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

All right. Perfect. We are going to get started here. So again, welcome to day 2 of the flagship TMT Conference. My name is Erik Woodring. I lead the hardware coverage here at Morgan Stanley. I am delighted to be joined today by Gianluca Romano, CFO of Seagate Technology. Before we get into things, let me just remind everyone to please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. Gianluca, thank you for joining us today.

Thank you, Erik. Now before we start, we'll be making forward-looking statements today, and you can learn more about the risks associated with those statements on our website. Now we are good to go.

Perfect. Good. So let's start on the demand picture. It's clear demand is quite strong. I'd love to better understand exactly how AI is becoming a tailwind for you guys, -- meaning it's clear the world will need to kind of store, retain, leverage more data in a world of multimodal models, Agentic AI, et cetera. So the broad tailwind is clear, but can you maybe help us understand some of the emerging use cases for HDDs in an AI world, just to get some context for what's helping to drive this acceleration behind AI?

Absolutely. No, demand is very strong, as you said. AI is one of the applications that is generating a lot of data and therefore, the need for data storage. In our industry, you don't need to produce a different hard disk to store AI data. AI is generating the same kind of data from a storage standpoint that the traditional application we're generating. So we don't have a different mix inside our products, where we can say exactly what is coming from an AI application or a non-AI application. So it's a bit more difficult for us to perfectly quantify. But for sure, in the last 1.5 years, I would say, AI has been the center of the discussion with our customers in terms of their need to increase storage. And more recently, probably in the last couple of quarters, in particular, Video AI has been the reason for that additional increase in demand that maybe came a little bit earlier than what we were expecting when we met in May at our Investor Day. So there is a little bit more demand than what we were expecting. But again, it's not that we were not counting on Video AI for the long term. It's just happening a little bit faster than what we were thinking.

And maybe just touching on video. The implications are significant when we think about the data requirements for a 30-, 60-second video relative to a text file. Is that -- and I'm not just trying to focus on the consumer side, but is that maybe the most exciting new application as we think about the potential to -- as we think about inferencing and as we think about the potential that AI can bring, are there any other kind of very focused items that we should be focusing on the video?

I think it's very exciting until the next up because that's the reality. 6 months ago, we were talking about something else. Today, we talk about Video AI. 6 months from now, hopefully, we talk even about something else that will be very important for people and for businesses and something that generate data and needs to be stored. And as you know, 90% of the storage is on hard disk. So everything is important. And as I said before, for us, data is the data independently from which application it will generate the data. I think you will see a lot of increase in data also from other applications outside AI like autonomous driving or started many years ago, but has not really developed a lot. There are many cities where you can see autonomous driving being a reality, other cities, where you don't see any. And this will continue to evolve and that needs a lot of data to work. But of course, Video AI is something that is taking a volume that is way higher than what we were expecting.

Okay. Let's talk about visibility. Last quarter at earnings, you talked about calendar '26 nearline orders effectively being covered for the year that you'd start signing purchase orders into the first half of calendar '27. Can you maybe just give us an update on demand visibility and maybe more importantly, just beyond that, the sustainability of HDD demand kind of beyond the first half of '27?

Yes. No, what we really care is to be sure that when we start a product in our manufacturing, we already have an order for that product. So an order that covers the mix that we are producing, the price for that product and the time of the delivery. This is why we focus mainly on the next 4, 5 quarters. But customers are very interested in volume. So of course, they want to discuss about exabyte volume when you go longer, so not only for calendar '26, but also for calendar '27 and even longer. So we have agreements with our customers on exabyte volume for the longer term, and we have very precise orders for calendar '26. And this is why we were able to say in January at our earnings release, based on this visibility, we expect every quarter of calendar '26 to increase in revenue and in profitability. Now of course, this was more difficult in the past when the industry was working in a different environment. Now we have this visibility, so we can predict and we can make our estimate. I also have to say that now we are beginning of March. So there are, of course, some contracts for the first part of calendar '27 that have been translated into POs. And everything is continuing as we have done for the last 11 quarters with that pricing environment that give us opportunity to reasonably increase pricing and take benefit of the cost reduction, when we move the mix from a PMR product to the fourth-generation HAMR 30 terabyte to the second-generation HAMR of 40 terabyte...

As a follow-up on this and speaking to visibility, how are you protecting the company from the risk of overordering amidst this demand strength and this elongation of visibility? How do you make sure you ring-fence that risk to limit any future kind of cyclical drawdown?

Yes. We are very disciplined on how we deploy our CapEx. Our CapEx is not going to be utilized for increasing units. It is all focused on increasing capacity per unit. So technology transition and of course, the HAMR production is a focus. We are not going to increase the units because we think through the technology transition, we can generate about 25% CAGR in the nearline space that should be enough to cover the short-term need of our customers in terms of data centers that are really building up.

And maybe just to hit that point again because I want to be explicit. There's been -- at least you guys have talked about leveraging third parties for some head and media content. Some have associated that with greenfield unit additions. I just -- we have set the record straight for everyone. You said it once, I just want to make sure you say it again so it's clear. The view on new unit capacity is there is none coming online at the point.

Yes. I don't think there is a need for more units. No, I think us as a company have enough units to serve our customers because we are able to move those units from a certain capacity per unit to a higher capacity per unit. For example, when you go from the first-generation HAMR 30 terabyte to the second-generation HAMR 40 terabyte, in theory, if you move all your customers from 30 to 40 terabyte, you can increase your exabyte output by more than 30%. So of course, this doesn't happen over a year, it takes a little bit longer. But there are opportunities to continue to increase the exabyte without the need to increase units that in the past was the problem that then generated oversupply instead of like undersupply and then generated that volatility and that impact on pricing. I think the industry is way more disciplined today, and this is the benefit of being in this business today.

Okay. Great. I would love for you to touch on maybe the conversations you're having with the major CSP customers. And the question is, we've heard a reference to kind of going from a transactional model to maybe a more partnership model, which allows you to have that visibility. Just can you speak to maybe the permanence of that change? Is that just a function of the supply-demand imbalance as we sit here today? Or has something actually changed in which there's a structural importance to HDDs that perhaps didn't fully exist given the need to store and retain and produce more data?

Yes, it's probably a little bit of both. Of course, the fact that there is a little bit of shortage in storage in hard disk in particular, is helping that partnership. Now that's the reality. But I also say there is a lot of collaboration with our customers on developing the right product for their storage needs. And the right product is the one that has more and more capacity per unit. So as you know, we entered the qualification of our 40 terabyte just a couple of quarters ago. And I'm pleased to announce today that both customers that were in full for the 40-terabyte drive has now qualified the drive. So we will start shipping some volume already this quarter and then more quarter after quarter.

So I guess you just eliminated one of my questions here. good. No, let's -- before we get into HAMR because obviously, it's critical. Just the point on pricing, right, supply-demand imbalance right now, clearly kind of insatiable demand, using aerial density to drive supply or to drive exabytes higher. Talk to us about what's happening with pricing because you've kind of characterized it as flattish to low single-digit growth. Your competitor has been maybe a little bit more outwardly bullish in talking about mid- to high single-digit year-over-year growth. Just is there kind of upside as you see the pricing environment? Is there ability to take more price, not just as we think about calendar '26, but into calendar '27?

Absolutely. No, I think it depends what is your starting point. Usually, I tend to talk about sequential improvement. So it's more a quarter after quarter. Of course, if you go year-over-year, the increase is substantially higher than what we can do sequentially. So I would say, generally, I guess the trend is very similar in terms of pricing. Again, the focus of our customers is more capacity per unit. So now that they can buy the 40 terabyte and those 2 big customers, of course, they will focus more and more on getting the volume. They need to give us the time to ramp. So there is a little bit of time to ramp high volume, but it's a huge improvement for them to go from 30 to 40 terabytes. Now if you think about the cost of a slot that they have a physical slot, if they can put 30 terabytes and monetize the 30 terabyte or for basically the same cost, having a 40 terabyte, now they monetize 30% more. So it's a huge benefit for them to increase in capacity. It's a huge benefit for us because with a similar cost per unit, we generate 10 more terabytes per unit. So the cost per terabyte now declined faster than what we have seen in the past. And again, with the pricing strategy that we have implemented and executed for more than 11 quarters and what we see for the future, we can reasonably say revenue would be higher and profit would be higher.

Okay. Good. So let's now touch on the comment that you made about HAMR. So you did start -- you kicked off qualification on Mosaic 4 products with your first CSP last July. I think the second one started last October, if I'm correct. The comment that you're making today effectively is we have now qualified those 2 CSPs on Mosaic 4. And just to make sure -- again, to make sure we hammer the point home, you're starting to see volume shipments calendar 1Q this quarter. Is that correct?

That's correct.

Okay. Now how do we think about maybe the pace of the rest of the CSPs out there? Just maybe help us understand the interest level in Mosaic 4 from a qualification standpoint, how you think about that trajectory could look like going forward?

Yes. I would say that technology is not so important to them anymore. They have basically all qualified the first-generation HAMR. So they know it's working well in their environment. So technology is not an issue anymore. They just focus on how to get to a bigger drive because that is where they have the best return. So I would say we need to get the time to ramp the first 2 customers that are really big customers. So they will take a lot of volume. But with the time, we will be ramping up also for other customers to get qualified and then take benefit of the bigger drive.

Okay. Awesome. Congratulations on that. So the -- you made a comment last earnings, you said the transition from Mosaic 3 to Mosaic 4, so 30 terabytes to 40 terabytes per drive you'll do that fairly aggressively. You also mentioned it will be a fairly prescriptive ramp. So obviously, Mosaic 3 took time to ramp and qualify. What exactly does that look like when we think about that mix shift that you've talked about historically for HAMR? Does that look any different than what you talked about last May in terms of the 40% mix, the turnover or the crossover, excuse me, does that look different now that you've had these qualifications?

No, we were counting on having those qualifications. I would say we are getting those calls maybe a few months earlier, not a few quarters earlier. So it's not that we can ramp a very different number of drive for the 40 terabyte. I would say we are still focusing on achieving those numbers that we said at the Investor Day. If we are at 70% of nearline exabyte sold with an HAMR technology by June 27, I think will be very, very good for us, especially because we start to better optimize our manufacturing. When you start a new technology, you have a period of time where you are not optimized. You have one technology that is new that somehow compete with the old technology. So what you extract from your manufacturing is not fully optimized. It's very good, but it's not fully optimized. There is a lot of opportunity to improve. And the more and more you ramp of the new technology, you become basically just running one kind of products, and that will help us to get the 25% exabyte or maybe a little bit more in the future.

Okay. And then just in terms of the technological volume ramp associated with Mosaic 3, but also Mosaic 4, are there any bottlenecks as you see it, whether it relates to cycle time or components, rare earths, et cetera? Just want to make sure we're kind of triaging any risks that could be associated with that ramp?

I would say the limiting factor is our own ramp. It's not, I would say, any external components that we buy is our ramp on how much we can -- as you know, the cycle time is not short. So we need to start earlier to produce as a media and then to do the assembly and to do the final test. Even the final test gets a little bit longer, not because of the technology, but because of the capacity of the drive. So everything takes a little bit more time. That means to do a ramp of millions of units take a little bit of time. But every quarter, you will see a higher volume and a better contribution of the 40-terabyte drive, not only to the revenue, but also to the profit line.

Okay. Great. Your competitor had an Analyst Day a few weeks ago. They were talking about kind of adding more heads and platters to a single drive. You've been very focused on areal density, kind of leading the market on areal density. Just your perspective, as you think about your technology innovation around more planners to a single drive. Is that something that you're focused on? Or is the focus kind of squarely on areal density where, again, you're kind of leading the charge there in the market?

Well, probably when you move to HAMR, the first focus is taking benefit of this increase of terabyte per disk. When you go from a 3 terabyte per disk to a 4 terabyte per disk, you had 33% of capacity, which is much more than adding 1 disk. If you had 1 disk out of 10, you have only 10% of increase. So increasing areal density per disk give you a better return. So going to 3 terabyte per disk to 4 terabyte per disk to 5 terabyte per disk to 6 terabyte per disk is probably the best return you can get. Now at a certain point, it will be interesting and financially having also a good return to start increasing disk. Of course, in the longer term, you want to take benefit of all the space that is inside the box, but you need to find the right time. Right now, we get more benefit in increasing the areal density at a certain point, probably will be good for us and I think for the industry in general to take all the space inside the box. If you -- if you start increasing disk when you are at a 5 terabyte or 6 terabyte, the return on the disk and 2 add is fairly huge.

Okay. So I think maybe as the CFO, this is -- and at least as an analyst, this is one of the most exciting parts of this journey in areal density is you're not changing the form factor, you're adding more capacity to the box, but you're not adding disks, you're not adding heads. You've talked about in-sourcing the laser diodes that you've been working on innovating there. What does that translate to when it comes to cost downs? We talked about price per terabyte earlier. You've been able to do something like 15% annual cost per terabyte declines. So now that we're mixing into more Mosaic 3 and in the second half, more Mosaic 4, how do we think about the trajectory of cost per terabyte decline?

It's actually very interesting. The bill of material going from the fourth-generation HAMR to the second-generation HAMR to the third-generation HAMR is fairly similar. As you said, it's still based on 10 disks and 20 heads. Of course, they are not the same disk and heads, our disk with more capacity and are new heads that need to be developed. Also the components that we buy externally need to evolve to support the higher capacity, but it's the same number of components. So the cost per unit is fairly stable, but we had a lot of terabytes per unit. So there is a huge and very important decline in terms of cost per terabyte. Now when you look at a period of time, it depends how many units you have sold for that new product. So every quarter, you will see we sell millions of units, and we sell PMR units. We sell fourth-generation HAMR. We now sell second-generation HAMR. Every quarter has a different mix and a different capacity. But the trend is, of course, is having a good cost reduction. And the more we can ramp of the 40 terabytes, the more we can take benefit of that decline cost. So this is part of what we said before. An important reason of why we expect a better profitability is the mix moving more and more to the 40-terabyte drives.

Right. Okay. Let's take what we've learned maybe on demand and now on the cost side and translate that into financial metrics. So I believe the latest is mid-20% nearline exabyte growth in line to even stronger revenue growth when we think about the benefits that you can get from pricing that we discussed earlier. A year ago or almost a year ago, you laid out a target of 50% plus incremental margins. Clearly, you've been well outperforming that metric. You've been doing 70% plus. Just given what we're talking here about demand, your ability to cost down, your ability to price up, that becomes a very powerful tool. Do we expect in totality kind of growth as we now look into the second half and then margin expansion as we look into the second half? Like are those metrics that we think should accelerate just given all of the kind of goodness that is now coming through the model? I know you said we can grow sequentially. Just trying to contextualize that growth.

Yes. When we had our Investor Day, I said we expect gross margin to increase 50% incrementally starting a certain level of revenue, and we have done significantly better. The reason why we have done better is mainly because demand is a bit stronger than what we were expecting now going back to the Video AI discussion we had before. And because with those calls that we have achieved, not only the last one that, of course, did not impact the prior P&L, but will impact the future, but the transition to the fourth-generation HMR also gave us an opportunity to reduce cost a little bit better than what we had in our plan and so to achieve a better margin. I think we are continuing with the same trend. As I said before, the pricing situation has not changed. It's actually now extending for us to the first part of calendar '27. So that is very good. That means demand from customers is still very strong because this is a big test when you go and finally put number in a PO, you can see how real is the demand, and this is a confirmation that demand is strong and is real. And of course, with the mix moving up and up in capacity, we expect to continue improving in gross margin. And finally, in net income because our OpEx is already at a very, very good point today.

Just very quickly touching on OpEx there. You've signaled a ton of leverage that you can drive in the model. Are there -- like maybe contextualize the added costs, if there are any associated with OpEx as we think about moving into the back half and into calendar year '27? Or if there was growth in OpEx, like where does that come from?

Yes. I think in terms of resources, we have a very good structure. So I don't expect an increase in the need for resources. So in terms of cost, it should be fairly similar to where it is today. Usually, we have the annual salary increase in the September quarter. So we could see a little bit of increase in that quarter and then, of course, in December, but kind of limited.

We've seen that this year, right?

We have seen it this year. So part is also variable compensation. So every year is a bit different on how much is a variable comp. But I would say -- if you look at calendar '26, I don't really expect a lot of difference in OpEx spending per quarter.

Okay. And then CapEx, you've been very consistent there. It doesn't seem like anything changes. But even as you ramp Mosaic 4 and beyond in testing beyond Mosaic 4, does anything change with that range that we think about CapEx as a percentage of revenue?

No, I would say 4% to 6% of revenue is a very good model, give us the opportunity to buy the tools that we need to ramp more volume of HAMR. So focusing on the technology transition and moving from lower capacity drive to higher capacity drives. And this is what we need. Of course, there is always CapEx maintenance, there are equipment that gets old that you need to replace. But again, all the focus is on components and transition from one product to the next. Of course, we don't focus on any increase in units.

Okay. Perfect. I know your Analyst Day probably feels like it was ages ago. It hasn't even been a year impressively. Can you just remind us how to think about margins and free cash margins on the other side of the equation, right? We're kind of dreaming the dream as we go up into the cycle. When you talk about your ability to -- I think you've guided to 40% plus gross margins, operating margins of 30% plus. Is that signaling kind of those are the floors as we think about the new model, meaning even if we go through a period of digestion at some point in the future, that's, again, notwithstanding certain quarters, but that's where we feel like the floor kind of is in our margin trajectory.

I would say we're already above those levels and the trend is to improve. So honestly, I don't see a reason why we should go in the other direction. We have all the visibility on calendar '26. I told you about the first part of calendar '27. So again, I see -- from here, I see improvement. I don't see a reason why we should go in the other direction.

Okay. And then maybe last question before we get into kind of capital allocation balance sheet. From the perspective of kind of new entrants in the market, this is a rational oligopoly right now. And I've long said rational oligopolies can be very powerful. Is there a threat of new entrants? Do you see that? Is that something that is on the horizon? Just would love your perspective. As you look out into the market, what you see in terms of this oligopoly structure potentially changing at all?

Well, from my point of view, the difficult part of this industry is not only manufacturing, but also the technology inside the drive, especially when you move to HAMR, there are way more additional complications and more difficulties. This is where the industry is competing is in product, in evolving the product so that we can generate more terabyte per unit for our customers. But it's no focus on volume or units or all those things. Those things are actually eventually creating a possible disruption for this industry in the future. So it's not the right focus. The right focus is technology, giving our customers what they need in terms of the product and increase the exabyte. -- so that they can build the data center where they need and they have the storage where they need. For a new entrant will be very difficult because they need to spend a lot of money, first of all, to set up the manufacturing, second to develop the technology. And this point is more complicated than 2 years ago or 3 years ago. Now they need to enter and having HAMR technology. If you enter and you don't have HAMR technology, you're already out of the game. So I'd say for the next few years, I don't see this happening.

Okay. Okay. Good. Let's touch on that capital structure capital allocation. First, on the structure side, you retired $600 million of your converts last month. your gross debt is, I think, right around $3.9 billion. That's exactly kind of what you've guided to or at least projected towards. Have you kind of reached the end of that deleveraging just as it relates to your gross debt? Are you kind of done and now you're returning to buying back more stock? Or is there a desire to maybe reduce that convert a little bit more? How do we think about balancing that?

Yes. To me, reducing the convertible has a double benefit. One is reducing the debt. But second, very important is to avoid further dilution from the convertible. So it kind of could be assimilated to a little bit of a share buyback. So we have retired $1.1 billion already in the last 2 quarters. We still have $400 million outstanding. So we will take care of that part of the convertible in the next few quarters. So in terms of debt, I'm fairly happy where we are today. Probably we will go a little bit lower. As you said, the free cash flow will be very strong. So we have the opportunity not only to do a strong return to our shareholders through dividend and share buyback, but also to reduce our debt a little bit more.

So as we think about maybe the balance of how you've utilized free cash flow, call it, over the last 2 quarters, it has been more levered to delevering. Now it's maybe a little bit more balanced as we look forward, reduce the convert a little bit more, buy back a little bit more and kind of transition that over towards buyback as we think about a few quarters.

Yes. Every quarter will be a little bit different, depending on what kind of treasury activity we are doing in the quarter, but you will have both. And some quarters, we'll have more share buyback and less reduction of debt and some quarters, we will maybe focus more on the convertible resources and some other debt reduction and a little bit less share buyback. But if you look over a longer period of time, excluding the debt, basically 100% of our free cash flow will return to our shareholders.

And I was going to touch on that, but my question was going to be the stated goal was kind of 75% of free cash. It sounds like given how confident you are in the outlook in your margin structure, innovation, all of that stuff, we could and/or should be expecting upside to that.

Absolutely.

Okay. That's amazing. Another good insight here. So before we end, last 2 questions. Just as CFO, just quickly addressing any risks that you think about in terms of things that you want to challenge your team to do better internally, things that you see on horizon, just making sure -- and anything is kind of ring-fenced as we all think about potential risks. And then one question after that, please.

Well, risk, unfortunately, is always there. Geopolitical risk, of course, is high in every industry, not only for us. So we control what we can. And what we can control is our manufacturing, how we address demand, how we implement the pricing strategy. I would say where we can extract more value in the next several quarters because demand is above supply is to moving the mix more and more into the higher capacity drive, so we can extract a little bit more exabyte from our manufacturing every quarter. And of course, those exabytes has a very good return for us. So that is, I think, the focus, focus on the quality of the product and the exabyte that we can generate quarter after quarter. And now the team is doing an incredible job in extracting as they can.

Amazing. So we've got Mosaic 4 ramping. That's new. We got more free cash flow returned to shareholders. I'm sure everyone here is happy about that. As you ramp up in kind of the last minute here, just leave everyone with a final word. What maybe is underappreciated? What should people thinking about the messages that you want to leave as you set up stage here?

Well underappreciated could be the state of the industry. Of course, everyone is impacted by the past. I would say the past was a different business was based on client business, so on desktop, laptop, different application for the storage. year after year, this business moving into the big cloud. 80% of our business is data center. So it's all focused on high-capacity drives. And this is a new situation, a new industry where demand is very strong, where the industry is full in terms of capacity, not adding units, but focusing a lot on technology. I think this will generate a lot of profitability. For us and for the industry in general. And this is something that maybe you need a little bit more time for people to get used to that. In the past, it was not exactly this. So -- but now it's 11 quarters. We did this already be for 11 quarters. When we talk about the next 4 quarters. So this is not 2, 3, 4 quarter cycle. This is a huge change in the industry, in my opinion.

Amazing. That's a great place to end. Gianluca. Thank you very much for your time.

Thank you, Erik. Thank you.