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

Okay. Well, let's get started. Good morning, everyone. I'm Sidney Ho. I cover semiconductors -- semi-cap equipment and IT hardware at Deutsche Bank. The next company we have here is Seagate. So Seagate supplies hard disk drive to both the enterprise and consumer markets and is increasingly becoming a key supplier for the growth of the public cloud. So today, it's my pleasure to introduce Seagate's CFO, Gianluca Romano with us, and welcome Gianluca.

Thank you, Sidney. Before we start, we remind everyone that I will be making forward-looking statements today, and you can learn more about the risks associated with those statements on our website.

Okay. Well, I'll try to make this session as interactive as possible. So if you have questions, raise your hand and we'll run my view. But Gianluca, maybe you did put out a press release this morning lowering your guidance for the quarter. Why don't I have it -- hand it over to you to address that before we start the Q&A?

Yes. Let me give some context about that announcement. At our earnings release in July, we talked about some issues in the business in general, more macroeconomic issues, different issues in different parts of the world. And those issues are not getting better right now. Actually, in some cases, are also getting worse. They are mainly temporary issues, and I will give more specifics. So we are not absolutely not worried about the long-term trajectory of the business -- of the industry in general and of Seagate in particular. But in the short-term, we have, of course, some impact as many other companies. So starting from maybe the east part of the world on [ Asia ] and China, in particular. The business in that part of the world is very slow. We think it's mainly a result of the last wave of COVID and all the lockdowns following that wave of COVID that is actually still there. So the business is low in all the segments, in consumer, in clients, in video and image applications, in cloud. So -- but it's not a difference between one segment or the other. All the segments are fairly down. So I would say the economic growth in China and in Asia in general is lower than what everyone was expecting, including the local authorities. They are now trying to address this issue with stimulus packages. Those stimulus packages will take some time to be effective and to be really impactful to the economy, but will be an help. And now we think, at the right time, we will have a fairly good rebound in Asia and in China in particular. On the western side of the world, first of all, it's still a war going on in Ukraine. Everyone was expecting a short duration for that event and now it's actually lasting for several months and -- but no really sign of when this will end. So this has, of course, a big impact on the inflation, on consumer. And for us, in particular, I would say, was the distribution channel part of our business in Europe is highly impacted by this situation. Hopefully, it will get solved. We don't know exactly when, of course, but that will be for sure an upside, hopefully, fairly soon. And then I would say in the U.S., the inflation is impacting consumer. The level of PC demand and the shortages of electronic components is impacting clients, is also impacting a little bit our nearline and cloud demand because that shortages of components is not allowing our big customers to build data centers at the pace they were doing before and probably they would like to do it right now. So that part of the business is delayed by more supply chain issues. There is inventory in some segments, in some customers, the depletion of that inventory is taking a little bit longer because the business is overall slow. So what we were expecting as a time frame for that inventory to be in clean is actually probably a little bit longer. So it's impacting this quarter. We don't want to keep extra volume which is not needed. We don't want to make the inventory situation worse. We actually want to make it better. So we have reduced our revenue guidance but it will take a little bit longer. And then, as I said before, for the longer term, there are no changes because if you look at the applications that we require a lot of data and we'll generate a lot of data and we'll need data storage like artificial intelligence and machine learning, IoT, autonomous driving and smart cities, smart factories, are all things that will happen. Now are happening at a bit lower than what was before and what we would like to be, but they will come back, we think, fairly strongly. So again, no change in our long-term expectations for the business. Back to you.

Okay. Great. That's -- thanks for that overview. The part that really stood out is in the press release called out the weakness in how you say certain U.S. cloud customers. Just want to double click on that. You touched on this a little bit earlier. But is that a demand issue? Is that a customer just being cautious? Is that inventory? How are you seeing the trend going forward? And perhaps compare and contrast what you're seeing it wasn't cloud and talk a little bit about [indiscernible] China?

Well, when we talk about U.S. cloud, not all the customers are the same. But in general, we see a level of inventory that is higher than what we were expecting and what normally is. And this is why we don't want to ship too much into that segment during the quarter. The reason why the inventory is higher is what I said before, they cannot build new data center at the pace they were doing before because they are constraining some part of their supply chain. And that is getting better, will get better. We know some semiconductor company has invested a lot and put in place capacity. Now that capacity is becoming a real product. And so the balance between supply and demand will get better. And so those data center will be built and will be deployed and the [ hard disk ] will be consumed. The timing is a little bit lower than what we were expecting. It will take a little bit a few more months. But the trend, I think, is very clear.

Okay. And then on the enterprise OEM side, along the same line you just kind of talk about whether there's a demand thing, is this just a customer being cautious and they don't want to build too much inventory? Or what are some of the high-level?

Yes, the inventory part, I think, it's fairly common to all the company, not only to our customers but also to ourselves and maybe to our suppliers. During the COVID that lasted now for almost 3 years. When you have an opportunity to buy a little bit more of components, you did it because you want it to be safe. So the safety stock has grown almost at every company. And now is the time where that safety stock maybe is not needed anymore. So people start to consume it and reduce it a little bit. So there is this impact coming from a few years of COVID impact, that has to be consumed.

Okay. That's fair. Well, the other part of the pre-announcement is that you talk about fiscal Q1 EPS will be meaningfully below the at least $1.20. I think the range that we gave was $1.40, plus or minus 20. So it's kind of below that range. Can you help us think about what the gross margin could look like, especially given the [indiscernible] is coming from the high end -- high-margin nearline market? Should we think about the underutilization charge there? And how does the current situation impact your ability to win price?

Yes, maybe 2 different questions on the cost and on the pricing. I would say maybe let's start from the pricing, especially on the high capacity drive, pricing is fairly stable. So there's not a lot of price competition at this point that is very good for the industry in general. Maybe in a very low capacity, but it's more competition between hard disk and, not too much between non-hard disk and hard disk. But -- so maybe you can see a little bit of price reduction in low capacity drives, but the high capacity that are basically being consumed in the nearline space and mass capacity placed in general, I'd say will be fairly stable to the prior quarter. So feel good environment for the pricing in the important part of the business. Cost is what we are still really assessing. The reduction in our production level is important. Now if you think just 8 months ago, we had the business at $3.1 billion. Now we are talking about the $2.1 billion. And just a few weeks ago, we were thinking maybe $2.5 billion at that level. So we need to reduce even more our production level because we don't want to oversupply the industry. So we are still making a final estimate on what that underutilization charges will be and how impactful they will be in the current quarter and how much will be impactful to maybe next quarter. But no, EPS will be impacted. We didn't specify a range in the press release. But right now, I probably think will be probably around $0.70.

Okay. $0.70. Great. Okay. Maybe just one more question on the pre-announcement. So coming out of the earnings in mid-July, I have the impression that you expect inventory adjustments will be completed by the end of this quarter and revenue will start going up in September quarter. Given what you announced today, how does that change your projection of when the inventory adjustment to be over?

I would say we are going through that trend. We are just going through that a little bit lower than what we were expecting. So we still believe sequentially, revenue will increase probably every quarter for the next -- for the rest of the fiscal year, but the inventory will probably not be fully clean by September. So probably, we will have some inventory still a little bit elevated in some customers in some parts of the business for next quarter. And so we will keep the production down until all that is solved.

Okay. But along the same lines, you have previously indicated that revenue in fiscal '23 ending June will be flat or slightly up. Can you give us an update how you think there? And what would the revenue trajectory look like over the next few quarters?

Yes. Probably, I would not talk about revenue for the entire fiscal year. At this point, as I said before, the situation is evolving in a way that is probably lower than what we were expecting. So we could have some delay in the recovery. But in January, what we expect is a sequential improvement quarter after quarter between Q2 versus Q3 and Q4. And we still see a fairly strong second half of our fiscal year.

That's assuming inventory adjustment is done...

I think the inventory will be to be clear between this quarter and next quarter. And of course, it depends on many things. But the majority of that can be addressed through our production level. And we are reducing production. We will reduce even more in the next few weeks. And the impact, of course, will be also in next fiscal.

Okay. Maybe one more question on the near-term. Looking at the supply chain. If you look at that, what areas are you still seeing improvements? And what areas do you expect it to continue to be a problem? But maybe just to level set, how much did supply issues impact your revenue and margin in most recent quarter?

Well, supply chain -- our supply chain is fairly stable at this point. So I would say we have even less risk than what we had in the prior quarter. I cannot think any component that can materially impact our supply chain right now. This is also why we don't need to increase our own inventory anymore. So we can start to think how maybe reduce a little bit of that inventory. But if we talk to our customer, probably they will point out to semiconductor supply chain and components that are still little bit short.

Okay. Well, pause here for a second, if you have any -- the audience have any questions, raise your hand, we can run the mic over to you. Okay. Why don't we move on to some of the longer-term questions. We start off with gross margin, my favorite topic. So you reported overall gross margin around 29% last quarter, but you did say hard drive margins already in long-term range of 30%, 33%. This quarter, you'll probably take some of the underutilized charges, so that will probably be below that. But putting aside the near-term stuff to get to the top end of the range, what are some of the factors that need to play out? Does it require a certain technology or product mix? Or is it still mostly driven by volume?

Well, a little bit of both. I think volume is, of course, important. So we need to be fairly fully utilized to go at the top of the range and maybe a little bit higher than that range. So today, we are not. But if you look at our results in June or September or December last year, we were approaching that balance of supply and demand that is allowing us to improve our gross margin. So first of all, of course, a certain level of volume is important. Mix, I think, is already going in the right direction. Mass capacity, revenue depending from the quarter, is between 70% and 80% of the business. So we are approaching that 90% that we discussed a couple of years ago at our Analyst Day. So I would say the mix is moving as we were expecting. Pricing is important. So the fact that the pricing is staying fairly stable in the mass capacity space is very important. It's a very big part of our gross margin expectation. And finally, the cost side. Being able to continue to reduce that cost per terabyte as we have done in the past in the last 2 or 3 quarters has been difficult because of inflation. So we had some of our component costs that have increased. And now it looks like that is more stable if they're not increasing anymore. Some cases are even getting a little bit better. But with higher volume and with a new technology like HAMR that will significantly increase areal density without significantly increase bill of materials. That will help in reducing the cost per terabyte. So I would say everything is important, of course, the pricing, we think is already where it should be can always improve, maybe later when demand gets stronger. The mix is moving in the right direction. And the cost will help us when HAMR will go into high volume.

Okay. That's fair. Maybe on -- while we talk about HAMR, I'll get to some technology questions later on. But on capital spending, your business is not really that capital intensive. And I think you're guiding fiscal '23 to the lower part of 4% to 6% range. Sounds like that number may come even lower after today's announcement. But if you look out the next few years, is there anything specific about the HAMR technology that would require capital intensity to go up? Or is it mostly still a function of mix supply growth regardless of whether is HAMR or not?

Yes, I would say there is nothing specific to HAMR. The main reason is that in the last, at least, 2 years, our CapEx has been both based on HAMR technology. So what we have purchased in terms of equipment tools can be used for HAMR already. So it can be used for the CMR technology, but can also be used for HAMR. So we don't see a big spike in CapEx. We are looking at CapEx right now. We will reduce our CapEx in the short-term. Of course, Q1 is a result of prior commitments that we had, so it will not be particularly low in -- not in the current quarter, but you will see the next 2 or 3 quarters will be fairly low. And then again, when demand is back and more extra [indiscernible] will be needed, we probably go back to the range that we discussed, the 4% to 6%. For this fiscal year, probably will be below the 4%.

Okay. Maybe moving on to capital return. You have a stated goal to return at least 70% of free cash flow to shareholders. But looking back in the last few fiscal years, you've been close to 200%, right? And you can take out some of the debt to -- the flip side of that is share count is a lot lower. But how will you think about capital returns in the current environment. Would you consider taking on more debt to accelerate share buybacks? And how you think about maybe M&A given equity value come down? Just generally speaking, how you think about capital allocation?