Western Digital Corporation (WDC) Earnings Call Transcript & Summary

So why don't we go ahead and get started. So I'm Aaron Rakers. I'm the IT hardware and semiconductor analyst here at Wells Fargo. I appreciate Wissam Jabre, the Executive Vice President and CFO of Western Digital, joining us here this afternoon to talk a little bit about hard disk drives, talk a little bit about flash. To say that you haven't been busy over the past year-plus is probably an understatement. You've had a few things going on with regard to what's going on with Western Digital and spinning out the flash business and what was announced in the most recent quarter. So first of all, I think you've got a piece of paper there. You want to read the safe harbor, and then I'll jump right into questions, and we'll go from there.

Thanks so much, Aaron. Happy to be here. Thanks for having me. Good afternoon, everyone. Let me first start with reading the safe harbor statement. So we will be making forward-looking statements based on current assumptions and expectations, and I ask that you refer to our most recent annual report on Form 10-K and our other filings with the SEC for more information on risks and uncertainties that could cause actual results to differ materially. We will also be making references to non-GAAP financials and a reconciliation of our GAAP and non-GAAP results can be found on our website.

Perfect. Good job. So both your businesses have gone through some down-cycle dynamics here in the last handful of quarters. I was just looking at some metrics before we got on stage, hard disk drives have come off and what I wanted to really kind of get at with this discussion is really understanding some of the foundational things that Western Digital has put in place throughout the midst of this downturn, will dive into both hard disk drives and flash. But what I really want to understand is how we've gotten those foundational things to get to the point where the company is going to separate the two entities as we look into next year. So maybe we start on hard disk drives. Can you talk a little bit about some of the things that you've done over the last year or so to really kind of realign the business in the midst of the downturn that we've seen?

Of course. Well, let me first start by saying I'm thrilled that we announced with our earnings the completion of our strategic review, and basically, we also announced the separation of the flash business and the creation of 2 independent publicly traded companies that would be leading in the storage industry, the HDD and the flash businesses. That will basically allow us to unlock the value, which was the purpose of our strategic review and leading to that, we have been doing a lot of work over the last few years to align the 2 businesses. So first when David Goeckeler, our current CEO joined, he put in place the 2 business units focused on hard drives and flash and then we reprioritized the capital allocation to delever the balance sheet. So since then, we've reduced $2.7 billion of debt. And with the beginning of the cyclical downturn, we've taken quite a bit of -- we've taken the opportunity to reduce quite a bit of cost from our system, whether on the fixed cost side or on the OpEx side. So when we look on the hard drive business, for instance, we've taken out 40% of the client manufacturing capacity, reducing the fixed cost rated to manufacturing by around 15% if we compare it relative to where we ended fiscal 2022. In parallel, we continue to -- we've also reduced the CapEx investment in both the hard drive and flash. And so on the CapEx side, we've reduced overall in fiscal '23, around 35% relative to fiscal '22. This year, we've taken also down our cash CapEx significantly to continue to focus on cash generation and ROI. In parallel, we've taken a lot of operating expenses out of the company where if we compare, for instance, the most recent September quarter where we ended at non-GAAP OpEx at $555 million, we compare that to the last -- the fiscal Q4 of 2022, which was at $760 million, you can see that we've taken quite a bit of OpEx down from total company to basically continue to manage the profitability as well as cash generation. Over the same time period, also we've settled tax dispute that would basically help clarify things. And so we've been really focused on taking action to strengthen both businesses and allowed both businesses to be -- to stand on their own in a very sustainable way. On the flash side, we've also reduced CapEx quite a bit in fiscal '23, and we'll continue to do so in fiscal '24. But we also continue to develop new technologies. We've announced our BiCS8 technology that would be ramping in the future. So there's a lot of actions that were taken to strengthen really both businesses.

Yes. Yes, that's good. So maybe I'm going to stick with hard disk drives, and we're going to go to flash. But maybe just double-clicking a bit on the hard disk drive business. So looking back at the last 4 quarters, I think you've recorded, I think it's somewhere around $300 million of underutilization costs. Last quarter it was $83 million. You've talked, I think, this quarter's guide is somewhere around $40 million. I guess what I'm trying to get at is how do I think about that number as we start to maybe think about the assemblance of a recovery, do we look out the next couple of quarters and that underutilization is kind of lifted out of the model? Is that a fair assessment or how are you thinking about that?

So the underutilization charges reflect basically the period costs associated with the unutilized assets. What we do -- the way we manage the business is we really focus on inventory management as well as margin -- gross margin management in addition to obviously, talked about the fixed cost structure that we've also taken out of the system. And so as utilization improves, underutilization charges decline. The way to think of it over the last -- over the next couple of quarters as we continue to see improved -- gradually improved demand, we would expect the underutilization charges to gradually decline.

Yes. And I guess what I'm ultimately getting to, I'll just stop beating around the bush, what is a normalized gross margin for the hard disk drive business? Like -- and the way that I'm thinking about it, I think a lot of investors ask me about it is that you've got a hard disk drive business that is down considerably relative to where it was peak, call it, early '22 kind of time frame-ish. And you've got at the same time taking you just mentioned 15% of cost structure out of the fixed cost organization. So do I think about one, what is normalized gross margin? And two, should I not think that you get to that normalized gross margin at 15% to 20% lower revenue or [indiscernible] how do you think about that normalization?

So the -- with the reduced or the lower fixed cost structure as well as the much bigger focus on cost and efficiencies. I would expect us to reach "normalized levels of gross margin" at a lower revenue relative to, let's say, the previous peaks. Now when we get to the target level, our target for the hard disk drive business, gross margin is still 31% to 34%. And if you see the performance of the business over the last few quarters and you adjust for the underutilization charges, you can see that the actions we've taken on the cost side have already started to show results. Obviously, they won't be fully visible until all the underutilization charges disappear. But nonetheless, we're starting to see good traction on the gross margins.

You can assume that I've done that math, right? And you're pushing 30% almost now last quarter when you adjust that gross margin. So there's nothing that structurally keeps you from being 31%, 34%, lifting out the rest of just sheer volume, basically, absorption?

That's correct, Aaron. And we've taken -- we continue to take also actions as we work with our customers on build-to-order type of model that would allow us to have a bit more visibility in advance to be able to manage our supply chain and our manufacturing capacity in a much more efficient way.

And kind of going back a little bit, I want to put this out there, just curious, last quarter, I mean, you're starting to see some demand stabilization in hard disk drives? Is that kind of how we think -- thought about the guidance into this current quarter?

I think that's fair. And as we said on the earnings call, we've started to see some signs of improvements, and we would expect continuous improvement for the rest of the fiscal year.

Okay. I'm going to keep working on this P&L, and we'll go to flash, trust me. But fixed cost structure reduction, everything else. How do I think about the OpEx structure of a hard disk drive business? Like do I look at your closest peer and say, hey, you should be similar to that on a straight-up HDD business? Because ultimately, what people are in the process now of thinking about is how to -- how does it look separating the 2 businesses out? And I think everybody is trying to understand that P&L. So how do you think about the normalized OpEx of the HDD business?

Yes, I understand that we all want to sort of get to a point where it's very clear what the HDD business would look like versus what the flash business looks like. But it's -- look, it's early days, and we still have a lot of work ahead of us to get to that point with respect to OpEx and not only OpEx, of course, capital structures and allocation, et cetera. And as we get closer to the date of the separation, we would be hosting and Investor Day to provide a lot of details for everybody to be able to [indiscernible] the business and get a clear picture of what we're dealing with. Back to the OpEx question though, what -- the way to think of it is at the company level, we've taken down our OpEx since the end of fiscal '22 by around, roughly speaking, 25%, 26%. We ended Q1 at around $555 million for the total company, which was probably a little bit on the lower side. I think as we normalize over the next few quarters, I would expect OpEx to sort of be in the sort of $580 million to $600 million range, depending, of course, on what the -- as we continue to see improvement in the top line and profitability. Of course, we won't be increasing our operating expenses faster than revenue. But as we see improvements, that would be probably a good number to use.

And then on the HDD business, the capital intensity is pretty nominal, right? I mean we wouldn't expect to see any low single-digit kind of CapEx intensity. I mean is there anything that we should be thinking about as far as investments on the CapEx side there?

I think the -- well, our target is 4% to 6%. I think we will -- total for the hard drive business. So I would expect at least in the short- to medium-term to be on the lower end of that range because we have the capacity we need for the next.

And one final question on the hard disk drive, I promise. Your closest competitor and maybe take a step back, I mean, this hard disk drive industry is a duopoly, right? I mean [indiscernible] Toshiba is still a competitor. But it's very competitively narrow. One of your closest competitors did extend the depreciation life of their equipment in their hard disk drive, obviously, the hard disk drive business. So have you implemented -- do you think about that? Is there anything to consider there on the gross margin as well?

So we've always been conservative on our accounting. And if you refer to our most recent 10-K, I think our depreciation lives for the vast majority of the machinery, software [indiscernible], et cetera, is around -- from the 2 to 7 years [indiscernible] range.

Okay. Shifting over to the Flash business. Maybe I'm going to start with just kind of the question of -- remind me again, I think some of your slide decks and stuff, some of your slide decks and stuff, you've mentioned how much actual cumulative footprint you've got in your portion of the JV. I think it is $18 billion to $19 billion, it might be $20 billion. Remind us again of how big of a capital investment you have in that -- in the JV operations?

So I think since inception, if my memory serves me right, the investment that's been put in place is more than $20 billion, closer to probably $21 billion, so it's a massive investment. It's highly capital-intensive, but also the JV offers -- the joint venture offers quite a bit of great scale in terms of manufacturing and technology development.

And just maybe for the audience, remind us again how the JV actually structurally works, right? You make joint decisions. You get your portion of the wafers out, you make those decisions across the portfolio, et cetera?

Yes. So the way the joint venture -- by the way, this joint venture has been in place for 23-plus years. So it's not recent. This is probably one of the longest joint ventures in technology. And the way it works is that the technology development happens at the joint venture for both partners and the manufacturing. And both partners benefit from the scale of the manufacturing with basically each partner gets 50% -- approximately 50% of the output. And so anything that happens within the joint venture from the development of the technology to the manufacturing until the wafers come out of the fab, are pretty much shared 50-50 with each partner responsible for the 50% of their capacity financially speaking. Once the wafers leave the fab, then each of the partners have different -- for instance, I can speak for our company. We have our own product portfolio. We have our own back-end assembly and test capacity where the wafers go, they get turned into finished products. And then we -- each of the partners have their own go-to-market strategy, marketing, distribution, et cetera, totally separate from each other.

Yes. And can you talk a little bit about what you've done similar to the Hard Disk Drive business, the capacity footprint, how you've realigned that in the midst of the cyclical downturn that we've been dealing with? And maybe also help us appreciate what you thought about in terms of the Flash business showing signs of recovery in the current kind of quarter progression?

Sure. So yes, one of the things we looked at and the way we sort of manage our business as we were in the depths of the cyclical downturn, we were looking at where our inventory is, where the demand of our products is relative to where the supply coming out of the fab was. And in January of 2023, we've taken the decision to reduce our wafer starts at the time by 30% to basically manage that inventory and cash flow situation. And since then, we've been managing in a very dynamic way, in a proactive way. We look at where the supply of our product is and where we think inventory is headed, and we basically manage the supply of our products accordingly. At the -- with -- so this has been quite successful for us when you look at where we ended in the September quarter, we pretty much -- our inventory situation for the Flash business was -- our days of inventory were at the 4-year low so we've been managing very closely, obviously, through proactive supply management, but also we had a record shipment quarter in Q3 -- in calendar Q3, which helped with getting to that low days of inventory. And so with the -- with that, we're seeing an improved environment from a demand perspective as well as the price erosion has slowed down. So there's -- as we said also on our earnings call, we're seeing improved pricing environment over the next few quarters in the Flash business.

Yes. And how do I think about you take out 30% of your [indiscernible] output, right, your wafer starts? How do I think about that coming back on the progression or what -- just kind of walk me through kind of the dynamics that would start to bring that capacity back on for you?

Yes. So as I said earlier, Aaron, we do look at this in a very dynamic way. We make these decisions week-to-week, month-to-month, quarter-to-quarter. And so as we always look at where the demand of our product is versus where the supply is and then we basically address the factory or the fab utilization accordingly. So as we -- there's also -- within that, also, you need to factor in over time the [indiscernible] transitions as we start moving from BiCS5 to BiCS6, right? So these are all things that we consider as we manage the business to make sure we manage the inventory and the supply of our products on a real-time basis.

So to get to the P&L impact of that dynamic, I think this most recent quarter, you talked about, I think, of $70 million to $80 million a quarter kind of underutilization, the progression of that as we start to see [indiscernible] shipments improve, you've got supply side, still probably realizing the effect of the output, the wafer reductions that not just you and the industry have implemented. How quickly could I start to see that $70 million, $80 million a quarter headwind reported in the P&L related to underutilization start to come out?

If we continue to see improvement in demand, I would expect our underutilization charges over time to decline. It's a bit too early for me to talk much more in detail about numbers, given that, as I said, this is something that we manage in a dynamic way. But if -- and when we see the continued improvement in demand and profitability in our business, we would see the underutilization charges decline. The -- if I look at the next couple of quarters, I still see, obviously, underutilization charges maybe slightly lower than where we are now, but I wouldn't expect it to be -- at least based on what I see on today's number.

Right. You mentioned it briefly there, but maybe walk us through where we're at as far as the progression of process nodes or the layer count, BiCS5, BiCS6, BiCS8, which is -- I'll touch on here in a little bit, architecturally different, just maybe level-set us of where we're at as far as that progression through Western Digital Flash business.

Of course. So the latest node we announced was the BiCS8 node, which is the follow-on to BiCS6. Today, most of our volume manufacturing is on BiCS5.BiCS6 is our 218-layer node. Look, what we've shown, I think, over the years is that we have a very capital-efficient technology. The way the technology has developed is based on looking at capital efficiency as well as cost reduction, having both of these in mind. Our engineering teams look at both of these and have both of these in mind as they develop the technology. So we've seen really from a capital efficiency perspective, probably we're near the [indiscernible] and when you look at, for instance, the BiCS8 technology, which is the 200-plus layers technology, you can see not only the capital efficiency is continuing, but you can also see the cost as well as the density improvement as we move from one technology to the next. There's always the talk about the number of layers and the perception that the higher number of layers means better technology. However, when you look at over the last few quarters and the performance of our -- for instance, our gross margin, we've shown that we're very competitive, we've pretty much outperformed many of our peers. And that's related to sort of to the number of players and the manufacturing costs associated with those.

So BiCS8 is architecturally, it's a hybrid bonded architecture, right? You're like -- I think you and obviously your JV partner, one of the first [indiscernible] to actually do the periphery and the CMOS together, it's actually a separate process. So the cost effectiveness of that, do we stay on the same cost curve as you cut over to BiCS8? And what's the -- am I not to think that there's a lot more capital intensity involved in that manufacturing processes changing?

So BiCS8 is based on what we call [indiscernible], which basically is made up of [indiscernible] wafers that are bonded on each other. One wafer that has the CMOS circuitry and one wafer that has the memory array, and they're bonded on each other. So yes, there is more capital intensity included and involved in the manufacturing process. However, the bits output more than makes up for that. So there's also higher bit count, meaning you get more bits out of every wafer as you manufacture these. That's sort of one. Two, there's also the potential of reusing the CMOS wafer. And so that, in some ways, allows for better capital efficiency because you really have to deploy that tool set once and then you can reuse it for sort of newer or more advanced memory arrays in the future. And so BiCS8, as I said, the 200-plus layer, it is cost competitive. We do expect to remain on that sort of cost curve, which is -- we've always targeted our cost reductions in the mid-teen percentage over time between sort of -- as we move from one technology node to the other. And I don't see today as BiCS8 being different.

When should we start to think about BiCS8 from a material -- materiality perspective on volume? When do you -- I mean, I don't know if you're going to say when do you think crossover might happen, but -- how do you think about the ramp of BiCS8?

Yes. I think it's a bit too early to speak about crossover, but we are in the process of converting our product portfolio overall to BiCS8. And it all depends really on the demand and profitability of the business. As we see demand and profitability improve, it could be -- we could start seeing BiCS8 ramp as early as the second half of next year.

Second half next year. Second half calendar year?

Yes. It all -- but again, it all depends on the demand and the profitability of the business.

So I've got a few other questions. I'm going to try and like really get through here real quick. So maybe I'm going to bounce around. I apologize [indiscernible]. One of the things that we've been saying, we've been reporting is that we're clearly seeing NAND flash pricing turning higher, like spot pricing on average looks like it's up 40% so far this quarter. I mean how would you characterize the -- have you seen signs that the [indiscernible] flash pricing has definitely improved faster?

So as -- look, as we said on our earnings call, we are seeing an improved pricing environment, and we anticipate that it would be -- we would continue to see that for the rest of our fiscal year.

Okay. That was a good try by me to ask about specific price. So I'm going to have another try. Capital structure, I think I know the answer to this but I'm going to ask it anyway. So everybody is trying to figure out how we kind of think about the debt for the combined company. I guess the way that I've thought about it a little bit is if I take your closest peer and I can assume that normalized, they would run typically 2 to 3x debt to EBITDA, I think about the hard disk drive business. Is that a good proxy in your mind? Am I crazy in thinking that way? Is there any kind of framing you can help me kind of like level-set, like here's how I should think about the capital structure at all?

So look, there's still a lot of work for us to do before we talk about specific numbers as we go through the work we need to do to get ready for the separation. I can maybe talk a little bit about the guiding principles, which basically -- our aim is to create 2 independent publicly traded companies that are competitive in their own markets that can -- that are sustainable, that can basically sustain long-term growth and long-term success. And so each of the businesses will be -- we would look at the profile of each of the business from a profitability and growth perspective. And based on that, obviously, those capital structures would be optimized.

Okay. As you look to turn positive free cash flow, how do you think about using positive free cash flow. Is it all about deleverage still? Is there any other thoughts in mind, I mean, as we move towards separation?

I mean we do have -- we want to continue to optimize our own capital structure as it stands today [indiscernible] issue convertible notes shortly after earnings that would help us address the -- that was done really to address the notes that mature in February 2024. We also have the delayed draw term loan that we drew down in August to cover part of the IRS -- the settlement payment that's due at the end of June. So we would want to basically cover these liabilities. And then for the rest, we would continue to optimize our capital structure [indiscernible].

So in the 4 or so minutes we've got left. One of the common questions I get and again, bouncing around here, but hard disk drive-wise, I get a lot of questions around [indiscernible] and you guys this last quarter, talked about having a 40 terabyte energy assist-based platform in the market. I'm not sure exactly if you gave a time frame of that. But how do I think about that? Because to me, that's an important kind of delineation between the competitive landscape that I've never seen historically in hard disk drives, different technologies being deployed. You've also said that you're not against using camera either. So can you -- why am I not concerned that your areal density curve on hard disk drives could fall behind that of your competitors?

So when you look at what we've done historically and we continue to do in terms of executing to our technology and product road map in the hard drive business, we've continuously improved the capacity points from one generation to the next, from one generation to the next. When you look at, for instance, the most recent -- today, we still have the technology leadership with our 26 terabyte SMR product, which, by the way, is almost 30% higher than where we were last year this time with the 20 terabytes. We've also announced a couple of weeks ago, the 28 terabyte SMR. And so the point is we will continue to improve from one generation to the next based on the energy assist PMR as well as technologies that have been proven over time that are very reliable, and we continue to innovate on them. And we see a line of -- we see basically a path to get into the high 30 terabyte, 40 terabyte following our current road map that we've executed to successfully. And we also have a HAMR development, and it will be added to our product portfolio in due course.

Okay. And then the final real quick question, I'm going to ask you is similar on the product side. Enterprise SSDs has been one area where I feel like I've reported on time and time again in Western Digital is that you're just not -- you don't show up as a big competitor in that market, but it looks like a lot of opportunity. I think at one point, a handful of quarters ago, you talked about having -- I think it was 2 or 3 different cloud hyperscale customers designed in for the NVMe drives. Where do we stand on you participating in enterprise SSDs in that competitive landscape in flash?

Yes. I mean we do have these products qualified. The unfortunate situation is that the enterprise, the cloud side of the SSD market has been really down quite a bit and hasn't yet recovered. We've seen on the flash side recovery or stabilization and recovery to some extent, in the consumer and client space but we haven't yet seen it on the cloud side as we start when -- as and when we see that recovery, we should start seeing some more shipments of [indiscernible].

I'll end it on this open-ended question, which is you think about the questions I've asked, you think about your discussions you've had with investors, is there anything you'd say like, hey, people aren't digging enough here, not paying enough attention to this part of the Western Digital story that maybe you'd leave us to kind of think about as we walk out?

Look, I think -- I'm very excited about the completion of our strategic review and the announcement of the separation of the flash business into a separate company. Over the last few quarters, as much as we were going through a cyclical downturn, we've taken the opportunity to really enhance the health of our -- both of the businesses and it's starting to show in our results. You can see from -- on the hard drive side with all the fixed cost actions we've taken, the lower CapEx, we're seeing good traction on gross margins. On the flash side, it just shows -- I think the cyclical downturn really showed the strength of the product portfolio from a consumer and client perspective that have sustained also higher gross margins than many of our peers. We've exited the September quarter with a very healthy inventory position. We continue to manage the business in a very conservative way from a cash flow perspective. And so both businesses are well poised to be able to stand up on their own.

And then the timing of this, just -- and we'll end here is, timing is -- the progression is Analyst Day at some point, unpack this thing at some point in '24 or mid-'24, -- is that...

So what we're planning -- what we said at the time is that we plan to execute on this before the end of -- by the end of '24. So I expect it basically at the Investor Day [indiscernible].

Okay. Perfect. Thank you so much. I appreciate you joining us.

Thank you so much for having me.