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

Welcome back to the Barclays Tech Conference. I'm Tom O'Malley, U.S. semiconductors and semi-cap equipment analyst. Lucky enough to have Seagate here, Gianluca Romano, CFO. Thank you so much for being here.

Thank you, Tom.

It feels like it's been a blur going into this correction and then coming out of it. And I think that most companies that are here today would say that they're near the bottom, if not at the bottom and improving. So I want to start off broadly and just ask about your expectations for the nearline recovery versus the last time we spoke at earnings. And what are you seeing in terms of customer inventories and order patterns? The whole shebang.

Okay. Before we start, let me remind everyone that I will be making forward-looking statements today and you can learn more about the risk associated with those statements on our website. Yes. So I think now we have a similar view. I would say at our last earnings release, and now even more recently, we have talked about the bottom that we possibly achieved in the September quarter. So we are now coming up from the lower part of the down cycle. We have seen improvement in different parts of the business. In last quarter, when mass capacity was already starting to improve sequentially, the majority of the benefit was coming from video and image application. This quarter, we see a better recovery from the cloud. And it's not only U.S. cloud, I would say it's U.S. cloud and China cloud. So in both more major regions, that part of the business finally start to recover. We recently discussed about our view for the quarter, we see the revenue coming as we guided at the midpoint of our guidance. We are also been fairly successful with our pricing increase as we recently discussed. And now we are a little bit more volume coming out in the next quarters. So we have a possibly lower amortization charges in the current quarter, so profitability could be a little bit better than what we guided at our last earnings release. So good news, of course, coming out from of the bottom of the cycle. So still not huge revenue, but at least some sequential improvement. And we also discussed about future quarters where we see continuous improvement on the top line. Despite the March quarter, we'll have some low seasonality impact on the legacy part of the business and possibly on video and image application, but we see nearline, so both cloud and enterprise OEMs, to more than offset that seasonality. So we expect another growth in the next quarter and even further.

Just wanted to dive a little bit into the comments on nearline. You're seeing it from U.S. cloud guys and others. When you look at that business, is a vast majority of nearline today at these lower levels than U.S. cloud guys? Or can you just give me a feel for that mix of business just because I know historically they've been the bigger customers for you, but at these lower levels I would just like to understand the makeup a little bit better.

Yes. Every quarter is a bit different. But I'd say before going into the down cycle, cloud and non-cloud inside the nearline space were very similar. With a little -- most of the time is now very close to 50-50, but then some quarter represent 55-45 or even a little bit higher. But it depends on the quarter, it's always been fairly similar. Then the downside are different dynamics, our enterprise OEM actually corrected earlier than cloud but then also started to recover earlier than cloud. Now cloud is recovering. So I would say we still be in that range 50%, 55% or maybe 60% of cloud. But in future, you will see cloud being higher percentage. In the longer term, when you look 3 to 5 years, we're saying cloud growth will be higher than enterprise OEM. Enterprise OEM will still be a good growth but cloud will be higher. And the other segment that will continue to grow positively similarly to the enterprise OEM is video and image application. So you will have those 3 subsegments growing. And the rest of the legacy business that actually will continue to positively decline year after year.

Yes. Breaking that down just a little bit further, could we talk about areas that you're seeing a more accelerated recovery? Because I know you kind of laid out those moving parts with those businesses before. But where are you signs of strength a little bit quicker than you would have originally anticipated?

In the short term is cloud, now we have this recovery. Now we were expecting, of course, a correction after the inventory utilization, but this may be coming a little bit earlier and a bit bigger than what we were expecting now a few months ago. Again, it's not a big jump in revenue that we have guided, but it's a good starting point for the upside. And as I said, we expect more in the next few quarters. And as I said, it's not only U.S. cloud. Even with U.S. cloud, it's probably 70% of the cloud business. But even in China, now we're seeing some good sign of recovery.

You mentioned earlier that you were having success with some of the pricing discussions that you have with customers. To me, going to a cloud guy with any sort of pricing discussion seems very scary. So how can you have those conversations and walk away with a better result?

Well, I would say, first of all, they have an interest in having a good supply chain. And they understand that right now, when you look at -- through that bottom of the cycle, the [ R-Disk ] industry now has not been in a good shape in terms of profitability. I would say Seagate in particular was at least generating good free cash flow while the rest of the industry were not only being in a net loss position but also consuming high level of cash. So that is not something that can be sustained for a long period of time and could put their own business at a certain point at risk. So starting from that situation, of course, they are more -- they understand better why the industry is going a certain direction. And second, the industry very consolidated, especially when you go into the high-capacity products, there are only now a couple of suppliers. So -- and now we have the same -- I think we have the same focus on improving profitability and improving cash flow because we have to, and because we have to support our own supply chain. We don't want that something will happen to our supply chain and the create a problem to us first and to our customers later. So I think, as you said, it's never easy to negotiate an increase in price, especially when you are still not through the bottom of the down cycle and now start to recovering but it's still early in the recover. So it's not easy, but I would say not only with the cloud, but everywhere in our business we're increasing pricing. No, we don't have crazy increasing. Now we do it a few points every quarter, but fairly consistently since already 2 or 3 quarters, so it's not something we just started.

So I think there's a debate right now in the industry as to what the traditional server market should grow at. And I think you've seen, like other end markets, a large ramp-up of the traditional sort of market followed by a period of digestion. And on top of that, you've had the origination or at least the advent of AI where it seemed to steal some wallet share as it came to market this year. When you look at your business, I would assume that there's an underlying expectation for what the traditional server market grows. Could you give me what your view is into '24?

Yes. And that maybe bring a bigger discussion on the impact of AI now in the short term and long term. But I would say what our view is similar to what you can see from other analysts that are working on those projections. So it will grow. It's probably growing little bit lower than what we have seen in the past. I think it's -- overall it's a bit of a timing issue because AI is consuming a big part of the CapEx from our customers to create the infrastructure of AI that doesn't need today storage. The storage is already there. There was a need to create is an infrastructure with the GPU and the CPU and other components that they don't have today. So AI cannot be used without that infrastructure. So they need to create the infrastructure. When the infrastructure is ready, you will see the major impact to storage because AI, first of all, AI works much better when it can access a lot of data. So people, businesses, governments that want to use AI will tend to delete much less than what they were deleting before because they want to have a large base of data to use AI. Secondly, more importantly, for the impact to storage is AI will access the data and create something new. That something new is new data. For example, if you are in manufacturing and now you have a new factory, you need a new manufacturing flow, so you ask AI to do it for you. And they will -- now AI will generate a new manufacturing flow, and that is data that will be saved in the cloud, in the [ R-Disk ], and then you do it again. Every time you have a change in your manufacturing flow or you have a new factory or you have new equipment, you ask -- you use AI to optimize your business. And that is new data going to the cloud. So this is still not happening. This will happen in possibly 2, 3 or 4 quarters. Today, their use of AI is very limited. Now I don't know how many people here are really using AI, it's very limited. But in a few quarters, it will be a normal practice for people and for businesses to use AI.

You talked about 1 million HAMR unit shipments in the first half of '24. Is that guide dependent upon the server market that is improving? Or do you think that happens regardless of the market atmosphere?

No, that 1 million unit is not dependent from the server. Now we are qualifying the product. We are through the end of this qualification with 1 main customer. And that volume, will probably go mainly to this main customer because it is the one that is qualified at that time. But starting next quarter, we qualify many other customers. So now we have request for qualification from all the major cloud customers, enterprise OEM. We also have request from video and image application customers. So the interest into that technology, in that product, is getting bigger and bigger. So in the first 6 months, we will sell about 1 million units. After that, when you go into calendar Q3 and calendar Q4, that volume will continue to increase and will be more diversified to a bigger number of customers.

When you look at the qualification process for a cloud customer, how much of the learnings can a customer take from the guy that got qualified first? Because you imagine that it's just a time horizon of running that product that's the biggest question. And if you see that work somewhere else and you've used storage arrays in your data center in the past, is it possible for the second, third and fourth guy to accelerate that qualification process? Or is it going to be the same time frame no matter what?

Well, I would say, first of all, that we start the qualification with a much higher confidence because they know the product is working, is qualified through now one of their peers. And if that peer that is huge scale and fairly complex architecture, so it's not an easy qualification. It's a difficult qualification. This is why we are working now with this partner. So I will say, everyone that will follow, we'll start already with a different level of confidence. And then usually, qualification takes now between 4 and 6 months. So that is a time that we will need to work with many customers, so it will be a good effort for us because when you try to qualify 3, 4, 5 customers at the same time, it's not easy. But now through we will take the time that is needed. The important is through our [ HAMR ] '24, we want to have all those big customers, including our enterprise OEM, including some of the video and image application qualified. So the volume will eventually grow, the number of customers will continue to grow, demand can be diversified, we should have also a good impact to our pricing.

Do you think that any of the sales of those HAMR drives in the first half would be cannibalistic to the recovery in your broad nearline market? For example, your main customer is ramping heavily in the first half, why would they go out and buy more drives now? Aren't they incentivized to wait until they have this new product sitting with them?

Well, there is not enough volume for big customers to wait. So even the current customer that is qualifying HAMR is still buying CMR. The benefit of HAMR is you can use HAMR in the same data center where you have CMR. So they can mix vendors, they can mix technology, so they can currently buy a 32 terabyte HAMR and a 24 terabyte CMR and use in the same data center. So depending on the volume where they need, they buy a little of both. And in future, I think now the majority of what we will sell will be HAMR-based. But for sure, you will have a transition between current technology and HAMR because of the volumes are all different.

I mean 1 million units at this point in the cycle is quite significant. But when you get back to a normalized run rate, it's slightly less so. But do you have a feeling for when you would expect cross-over from a HAMR product perspective, where you're saying 1 million in the first half. You're saying higher than that in the second half. So clearly not in 2024. But how quickly can that accelerate? Is it a '25, '26 story? Or are you still thinking out past the decade?

Oh, no. We think we will have a lot of products based on HAMR technology already in calendar '25. So you will see sequential improvement, not exactly cross-over dependent, I think the exabyte cross-over will happen much earlier than in units, of course. But again, the focus now is qualifying customers so that they can buy HAMR, and then we have to have the time to ramp because the ramp is not short cycle time. So when we start to get demand in order, then we need to ramp. Everything needs a little bit of time to happen, but we are going in the direction we were expecting actually a bit faster than what we were expecting. So confidence is high and so far, so good.

Helpful. I want to shift gears to VIA. You specifically called out China as weak in the quarter and kind of pointed to some uneven recovery there. Is there a specific area in China that you would point to that is causing the weakness that you're pointing out? And then you're saying uneven recovery. Does that mean up and down? Or does that mean kind of flat to down?

Well, I would say every segment is a bit different. So now we see China cloud starting to recover. So we think this will continue to recover in the future quarters. When you look at video and image application, it is more seasonal. So usually December is high volume. Because we are raising pricing, we think customer have anticipated a good bit of demand in June and September. So that has those 2 quarters to be particularly good. They are still buying up in December but probably lower than what we saw in September. So that normal seasonality we see is not happening exactly as the same, mainly because of our pricing. But of course, they are still buying good volume. And they, after the seasonality in -- low seasonality in March, they will come back to high volume starting in June and then the second part of the calendar year. And then when you go into, let's say, the legacy part, that is still very depressed. So the consumer, the client, even the mission-critical is fairly depressed. So this is a part that we're still waiting to recover on top of the other segments to grow because they are growing, but they're not even close to the levels they were before the down cycle. So we expect that to continue to grow very strongly. But even the legacy, now, it usually decline, we think, right now, it's so depressed that maybe it will rebound a little bit before following the normal rate of decline.

Yes. I wanted to ask you on that because traditionally in technologies that are winding down, even when you see a big setback in demand, you don't often see that come back and recover because people just use that opportunity to move on. What gives you the confidence that, like your other segments that have, I would say, growth trajectories in the future, people should get back to the normal order rates. But what gives you the confidence that a legacy business that you've already talked about kind of winding down should step up before it continues to decline?

The main reason also known as the [ rate ] technology that is replacing [ R-Disk ] in the legacy part has also the same cycle. So they're also very depressed. So I don't think there has been a change from [ R-Disk ] to NAND in consumer and mission-critical, maybe in client, yes, but not too much in consumer and mission-critical. So the demand comes back up, it's not that they have changed the design to a NAND design yet. So I think -- but they will do in the future because that is a part where NAND has the benefit of the speed and the size. So that part will continue to move to NAND, but possibly, you could see a little bit of rebound compared to very low level of demand we have today before getting to the normal trend in the past. Our revenue decline for legacy was about 15%, between 15% and 20% per year. Now it's a small part of our business. It's only 20% of our revenue. So it's not a huge impact. And it's also now the part of the business with a lower gross margin. So it's a transition when we are going through, but it's not anything that will really impact the overall growth of the company.

I wanted to ask one more on competition before I move to some of the financials. We had your competitor here and they talked about last quarter, half of their exabytes being on the 26TB platform in the nearline business. Can you just -- I think that there's a narrative that before HAMR, if you were at higher capacity drives or what you claim to be a higher capacity drive, you will soak up the demand prior to a technology transition. Do you think, one, that there is a lead in their product portfolio prior to your transition to HAMR? And do you think that you're seeing any shift in share right now?

Yes. You can look at their market share last quarter, there is no shift in share now despite what they are saying on the 26 terabytes. We have -- I think we still have the leadership even with CMR, even before HAMR. So we launched our 24 terabyte CMR before competition. That drive, if you sold in the SMR version can be 26, 28 terabyte. So I would say the 2 companies are fairly well aligned on the current road map. The difference is we have a major advantage on HAMR, and we are starting to sell HAMR next quarter. So it's not that we need to wait another year to take benefit of that better technology and better products. We will start next quarter, and we will grow through the calendar '24 and later. So talking about the current road map, I don't see Seagate as being disadvantage because we actually decided to develop that 24 terabyte CMR or 26 terabyte SMR to be sure we didn't have a period of time of disadvantage, to be at least at parity and then take in the benefit of HAMR later.

I want to switch to the gross margin side. So the recovery got pushed out a little last quarter. Could you walk through the pieces related to underutilization right now? I know you've talked recently about how it could be a bit lower as things go into this quarter. Why is that happening? And then you also expect those charges to persist into the first half of the calendar year. Given it's a little bit better, talk about your view on where underutilization goes.

Underutilization, no, now we expect it to be lower because now we start to ramp at a bit higher volume than what we were thinking. So the recovery is happening and it's happening slightly higher than what we were expecting. Still not, as I said before, not a huge jump in revenue but start to be a good improvement. So that will decrease our underutilization in charges. Now we are still far from our capacity level. So we will have underutilization in charges for a few more quarters, but the amount will decline based on the increase in production. The current capacity is about 25% lower than what we had as a [ pick ]. But we can rebuild that capacity with a little bit of time. So the reduction in capacity is coming from taking equipment offline, and unfortunately, reducing the number of people in manufacturing. So we had to lay off about 10,000 people through those very painful 7 consecutive quarters of decline. So once we arrive at full capacity and as I said before, we still have time. But once we arrive there, we need to do 2 things. We need to put those equipment back in manufacturing and we need to start hiring certain number of people. We will not need to hire the same number of people we had before. We can achieve that level of capacity with a lower number of people. But we still need to go out and hire 5,000, 6,000 people. So it's a big number. So between hiring people and putting that equipment in the manufacturing line, it could take 5, 6 months.

So that seems like something that's going to happen over the longer term. You're talking about underutilization being a bit better. Is there any headwinds to the gross margin that you can think about over the next couple of quarters that would be worse that would offset some of that? Is there anything from a pricing perspective, from cost associated with HAMR, from other charges that you're seeing elsewhere? Can you just walk me through because there are a lot of moving pieces.

Yes. No, pricing I think that our strategy is fairly clear. Of course, we always adjust our strategy depending what's happening in the market. And now it's a very competitive landscape. So of course we're always monitoring what's happening in the industry. But our point of view, profitability is still very low. So we still need to work with customers in improving our pricing. So we will continue to do it. So next quarter, we expect pricing to be a few points better and possibly even the following quarter. In terms of cost, cost should be better because underutilization will start to decline. The volume of HAMR is still fairly small compared to the total volume that we move. So the impact to P&L is limited, but we said HAMR is going to be accretive to gross margin. So more volume of HAMR you will see in our results and better margin you should expect.

I want to switch gears over to the non-HDD portion of the business. It's kind of guided to stay at these levels through the end of '23. Do you have a view on enterprise spend into '24? I would say others at the conference have kind of talked limited visibility and probably biased more negative. What's your view with your business?

Our non-HDD has 2 main products, one is system solution that it's still based on [ R-Disk ] because the size the system, we have mainly [ R-Disk ]. And SSD, we also have now a fairly small business on SSD. I would say the SSD will follow the trend of the overall SSD, both in consumer and enterprise SSD. The system solution, we think long-term this could be a business that now can grow a lot depend -- probably depend on how our customer will want to manage their architecture. If they want to manage their architecture like a big cloud is doing today, they don't use system. They buy [ R-Disk ] and they buy other component, and they create their system inside the data center. If they want to simplify, they can buy a system that is basically ready for utilization. Now if they think they can get a better result with their architecture, they will continue to buy as they do today. If they think system is an easier solution, and finally, similar results, maybe they will do move more into the system. But it's basically serving the same need in a different way. So it's more depending on how customer want to manage.

Well, we're running out of time here, so I had one last broader one that I wanted to touch on. So you've continuously noted in the past the importance of maintaining your dividend. That question has abated slightly as you've seen the beginnings of a recovery. But if I look at even in an improving revenue environment and even in a pretty efficient working capital environment, in the back half of '24, I do see cash levels still getting down to low hundreds of millions, at least in my model. Maybe it's different from yours. But what additional actions can you take from here that help you protect cash? And which would you use first?

Yes. We are always very focused on the cash balance and generating positive cash flow. So even last quarter, which was hopefully the bottom of our down cycle, we were producing a positive cash flow. And we also had to pay a lot of the restructuring cost in the same quarter. So I think we have a good track record on generating free cash flow. As you said, we have to use a little bit of working capital in the last several quarters to generate also that cash flow. So when we go into the up cycle, maybe we'll use a little bit of cash to change a bit our working capital. But in general, the business will generate strong free cash flow now through the calendar '24 and then even much better through the calendar '25.

Perfect. Thank you for being here, Gianluca. I really appreciate it.

Thank you, Tom.

Have a great week.

Thank you.