside to sort of what your prior targets were. If crypto demand wanes, then you still have a plan to make at least your existing targets?

Yes. So basically, this new demand is basically helping us to improve for sure in the short term and bridge from a situation of underutilized capacity to a situation of almost fully utilized capacity. And then in 2 or 3 quarters, we see where we are in, but is still a great opportunity we can upside and increase the volume or staying as we were planning before, still in a very good situation.

Can you also maybe address, Gianluca, just sort of the linearity in the quarter? I mean it feels as though this crypto thing sort of took off in a matter of weeks. And so if you -- and the persistence of that seems to be indicating that there's incremental sort of tightness as you're going through the course of the quarter, which means you're probably going to exit the quarter with some real like demand backlog as it pertains to this. So it feels as though you should be able to sustain this for longer. Is that the right way to think about it?

I would say linearity was fairly good in the quarter. So we started fairly well. We are continuing to ship fairly well, good linearity. As you said, we expect a fairly good backlog at the end of the quarter, and this is giving us confidence for the second part of the calendar year.

Okay. That's great. Can you maybe address some of the supply chain issues that also seem quite topical, particularly as it pertains to the manufacturing ability to sort of not have disruptions in manufacturing, especially given that Malaysia and some other places where there is significant footprint have announced some lockdowns. Is that impacting you right now? Or are you able to run everything at full capacity?

Well, no, right now, it's not impacting us. So we are still able to have basically the same number of employees that we had, let's say, a month ago or 2 months ago. So the factory is continuing to work very well. Of course, we are not at 100% utilization and now we expect that to improve and be a possible upside for the next couple of quarters. But nothing different than what was a couple of months ago. So we have enough to cover all the demand that we can serve in the current quarter and even the next quarter.

Okay. That's great. Are you seeing any impact sort of not maybe directly? And I know it's hard to measure, but indirectly, given that your customers might be having issues with supply, so whether it be on the server side or on the PC side? I mean everyone's talking about these supply constraints impacting their own products and their own production, so sort of the secondary impact of that, are you seeing anything material in terms of order rates changing or anything that you can comment on?

Well, right now, we just see upside. No, we have not seen any downside in demand. So I don't think our major customers are experiencing any material problem for what we are concerned. So we have not seen any reduction in volume or any push out in time, actually. Eventually is the other way around, I would say.

Gianluca, can you talk a little bit about sort of within the nearline context, is there specific like recovery in demand? You called out the VIA market earlier in your comments. How sustainable do you see the trajectory of that? I mean cloud feels like it's quite sustainable. VIA has sort of had more cyclicality. But as you think about where we're coming off of, does it feel like for the next several quarters, the visibility is pretty good in the VIA market?

Yes. Now for the visibility we have today, we continue to believe that nearline is going to be strong and very solid. We are coming out from several quarters of record volume in that specific segment. And we think is the trajectory that will stay with us for sure for a few more quarters, and I don't want to anticipate too much of what we will discuss at next earnings release. But again, it's a very strong segment, is where the industry is focusing because it's a business that will continue to grow, not only this year but for the next several years. On surveillance and the VIA market, as you said, it's a little bit more seasonal. Usually is strong in calendar Q3 and calendar Q4 and a little bit less strong in the first 2 quarters of the calendar year. So it's normal for us to see an increase in demand right now. And now we expect that to continue for really the next 6 months. And then we see what's happening in calendar Q1 next year.

Okay. That's helpful. And then what about on the cloud side? Are you seeing continued sort of strong demand in cloud? I mean there's a lot of concern with some folks thinking that cloud had sort of obviously, during COVID, there was a big shift to cloud that might have changed sort of the demand trajectory and tougher comps for a lot of companies. How do you think about it?

I think -- but it was an acceleration. And that doesn't mean that will slow down right now. I think it was just accelerated but will continue because that is where the business is going, where the development is continuing to improve. So the cloud is a space that we focus as a major business. Is not the only business, but of course, is probably the -- as individual segment, is the one that will grow the most in the next few years. And so we don't see any slowdown actually. We just see an acceleration. And we believe that will actually be a good reason to continue in that direction, not a slowdown, but it's not really a cycle, that is a trend, is a different situation.

Okay. That's helpful. So Gianluca, when you preannounced this morning, I got some feedback from investors and there's some concern. And I think this has been a concern for some time is just around hitting peaks in EPS -- hitting a peak in EPS close to $2 quarterly peak. I think when you look at a lot of companies that sort of have seen very strong demand, there is this perception that the demand is going to fall off. I mean we've seen this with Apple, with HP, with a lot of companies like where the quarters are amazing and yet the stocks don't perform because people are worried about this peak thesis. How would you respond to sort of a peak thesis in the context of Seagate?

Well, what we're -- now we're trying to do is to give confidence that we are not there. And the only way we can give confidence is talking a little bit about the future. So at the last earnings release, so in April, we discussed about calendar '21, so a fairly long visibility. And we said, we expect calendar '21 to be at least 10% higher than calendar '20. So it's a major improvement. Right now, I can confirm that we are even more confident that we can be at least 10%, even probably higher, but we will discuss this at the next earnings release. So that's how we give confidence. Again, I believe right now, we're in a situation where especially in the mass capacity, we are not talking about cycles. We are talking about a very large increase in demand because data is growing so fast. But there is no reason to have a cycle. But will it just be a trend? This trend will be always in that direction of increasing demand, increasing storage capacity, increasing cloud efficiencies, and we are there to serve that business that is growing and is growing faster.

So given those statements about your confidence in this visibility, can you give us any insight as to these long-term contract agreements that you have with these customers? Like how -- what's the structure of it? What is it that investors should take confidence that, yes, the margins can improve in this business?

Yes. We have different structures, of course, with different customers. I would say the constant part of the agreement is volume. So I would say our customer interest is, first of all, be sure they get a certain level of volume for each quarter. And this is good for us because we need to plan our production. And again, we want to have that alignment between supply and demand. And knowing what is the demand that is sure where they will have to consume is a big help for us. With some customers, we also have a pricing agreement and with others is task volume, and then we discuss the pricing on a quarterly basis or on a 6-month basis. So it's different from -- for the different customers. But I would say the important part is big customers are now interested in fixing the volume because they see there is not infinite capacity in this business anymore.

Yes. So Gianluca, just a follow-up on that comment. And I mean if you have that sort of -- those sort of agreements, would it be fair to say that the upside in the quarter was largely channel-driven, or I mean that because it seems as though, although the aggregate pricing environment could be improving, you're yet to really see the material part of that given the structure of these contracts?

I would say this is how it usually starts for nondistribution channel and then move into the other segments. I think this is a good way to look at the situation.

Okay. Great. So I'm going to ask you this question. I don't know how much of a liberty you are to answer it, but we've been receiving a lot of questions around a particular customer of yours where there are some restrictions in place for shipments. And I was wondering if you could comment at all on that.

Who is the customer?

Huawei.

Well, we have -- we always answer to this specific questions in the same way because that is the truth is now we comply with all the rules and regulations. And based on that, we ship to all our customers, following those rules and regulations, we don't comment on specific customers as we don't comment on specific suppliers or investors. But in general, now it's part of our job to ensure that we understand and then we follow all the rules and regulations and all of that of trade.

Okay. No, I appreciate that. That's helpful. So Gianluca, maybe shifting gears just a little bit, talking about capital structure. How do you think about the right levels of debt for the company? And given where the stock is, in some ways, yes, it's about historical valuation. But historically, Seagate has had some headwinds, particularly in legacy markets that did not allow it to grow. So we're sort of going through this valuation, re-weighting, almost, for the company. And you pointed out all these things about 10% growth this year and just the market getting better around pricing, your gross margin targets are a lot higher than what you're operating at. So it feels like there are a lot of levers for [ off running ]. So given that context, how do you think about the state of the balance sheet, the willingness to lever up more and buy back more stock?

Yes. As you know, in terms of capital allocation, we have maybe 2 different methodologies. One is applied to dividend where we want to be very programmatic. And every year, we look at the dividend yield. We look at our liquidity situation. And in general, as you have seen, we try to have an increase of our dividend and to remunerate our shareholders through dividend as a stable way of remuneration. The share buyback is more opportunistic. We have done a lot in the December quarter. We have done a lot in the March quarter. I think the average share price that we repurchased in those 2 quarters were now in the [ 60s ]. So we are now way higher than that. So I think it was a good strategy. We believe the share price is still very attractive. As you said, we should not look at the past, we should look at the future. And we think that based on our future plans, based on how the industry is going, how demand is going, this industry will see good upside. So for sure, we have more than $4 billion, probably $4.4 billion at the beginning of the quarter as outstanding authorization for share buyback. We will use it, we will use it in a certain period of time. And of course, will not be very, very short, but depends from the opportunity from where the share price will be, from where the liquidity will be. And the debt level is part of this discussion. If we have -- if we see an opportunity there, of course, we can access the market and then use the proceed from the debt for an accelerated share buyback, or we can wait and do it later. We generate a very strong free cash flow, now is one of our priorities. Now if we look at all our financial metrics, the revenue growth, the gross margin, as we discussed at the Analyst Day. But our first priority is always free cash flow. And we want to give a stable, fairly predictable free cash flow. And every year, we try to improve that free cash flow and increase the level of free cash flow. So we will discuss this at our next earnings release, but continue to generate a strong free cash flow and possibly increase the level of free cash flow, give us also opportunity for more share buyback.

I think, Gianluca, when I hosted a call with Dave here last week, he expressed similar confidence about free cash flow and Seagate's ability to maybe drive more free cash flow in the next 10 years versus the past 10 years. And if I was to think about that, that would average around $1.6 billion each year, and I'm not saying that, that's sort of the trajectory necessarily is linear. But when you think about sort of those levels of free cash flow, at the same time, think about, this quarter itself, you're basically exiting at a close to $8 run rate on earnings. And if you do $250 million, which, in one of the next couple quarters, which doesn't seem unreasonable, you would be operating at almost $10 in run rate EPS, with the stock at $100, that's 10x PE. So really no re-rating on the stock when you look at it in that context and the confidence in free cash flow. So doesn't it feel like this is still a very good time to deploy more capital towards buybacks?

Absolutely. No, we -- I said before, we still believe the share price today is very attractive. And there is the person that many years ago said we will have a 20-terabyte HAMR sold before the end of calendar 2020, and we did it. So I have full confidence that if you expect to have a free cash flow higher in the next 10 years than what we generate in the last 10 years, we will do it.

So Dave -- I'm sorry, Gianluca, I wanted to ask you, when investors think about of some of your largest holders that have recently sold some stock, would you say this is just a rebalancing within portfolio? I mean obviously, they have been tremendously successful in their investment, I mean sort of tripled their investment. And it sort of -- we have to put that in that context, but anything that -- discussions that you can share with us? Or is that something that's out of purview in some ways?

Well, they are our shareholders. So they have, of course, their rules for their portfolio management. No, I think it's, no, eventually better to discuss directly with them. From what I have seen, we have full support from those shareholders. And I don't see a change in their strategy, but of course, it is better to talk to them. And again, I think it's mainly linked to their internal rules on portfolio management.

Okay. That's helpful color. Gianluca, I also wanted to ask you around OpEx levels, right? So you expressed this confidence in growth, in pricing, in margins. We saw in this quarter, obviously, it translated very strongly from an operating leverage standpoint down into EPS and incremental margins. How should we think about OpEx more on a sustained basis as you're driving this level, very strong levels of growth?

Well, in the next few quarters, I think the level will not change too much from where it is today. Very little bit of increase because we are starting traveling. That is a good news. But of course, there's some costs. So we will also restart some of the marketing activities a little bit, but nothing that will materially deviate from the $340 million, $345 million per quarter. And then now, let's see maybe in 2 quarters from now, how the situation is and if we need to update the estimate. But for the time being, I don't see a reason for a change.

And if you do have to change that estimate, Gianluca, what would you say would be the main driver of that?

It's basically just the full restart of the activity after COVID, so mainly the sales and marketing activity.

Okay. Okay. That's helpful. I know we're coming up at the end of our allotted time. So I wanted to ask you 2 more quick questions. So one, is there any color you can give us on sort of the margin structure for legacy versus mass capacity as investors try to think about the relative growth of these? Like what -- how would you say those margin structures look like?

Well, mass capacity has a little bit higher gross margin level compared to the legacy. I would say right now, they are both enjoying a little bit better pricing environment. So they are both improving. But the difference between the 2 is still there. I think it will always be there, mainly because the legacy part, that is not huge anymore, but it's declining a little bit year-over-year. So there is always a little bit of capacity available on that part of the business. The mass capacity is going into a different situation where we get much better aligned to demand. And so we expect the pricing to be eventually a little bit stronger in the mass capacity segment than in the legacy. So maybe the gap for the gross margin will open a little bit between the 2 segments. But the overall company is going towards the target that we discussed just a few months ago at the Analyst Day.

Okay. That's great. Gianluca, I think we're just about getting to be out of time here. So maybe I'll give you an opportunity to just address all the investors on the call about why you are excited and why they should be excited about investment in Seagate?

Well, I would say the most important thing to run a good business is to drive this alignment between supply-demand and to be the leader in terms of products. Right now, we are going into that direction in terms of alignment. We are the leader with our product, we will be the leader in the future with our new technology, HAMR, that we are, by the way, already selling on 20-terabyte. But at the right time, when we will have a drive with 30 terabytes or higher based on the HAMR technology, that will be another, a new major change for the industry in general. And that will bring more success to the industry and hopefully to Seagate in particular.

Well, thank you so much, Gianluca. We really appreciate you taking the time and answering all our questions today.

Thank you, Wamsi. Have a good day.

Thank you. Good luck.