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

Okay. Hi, everyone, and thank you for joining us. My name is Shannon Cross and I'm the IT hardware analyst here at Crédit Suisse. I'm now joined by the CFO of Seagate, Gianluca Romano, who's going to give us some insights into Seagate today. However, prior to getting started, I'm going to readout disclosure for you. Today's discussion may contain forward-looking statements that reflect management's current views. Actual results may differ materially from those contained in the forward-looking statements. You can learn more about the risks, uncertainties and other factors associated with these statements in Seagate's SEC filings, which are available on the Investors' section of the company's website. Additionally, management refer to non-GAAP financial measures during our discussion. This is preparing me for my career in IR. For a reconciliation to the corresponding GAAP figures, please refer to the latest supplemental information slides posted on the quarterly results section of the company's website. So with that, let's start Q&A.

So Gianluca, again, thank you for being here today.

Thank you. Thank you for inviting us.

Yes. Could you provide some color on the current macro? I mean there's obviously so much going on right now. And maybe if you can talk a bit on a segment basis or even geographic basis, however you want to frame it, what you're seeing?

Yes. No, as you said, many things are going on. However, I'll say since when we reported our earning release, there are no many changes. Basically, 3 major factors impacting the industry right now and Seagate in particular. The first one is the situation in China with COVID. The continuous lockdown in that region are really slowing down all the projects that are still ongoing, but at a much slower pace than what it was in the past. The second one that now everyone is talking about is U.S. cloud inventory, fairly high level of inventory that we are addressing since, I would say, beginning of September with another cut in our production and try to clean that extra inventory as fast as possible. It will take a few more months but it is, for sure, underway and is progressing in the right direction. The third factor that is maybe not very material to our revenue. But we think it will stay with us for maybe longer than the other 2 is the situation with consumers. So the high-level inflation, the war in Ukraine have really impacted that part of the business. And now unfortunately, we think it will last more than a quarter or 2.

Have you seen the situation in China worsen since you reported? I mean, again, we see all the news of that. But is it -- from your perspective and related to the projects that are ongoing, have things slipped?

I would say it's no worse. Right now, it's not even much better. But there are some signs of improvement, I will say, coming out from the big political convention in October, I think there is an interest from the government to support the business. And they are clearly looking at the level of the GDP for 2022 is below their expectations. Basically, as I said, they want to support economy for a better growth in 2023. So we are almost there, one more month and then we are in 2023. So we expect some support there. It looks like they are also redesigning their COVID control and how they want to address that problem, that is still a problem in the region. And hopefully, they will be able to find a solution that will allow the business to go back to where it was before COVID or even before they implemented the continuous lockdown. And that will be a major improvement for Seagate. As you know, the data storage is very important in China and in Asia, in general. Seagate is also particularly strong in that part of the world. So right now, we are suffering from the down cycle, but at the same time, we think we will get the upside when the business is coming back there.

And just one last question. Did you see when the dollar shifted in COVID to -- or sorry, in China, to COVID testing and all of that from a regional perspective, do you think that took away from what they might have been investing in other areas or is that sort of 2 different buckets of money?

Yes, I don't know if they're directly related. But what is very impactful for us is the fact that those lockdowns are happening very often, even in the same cities, in the same regions inside China. And therefore, companies have lost a little bit of the confidence even coming out from the lockdown, tourist starts the project at the same pace they had before. Now before -- even when there was a lockdown, coming out from the lockdown, they were actually trying to recover the time they lost during the lockdown. So they were actually ordering a lot of hard disk and add other data storage in order to go fast. But a few times, I guess, they were surprised from another lockdown and they ended up with inventory that they were not able to deploy in their own project. So right now, when they come back, they are more careful on how much they order and looks like they are expecting to go in lockdown again. So it's a different mindset that hopefully, going into the calendar 2023 will change and will improve.

And how much of the current downturn, not necessarily related, obviously, to China probably more almost the U.S. cloud providers, do you think is just inventory related, we had the pandemic? I remember one of your customers, CFO, telling me at one point, fairly early in the pandemic, like we're just buying everything we can get our hands on, which at the time seems like a good idea; in retrospect, was maybe not the best inventory management system, but live and learn. So I guess how much of when you think about the pressure you're seeing is literally just the enterprise OEMs, the cloud providers going -- we've got too many drives sitting on our shelves versus we don't see any demand.

Yes. It's a fairly complex situation for many reasons. The first one is, no one was expecting COVID to last 3 years and actually, it's not even over yet, but it's now 3 years. So even Seagate, as a Seagate, we were buying more of the components that were available and creating safety stock. And our customers are -- they were doing the same. But now, we were thinking to do that for 2 or 3 quarters, not for 2 or 3 years. And you end up after those 3 years with too much inventory. And so we are not, of course, blaming our customers. We are in a similar situation and we are addressing the problem in a similar situation from a Seagate standpoint, we need to bring that inventory down to where it was before COVID. Now there's a risk in the supply chain is limited compared to where it was before. We don't need that extra safety stock. So we understand why as they are in that situation. And again, we are in a similar situation. So we need to go through this period where we drive the inventory down. And that implied some reduction in our production level for a quarter or 2. And then hopefully, we go back to a more normal way of doing business.

And maybe sort of dovetailing off of that, you recently announced an 8% head count reduction. How much of that is a structural change in how you're going to do business versus a response to the current demand environment?

I think it's both. That is part of the reduction in force but unfortunately, we had to go through that is direct labor. And that, of course, somehow will come back when we ramp back the production. Another big part is actually in direct labor, where probably we will not have the need to replace. So we will keep a significant part of the saving that we've discussed at our earnings release, about $110 million on an annualized basis. I think a big part of that will stay with us, but there is a part of that actually more related to the direct labor that we will have to hire people back.

And with indirect labor, is this something that you're able to do because you're implementing back-office systems or process changes or?

Yes, it's many things. The main one, I would say, is on the R&D side. For a certain number of years now in Seagate, we had to develop 2 technology: it was the current technology, CMR and the new technology HAMR. Now we have HAMR. We actually announced our 30-terabyte product to be sold beginning of the summer, so in just a few months from now. We're probably going through another product in CMR that is a current technology. But after that, we will not need to do the 2 technology. All our products will be basically on the new HAMR technology. So we don't need basically 2 teams. We can have only the HAMR team, may it will be bigger, but just one team. So we don't need to replace that part of the R&D.

And from a -- what your competitor talks a lot about SMR and the opportunity there. Maybe can you address sort of how you see the competitive landscape right now?

Yes. So I will say the current technology is called CMR or PMR, there is a different version of a same drive. So a 22-terabyte CMR drive can be basically sold as a 26 terabyte SMR. It's basically the same structure of the drive. It -- just reduce a little bit of performance, but you increase the storage space. So it can only be used for certain application. Mainly the archived part of the data storage. We sell probably 20% of our exabytes in SMR form today. We don't talk too much because, first of all, it's not the majority of the volume. And it's basically the same drive of the CMR. So also to avoid a little bit of the confusion is basically the same drive that can be reducing performance, increase in capacity.

Is it effectively like a software layer or a firmware layer that's sits on top?

It's -- and I'm not an engineer, but it's some tweaks -- it's basically a shingle magnetic record. So it's a little bit different. But the result is the read and write performance is not the same. So it cannot be used for the majority of the application where the hard disk is used to be. So it's important for us is the next technology. So the HAMR drive that we are going to sell in just a few months. That is a big change for many reasons: The first one is, today, a 20-terabyte CMR is based on 10 disks and 20 heads. When we are going to sell the 30 terabytes in just a few months, we'll also be 10 disks and 20 heads. Of course, there is a laser. Some of the components are not exactly the same. So that is a little bit higher cost per unit. But you have 50% more terabytes. So the cost per terabyte starts to decline. More importantly, when you go from 30 to 36 and then 36 to 40, those drives are still based on 10 disks and 20 heads. So it's exactly the same below material of the 30 terabytes, but you increase the capacity, because the capacity increase is all coming from areal density. It's not coming from more bill of material. The CMR was basically growing through bill of material going from 1 disk and 2 heads up to 10 disks and 20 heads. HAMR will not need to increase in below material. It's all increased through areal density. So this is where you generate the majority of the cost reduction.

How much of a CapEx investment is required to move?

Well, finally, I would say 2 things. The first one is we are already buying equipment that are tangible for HAMR since at least a couple of years. So we have already spent a big part of the CapEx for HAMR that we are actually using for CMR today. And then depending on how much volume we will ramp. And it will be fairly big volume. But the fourth product, 30 terabyte, of course, we need to learn how to run that in high-volume manufacturing and see how the yield will be at that point. So we could take a little bit of time to ramp the fourth product. And then when we go in the second part of the life of this product or when we move to the 36 terabyte is when we really go in high volume. So we have time also to take care of the CapEx. This year, so fiscal '23, we said we will be below our normal range of 4% to 6%. I think next year, based on the ramp, we will be in that range. We can be in the middle of the range, maybe for a year or 2. Once we fully prepare the ramp of HAMR, we don't expect to go out of that range.

At what point do you think HAMR will constitute the vast majority of your shipments? Is that more of a '24-'25?

Well, there are many opportunities for HAMR. So right now, the fourth part of the ramp will go to certain cloud service providers. Of course, we have identified some of those that will take the majority of the volume. The volume as I said before, in the first quarter or 2 will not be huge. So they will be the only one getting HAMR. But HAMR can be used for many different capacities. So if you think 40 terabyte HAMR, we'll have 10 disks and 20 heads. That means you can have a 20-terabyte HAMR with 5 disks. So that is a major change compared to what is today, a major change. So today's 10 disks to more we could have 5 disks.

How does that roll through from a gross margin perspective and change the potential gross margin for Seagate?

Well, we think long-term basis, the major opportunities we have to improve the gross margin for the hard risk is going through a strong cost reduction per terabyte and of course, keeping a good part of the cost reduction in Seagate to improve our margin. Of course, we will give some of that to our customers, so they are incentivized to adopt our new drives. But again, because of the competitive landscape, because of the major reduction we expect in terms of cost per terabyte, we need to keep some in Seagate and first of all, going back immediately to where we were just a few quarters ago in terms of gross margin and then, of course, having the opportunity to go above that level.

And how do you think about the pricing? I mean you talked about it a little bit where you'll have to give your customers some price benefit. But do you think that the landscape has settled down enough from an oligopoly and it's a bad word to use, anyway, not that there's any price collusion. But just in general, do you think all the actors are acting much more rationally and maybe this painful downturn that we've gone through will cause people to want to keep margin for a longer period of time?

Yes. I think it's a little bit different industry. First of all, as you said, a lot of consolidation in the past. There are now 3 players in the high capacity drives, I would say, there are only 2 players. I would say there's a focus for sure for Seagate. But I would say, in general, for the industry, it seems to be more on keeping a certain level of profitability instead of fighting for the last 2% or 3% of market share. But that doesn't really make sense at this point. Of course, now, in the near term, there's a down cycle. So of course, customers have some power. But in general, what is important is where the suppliers, the RD suppliers want to be in the longer term. And I think the industry is going in the right direction. Then HAMR should be a good competitive advantage for us because we think we have a little bit of time advantage there. And therefore, we could have the opportunity to keep a little bit more of that cost reduction in Seagate now more than what usually happened with the CMR technology, where the 2 companies are fairly well aligned.

When you do your long-term financial sort of strategic planning like for your crystal ball, how do you think about where data lies over the next like 5 to 10 years? Are you more on the hybrid cloud, where there's going to be on-prem, there'll be a data center. And it doesn't have to sit on-prem; it could be in a data center somewhere, but it basically a private cloud concept and a public cloud concept or are you more thinking that most of the data capacity will shift to public?

Well, we think finally, all those application will actually increase. So it can be a private cloud, a public cloud, a multi-cloud, hybrid cloud. The reality is the world will continue to create more and more data. Because of the important new applications like artificial intelligence and machine learning, smart cities, manufactories, autonomous driving. All those things are now just as a beginning. In the next few years, you will really see the data that those applications will generate. And when you have a lot of data, you need a lot of data storage. So finally, for us, it's not really different, if the data store in a cloud or on-prem or a multi-cloud. The important is that there is a demand for data storage. And we have very good partnership with all customers, enterprise OEM or cloud customers or building image applications, everywhere. So for us, it's not so important where the data finally will be stored. The important is those applications will generate a lot of data.

Makes sense. And maybe moving to the balance sheet. How are you thinking about cash flow, capital allocation? You recently completed a debt exchange and covenant renegotiations. So -- and how are you flexing the model to make sure that you don't bust through covenants that the new ones in that if this is a more prolonged downturn?

Yes. Well, because it's a down cycle, we need to manage the short term. We are not changing our long-term strategy. So our long-term strategy is based on a very strong shareholder return, based on dividends, dividends increase, based on share buyback. So long-term base is what we want to do. Short term, we need to manage a little bit the situation, so of course, we keep our dividends. But we have put our share buyback on hold and we are taking care of the debt. So we have done with the transaction that we finalized just yesterday, so reducing a little bit our debt on the balance sheet. We have more notes that will expire in June, but we probably will not refinance. So we'll just buy them back and reduce our debt even further. And then we see depending where we are in April-May, we can decide to do something, maybe a little bit different, but as important is to keep everything in balance.

And how -- like how far do you think you have or how much knowledge you have of your customers' inventory levels? And I'm just thinking of the guy I talked to who said, we're buying everything. And then when I went to launch at Credit Suisse, one of the reasons I was more hesitant on some of the component names was just every OEM I talked to is like we're getting our cash next year off the balance sheet. And I'm like, okay, well, that means not going to be buying anything. So I guess, how -- maybe how do you have insight into what they're doing? And then also maybe how have you changed the way that you track everything, given what's going on in the pandemic?

Well, I would say, until probably June, those customers where we have LTAs, they were buying the volume in LTAs and actually more. And so they were, of course, respecting the LTAs, but even upside in the LTAs every quarter. Then when we went into the -- sorry, September quarter, they basically bought only the LTA. So we start to see some signal that they needed it a little bit less than usual. And then when we went into the renegotiation of the LTAs, they basically told us we have enough inventory, we have built some inventory in the last several quarters. But now we feel comfortable we don't need anymore. And therefore, we had this discussion on how much inventory and that basically drove our decision to reduce manufacturing. So we started in August. We reduced even more beginning of September when we start discussing the next LTAs. And we kept that level very, very low for October-November, even the beginning of December will be low. And then usually in the first couple of weeks of December is when we talk to those customers again and see what is their view for the March quarter, possibly even in the June quarter and see when it's the right time for us to re-ramp production.

So -- and when you think about the improvement, if assuming like December is the bottom, are you thinking you kind of bounce along a little bit? Or is there more of like a slope upward, I guess just trying to understand the trajectory you're expecting?

I think for us, as I said before, the #1 factor is actually Asia and China in particular. So we need to see when that part of the world can go back to a more normal way of doing business. I think we can manage better the inventory situation because, of course, reducing our own production. That means our customers will have to use their inventory, so that, I think will get solved in the next few months. But China is a big unknown. We all think, as I said before, and we all hope that maybe February, beginning of March is a time where things will start to change. And then there should be a progression through the rest of the calendar year.

Yes. No, it's -- hopefully. I don't know. It doesn't look good over there these days, unfortunately, but maybe they'll figure it out. I guess just from a -- maybe we can end on a more optimistic note. Like how do you see Seagate in its position over the next several years? I mean, are you looking for share gains? Do you think that more importantly, it's just the market will expand and everybody will benefit? And then also, how do you sort of balance the growth that you're going to have with where you're at in OpEx so that perhaps operating margin -- potential operating margin once you get to HAMR is significantly better than maybe the potential one was 5 years ago?

Yes. I would say the TAM will improve a lot. As I said before, all those applications we generate a lot of data and therefore, the need for data storage. That is the driver of the industry. So we are sure that TAM will grow, we are very confident. And therefore, the industry in general, will benefit from that. We don't really go for market share. We just look at our demand and how to serve that demand and as I said before, how we can get some better profit from that business, of course. So we will -- I think the industry in general will benefit. And it's not just 1 or 2 years driver, it's actually a multiyear driver. Data, the world will need more and more data for all those -- the things we discussed before. And -- but there's no better way to store your data than in hard disk. 90% of the data is actually in a cloud, is actually stored on hard disk. HAMR will just be a further improvement for us, for the industry and for the customers because it's actually a more economical way to store data. And of course no other applications, are not used to store data are using different ways in the cloud. And by the way, they are way more expensive than the hard disk.

Just one final question. What milestones should we watch for with HAMR in terms -- to gauge that you're on the track, you're on -- the time line's working in line with your expectations?

I would say 2 things are very important. The first one is the 30-terabyte time, we said beginning of the summer, of course, we want to deliver. And that is basically the first HAMR product that will be sold in the industry. So that is milestone #1. Milestone #2 will be the second product in HAMR, so 36 terabyte with the same bill of material of the first one. That will be a demonstration that HAMR can grow without increasing bill of material. And that is my opinion, a major benefit of this new technology.

And how many months, quarters do you think it -- I mean I don't want any specifics?

Yes, we didn't announce that -- we are still working on the first one. But no, usually on CMR, our time for products is between 12 and 18 months. So assuming it is a similar timing, it will be around 1 year or 1.5 year.

Okay, great. Well, thank you so much for your time, and thank you, everyone, for joining. And we look forward to seeing HAMR as it progresses.

Absolutely. Thank you very much for inviting us.