Western Digital Corporation (WDC) Earnings Call Transcript & Summary

Good morning, everybody. I'm Joe Moore. Before we start, just a quick safe harbor, which you may have heard before. Please note that all important disclosures, including personal holdings disclosures and Morgan Stanley disclosures appear on our Morgan Stanley public website or at the registration desk. So with that, very happy to have with us today, Bob Eulau, the CFO of Western Digital. Thanks for being here.

Yes. Thanks, Joe. It's really a pleasure to be here.

Appreciate it. I know it hasn't been the easiest of circumstances for people to get here, but thanks for coming.

So maybe if we could just start out the question -- I sort of hate to start with this in a way, but it's the main question on everybody's mind. Can you just update us on your thoughts on the coronavirus, the impact on your employees and the impact on your business since the last time we talked?

Yes. And before I get going, I have to do our safe harbor as well. So again, I may make some forward-looking statements. So please keep that in mind and review the risk factors that we have in our 10-Qs and Ks that we filed. And as I refer to numbers, I will probably be referring to non-GAAP numbers, and we have reconciliations in all our press releases on those. So with that, I will answer the question. That's on top of everybody's mind on COVID-19 and the impact on our company. And obviously, it's still a very dynamic situation. It has been for quite a while. And I'll start first with the supply side. So far, we've been really pleased in terms of how our team has executed. We probably got a little bit lucky in some ways because we had planned to operate through Chinese New Year anyway. So we kept the employees, 80%, 90% of employees on our site, and we were able to continue to execute during Chinese New Year. And even when it was extended, we did have some discussions with the government. But based on the precautions that we had taken naturally for our employees of wearing masks, checking temperatures on the way in and disinfecting on a daily basis very rigorously, the government was comfortable with us continuing to operate. So we have a factory in Shanghai and a factory in Shenzhen that we were able to operate through that whole period of time. So that's gone extremely well. We've done a lot of work in terms of the downstream supply chain, and it's also done very well. We had a couple of suppliers that were in the Wuhan area. One of them is back up and running. One, we're expecting to be back up and running on March 10. And from this quarter's standpoint, we're obviously burning into some of our buffer inventory, but we think we'll be fine in terms of the shipments for this quarter. And that we expect to have our buffer inventories back to normal levels by the end of April. So I'd say from a supply standpoint, so far, we're pretty pleased with how things have gone. Overall, as a company, we're obviously restricting travel and being very cautious in a number of countries around the world that we operate in. And the hard part to understand is the demand side. And so far, demand has been fine. Now the reality is we tend to ship a lot of our revenue in the last month of the quarter. So it's obviously a little early to predict how things will land. But thus far, everything has been going okay. I think it's well documented, some of the downsides our customers are seeing in terms of handsets and mobile, which is a less significant segment for us than it once was, and then also on the PC side. But on the data center side, we're actually seeing normal business and maybe even a little bit of upside there. So net-net, so far, it looks like it's okay. But as I said, it's a very dynamic situation, and it could easily change in the next few weeks.

That makes sense. And on this cloud side, I guess, we've heard from a number of people that the challenge is maybe they can get all the components they need from you, but there's other components -- there's other bottlenecks that they have. And so maybe the builds are deferred a little bit as they're struggling with some of that. But it seems like the end demand there is pretty good.

Yes. I think it's pretty good. The other thing I would say on data center relative to prior periods of time, we're very well diversified there in terms of the customers we're working with. We've had fantastic adoption of our capacity enterprise drives. We're seeing good uptick in terms of our enterprise SSDs. So even if we -- if there may be softness in one of them, we're seeing others pick up the slack. And so far, we don't see a widespread issue in that segment.

Okay. Great. And maybe if we could take a step back, bigger picture. It's been 4 years now since you acquired SanDisk, predated your joining the company. But you've seen a good NAND environment, you've seen a bad NAND environment. It feels like we're getting into a better NAND environment, knock on wood. The underlying rationale that you had was to sort of be an agnostic storage supplier. Can you go back to that thought process and just give us a high-level view of where you stand today with the overall portfolio?

Yes. I wasn't here, you're right, so I can be somewhat objective. And I think it definitely was the right strategic move. I mean if you're customer focused, you want to be agnostic in terms of how you help solve their problems. And I think we've done a really good job on that front. The -- from an actual do the acquisition makes sense standpoint, I think the first couple of years, we looked like geniuses. And generally, I wasn't here to be one of the geniuses. But we were generating all kinds of cash. And I think the initial stages of the acquisition worked out really well. And then you're right. We hit the downside. We've made some cost structure adjustments over the last year. I think we clearly lowered our breakeven point. And I think we're better positioned to endure these troughs. But it's still a learning process for us, and we do think the market is starting to get better. We really feel the June quarter was about the bottom of the trough. We -- at that time, had suggested, we thought we'd get to an inventory equilibrium. By around the end of the calendar year, we think that's basically what happened. And now we're into this year. We had initially thought that we'd be seeing kind of modest growth in the first half and then strong growth in the second half, then that started to get pulled forward. Now we have the virus question. So it's still looking like a pretty good year. It's just, I think, in my mind, more a question of timing.

Yes. And how do you think when you think about the synergies between the 2 businesses? And it's very obvious as you go to market what those synergies are. But certainly, from a technology standpoint, it's very different. You've got NAND on the one side, hard drives on the other. How do you balance that? And how do you make sure you're giving the right sort of technology investment into both of those segments?

Yes. I mean we have -- Siva runs our strategy and technology group as they're involved in both sides of the technology. We have people who have years and decades of experience in both areas of the technology. We've tried to see what we can do in terms of cross-training and learning across the different platforms. And we're finding -- from a product standpoint, we're finding some areas where there's good learning. Theft is a good example, where there's certain ideas that we have on one side that we can apply to the other and vice versa, and that's paid some dividends so far. And so I think there definitely are some interesting discussions from a technical standpoint. But I think your earlier point, in terms of go-to-market, I think it's clearly benefited us. And I think the best example of that right now is with the enterprise SSDs. So because we've been so strong in data center for so many years as we really have the right product program for enterprise SSDs, we've had a lot of success with the customers pretty quickly.

Yes. Okay. Maybe before we go into the 2 businesses in a little bit more depth, just in general on this topic of cloud storage, we've -- just as we've seen this boom and bust cycle in memory, we've also seen this period of really strong investment and then digestion. It seems like now we're on a pretty good trajectory. But do you have any view on whether that's the normal pattern? And I know Intel has made these comments that, "We've had 3 good quarters in a row, so we may see digestion after." It doesn't seem like they necessarily see it, but they're sort of anticipating that maybe it will happen. Just how do you feel about that whole build and digestion cycle from cloud?

Yes. So when we look at it from a storage standpoint, we see a long-term trend, if you go back a few years and then you think about it going forward a few years of roughly 35% a year exabyte growth. And what happened prior to the last digestion period is the growth rate got up above that 35%. I think it got more like 45% or 50%. And then, of course, that all had to be deployed. And so you went through a soft period. So our model -- we think the industry's model is around 35% growth. And so if you see the customers roughly growing in that range, I think we're in a pretty good place. If you start to see us -- see the industry getting well above a 35% year-over-year growth rate, then that's probably something that should give us a little bit of pause. The other thing I already mentioned earlier is we're pretty diversified at this point in time. So we have a number of customers. And I think part of what happened this last time, for a variety of reasons, we ended up with customers kind of synchronized in terms of when they went through that digestion period. And so I think the key is to stay diversified, keep an eye on what the year-over-year growth rates are doing in aggregate and make sure we don't get ahead of ourselves.

And when you think about that 35% bogey for exabyte, I mean last year, I think you were about 40%. So you were in that ballpark. But from a quarterly basis, obviously, we're well above that now. Is that telling us there'll be a deceleration coming?

Well, I think what it says, again, quarter-to-quarter, it will always be a little bumpy. We're talking about kind of a long-term trend line. And part of why it was up recently is because we pulled back so hard in prior years. So you have to keep in mind the compare that you're looking at. But over time, we're expecting it to kind of approach that 35% growth point.

Yes. Makes sense. In terms of your business, you had a strong position in this capacity enterprise for 14 terabyte. You're now sampling 16 and 18. You'll have 20 terabyte later this year. Can you talk about that transition and any transitional risk as you look at those migrations?

Yes. We're super excited about the new product platform, and it really makes the qualification process pretty easy for our customers. We started sampling kind of mid- to late-December. And we have 16-, 18- and 20-terabyte products out in the hands of our customers. We're getting feedback right now, particularly on the 16 and the 18s, and it's really quite positive. We're expecting to get some revenue this quarter on the 16s and 18s and obviously, then expecting -- assuming we -- everything continues to go well, expecting starting to get to some reasonable revenue in the June quarter.

Okay. And can you give us maybe -- I don't want go too far on the weight on technology, but maybe a little bit of insight into the energy-assisted, like the reporting road map and your confidence there.

Yes. So we've had an areal density advantage in terms of our CMR road map for a long period of time. And so we're going to continue to use that to create value for our customers and value for our shareholders. And so we've got a really good road map. Now we're introducing the first energy-assist products. From our standpoint, we're largely technology-agnostic. I mean it's really a matter of how do we solve problems for customers and what's the right technology at the right point in time. So we think we've got a few more generations of CMR- or MAMR-type technology before we need to contemplate HAMR. But we are working on HAMR in our labs and feel like we're getting to where we understand that technology pretty well.

Okay. Great. And then another segment of hard disk drives has been surveillance. It's been an area of secular growth for you guys. How dependent is that on China? And as you look at these coronavirus sort of challenges and the entity list challenges, any impact on WD?

Yes. So that's a good question. And we're actually calling it smart video rather than surveillance now. It's a technology that's -- it's basically video recording that's used for a variety of really positive purposes. And sometimes, it gets used for reasons that are not so good, which I won't get into. But that's an important business for us. It's a growth business we expect over the next few years. We have had to work through challenges with customers that are on the entity list. And we've had discussions with them in terms of not using our products for the wrong reasons. And we think we've been able to manage that reasonably well. There -- a lot of that product has been going into China, but those are truly global products. And you see them in the United States. You see them around the world. So I think that market will continue to evolve and will actually provide safety for a lot of people around the world.

And are you specifically impacted by the entity list?

We have not been specifically impacted.

Okay. And then the last hard drive question for me. The gross margins of the hard drive business has improved quite a bit to 31% level. Can you talk a little bit about where that -- the direction of that long term?

Yes. Again, we're really pleased with the cost structure of our products, both the ones we're shipping today and the ones we're ramping right now. And that's part of what gives us a big cost structure advantage. So the pricing, we think, has been reasonably good. And so we're able to generate good margins. We're expecting gross margins to improve over time. And it's really just a matter of the capacity enterprise becoming a larger and larger percentage of our total hard drive shipments. And so that will naturally bring up the gross margins over time. Now at the same time, we're not completely moving away from clients. So we have to continue to manage that business, and we'll continue to see what we can do to generate cash there and make sure we've got very positive ROICs on the client side.

Okay. Great. So shifting over to the NAND side. You guys have been relatively straightforward about the expectations over the year, talking about getting gross margins back to the high 30s versus where you've been in high teens. I realize that predated the coronavirus situation, so there's always questions. But that's pretty long-term guidance for a memory company. So what gives you the confidence in that outlook?

Yes. It's really the book of business that we see coming this year and the expansion in existing markets we're in. We mentioned that gaming consoles will be hitting the market later this year. They'll use flash rather than hard drives. And by the way, we have not been shipping hard drives into game consoles. So that transition will only benefit us as we're able to participate on the flash side. So it's nice to have a new piece of business coming into the market. We're expecting penetration to continue on the client SSD side, where we had very nice penetration last year, and we had very good share in that space. And then as I mentioned earlier, on the enterprise SSD side, we're seeing very good uptake on our products. And we're probably 10%-or-so market share today, going towards 20% at the end of the calendar year. And all of those areas will give us, I think, a nice tailwind for growing the business. And we should be in an environment where we can generate good margins.

Okay. And I mean as you think about supply/demand balance, it's kind of almost weird to me that the checks come back really good. Pricing seems really solid. There's prices increasing in a lot of areas. And yet, if I look at Q1, I mean, Apple preannounced -- Microsoft preannounced a hardware shortfall. China handset sales, just like every day, the news flow gets a little worse. So how do you reconcile those 2 things? I mean if you would just told me the demand side of that equation, I'd be pretty worried about NAND, and yet NAND seems very healthy.

Yes. As I mentioned earlier, when we were originally talking about the COVID-19, I think the supply side, we've got pretty well wired, at least for now. There's less certainty on the demand side. We acknowledge that. At this point with customers, we think we're getting a reasonable picture. Some of that demand will likely go away. Some of it will just get pushed out. And so the question is for all of us is how is the market going to shape up over several quarters, not just 1 quarter? And we had always expected the second half of the year to be quite strong. And the question is, will some of those first half volume shift to the second half? And then it will be an even bigger challenge in terms of getting all the products out the door.

Yes. Presumably, we still need end demand to be good.

Yes. Well, I'm saying maybe -- I'm talking about the end demand shift to the second half.

Yes. Okay. Makes sense. And then I guess, when you think long term about your NAND gross margins, I mean, DRAM has actually shifted where we're sort of seeing new territory in both directions. If I look at NAND, I sort of think of SanDisk as sub-20% gross margin at trough, above 50% at peak. Since you've acquired the company, you've sort of been in those ranges. Anything in your mind you think that would keep us from seeing gross margin get back into that 50% level at some point? And anything that you think that, that cycle -- when I think about the gross margin range through a cycle should look different going forward?

Yes. So let me talk first about the trough part of the cycle. A lot of what triggered this most recent trough was supply side. So as the industry transitioned from 2D to 3D, we had a -- and yields came up, all of a sudden, we had a lot of supply, a lot of bids hitting the market. And that's really what triggered the dramatic decline that we saw this last time. And actually, the trough was lower than it had been the prior 2 cycles. And we attribute that to the 2D to 3D transition. Now that we're in the 3D era, it's a much more capital-intensive era. And it's our theory, and we hope it plays out this way, that because it's more capital-intensive, you'll see the downside has dampened more. All of us will be a bit more cautious in terms of putting new capital equipment in place. Now on the upside, I -- clearly, I think the industry needs to be operating in that 40% range or so to get the kinds of ROICs that allow all of us to reinvest in the business and in the capital that's required. As you get to short-term supply/demand dynamics, it's very sensitive. So it very well could get back above 50%. But there's no guarantee that's going to happen. It's really a short-term phenomenon. And it's kind of how tight are things, at a given point in time, what's going on with supply and when is new capacity coming online.

Yes. And I feel like one of the things that maybe I didn't appreciate until we got into this year was how much inventory producers had burned off in the second half of last year so that your effective supply growth actually slows down as you run out of inventory. I know you saw that phenomenon as well. So you implicitly, it's not production declines, but your supply growth is effectively constrained in the first half. So how do you think about, from WD's perspective, your own capital spending, your own supply growth? I think you've talked about sort of not needing to do a whole lot different to get to 35%-or-so big growth just because last year, you had underutilization for a while. You had power outages impact the second half of the year. So can you just talk about generally how you think about supply in calendar '20 and how capital spending fits in with that?

Yes. Again, we know what's going on with us. We hear what's going on with our competitors. And it feels like industry supply growth will be in the high 20s, maybe 30%. I believe that the demand side will be closer to mid-30s, call it, 35%. So there is a gap there heading into this year. And I think that's because all of us had a really tough year last year. And so hopefully, that all plays out as expected and the pricing environment continues to get better as it has been recently. So in terms of our particular situation, as you noted, we took a lot of capacity off-line last year. So our growth rate in terms of bits produced will actually be higher than average. But we're not trying -- we're just trying to get back to our normal capacity bit share.

Understood.

And so I think we'll be in pretty good shape.

And from a capital spending perspective, as you're looking at these, we'll talk about the technology.

Yes. Yes. This year, this fiscal year, which ends in June, has been very unusual from -- in terms of the cash CapEx that we actually report on our financial statements, it will be right around breakeven. Now when we define CapEx, including the capital investments we're making in the JV, it will be kind of gross -- we call that gross CapEx, will be kind of in the $2 billion to $2.5 billion range this year. And then as we go into next year, FY '21, we're thinking we'll be back in that range of $2.5 billion to $3 billion in terms of gross CapEx.

Yes. I mean you guys -- and going back to SanDisk, for 15 years, it does a lot with a relatively small gross CapEx budget.

Yes. I mean we've got a great partnership. We think we're very capital-efficient. We make product decisions based on how are we most efficient from a capital standpoint and trying to make the right cost and performance trade-offs.

Okay. Great. And then on the earnings call, I think you talked about BiCS5, which is your next generation, the 112-layer product in NAND. Can you just give us a sense of that? And how competitive do you expect that to be? And what's the pace of ramping that technology?

Yes. So if you saw that press release, I mean, we're expecting this next generation to give us about 40% more bits per wafer. It will be, I think, roughly 50% better performance. It's going to be a very, very competitive product in the marketplace. We have -- sometimes we get asked why 112 and not 128 layers. Well, it's very finely tuned product, and we were able to shrink on the XY axes. And so we didn't need to go as high in terms of number of layers. And that actually allows us to be more cost-effective, allows us to be more capital-effective. And we're able, as I mentioned, to get the bit growth in the performance that we wanted out of those products.

Okay. Great. And you mentioned earlier the improvement in enterprise-grade NAND, I think the 10% share in enterprise SSD, moving up to 20%. Can you talk about that a little? And in particular, I would sort of think of WD's big advantages being early to something like the NVMe transition. You struggled a little bit with that and kind of now ramping it nicely now. So what's the prognosis for that enterprise-grade business? And how hard is it to take share at this point?

Yes. So a good question. And just -- I haven't -- I've only been here a little less than a year. But you go back in time when -- at the time of the acquisition, this was one of the opportunities that Western Digital saw with SanDisk is really had not had success in the enterprise space. And we made investments and made incremental investments. To be honest, we didn't execute as well as we could or should have. And it's just in the last year that we've really executed well on the road map. In the meantime, the customers, because they're all our customers on the hard drive side, they wanted us to be successful with those products. So now that we've got good, solid products, we have an excellent road map. It's -- I think it's just a matter of finding the right point in time to get into those accounts. And it's a chunky market share. You don't get kind of a point or 2 over time. When you win in some of these hyperscale environments, you all of a sudden pick up 5 points of market share. So it's an environment that I'm convinced we have the right products for now. We have the right customer relationships. And we understand the kind of quality and reliability expectations that customers in those markets have.

Yes. And it seems like 10% is kind of an inflection where you get qualified by everybody and you can...

Yes. We should be able to make very good progress there.

Yes. Okay. Great. And then moving to the financial balance sheet side of things, and I'll open up for questions after this. Your cash flow has been a little bit constrained. Now it's getting better or at least looks like it's getting better. Can you talk about the priorities for cash, the dividend, debt repayment, cash return, eventually, strategic priorities? Just how do you balance those things?

Yes. No, it's a great question. I'm very much into cash flow. And the last 2 quarters, we've actually had very good free cash flow. So I'm pretty pleased by that. This quarter is a little more challenging with all the dynamics going on. But it's pretty clear, and we've been, I think, very clear that as we generate cash, we're going to fund the business, make sure we make the right product investments, the right capital investments, and then we're going to pay the dividend. And then after that, it's about reducing our debt. And we've done that each of the last 2 quarters, and it was in our 10-Q. We've already paid down another $150 million this quarter. So that's going to -- we're going to keep pushing on lowering the total debt. And I'm convinced we'll make a lot of progress as the cycle gets better.

And obviously, there's a CEO transition, so you may not know. But just in general like, how do you think about the right level of debt on the balance sheet?

Yes. We didn't put a specific target out there. I've been saying for quite a while there's no way we want to enter the next down cycle with anywhere close to this amount of total debt. And internally, we've got some goals, but we're not ready to start talking about it externally. I'd like to really make sure we demonstrate the progress. And then I think everybody will buy into the goals we have.

Great. Okay. Let's see if we have questions from anyone in the audience. All right. We'll just go ahead and wrap up there then. Great.

All right.

Thanks so much.

Well, thanks a lot, Joe. Appreciate it. Thanks, everyone.