Western Digital Corporation (WDC) Earnings Call Transcript & Summary

Good morning. And thank you for attending JP Morgan's 48th Annual Technology, Media and Communications Conference. My name is Harlan Sur. I'm the semiconductor and semiconductor capital equipments analyst for the firm. Very pleased to have the executive team here from Western Digital, Chief Executive Officer, David Goeckeler; Chief Financial Officer, Bob Eulau; and Head of Investor Relations, Peter Andrew. David, as most of you know, joined the Western Digital team as CEO in early March, coming from Cisco with a solid 19-year track record. I've asked David to start us off by giving a brief background of himself and to discuss what he's looking to bring to Western Digital from a strategic, operational and financial best practices perspective, and then we'll go ahead and kick off the Q&A. Remember, if you guys have any questions, use the Q&A button at the bottom of your screen. With that, thanks, everyone, for joining us today. Let me turn it over to you, David.

Harlan, first of all, good morning. Thanks for inviting us here. Bob?

Yes. Good morning, everybody. And before David gets going too far, I just want to remind you, we may make some forward-looking statements. We'll probably talk primarily about non-GAAP measures, and I would encourage you to review all the risks in our SEC filings and our Forms 10-Q and 10-K. So with that, thanks for having us. Harlan, I'll let Dave talk.

Harlan, first of all, thanks for the opportunity, and we look forward to talking with you here this morning. So I appreciate the kind comments about my background at Cisco. I was there for quite some time and most recently ran the networking and security business, which is a $34 billion portfolio. I'm thrilled to be at Western Digital. I think we have a wonderful opportunity. I think I bring a very strong product background, a very strong background in running a P&L; and also a lot of background in a whole bunch of different business models, everything from running silicon projects to running them with some of the world's biggest SaaS franchises and software franchises in the world. So also a tremendous amount of operational discipline and scale running a business of that size. So as I said, I'm thrilled to be at Western Digital. I think the company is very well positioned, and we're in some great markets with great technology and portfolio and team, and I look forward to talking about it in more detail.

Great. Well, thank you for -- and thank you for the background, and thank you for the opening remarks. Why don't we start off with sort of maybe more of the near term? You guys just reported earnings a couple of weeks back. And on the recent earnings call, which did include the suspension of the dividend, I've spoken with quite a few investors with mixed reactions. I think the common concern amongst all investors were the company withdrew several guideposts with which we do benchmark the health and execution of the company. Among the most important ones are the withdrawal of your view of business conditions and view of things like flash and HDD gross margins in the second half of the calendar year, coupled with the dividend suspension. I'll get into the dividend suspension next, but on the second half guidepost, is it the macro uncertainty that's holding the team back? Or will it just be policy now to only provide a view on trends sort of one quarter out?

So I think we'll -- I mean, I think the main focus is to provide guidance one quarter out. We'll talk more about what the market looks like. It's just pinning specific numbers. So if I look at the second half of the year, that's where you want to start. I mean I see a very exciting time for the company. I think the portfolio is in great shape. If I look at the flash portfolio, we're clearly pivoting to higher-margin businesses like enterprise SSD. That's been a big focus, really good products there. I expect us to be scaling that and gaining share in a growing market. We're undergoing a BiCS5 transition, which is ahead of our internal plan. So that transition looks good, so that will help us as well on the cost side. And if I look at the drive side of the business, we're going to be ramping a market-leading product. I mean we're in a transition right now. Our 18-t products, we talked about it on the call, we took revenue for them in the last quarter. The ramp is on schedule, and the customer reaction is very good. And so -- and that positions the portfolio directly in the capacity enterprise, which is, as I talked about, correlated to the cloud, which is a great place to be from a portfolio perspective. So I think across the things we can control, feel very good about where the portfolio is and what we're going to be driving throughout the rest of the year. I mean clearly, we're in unprecedented times from a macro point of view, but we'll react to that, and we'll be prudent with our investments. But as far as where the company is positioned, I think it's -- we're in good shape.

Makes a lot of sense and thanks for the insights there. And then on the suspension of the dividend, can you just tell us the factors that went into the decision for the suspension? Was it driven by the macro uncertainty and potentially large economic balance shift caused by COVID-19? Is it more focused on reinvestment in the business and your optimization of the capital structure more in line with the cyclical dynamics of the storage markets? Or maybe a combination of all of the above?

Yes. So first of all, a couple of comments on that. So first of all, it is a very significant decision that was taken very carefully, deliberated quite strongly across the board. And we knew it was a big decision. Secondly, it was an elective decision. It was something we decided to do to best position the company for long-term shareholder value. It's not something we had to do. It wasn't driven by any situation that we were in at the time. It was a decision that we decided that given the cyclical nature of the business, given the fact that it's an investment required -- capital investment is required in this business. Given the fact that we play in very attractive markets, and we feel good about where the portfolio is to drive long-term customer shareholder value, long-term shareholder value, we thought it was the best decision to position us, and that's why we took the decision. Now we understand that a dividend is an important tool. And we look forward to getting back into a position. We're going to delever. We're focused on that. We look forward to getting back into a position where we can make -- we can revisit that decision.

So I think within that, I think I also seem to hear that a part of it is reinvestment in the business. And if I look at -- if I take a snapshot of the profile of the leadership of the WD team today, it's very strong, strong #1 or strong #2 position in the hard disk drive market. It's certainly viewed as a technology and innovation leader there in the NAND business, strong #2 share in SSDs, looking like you'll be #2 in enterprise SSD market soon, technology and cost leader on the manufacturing front, and you've got significant R&D and manufacturing scale economies with the JV partnership with Kioxia. It's really been, from my perspective, more about execution. But as you think about the industry trends and dynamics, where do you see the opportunities for the team as it relates to areas of investment? Is it more system-level focus, is it software focus? Is it silicon controller development? Help us understand areas for reinvestment.

So let me make a few comments. I'll invite Bob to make a few comments as well. So you're right. I mean the team -- I've come into the company. The team is everything I expected to be in the portfolio, well positioned. Obviously, a very, very strong team has led in the markets we're in for quite some time. So I think we are well positioned. I do see opportunity -- a good example is like the gaming console business. I mean here's something where we're seeing a whole new shift from hard drives into flash. It provides opportunity. Those are the kinds of things we need to invest in. So we see opportunity out there. We're in good markets, and we have a good portfolio, and I think we're well positioned. And as far as the long-term strategy of where we're going to go, now that's something we're going to work on over the next several months. I think 6 or 8 weeks in now, 8 weeks in, 8 going on 9. We are in unprecedented times, and we've been managing through that. But that's one of the things I'm going to focus on. The organization, as you said, the team is great, we can be better. We're going to focus on where we can be more nimble, where we can be more aggressive. We'll come -- we'll -- the strategy is well placed. The portfolio is well placed in the near to midterm. For the foreseeable future, we're in a very, very good spot, as I talked about earlier, of all the positioning that's been going on in the markets we're playing in. Obviously, I'm going to look at the long-term strategy, and we'll have more to say about that over the next several quarters as we work through it.

Great. Well, we'll be looking forward to that. Go ahead, Bob. Do you have some comments?

Well, I can just add, we're really excited about the opportunities in front of us. And obviously, we've got some things we can't control right now with the pandemic going on. But the company's focus, I think, as long as I can remember being involved and even before that, has always been to reinvest in the business first. That's always been the #1 priority. And I think really, what we're doing is saying deleveraging is even at a higher priority for us than it was in the past. So that's -- I'd say the change. I don't think there's so much a change in terms of reinvesting in the business as it is to delever the business.

And I guess on that front, so on the cap structure, driving to a 1 to 3.5x gross leverage ratio versus the 5x today, what's your target in terms of percentage of the free cash flow -- new cycle free cash flow that the team is going to be committing to paying down the debt?

Yes. That's a good question, and you commented on our targets, and it was really around our modeling of the last cycle. So from peak to trough, how did our gross leverage looked in the last cycle. And in terms of free cash flow, we obviously have internal plans that I'm not ready to talk about. But if you look at the last 4 years, we've probably averaged about 10% in terms of free cash flow as a percent of revenue. So I think this business has demonstrated, over a number of years, the ability to generate very significant cash and our goal is to get back to where we're generating significant cash. We had a good cash quarter last quarter. We think it will be pretty good this quarter as well. And we'll just keep improving, and we'll keep paying down the debt. That will then give us a lot of flexibility in terms of how we return capital to shareholders and how we, on an ongoing basis, reinvest in the business.

Great. Why don't we switch over to some of the COVID-19-related impacts on the business? On the COVID-19 operational and supply chain constraints, I know it's only been 14 days since the team has reported, but in this environment, I mean, things are changing almost on a weekly basis. You've got shelter-in-place and movement control in the Bay Area, Philippines, Thailand, Malaysia, all areas where the team has pretty big operations. On top of that, there are logistical problems, limited airfreight. And then I think you've also had some component and material constraints. First, the team has been managing through this actually very effectively, but you did expect much of these issues to improve as the quarter progressed. And so are you seeing that? And can you give us an update?

Yes. I mean I think you hit on it. The situation has been changing day-to-day, week-to-week. It's a very dynamic environment. The team has been executing extremely well. I came into the business on March 9. And March 11 was actually when the global pandemic was declared. But the team had been working this for quite some time. We have facilities in China and had really worked to develop best practices of how do we really keep everybody safe. I mean that's the number one concern, keeping all of our employees safe, working with our suppliers, our customers to make sure that, that's the number one concern. And the team was able to develop best practices early on. And then as it spread across to all the different global sites, we were able to very quickly implement those best practices. But as you said, there were -- every region we operate in has a different set of rules, whether it was movement control orders, whether it was blockade, shelter-in-place. The good thing is, we're declared an essential business in everywhere we operate. So that allowed us to keep things going to the extent we could make sure we got people in to work and at certain levels that we were held to. It has gotten better over the last several weeks. Every week, I think it gets a little stronger, and we're back to a position where we're nearly at full capacity from a production perspective. And so we feel like we're in a very good spot. And -- but again, it's a very dynamic situation, and we're going to stay on top of it and make sure, as I said, our teams are safe. We're implementing absolutely the best practices around the world, and we're also keeping the business moving.

Another vector I'm not sure if it was asked on the call or not, but I cover the semiconductor capital equipment companies, and many of them are being impacted by many of the same operational and supply chain issues, and that's limiting their ability to ship equipment. Is your JV operations concerned around equipment constraints and especially as the team is bringing up the K1 fab output?

Yes. I can start with that one. We believe the industry overall is impacted probably by a month or 2 in terms of just our vendors not being able to get support on-site to help us as equipment is being brought up. So I don't want to get into specifics on the JV, but I think it's a phenomenon that is fairly pervasive right now.

On the near-term side, I mean, there obviously, in Japan, there's similar shelter-in-place, work from home. But again, that's a place where we were able to move the best practices in, work with our partner. Production is still up and running. No issues there. I mean there is some issues on longer term, the ability to drive transitions, as Bob talked about, but everything is moving forward at this point.

Yes. Probably some impact this year, bigger impact next year in terms of those delays.

Got it. Let's talk about China-U.S. trade. On the recent Department of Commerce BIS memo, on licensing requirements for components targeted for military applications, even if those same parts are used for civilian products. I'm sure the team has reviewed this, but do you expect any impact to WD's products?

The team has reviewed it as it's written now, and we don't expect a material impact the way it's written now. Obviously, we're going to stay very close to this, and we'll continue to evaluate. But right now, we don't see a material impact.

Okay. Great. Why don't we pivot over to talk about some of the products and the technology execution? And so as you mentioned in your opening remarks, David, the team has been focused on executing to a richer mix in your NAND business. You've actually done a great job on the enterprise SSD front, right? You actually had -- the team had low single digits percentage market share in middle of last year. You exited 2019 with about 6% to 7% market share. You've gotten qualified at multiple hyperscale customers with your NVMe platform. Just given the strong growth in March, it looks like the team actually did gain quite a bit of share. But based on your estimates, did the team achieve double-digit percentage market share with your enterprise product in the March quarter? And do you expect that share to continue to grow here in the June quarter?

Yes. I think we're right around that. And certainly, this is a market where we've been targeting and investing in. The team has been doing that. And we -- it's a growing market. It's a great market, and it's something where we expect to continue to gain share. We're certainly going to stay focused on that.

The -- sticking with the SSD front and just the NAND front in general. The team is positioned pretty strongly via its position in client SSD to participate in the upcoming. And you again mentioned a game console refresh cycle starting in the second half of the year. This is a very good example of market expansion of flash into new opportunities, right? And certainly, for WD, as you did not have any exposure on the HDD side, on prior generation of game consoles. And so we're thinking that estimating that this is about a $200 million, $250 million revenue driver for WD in the second half of this year. But we also have things like new AI and deep learning compute clusters that are also making heavy use of SSDs, given the performance benefits versus HDD. Any other applications where you see flash penetration due to cost or performance-related benefits going forward?

Yes. I think -- look, I think you hit it. This is -- when we talk about reinvesting in the business, we think there's going to be incremental opportunity given the dynamics of this market. You see the game console market coming on is going to be a good market for us. You can look at things like virtual reality headsets, we think, are going to start to ramp in the second half of the year. So we don't know the exact date of all these things, but this is the idea where we're working -- there's going to be incremental opportunity for us in these markets that we play in, and we think that's going to continue, but there's clearly some good ones coming up. Bob, do you have something to add?

No, I agree. I mean we're really excited about how we're doing in the client SSD market. We think we've got a lot of momentum in enterprise SSDs, and we're not backing off at all from our goals we had before of getting to 20% on the SSDs. So those are great markets.

On the technology and manufacturing front, is the team still on track to ramp your 112-layer BiCS5 NAND technology later this calendar year? And I know you don't want to talk about gross margins beyond the June quarter, but the things that you do have control over, like yields and manufacturability, is the team still executing to around 15% per year sort of cost per bit declines?

Yes. We are still executing to that number. So -- and the BiCS5 transition continues to go well. I think we're exceeding our internal goals we had set for how -- for yields, and we'll be looking for that transition to continue in the second half of the year.

Great. I'm going to -- we actually do have a number of questions from our investors. And so the first question is, can you ask the team to provide more color on the appropriate time skills to think about with regards to some of your domestic China competitors like YMTC, for example? So what is your view in terms of time lines, given your competitive views on the China domestic guys as well as just the overall competitiveness of the technology?

Yes. So I'll start, and then Dave can add in. But obviously, we've been monitoring YMTC for a number of years. So they have very ambitious plans. We think they're pretty aggressive plans to skip the 64-layer and go right to 96. And we know how challenging that is because we've been through that kind of transition. But we have to be really, really cautious in terms of what they do. Initially, we think they'll probably be successful in the Chinese domestic market. And we have some retail business there that I'm sure we'll face increased competition. But we don't see a lot of change in the next couple of years. I mean they've got a very ambitious road map they need to execute on.

Another investor question, we had Micron present at our conference yesterday. And so Micron is talking a lot about how combining DRAM and NAND is going to give some of the players that can do both DRAM and NAND, there's like Samsung and Micron, an advantage in both enterprise as well as we can already see it in smartphones with MCP-type architectures. What is Western Digital thoughts about combined NAND, DRAM-type solutions, both for data center as well as for smartphones? And what are the partnerships or alternatives that you have for capturing DRAM if you do need it in certain of your applications?

Well I certainly think we have opportunity to work with suppliers if we see attractive markets there. I think we're happy with where our portfolio is. We're happy with the markets we're playing in. We think we're well positioned. I mean obviously, it's a dynamic market and there's going to be incremental opportunity, depending on how your portfolio is structured, but we're very happy with where our portfolio sits both on the drive side and on the NAND side of the portfolio. Bob, anything to add?

No. I agree. I mean there's a big market opportunity out there outside of MCP and I think that, obviously, we've demonstrated we're doing well on client SSDs, we're doing well in enterprise SSDs. And we've got a very strong retail presence that a little bit of a headwind right now, but is a huge competitive advantage for us as we move forward.

I'm going to move over to the Client Solutions business. It's been weak in the first half of the year and it's not a surprise as this is what a lot of your retail-focused products are. But the team has a very strong brand recognition here. I believe these products carry higher than flash segment gross margin. So as the economy starts to improve and retail starts to open back up post COVID-19, I assume that this is yet another potential gross margin tailwind for the team. Am I correct in assuming that?

Yes, I think that's right. I mean we talked about this in Q3. You're right. I mean we're in -- as I said, we're in unprecedented times. Obviously, what's happening in retail is a lot of disruption. The team has managed it well as far as shifting more to online, really supporting our customers as they shift to pick up at the curb and those kind of models. But it is -- we do think this is a big advantage for us. We have a very, very large distribution network. We have a very good brand. That brand -- in certain parts of the market that is accretive to us on a gross margin perspective. As you said, obviously, there's a lot of headwinds given the uncertainty of the macro situation. But as that starts to improve, that business will improve as well.

I have another investor question here, maybe more near term. So common trend here in the first half has been strong cloud and hyperscale data center spending, strong notebook PC demand, much of which you guys highlighted on your call and contributing here to the June quarter -- strong June quarter outlook by the WD team. But specifically on data center, do you expect the strong spending trends to sustain into the second half of this year?

Yes. I mean so first of all, I think what we've seen is a massive acceleration into this technology-enabled world. Clearly, that was -- the foundation for that was set well and the architecture was set, and we've had, unfortunately, is a pandemic, but a massive acceleration into the reliance on technology. And the public cloud is a -- I talk about the public cloud as a seminal technology trend of our day. It changes everything about the technology market. And the portfolio is very well aligned with that trend. Now is it going to grow into the second half? I mean I think we're starting to get visibility into beyond the current quarter. We see continued good trends there. Exactly how it's going to land, we'll talk about more at the end of Q4. But it's always hard to call on a quarter-by-quarter basis when you start going out many quarters. But I think the trend is well set, and I think that the portfolio is well correlated to public cloud growth. We have a very good position in the public cloud and great customer relationships there.

And I think we're more diversified today with some of the cloud customers than we were a couple of years ago. So we're -- we feel like as one customer is experiencing different things than another one it's a -- we can diversify away some of that risk. And long term, it's just a fantastic market.

On top of that, turning to the HDD business, I mean, 14-terabyte nearline HDD is still the sweet spot in the strong demand environment for cloud. However, there is a shift to 16-terabyte that is taking place rather aggressively. The drive qualification cycle for your cloud customer is quite long, so what is the team's expectation on when you expect to see qualifications of 16- and 18-terabyte platforms, by our large cloud customers, which typically then does signal the move to very high-volume production?

Well, the -- I mean, the qualifications are underway or imminent with the cloud customers. So we feel good about where we are in that cycle. We're providing product to them to do that. We're getting very good feedback on the product. So we expect -- we talked about the ramp is on track for our 16 and 18, and we expect that to continue in the second half of the year.

China cloud data center CapEx spending for the next several years actually looks strong as they look to catch up with their large U.S. peers. And I think the view is that although there's a double digits kind of data center CapEx outlook from the cloud and hyperscalers over the next few years, China is going to be much faster-growing within that, right? But the China customers have been historically sort of one step behind in terms of density on nearline HDD. This has been an area where WD has also tried to take advantage of. Where is the sweet spot for China cloud titans? Is it still sub-14 terabyte? Or are they now aligning with U.S. peers in terms of density?

Yes. I would say it's still sub-14 terabyte, but that will change as they start to continue to ramp. So the majority of the spend still is in the big cloud titans in the U.S., but it's an attractive market. The China cloud customers, attractive market, as you said, growing that we're in. The sweet spot is probably a little bit below 14 for now, but we expect that to continue to move up.

No, I think that's right. And I'm sure you know. I mean, globally, the 14-terabyte drive is still expected to be the highest volume drive through the September quarter. So we feel good about how we're positioned there.

Let's maybe turn a little bit to the financials. And so the team -- so maybe let's start off is, as we think about your commentary on future uses of free cash flow. And as we think about the OpEx longer term, given one of your prioritization of free cash flow on reinvestment in the business or potentially higher R&D spending through cycle, how should we think about your R&D target now as a percent of sales?

Yes. I don't know that we want to go into percent of sales yet. We're going through our annual planning process right now. But one of the things I did say on the last call is, you should expect our OpEx to be roughly in the range it is this quarter for the next few quarters. And I think that's probably the safest assumption.

Got it. And so looking at sort of -- if -- as you mentioned, the team has done a good job of maintaining a pretty disciplined OpEx profile coming out of the NAND industry from the last downturn and even as we moved into the COVID-19-related weakness. So in the event of a, let's say, protracted economic downturn in the second half, how much can the team flex its OpEx lower from current levels without major headcount reductions?

Yes. I think -- I don't know if I want to get too specific on that. I mean we're -- as I said, going through our planning process right now. As you said, Harlan, our team has been very disciplined in the past. We've demonstrated that capability and we need to make sure we prioritize properly where we make our investments. And we believe we've made good calls in the past, and we think we'll make good calls as we move forward here. But in terms of is there incremental downsizing? I think that's something we need to continue to keep an eye on, but there's no plan right now.

Got it. And then here's a question from an investor. So the team has provided a view of continued strength in NAND pricing here into the June quarter. Are there any updates? Are you continuing to see the strong NAND pricing environment as you had expected? And broadly speaking, you had talked about certain end markets strength is peaking. And the bottom line is, is the end markets that you thought would be strong, strong? And are you continuing to see an environment of relatively healthy NAND pricing?

I think in this quarter, it's playing out. We're not -- we're half -- not even halfway through yet, but things are playing out as we expected as we guided. So we're still seeing the pricing environment we saw going into it. We're starting to look at Q3 pricing, and we'll have more to say about that when we get further along in this quarter.

Okay, great. And then one last question from an investor. This goes back to some of the opening commentary and dialogue that we have around dividend elimination. But I think the question is, why not telegraph the dividend elimination and prepare the market? It seemed rather abrupt, which leads to questions around the strength of the end markets, demand, competitiveness of the team and so on.

Yes. I mean it's -- look, it was my first quarter in the business. So I don't know how much I could have telegraphed that. We -- again, we believe it's the right decision for long-term shareholder value to position the company as best we can for the markets we play in. Given our portfolio, we think there's going to be incremental opportunity out there, and it sets us up for a multiyear growth story. Now we have to go execute that. But again, we think it's very much the right decision and puts us in the best position possible to generate long-term shareholder value.

So one of my last questions is going to be more just around the competitive environment. And I think that when we had the Micron team yesterday, I think they work with -- their DRAM business is 70% of their business. They work within a competitive environment where there are 3 competitors, it's a slower growth market. I think competitors there realize that probably better to focus on profitability, free cash flow and sustain healthy financial structure there, of which to fund the faster-growing NAND business. In the NAND industry, obviously, where you guys dominate, there are 6 players maybe moving to 7 if YMTC can execute. What have you guys been -- obviously, the WD team and your JV partner have been extremely disciplined on reining in supply in times of weakness, focusing on profitability, free cash flow. The rhetoric from your competitors as well as the actions in the most recent downturn have also seemed to indicate really good supply side discipline. I mean is that the way that you're thinking about the dynamics, the structural dynamics in the industry that even with more players? It has become more disciplined, everybody does seem to be more focused on profitability and free cash flow. Would love to get your views there.

Yes. So first of all, it is a dynamic market. It's a very attractive market. We're going to stay very focused on our view of the market and work with our JV partner appropriately. But we believe it's important to make sure that we get this demand and supply balance right, and we're going to be very prudent with our decisions. We're looking at our markets. Obviously, again, we're in unprecedented times and to try and get the best view possible of what the -- how the market is going to develop over the next 4, 5, 6, 8 quarters and make capital investments that are appropriate for what we believe that demand environment to be. But it's a big focus of ours, and we're going to stay very vigilant on making sure that our investments are prudent that we get balanced supply and demand.

We're just about out of time. So David, Bob, Peter, thank you very much for joining us this morning. Look forward to monitoring the progress of the team as the year unfolds. Thank you very much.

All right. Thanks, Harlan.

Thank you very much for the time. We appreciate it.

Yes. Thank you.