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

Good morning, everyone. I'm Katy Huberty, IT hardware analyst and Director of North America Research at Morgan Stanley. And it's my absolute pleasure to welcome Dave Mosley, CEO of Seagate. Dave has been instrumental in leading the investment in growth markets like cloud and edge. And that has driven both secular growth and improving profitability at Seagate. So very much look forward to the discussion. Just before we begin, please see Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to Morgan Stanley sales reps. So Dave, thank you so much for joining us.

Thanks for having me.

So just to start the discussion, and I referenced this in the intro, I think one of the most underappreciated elements of the Seagate business is that it is becoming less cyclical because you've invested in growth markets like cloud. Just talk about where does the mix of the business stand today? And what does that translate to in terms of sustainable long-term growth?

Yes. cyclicality is a good way to think about it. Before I even start, I'll be making forward-looking statements, and all the risk factors are in our SEC filings on our website. So just keep that in mind. Was 2 years ago at this conference when COVID started, and everybody was wondering what was going to happen. And we were just chatting about that backstage. At the time, we saw kind of a classic response. We saw demand pull in, and then the reality of the demand situation for our customers came through. And so calendar year '20 was dramatically impacted by demand downswing. And then calendar year '21 for us was great. And the reason was because we saw massive adoption of mass capacity data solutions. So it's just a big swing. So I don't know that cyclicality really even applied during COVID because the locality of the data was changing and so on. We had 18% revenue growth, '21 over '20. Our free cash flow was up 40%. So just like a lot of other hardware-intensive businesses, we were managing for free cash flow at the time of the pandemic, and we did pretty well on that front. As we entered 2022, we talked 6 months ago about how this quarter would be a little bit slow, but the cloud just keeps coming. Mass capacity solutions just keep coming. We still really see that there's some tactical issues that we're going through this quarter. So I don't know that it's cyclicality in the mass capacity markets but VIA in particular, is pretty disruptive. And some of that was -- it's always kind of opaque, seen through certain parts of the Chinese New Year and what those investments are. So we, in our guidance ranges, we're still good for the ranges, but we do think we're going to be at the lower end of the ranges, just to be completely transparent. The market is turning back on, though, in China, and that's good. There are some other things going on in the world, which I'm sure you'll ask about. But I don't think that -- I think the linearity's poor this quarter like it usually is in a Q3 for us. But I don't think it's the same kind of cyclicality or seasonality, if you will, that we saw back in the PC days because it's not really coupled to PC. We do think that things are coming back. So whatever we're going through right now is very transitory. And we'll get back on the mass capacity horse here pretty soon. So all the guidance that we gave for fiscal year revenue growth and calendar year revenue growth still holds. Like I said, there's things going on in the world that we're watching very carefully right now and trying to react to it. The typical cyclicality that we had seen 2 or 3 years ago, driven by some of the legacy markets has gone. The mass capacity markets are much, much stronger because of how everything's happened. And so that's the way I'd answer it. Right now, we see pretty substantial exabyte growth for the next few calendar years, at least.

And just a follow-up on the quarter tracking to the low end of the ranges, it sounds like that's driven by VIA largely and disruption in...

I would say VIA in China, just things turning back on after Chinese New Year. Like I said, the linearity was kind of poor early in January. That's not atypical for a Q3, but just the world waking back up was a little slow. And we've still got a few weeks to go in the quarter so that we get to go react to it. There are other things going on in the world, of course, and we're watching those as well.

And so when you think about calendar '22, and as you said, no change to the 3% to 6% revenue growth for the year. Does it change the arc -- what you're seeing right now, does it change the arc of the year bleeding into 2Q? Or is it really isolated mostly to the first quarter?

It's fairly isolated. Not yet. What I would say is that we keep waiting for some of these smart city edge applications to turn on. While there are demands for other -- for money elsewhere, whether it's due to COVID or whatever other dislocations are going on in the market, I think some of those investments are put off. It's -- at some point, the cloud, even though it's growing very strong, it's not going to be able to hold all the data of the world. And you're going to have to deploy into edges, whether it's a metro or in local instances. And we think the exabyte growth is going to come there. It's been a little muted though. It's typically seasonally muted as governments would make investments in Q1 and Q2 and not so much in Q3 and Q4. That's changed a little over time, but it's -- I think there's some pent-up demand for edge, smart city, smart hospital, smart factory applications right now just because of everything that's going on.

And you mentioned there's a lot going on in the world. Certainly, the Russia-Ukraine situation is something that everyone is monitoring. Is there any noticeable impact in the business that you can tie to that dynamic as it relates to supply chain disruption or demand?

Sure. Almost from the instant that the things started, we stopped shipping. We're on ship hold mainly because of credit checks around the world, just new credit risk everywhere. And I'm not just talking about Russia. I'm talking about all of Eastern Europe. The distributors are managing their business in a really smart way. And with currency fluctuations being what they are, then everybody is reacting that way. So we -- I don't actually see that changing very much over time. And then, of course, there's a new -- a lot of new rules and regs coming in that we'll have to give those to the distributors as time marches on. So I do think there's going to be some demand dislocation for quite some time. Obviously, our focus has always been -- I talked about this a lot last week. People -- the people in the region that are affected, making sure everybody is as safe as possible. Long term demand, I don't really care about that. Russia itself and even Eastern Europe is a couple of percent of our revenue type of fleet.

Low single digits.

Yes. So there is some impact, but I don't think it's anything that the business can't handle. I do think that as I think longer term, we have to get the people stable, and then they can start working the issues. And right now, it's not been great. Watching -- everybody is dislocated. Some families are broken apart. We have to help people get back together. Or since they're in places they don't live, they need support and things like that. That's employees, that's contractors that have served us for a long time, that's where all of our focus has been.

Absolutely. So if we take a step back from some of the near-term dislocations you're seeing in the business, mentioned that you had guided to revenue growth in calendar '22 of 3% to 6%, which is in line with your long-term model, but pretty impressive given the 18% comp from last year. Talk about what drove the confidence that you can continue to grow as you annualize a really strong 2021.

A couple of things. First off, we -- 2 years ago, as you well know, we transitioned to a mass capacity platform that was highly leverageable. And we've been basically turning the crank on that ever since, so 16 terabyte and 18 terabyte. Now as we refresh at 20, it's even some of the people who are still on 16s are wanting to move to 20. Some people are using it with SMR variants at 22. So there's enough of a compelling value proposition that we're getting good long-term visibility with our customers. We're driving that transition as hard as we can. I think the transition may actually even happen faster than the 16s did. And that's the thing that gives us a lot of confidence on that high end. We are also refreshing some of our lower capacity products for the nearline markets and some of the VIA markets as well to more cost-optimized platforms. And that -- we think that will swing our ability to service certain price points a little bit better and swing the market a little higher next bit. Again, smart cities, some of those smart applications need to start growing. But I'm confident they will at some point. The world will stabilize.

And one of the reasons that you have pretty good visibility in the nearline business is that you have seen more long-term agreements with your customers. Talk about the characteristics of those agreements. What's the average length of visibility that you have? How many customers sign up for these agreements? And is it typically volume or price driven or both?

Yes, it is really about predictability on volume and price. And its predictability for ourselves because our lead times are quite long. Wafer lead times for some of those products are 6 months. So you need some kind of visibility as to what you're starting and where it's ultimately going to go. Funny, the customers, generally speaking, like the visibility as well. They're living in a world where supply can be very volatile, where pricing can be volatile for certain components. So if you could stabilize the investment you're making in hard drives and so cost takedown or especially better TCO proposition either transitioning to new products, that's a great thing for you as well as I think that's driving on both sides predictability discussions. Freight and logistics has been such a big impact through COVID. That's probably the biggest cost rise that we've seen. It's actually continuing because of some of the disruptions that we see in Russia and with the situation in Eastern Europe. Price of oil keeps going up, it has massive impact. We don't look immediately to pass that along to our customers. We try to work it together, but then they have to get things on the boat. And so it drives more of a need for LTAs. You want to be predictable. You want to give your customers optionality to lower their costs as much as they can. And it's been great for us. I mean it's the right way to run our business, I think, given the lead time and investments that we have to make.

How should investors think about nearline demand, and particularly, cloud demand in the U.S. versus China? You talked a little bit about VIA in China, but what are you seeing in the two different markets on the cloud side?

I think there's still strong exabyte demand amongst the U.S. hyperscalers. Some of their application space is changing a little bit. But I think the big data in their portfolio really cements their value proposition. They have so many other rich applications that can be built upon that. So we think the 30% to 35% numbers that we've given before are still very valid. Globally, typically, in the past, some people would be using lower capacity drives. And that was because of architectural transitions, maybe it was chipsets or maybe it was software. I think that has abated over time. And now you see people in Asia, people in Europe ramping 18 terabytes and 20 terabytes just as fast as any of the major U.S. cloud service providers. So that makes it a little bit better for our portfolio because we have less complexity than in our factories, and we know what to start. And we'll have more optionality for all customers if they have to change their demand upside or downside, we only have one thing going through the factory, which makes it more efficient for us.

A really important element of your business is providing that aerial density to the big cloud customers. You mentioned a very fast transition to 20 terabytes. Just talk about how that product is tracking relative to the competition. And when do you see 20-terabyte becoming the mainstream capacity point?

Yes, I don't really know very much about how the competition is doing on it. I mean I think there's a competitive nature at 16s and 18s relative to 20s. For us, it's a fairly easy pivot off of our 18. So the heads and media are already in high-volume production for us. So we're very confident in the transition. I think as far as mainstream capacity point, we're still a couple of quarters away because the demand for 18s is still fairly strong, but the ramp for 20 is really high. I doubt that anybody else is going through that. But I also think that everyone is living in the same world today, which is the customers want predictability from you. They don't want you to speculatively do things and then not be there for them at a time later. So I think at least our customers are managing us that way. They say this is what exactly I need from you and that's helping us with visibility on what to start in our factories. We are at the top of this technology transition, like you talked about with 20 terabytes. And maybe we can squeeze another terabyte out here or there, but I don't think that's really relevant. What we've been working on better part of the last decade is how do we get the big jumps, 30 terabytes if you will. It's looking great in the labs. We've been saying that for about the last 6 months. It continues to make good progress. We call that heat-assisted magnetic recording. It's a change to a lot of parts of subsystem. But when it comes to the drive loads, basically plug-and-play drive, it's just a higher capacity point. So we're working with customers on that because some of the customers have samples right now. They're going through all the learnings that they're going to have to do, not just because it's a new technology inside, but also because this drive is bigger and will behave differently. So you have to make sure you adopt that into your software and your application stack and everything else. It's a great transition that we're really looking forward to and we're going to push it as hard as we can.

How does the early performance of the 20-terabyte HAMR in the labs and the customer feedback inform your view around when you think HAMR starts to scale at a production level?

I think we still see -- and this you can see it going from 18 terabytes to 20 terabytes on normal PMR. I mean the customers are still seeing a significant value proposition by -- even though it's only 2 terabytes, it seems like a little bit. Some customers will say, I'll just be patient and maybe ride through and wait for a bigger jump. But some other customers are saying that's such a good TCO proposition as I transition my data center. For the next 5 years that I'm going to be running, it requires less ancillary hardware, which is hard to get right now, less networking capability, less of all the other parts that I'm going to actually even go for 2 terabytes. So I think when we start offering 10 terabyte jumps, I think that's a very compelling transition for us. And of course, the high capacity point gets a lot of the press. But the reality is if you're running factories, it's about your ability to what we call deep op. So go to lower capacity points for a better value proposition as well. So those customers that aren't buying the highest capacity point can now be buying a lower capacity point with fewer internal complements from us, and we can work the margins and hit better price points for them and things like that. So that's where it gets really compelling.

Right. And your HAMR road map is fairly unique relative to the industry. So how are you thinking about longer term over many years, is there a market share opportunity? Is there a margin expansion opportunity as you move towards HAMR?

Yes. I wouldn't want to get too far ahead of ourselves because it's a very competitive industry, and there's a lot of smart people with great ideas all the time. We've invested a lot in HAMR, and it really -- fundamentally, it comes down to your changing the material set on the disk and then you have to be able to write that disk with a new technology assist. That is not easy to do. And so it's not something that you can just look at our solution and copy it. It does not work that way at all. So I do think that, that's going to be a bit unique. I do think also people are going to have to make the same kinds of investments. No, we're -- maybe I read too much into your question, but the way I think about it is, okay, I've got a fab that's pretty full right now. If I want to transition to this new technology, I have to get the yields up and the reliability to the point where it's predictable and everything else. And if there's more process content going through that and I lose a little bit of capacity, which is painful, and so how much capacity do you add for this, it's the same kind of thing anybody running wafer fabs has to ask. We have to do it in our wafer fabs per recording heads. We don't have to do it for media. So it's a balancing act between all of these things. But we will make the transition very aggressively because we think it provides such a great value proposition. And I do think, as we do that, there's opportunities for us.

And what does the medium term look like on the common platform? You said maybe you could eke out another terabyte or so. But does that mean would you have to add another disk to get to 22 or 24 on the common platform, and that's when you have to be thinking about going to HAMR?

Well, we could. Adding a disk is disruptive. You have to change tooling and things like that. From my perspective, it's not about how many disks you have, it's how those heads and disks are running in your factories because they're such long lead time. So if you wanted to change aerial density by just making a tweak to the head -- the recording head, it may take you 6 months to actually get that part through. And then it's not common with anything else, and it's not -- you can't put it in a different market segment. So I think the number of heads and disks gets way too much airplay, frankly. It's more how you're running your factories are you running your factories efficiently. And that's the way to -- if you get your yields up and your scrap down on all the stuff that's running through, that's the way to do it. Which makes the barrier to entry to any new technology, whether it's a 22 or 24 on PMR, means you have to hit those high yields. Or HAMR, if you get to 25 or 30 terabytes on HAMR, you have to hit those high yields and those great qualities to make that repositioning of your fabs make sense.

One of the new growth drivers you talked about at the Analyst Day last year was live, which is the edge to cloud mass storage platform. This is a longer-term strategy, talk about how that's developed since 2021? And how are you thinking about the timing of when it will have significant financial impact to the business?

Right. To explain it, I kind of have to go back. So you'll have to pardon me a little bit. But I remember when we first started talking about making USB-attached drives and selling them retail outlets and people thought we were crazy. And I think that's been a compelling value proposition for people over time, just simple storage. It's efficient. You're not paying for a lot of bells and whistles. It's yours, you can unplug it whenever you want. It's very secure in that way. And our consumer business continues to be quite good. It's -- especially in like gaming and some of the cool segments around right now. It's doing quite well. So I'm really proud of the team. We want to take that same value proposition to the way people want to buy storage 10 years from now, which is online, if you will, right? So it's more of a cloud-based solution. So we're not really trying to build application stacks like a lot of other people would in their clouds. We're just trying to provide simple storage. And the -- it's not a threat to anyone, I think. It's something that people can use temporarily. Permanently, if they want to, but temporarily. And then when the data finds its way to its final resting point, there's maybe more data to be aggregated. So I think that value proposition is really resonating with people. We've got work to do to let people know about it, to make sure it's appropriate in many different kinds of application spaces. And then geographically as well, we just -- I was in Asia last week and we launched the Live Cloud in Asia. So we've got to get those instances at those metro edges that makes sense as well. But we're building data center installs right now with our partner, Equinix. We've been pretty transparent about that. And it's going pretty well. And it also affords a lot of great conversations with people about how they want to consume storage in the future. And I do think 10 years from now, the world is going to be very different than what we're accustomed to. I don't think it's going to be as much local devices anymore as it will be -- my data needs to be protected, but it's out there somewhere.

I mentioned in the beginning, as you've invested in these markets where there's really insatiable demand for data storage like cloud, the margins have also been moving higher. And you recently increased your operating margin target to 18% to 22%. That was up from 15% to 20%, which was up from 13% to 16%. And so you've seen a really nice trajectory alongside these bets that you've made in the business. Just talk about what are the underlying key drivers of the margin improvement?

Yes. I think there's a couple of things going on, and we always have to keep in mind that these are our long-term targets. So it's what kind of investments are we making and what kind of returns do we expect that are out there given market size and the demand for storage and the various aspects that we'll actually serve. So the operating margin -- we lead with operating margin then because that's the bottom line, if you will. There are a lot of other dynamics as well. The gross margins are probably most driven by the fact that the internal components of a drive now are much richer on the stuff that we actually do, heads and media. Back in the old days, when we built a supply chain -- this is only 10 years ago, but we built a supply chain for notebook drives, where there's 1 disk and 2 heads. And you had to get it cheap, cheap, cheap, so everybody could get on the Internet. It's only 10 years ago. We've dramatically pivoted over now to the point where most of our drives have -- well, the average drive has 4 disks and some have many, many more than that, 9 or 10. So to the extent that all those constituents of the bill materials are under our control, it stabilizes gross margins against those expectations. And then we can also leverage since there's a lot fewer platforms. We don't have mission-critical 10K and 15K in notebook and desktop and DVR and all these segments that we once had, we can stabilize against just a few mass capacity SKUs and get a lot bigger bang for our buck on our R&D. Our development teams don't have as many different variants that they have to solution. So that helps our model as well.

One of the benefits over the last year is that supply-demand has been imbalanced. And if anything, in some cases, supply has been tight and not allowed for a smaller price per exabyte decline than you've seen in the past. Is that a dynamic that you think is structural and can continue? Or as demand normalizes, you would expect a return to the more normal level of price declines?

It's a tough equation. I sure hope that we can keep supply and demand somewhat in balance. There are shocks that happen, and we've seen a number of them over the last decade. The COVID shock of 2 years ago was a great exemplar of all of a sudden, demand just falls out from under. And you still have to pay all the people in the factories and the supply chain because they have to be there for you the next day, and the next day, and the next day. So you want to try to keep this as balanced as possible. You don't want to overinvest and then have that kind of whipsaw. I think to the extent that it's all mass capacity now, that helps us a lot run this. As I look out over time, there will continue to be shocks. We just have to make sure that we control ourselves during that time. If I've learned one lesson, it's don't overbuild. And so sometimes -- and this has punished me a couple of times. But if you pull back when you see one of these demand swings coming, you know that you're going to be building the right things for the customers on the other side of it versus just trying to move a bunch of stuff that you built. That's always dilutive. So having too much capacity can create situations where you try to run things a little too hot and then you end up in that -- you're over exaggerating some of those -- some of that cyclicality.

Sure. Now on your last earnings call, you talked about an expectation that the March quarter would represent a trough in gross margins for the year. based on some of the dislocations and you talked about freight and logistics, should we think about that trough as maybe lower than you thought a month ago? And do you still view the March quarter as the trough and June should start to improve?

Yes, it's a little too early to tell, but we are watching the price of oil and because freight and logistics has been the biggest impact. We talked about COVID costs and factory shutting down and having to get people back to work and safety measures and things like that. Those have costs, but they're not nearly as big as the freight logistics cost. Even airplanes not flying, ocean lines being choked full of product. That's been the thing that's been the biggest impact. Do I think that the current environment is maybe more uncertain? Maybe a little bit, but I think it's too early to tell, really. We do think that the world is going to get back to a somewhat normal pattern again with freight and logistics. So at some point, those costs should come down. But again, just as a proxy for the whole discussion, look at the price of oil and then we'll have to figure out what we do about that. Again, we want to work with our customers so that we share that -- we balance that load a little bit. And they do, too, I think, because they're not only being impacted by our product. They're experts at supply chains, and they see it everywhere.

And naturally, management teams forecast their business. And so you and others have been calling when is there some normalization in the supply chain? Is it fair to say that right now, visibility isn't great in terms of the timing of that, just given the dynamics around logistics and oil?

Yes, I would have thought it was improving actually. We got through Christmas and Chinese New Year and the normal kind of seasonal events. And I do think the world is opening up, at least, from my observation a little bit more. So I do think things will abate. Current circumstances that are -- the current events notwithstanding, because I don't know that anybody can really forecast that. But I anticipate that all things being equal, the back half of this year there's going to be more freight and logistics lanes open. There will be more customer demand. There's more opportunities for us.

So just to wrap up, as you think about calendar year '22, the near term, the current quarter set aside, just looking at the full year, what are the one or two biggest upside risks to your financial forecast, what are the one or two biggest downside risks?

Yes. Obviously, the cloud controls a lot because it's all mass capacity right now. I would say the VIA markets and some of the smart city applications, if this came back very quickly, that would be an upside risk. We've been disappointed in this by -- for a couple of quarters now on smart city applications growing. So we've judged things down a little bit. But in the downside risks, we see them every day in the news. So we'll just have to manage that the way we have any kinds of demand contractions like we have in the last 10 years. I still think the fundamental growth vector that's causing us to be excited is data. And in some cases, that data is being exposed as people aren't stacking as much software and things like that, that's complicated on top of the data. And rather, what the models are doing is to say, I need more data to process and draw inferences from. So that provides more opportunity for us. I actually think that of all the data growth in the last 10 years, a lot of data was just being thrown away or stuck in a repository where it couldn't be accessed. I think people are looking at data now and saying, no, those are the problems that I want to solve. And a lot of times, that comes back to our products. So we continue to foresee great exabyte growth. We're really optimistic about it. All the discussions we have with customers that are on along these lines. And so demand gyrations notwithstanding, I think that we're entering a decade or more of growth of data that's going to be good for us. We keep our heads down, keep working on our technology.

Yes. We hear that from companies in every industry that, from the C-suite down, the focus is on how do we get more data, store more data and then really get the value out of it. So that's a great place to end. Thank you so much for joining us.

Thanks, Katy.

Thank you, everyone.