Seagate Technology Holdings plc (NASDAQ:STX) Evercore ISI 2nd Annual Technology Conference September 7, 2022 3:45 PM ET
Company Participants
Gianluca Romano – Chief Financial Officer
Conference Call Participants
C.J. Muse – Evercore ISI
C.J. Muse
All right. So why don’t we get started? Thank you all for coming. My name is C.J. Muse with Evercore ISI. Very pleased to have Seagate with us Gianluca Romano, CFO of the company. Welcome. Thanks for coming and great to be here live.
Gianluca Romano
Thank you, C.J. Thank you very much. Before we start, let me remind everyone that I will be making forward-looking statements today, and you can learn more about the risks associated with those statements on our website.
C.J. Muse
Perfect. So you kind of stole our thunder at the end of last week.
Gianluca Romano
Sorry.
C.J. Muse
Not, not ours, but just updating current trends. So maybe we can just start there on the near-term what has changed over the last time period, I can’t do the math. I’m too tired. Six weeks since you last reported.
Gianluca Romano
Yes. So last week we spoke about three main factors that are impacting our business in the short term. All those factors are actually more microeconomic factors and kind of external to the underlying demand that we are very confident for the long-term continue to being very strong. But in the short term, we have those three main issues. The first one and the one that has the biggest impact is the business level in Asia and in China in particular. And this is today our visibility, we say the business is actually moving even slower than what it was in the prior two quarters, so in March and June. We had some good sign in June, so we were hoping for a faster recovery, but then the months of July and August were fairly low. So it’s kind of a false start unfortunately.
The reason why the business in Asia and in China in particular is moving so slow is mainly because of the lockdown recovery from COVID. We had many more cities in lockdown in the last few months, including Boise, where we have a factory, but was not impacted in term of money fashion we were able to manage, but the rest of the city and other business were impacted.
So the recovery from this last wave of COVID is particularly slow. I think it’s also slow than what the local authorities were expecting. And when they compare the GDP number that just came out to their own expectation, this was much lower number. And now they are acting in support of the business with some stimulus package that hopefully will help to recover it to be faster. But of course will take a few more months.
The second factor that is impacting us and that actually we discussed at our earning release is inventory, more in U.S., and probably more in the nearline space. The inventory now is fairly high with some of our customers, mainly because for the last several quarters, since the beginning of the COVID situation, every customer, every business was actually creating a safety stock. And this safety stock continued to grow because the COVID situation lasted for much longer than what everyone was expecting.
I guess that right now company, especially in the west part of the world, feel more comfortable in how they can manage their supply chain, at least part of their supply chain. And they have assessed as they don’t need the safety stock anymore. So they try to reduce the inventory and they want to do it fairly quickly. So this is an impact to our short term, it’s not really an impact to the long term view, but more an impact to the short term and an adjustment to the short term.
At the same time, another part of the supply chain is still struggling mainly in some of the semiconductor component. And this is also impacting our customers that are not able to deploy the new data center as they would like to. So also now having that part moving a little bit slowly than – or slower than what we were expecting is also reducing the pace of the consumption of the hard disk. So, the ability and opportunity to reduce inventory is going a little bit slower than what we were expecting. And in July, at the end of July, we said, now we will try to clear this inventory in the quarter, so before the end of September. And now we see probably not being able to do this in the end of September. By the end of September, we’ll probably take a little bit long. So we see some impact also to next quarter, similar to the situation in Asia.
And the third factor that is in term of revenue level is lower, but is still material is on consumer. And this is mainly now between Europe and U.S. for different reason, but inflation is a driver. And so the consumer level of our business is now fairly low. This is also the part of the business that now we are not so confident it’s coming back quickly, especially because of the situation of the war in Europe and what – that could imply in term of no energy cost going into the winter season.
So those are the three main factors that we discussed last weekend that are impacting our short term. I also said we expect this quarter to be the lowest quarter of the fiscal year, and we will see revenue increasing sequentially in the next no three quarters. And I would say it’s the same probably for our free cash flow.
C.J. Muse
Okay. Very helpful recap. I guess, I was hoping to kind of dig into each kind of the drivers on the mass capacity and legacy side, but maybe as a starting point to kick start the conversation, I guess, in a question I get from many investors, what gives you the confidence that September is in fact, the bottom given all of these kind of underlying drivers that you clearly have uncertainty.
Gianluca Romano
Yes. As we said, maybe on consumer, now is the one that we have lower confidence, but on the other two, we are now seeing some sign. As I said now, in Asia, in China in particular the local authorities are now starting to support the business. Several projects are government project, but they will support and restart. They were basically put on hold for fairly long time. So it’s is now, I think, is their interest to restart. And the inventory, of course depend on how aggressively we are in reducing our manufacturing. And we have done a second cut to our manufacturing at the beginning of September. So on top of what we discuss at the end of July, we have done another cut. Beginning of September this will impact also our production probably as a beginning of our fiscal Q2, so in October. And then by the end of October, we will reassess and see what is still needed.
C.J. Muse
So, so maybe if we could probe a little bit deeper into each of those. So I guess, what are you seeing from a China stimulus perspective?
Gianluca Romano
Well, that is more not general support to the business in the region for all those projects that are implying a data storage increase, video and image application of course, is a big segment for us, but even cloud has been really impacted in the last quarter or two. So all those projects and all those, no lockdowns and difficulties to manage the business in a normalized way that we are put in place in the last several months, probably two or three quarters. Now they should be somehow a little bit easier. And so when the business come back, the pace of the business will be faster. And we think we will go back to a more normalized level of business in that part of the world.
C.J. Muse
Very helpful. How about on the inventory side? Obviously cutting utilization out twice helps in internally, but how are you thinking about downstream inventory?
Gianluca Romano
Well, it depends, every component is different. I would say Seagate has also increased inventory in the last two or three years from level of 1.1 billion to a level of 1.5 billion. So it is a significant increase. We think we have managed a supply chain fairly well. We were not having any disruption in the hard disk production. We had some in the system solution production, but is becoming a little bit better right now, but in general, I think even Seagate will start reducing inventory and at a fairly lower level.
C.J. Muse
And in terms of just taking a step back and thinking about how you adjusted utilization twice over two month period or so, how different is that from prior cycles?
Gianluca Romano
I would say the difference is more on the reason that are driving this reduction in revenue and therefore reduction in production. In the past, it was more a business-driven. So the majority of the reduction was coming from a decrease on the legacy business. And the fact that the mass capacity was still very smooth so not able to offset the decrease. Right now is mainly external factors, our mass capacity now will continue to grow. It has grown very rapidly in the last three or four years. Now for a short-term period of time, we will have some impact also in this segment, but we are confident that the long-term is still growing as the same pace that we were now discussing few months ago. So the main difference is the reason, but the execution is fairly similar.
So we started reducing manufacturing. We are reducing CapEx, we are reducing OpEx. So we look at the short-term in term of the spending. We look at our CapEx level for the entire fiscal year and start reducing also the CapEx. Actually the CapEx production is a little bit delayed in time, because what we have committed to receive this quarter or last quarter, but we are paying this quarter is actually coming in. We are not taking back our commitment, but for the next few quarters, you will see a fairly strong reduction in CapEx.
In the OpEx also, you will see a reduction this quarter compared to last quarter and probably the December quarter will be even could be lower. Now, there is in need a little bit of time to start all those project that now reduce our spending. So the execution will be important, takes a couple of quarters.
C.J. Muse
So if September can mark a bottom, December up sequentially, what would be the required growth drivers there. And within that, I’d love to hear kind of your thoughts on if there’s any impact whatsoever on Nvidia, AMD, AI chip embargo on kind of storage solutions and/or VIA type solutions.
Gianluca Romano
Well, I think in general, geopolitical disruption could be important and could be very disrupted to every company, of course. We have – we can have a direct impact or indirect impact. I would say, everything that is slowing down, data storage in any part of the world will be an impact to us. So we need to wait and see exactly if there are new rules, what are the new rules, I’ll – they will be applied to our business and what will be the impact in the short-term? I don’t think this is one of the major reason for our revenue reduction, more as the reason, but we discussed before.
C.J. Muse
Sure, sure. Just curious if you’ve seen that play a role yet, but I guess maybe bigger picture, is it kind of U.S. cloud that you see kind of driving the recovery? Is it confluence of different factors?
Gianluca Romano
For us, the most important is probably Asia and China in particular. This is where we have the majority of the negative impact today. So the recovery in general business recovery, because in China, all the segments are down. It’s not one segment, it’s cloud is down, video and image application is down, legacy is down. So the general recovery in China that we think through this stimulus will starting to happen, hopefully, in the next few months is probably the most important factor. Second one is the cloud in U.S. that is more the inventory correction and hopefully some easing of their supply chain disruption on the semiconductor part.
C.J. Muse
So on the China side, is there any way to quantify, how low it is relative to kind of normalized levels?
Gianluca Romano
Well, compared to – I don’t know if it is a normalized quarter-by-quarter, where of those impacts were not so evident in September last year or December last year right now is way, way lower. I mean, it’s way lower.
C.J. Muse
So I mean, talking 20%, 50%.
Gianluca Romano
We said is the major factor of our reduction revenue from that (0:18:42) level. That was $3.1 billion to what we just discussed last week, which is $1 billion lower, I’d say is a single factor, single major factor is China.
C.J. Muse
Got you. Okay.
Gianluca Romano
And then of course, even the other two are very important, but the biggest one is the China business.
C.J. Muse
And I guess, how important is, I guess, I think October 12 is the big [indiscernible] (0:19:09) meeting, are you kind of assuming that post that things open up or it’s just really kind of the confluence of stimulus and that they can’t keep the economy down forever? Is that what is driving this [indiscernible] (0:19:24)
Gianluca Romano
I think maybe it’s a little bit of both. That will be a good checkpoint, I think. But the most important is what they are discussing right now in term of support of the business in general in China that will drive a lot of the project where data storage is part of the business. And so will drive also our part and possibly a good recovery of our revenue.
C.J. Muse
Got you. So the China and the VIA make a ton of sense, I guess, from the nearline U.S. cloud perspective, that your perspective there is that this is really just inventory draw down and that the demand will eventually come back and that that will be just a muted kind of pause. Is that right?
Gianluca Romano
Yes. We have seen the exabyte volume growth in the last three years to be very strong, especially in that segment. We think the demand driver, so all the new application that will drive an increase in data storage still to be not deployed aggressively, like no artificial intelligence and machine learning and smart cities and smart factories, Internet of Things, autonomous driving and many other application they’re not put on it, they may be slowed down a little bit, but those are the drivers for more data storage and this is the development of the cloud. Now it’s just following the development and the deployment of those applications. So we are very confident that in the longer term, this segment nearline in general mass capacity in general, but inside mass capacity cloud is probably the segment that will grow the most in the next few years.
C.J. Muse
Makes sense. I guess just kind of hitting on the near-term, but trying to bridge it to the longer-term on the gross margin side. Is there a rule of thumb to think about a point lower gross margins for X points of cut to utilization?
Gianluca Romano
Yes. We are not giving that information so precisely, but of course, when you cut your production from a business that above $3 billion to a business that is slightly above the $2 billion. Now there is an impact in manufacturing. There is a lot of under utilization cost coming in the quarter, it’ll impact probably this quarter and little bit next quarter, depending from the level of production also for the next quarter. But again, those are more temporary items that will impact us, it’s not impacting our view of the profitability of the longer-term. But as you know, we gave a range for our gross margin and for our operating margin. We think we can recover into better range quickly, as soon as those external factors will start to abate.
C.J. Muse
So if we think about kind of the implied EPS for September that you talked about, we should just be thinking that the lion share of the negative impact is just under utilization impact to gross margins.
Gianluca Romano
Absolutely, yes.
C.J. Muse
And as you think about kind of the timing of when you turn back on and the timing of kind of reduced under utilization charges, how should we think about that?
Gianluca Romano
Well, there is little bit of a time lag, and also know when you recognize those costs in European Union, but again, from a financial statement, point of view, I think know the current quarter and next quarter are the one that would be more impacted by this additional cost. And no, hopefully after that, we go back to a higher level of manufacturing. And so in higher level of profitability. I’ll say on the pricing side, which is the other important part for progress margin. On mass capacity, now, I would say pricing is fairly stable. So there is a good focus on profitability from the industry.
On the lower capacity drive, like the know 1-terabyte, 2-terabyte, maybe even the 4-terabyte, there is a little bit more pricing pressure, maybe some no price erosion, mainly coming from the low price on end, more than competition in hard disk. So there is a different kind of competition at very low capacity. And so that is a part that maybe know, in the short term, most of the profitability is a bit eroded, but on mass capacity, I would say profitability is in term of product profitability is fairly good.
C.J. Muse
So that, that’s interesting. I mean, is that how different is that versus prior cycles? And this is where I just, I don’t have the history.
Gianluca Romano
I would say the difference is that right now, 75% or even more than 75% of hard disk business is mass capacity. So is not impacted by the NAND pricing, on the 25% we have some impact in the past was the opposite, 75% was legacy. So the impact was much higher.
C.J. Muse
Well, I guess it’s more the perspective of the competitive landscape acting rational in over capacity environment. And is that a change statement considering excess inventories and the focus on cutting utilization and maintaining pricing is that – is that new?
Gianluca Romano
It seems to be different. It seems the industry in general is protecting profitability in this part of the business that we continue to grow and will be the future of the hard disk. So yes, probably I would say is an improvement of the industry in general.
C.J. Muse
I guess was hoping to spend a little bit of time on the technology side, and maybe get an update from you on kind of views of SMR and, I think WDs [ph] talked about qualification at Google and Amazon, and is that a risk for you guys? Or is that just kind of part for the course in terms of how you both kind of go-to-market?
Gianluca Romano
No, I would say we are very similar. Maybe we have not talking too much about SMR. But we have sold many, many SMR in the past already. So it’s not absolutely new technology for us. We are very well aligned in term of roadmap of both in CMR and SMR. SMR can only be used for a certain application is actually a lower performance drive. So it’s limited in the application. But for us is nothing new. So I have to say is a vast majority of our business is on CMR. But if a customer want SMR, actually they are buying SMR from us already is nothing, but is any different from what we have done in the past.
C.J. Muse
Okay. That’s helpful. And I guess, sticking with CMR, how should we think about your path to 22 terabytes CMR and beyond?
Gianluca Romano
Yes, no, it’s the difference right now in CMR is the increasing capacity is fairly limited, right. As the beginning of this technology, you were going now from two terabyte to four terabyte is a major change. Now from 20 to 22, 22 to 24 is fairly small. So we talk about 20-terabyte plus that is including CMR, SMR, everything that is 20 terabyte plus. We have – though we have 22-terabyte, we have 26-terabyte SMR. We have all those products. We just now don’t think is so important anymore to talk about those products specifically is a platform that we have is a common platform starting actually our 16 terabyte. So is no [ph] I’ll say is important to as a product, is important how you ramp the product, because if you just have the product and you sell few thousands of those, it’s not input to your financials. So we have ramped very well, hour 16, hour 18, hour 20, and we will continue to ramp all our product as we have done in the past. And now we think we have a very, very competitive position in CMR and we will be even better position with HAMR in few months.
C.J. Muse
Sounds good. I guess I think you’re talking about launching shipments within the next 12 months.
Gianluca Romano
Yes.
C.J. Muse
Any update there?
Gianluca Romano
No, we are – no, very consistent with what we discussed in July. So we are not slowing down any project related to HAMR. And now we expect that to be sold as we said in 12 months from July. So let’s say summer – next summer.
C.J. Muse
And how should we think about relative pricing premium?
Gianluca Romano
Well, it depends. Now that was a bit too early to discuss about pricing, but it depend where we will be in term of cost where no other products – competitive products will be at that time. We think it’ll be accretive to our gross margin HAMR in general, but even starting from 30-terabyte now assuming a good level of yield. As you know, this is our first product in HAMR, so we need to have a little bit of manufacturing learning and bring the yield as a level of CMR of or a good level of yield. But assuming we can do that fairly quickly, we will have a fairly similar below material, same number of disks, same number of heads of a 20-terabyte with a 30-terabytes capacity. So it’s a big improvement.
Of course you have a little bit higher cost in term of the laser that is not present today in a CMR drive and will be included in a HAMR drive, few other components, right to be more expensive, but the growth in capacity is huge. And when you go to the following generation of product, like 36, the 40, the 50-terabyte they will have the same below material of a 30-terabyte. Same below material in much higher capacity, so it was a opportunity for us to reduce the cost per terabyte is huge. We know we want to provide a good TCO to our customers. We also want to increase our profitability, so we will keep some of that benefit for sure to Seagate.
C.J. Muse
Makes sense. I guess maybe let’s talk about customer relationships and long-term agreements. I guess when I think about other businesses in the storage arena where LTAs, I guess haven’t held up that well. How do you kind of see these contracts and how have you kind of – how maybe do you think about them differently now that in terms of a correction or do you think that they’re working well?
Gianluca Romano
No, I don’t think about that differently. I would say so far, all our customers that are under LTAs have honored the LTAs. I would say in the past, no, you have an LTA with a certain volume and a certain price in the certain, in the past when demand was higher; they were going above the LTA. And now they are maybe limiting the volume to the LTAs, but they are not going below the LTA. So they’re honoring the LTA. So there is a good partnership there in the future. I think the no more LTAs we have better. It is again, doesn’t mean that there is no variability to the business because no, the LTAs has some volume, but they can buy more and they have no purchase more in the. So we can always have some variation, no customer to pass. But in general, I think it’s a positive to the industry and the positive to Seagate.
C.J. Muse
And I think 50% of your cloud business is currently under LTAs. And so curious I guess, what kind of trend do you see there over the coming 12, 24 months in terms of a change in the overall percentage, and then maybe more importantly, what does that offer you in terms of visibility? I think, you’ve talked positively about AI and machine learning, driving strong U.S. cloud in 2023. Could you speak more to that?
Gianluca Romano
Well, I would say is in the interest of both, us and our customers to have LTAs when demand volume continue to grow as a certain point, I think is more in the interest of the customer to be sure they can get what they want and what they need. So having LTAs is giving them some confidence that they will not get short. So, as I said before, we are now reducing our CapEx today, of course, now based on those LTAs, we will restart increasing the CapEx if it is needed, but we also want to be sure that we don’t go into a situation where supply is well above demand.
We want to have that good alignment between supply and demand and if know, the best way to have that alignment is to have a big part of your business under LTAs. So we can have confidence on the demand and they can have confidence on the supply and raise a good balance. So again, as I said before, I think is it in the common interest of a business that is growing and is growing fairly rapidly to have LTAs in place?
C.J. Muse
So when you think about a business bottoming LTAs that give you visibility, confidence that on the nearline cloud side of the world that, you’ll see a recovery, how does that inform kind of your outlook for free cash flow and your plans for capital returns? Notably I think on a trailing 12-month basis, you’ve returned more than 190% to shareholders. So would love to hear your thoughts on those two fronts.
Gianluca Romano
Yes. Free cash flow is a big priority for the company and is no – linked to the other priority is shareholder return, as you said, we did a fairly high level of shareholder return in the last two or three years. We have not changed our strategy. We think the free cash flow for the current fiscal year will still be a good free cash flow level. And we will use the free cash flow mainly for shareholder return.
And now in the past, we have done even more than our free cash flow. Right now, there’s a visibility a little bit more limited, maybe we limit our shareholder return to that level of free cash flow and then when we have a better visibility we can tactically adjust our level of share buyback if it’s needed depend of course also from the opportunity, so from the level of the share price.
C.J. Muse
So I think I asked you this question all the time. And so, don’t mean to put you on the spot, but is there a time where you’ll share kind of the free cash flow margin target and/or kind of longer term vision of where you think Seagate can achieve?
Gianluca Romano
Yes. Free cash flow has improved in the last three or four years. Excluding those factors that we discussed before in term of macro-economic impact, the business will create higher free cash flow mainly because revenue will grow, profitability will improve. That will result in better operating cash flow. CapEx will now grow out of the range that we discuss in the past between 4% and 6% of the revenue. So that financial model will drive an increase in free cash. And of course, you need to look as a longer term. So just don’t look at one quarter or one year, look at a bit longer and you will see that that is happening actually.
C.J. Muse
All right. Any concluding remarks, I think we’ve got a minute and a half, anything that we missed that you want to touch on?
Gianluca Romano
Well, I’ll say – again, I just want to reiterate with the confidence from the company, from the management team in the long-term opportunities of this business, of the hard disk industry is huge. So we have high confidence that we will continue to deliver good result. And as soon as those external factors will start to abate, we will come back to a growth, but we have demonstrated been possible in the last fiscal year. And so, we are confident in just a matter of manage this situation in the short-term tactically, being aggressive on our spending reduction and then taking benefit of the rebound when that happens.
C.J. Muse
Excellent. Well thank you for your time.
Gianluca Romano
Thank you, C.J.
C.J. Muse
Really appreciate it.
Gianluca Romano
Thank you.
Question-and-Answer Session
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