Seagate Technology Holdings plc (NASDAQ:STX) UBS 50th Annual Global TMT Conference December 6, 2022 8:20 AM ET
Company Participants
Gianluca Romano – CFO
Conference Call Participants
Timothy Arcuri – UBS
Timothy Arcuri
Good morning, thank you. Can you hear me? Good morning, thank you. I am Tim Arcuri. I am the semi and semi equipment analyst here at UBS, very happy to have Seagate with us. On this next slate, we have Gianluca Romano, who is the CFO of Seagate. So we’re going to talk about the company and I have a bunch of questions, so maybe you want to read a statement first and then we can go into the Q&A.
Gianluca Romano
Yes, thank you Tim, thank you for inviting us today. Well, first of all, I’m here to 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.
Timothy Arcuri
Great, awesome. Thank you for that. So Gianluca, let’s start by taking about and may be you can sort of give us a, just your sense of where end demand is and obviously we’ve, there is some digestion going on for Nearline, that’s pretty early, you were very, very clear and you were clear about that last call. So can you just talk about some of the dynamics in terms of demand for cloud and enterprise and some of the other end markets?
Gianluca Romano
Yes, we discussed a bit about earnings release and few meetings after the earnings release. There are different factors that are impacting demand in the short-term. The first one actually is not really the U.S. cloud inventory. I think the major factor for us is actually the slowdown of the economy in China, that is in terms of revenue, is where we get to the majority of the short-term impact. And of course, this is related to the lockdowns and the COVID situation, but hopefully it is starting to move in a better direction for the economy, but it’s still now very negatively impacting our business in the short-term.
The second part is still very important is actually the U.S. Cloud inventory. And they have accumulated a little bit of inventory, a little bit every quarter, but for a fairly long period of time, starting the COVID situation, many companies were buying little bit more for their safety stock to avoid supply chain disruptions, and because COVID lasted basically three years, and actually still the scare is not over yet.
Companies have accumulated a lot of inventory, and right now I think the fear of a major supply chain disruption, especially on the storage space, is not there anymore and therefore no big companies want to reduce their inventory. We are actually doing the same things. Now, if you look at our own inventory, before COVID we were at about $1.4 million. Right now, we are running at $1.6 million. So even on our side, we have accumulated inventory to avoid supply chain disruptions. And now as our customers are doing, we will also reduce our own inventory.
The third factor that is way smaller than the other two, but is still material, is consumer. And on the consumer side, of course, the high level of inflation and the war in Ukraine are of course contributing to a lower level of demand in the short-term. We are still very, very confident in the long-term of this business. There are so many new applications that right now we’re just starting, like artificial intelligence and machine learning and autonomous driving, Internet of Things, and smart cities, smart factories, all those new applications will generate an enormous quantity of data and that data will have to be stored. And as you know, 90% of the data storage is actually in the cloud, is actually happening on hard disk. So very confident in the long-term, but of course, we need to manage this short-term down cycle.
Timothy Arcuri
And just in terms of the shape of the recovery, can you kind of speak to that a little bit?
Gianluca Romano
Of course, it’s difficult to predict. I would say, in the coming quarter we are trending as we discussed at our earning release. So we don’t — so far we don’t have differences there in terms of revenue. As you know, there are possibly good signs from China in terms of how they managed COVID and lockdowns, so hopefully that will be a positive to us. It will take a little bit of time. Those are things that doesn’t really change in one week, takes maybe a month, two months or three months, so a little bit of time. And then through our very low level of production that we have today, we are also trying to help our customers to reduce their inventory and try to go back to more normalized business model in the next few months.
Timothy Arcuri
Speaking of normalize, can you talk about gross margin? There’s some atypical headwinds right now because of under absorption and things like that. So can you sort of level set us in terms of gross margin? I think as I look at some of the street numbers on gross margin, I feel like the — what’s being assumed is not sort of taking into account some of the headwinds that you have today and it seems to me like gross margin ought to recover to a level that’s higher than what the current Street numbers would show?
Gianluca Romano
Yes, there is no reason why the gross margin should not go back to where it was before, once the revenue level becomes on the same level. I would say actually through our structuring and our reduction in force, we should have an even better cost structure at a certain point when revenue goes back into the $3 billion to $3.1 billion that we were basically a year ago, December quarter last year.
So I would say again, long-term there are no reasons to be pessimistic. I think we will go back to where we were before, even better. Now, in the short-term, as you said, we have a lot of underutilization charges, so we want to keep our production down until the inventory is clean. And of course, in the short-term, that is, it is a big number, is probably going to be bigger than what we were estimating at the beginning of the quarter. But it’s all, no, it’s all part of our decision and our strategy.
Timothy Arcuri
Right. Because if I look at December and I exclude the headwinds, you’re sort of about a 26% gross margin ex those headwinds. So if I run sort of a normal drop through on that, it seems like you don’t have to get back to $3 billion to get to 30%. You could do 30% at something less than $3 billion, maybe $2.6 billion, something like that. So it seems like there is, given all the cost actions that you’ve taken, you should be able to get to about 30% at quite a lower revenue number.
Gianluca Romano
Yes. If you look over about a year ago we were about $3 billion, but we were well above the 30%. We were basically 32%. So again, I don’t see why we should not be in the same situation or even a little bit better based on the new cost structure that we are going through.
Timothy Arcuri
Great. Can we talk about the product roadmap for a second? You know, CMR versus SMR, I still sense some confusion among investors that assume that you don’t have SMR and they don’t fully seem to appreciate that a 22T CMR product can be used as a 26T SMR product. So, and with some software changes on the customer side obviously, so can you kind of talk about the product roadmap a little bit?
Gianluca Romano
Yes. There is a little bit of confusion. The technology, CMR technology, with basically a software change can be used as an SMR. So with the same drive, when you go into the final test you change the software, then you can have SMR drive to 22 terabyte CMR and the customer has to have SMR version, you have to change the firmware. You have a 26 terabyte SMR. That has a different read and write, mainly the write is different. So it cannot be used for all the applications, but if the customer for certain applications prefer to have SMR, because give more priority to capacity, then random write compared to secure [indiscernible] write, you can, and it’s just the software. We sell about 20%, 25% of our exabyte in SMR version today. We didn’t talk about SMR too much until now, because for us it was not a big deal. It is the same drive. You just change the software and you have an SMR.
I think what is not maybe well understood is HAMR. Maybe people don’t fully appreciate that also HAMR can be used as pure HAMR or as an MR [ph] drive. If you change the software and you have an SMR drive based on the HAMR technology, the 30 terabyte HAMR would be mid 30 terabyte in SMR version. So you need to compare SMR to SMR. You don’t compare a base HAMR to an SMR. They are used for different applications. If you want an SMR version, now you are comparing a mid-30 terabyte SMR drive based on HAMR technology.
Timothy Arcuri
And I think you said that the portion of exabytes that are on SMR is probably in the 20% range today?
Gianluca Romano
Yes.
Timothy Arcuri
Roughly. Great. Can you just talk about HAMR a little more and sort of the investments you’ve made there and how that’s going to help your growth margin over the longer-term?
Gianluca Romano
Yes. As you know, we developed HAMR for more than 10 years. A lot of R&D was actually going to HAMR, but at the same time, we had to continue to develop CMR. So we basically had two groups inside Seagate, one working on the CMR and CMR product, one working more on the HAMR technology. Of course, as you know, we have announced our 30 terabyte HAMR to be in the market beginning of summer. So in just few months from now, and this is also part of our structuring. We don’t need to have two groups over in the anymore. CMR is basically at the end of its life.
We probably have another product coming out in few months, but then all the new products will be on HAMR. So it’s a very difficult and long technology to develop. We are very happy that we — now we are at this point and we have product ready to come out. Again, a 30 terabyte HAMR beginning of the summer, if you want to use that HAMR into SMR version it will be a mid-30 terabyte. So it is a big increase compared to that that are in the market right now. But what is the real benefit of HAMR, is basically the fact that HAMR will continue to grow capacity per drive based on aerial density. So you increase the capacity of the disc. Today, a 20 terabyte drive has 10 disks and 20 heads.
Now if you go back in the past, the drive had one disk and two heads and then two disks up to 10 disks. This is how CMR was growing capacity, adding bill of material inside the box. HAMR is very different. HAMR will stay on 10 disks and 20 heads start at 30 terabytes. The second product will be 36 terabytes, and then 40 terabytes still on 10 disks and 20 heads. This is the major improvement of this technology. It doesn’t need to have more bill of material inside the box, but by the way, it’s physically limited at a certain point, just increase the capacity of each of the disks.
Timothy Arcuri
Right. I mean the HAMR [ph] has pretty powerful ability to drive cost per terabyte down through aerial density alone without adding to the bill of materials is quite powerful. So in that vein, can we talk about sort of longer-term gross margin and your ability to drive gross margin and the cost curve of HDD versus SSD? If you look at SSD today versus HDD, the cost delta today with NAND is 8x to 9x, but even if it were cut to 3x to 4x, yes that might be enough for customers to cut over to NAND, but HAMR seems like it’s going to result in an improvement of the HDD cost curve versus NAND that is actually seeing some diminishing returns actually?
Gianluca Romano
Absolutely. No I think NAND already went through the technology improvement when there was a move from planner [ph] to vertical, and that was a major cost reduction in the end, and then starting at 32 layers and then 64 and 96, the improvement in the cost is diminishing. HAMR is just starting now. So we are at the beginning of this score in terms of cost reduction. I also say there is a limited part of the market, were really overlapped. On the legacy part, of course there is an overlap. So the low capacity drive where the NAND can replace hard disk assuming the cost is, now it’s fairly similar, but on the high capacity drives, if you go into a data center today, you already have hard disk and NAND.
They are both used in the data center for different parts of application. 90% of the data storage is on hard disk. It is cheap, and this what the hard disk is done for. And then you have a lot of NAND, but the NAND done for that 10% of data storage that is used very frequently and is used to help for analytics and compute. So it’s not, they’re not used in the same way. They have not been used in the same way since the beginning, and it was 90% few years ago is 90% now. If you talk to cloud customers, they will tell you that 90% of the data storage will continue to be stored on hard disk.
Timothy Arcuri
Right. So if you sort of take that and you project out to where the long-term margins can go, obviously the customers have the power in the near-term just given the supply-demand dynamics. But given what’s happening with HAMR, given what’s happening with the cost curve, given the fact that all the client capacity basically has already been absorbed, you and WD are going to embark on a CapEx cycle, if customers want more exabytes, then there’s going to have to be more CapEx put in the ground for that. Once we absorb all these near-term issues. So the industry, it reminds me a bit of DRAM five, six, seven years ago, and we can see what’s happened to, I mean, yes, obviously they’re going through a difficult time now too, but the margins there have been going up over time. So it seems to me that this is not a low 30% gross margin business over longer-term. There is no reason. Would you agree that this business can’t be a high 30s, 40% gross margin over the longer-term?
Gianluca Romano
Yes, now a couple of years ago at our Analyst Day we gave a financial model where the gross margin was between 30% and 33%. But we said this is before HAMR. So, and next Analyst Day we have probably a different model. Of course, we need to rent a good quantity of HAMR to impact the P&L, but of course, we believe it is accretive to our gross margin. And as I said, it’s not only the first product. Actually the most important is when you scale even higher, 36, 40 terabytes with the same bill of material as we discussed before. I think that will be really the time where we should get a good boost to our profitability.
Timothy Arcuri
Can we talk also part of that, the idea that you can push gross margin higher longer-term is the concept of LTAs and I’m not a huge believer in LTAs that they really hold, whenever it’s, bad times for them, they want LTAs, whenever it’s good times for them they don’t want to adhere to the LTA. But can you kind of talk about just the evolution of the LTAs and how much teeth that they have?
Gianluca Romano
I think LTA is very good. It’s good for us. It’s good for customers, gives some stability. I would say, we had and we still have LTAs on about 50% of the cloud business. So it’s not 50% of our revenue, it’s 50% of the cloud. I hope one day we will have LTAs on 50% or more of our sort already. I think this is good, is helping us in how to manage our manufacturing right now is still not big enough. And I would say customer, of course now when they have too much inventory and they don’t need the product, they’re not maybe too happy to have an LTA in place if the volume is above what they need. But our experience is they still buy what is in LTAs. Of course, they just push the problem a little bit farther.
So when you arrive at the time that LTA expires and you need to renegotiate the LTA, that is when they tell you for certain period of time we need less because if the agreement, they need to use the agreement. So it’s more a timing issue, but it’s not that they don’t respect LTAs. And actually in the past they were buying more than the LTAs. So if it is an LTA with a certain volume, they buy the volume and they give you further for an upside. And then when they don’t need the upside, they go to the LTA. And when the LTA expire, they negotiate a new LTA, of course, considering their level of inventory where they are.
So assuming they are able to manage the inventory, and of course COVID is a very difficult situation because I think they were managing their inventory, they just wanted more, and now they don’t want so much more anymore. So they need to readjust that. But longer-term LTA I think is good for us. It’s good for customers. It’s good for the industry. Give a little bit of stabilization.
Timothy Arcuri
And so it’s the first couple weeks of December, I’m sure you’re engaging with customers on LTAs for next year. What’s the tenor of those discussions? Obviously it’s sort of max pain or the pendulum has swung to pretty much the max in favor of your customers right now, has that affected their appetite to engage in LTAs and sort of how’s the tenor of those discussions as you kind of head into next year?
Gianluca Romano
No, I would not say they changed their mind one of the reason why longer-term the LTA is good for them too. So we still have LTAs. Of course, those LTAs for a period of time as a volume that includes the fact that they need to reduce their inventory.
Timothy Arcuri
Right. So they’re — so in terms of the duration of the LTAs, do you expect these to still be annual or like multiyear?
Gianluca Romano
I would say the majority is not annual. It’s actually more on the six to nine months. Although we have couple of cases maybe a bit longer, but the majority are between six and nine months.
Timothy Arcuri
And what portion, is there a way to determine what portion of the LTAs, if we rewind a year or even 18 months, what portion of the LTAs were lit up to? Or was it just that the volume got pushed out that’s all?
Gianluca Romano
Actually the customer that had the LTAs, they consumed the product until the end. They were not consuming more than the LTAs, but they were still getting the volume that was in the LTAs. And then as I said before, at the end of the LTA when we renegotiated the new LTA, their volumes went down because they have to use the inventory.
Timothy Arcuri
Got it. So do you think have the LTAs actually created more volatility actually?
Gianluca Romano
That is a good question. Again, I would say we are not in a normal time. This COVID situation is difficult to manage for everyone. As I said, even for Seagate, we created more inventory, not because we were not planning in the right way, because we wanted more inventory. And I think now maybe our customer wanted more inventory for a while. And now we need to go to a period where we readjust and hopefully COVID will not create more disruption anywhere in the world, not only on the western part of the world, but everywhere in the world. And then the planning doesn’t need to include that extra inventory for no cause now for safety stock. And I think that will be a new phase, but before we go into that new phase we need to consume that additional inventory.
Timothy Arcuri
Got it. Can we talk about your capital strategy? It was notable with the recent debt exchange and the successful covenant renegotiation. I got some questions as to the interest rate on some of the new debt, but can you sort of walk through the capital strategy?
Gianluca Romano
Yes, the capital strategy longer-term, we don’t think it will change. No, we are, we have always been, and we want to be very focused on shareholder return. And this includes a good level of dividend and a certain level of share buyback. We were active in the market until September quarter. And then cause of the down cycle we said okay for maybe few quarters we will go on polls in terms of share buyback and we focused a little bit on our debt structure, because this fairly big reduction in the business of course we need to financially manage it.
So we, first of all, we renegotiated our covenants that were based on four times in terms of leverage and we did negotiate to five times. And we also reduced a little bit our debt through exchange notes that we have just concluded last Monday. So and we’ve also said probably we will reduce our debt even more in the next three to six months. It’s just part of the financial management of the down cycle.
Timothy Arcuri
Right. I think you replaced four tranches of 2029 and 2031s, all of which was at roughly 4% roughly and you replaced it with 2032 debt at nearly 10%. So can you speak about like changes in the debt service requirements?
Gianluca Romano
Yes, so first of all, we reduced the principle amount by about $200 million. So by percentage is on a lower debt. I think overall our interest rate moved from like 4.5% to 4.9% as a total company. Of course we need to trade a little bit between the debt value and the interest right of course, in this period of time is much higher. This new debt will basically temporarily increase our interest by about $10 million a quarter. But as I said before, we are going to buyback more or redeem notes and reduce our debt. I would say probably when we arrive at the end of this fiscal year, that is June, it will probably be similar level of interest. So we still reduced our debt so that the interest go back fairly close to where it was before.
Timothy Arcuri
Right? So there’s a penalty in the near-term, but you’re going to continue to work down the debt throughout the year.
Gianluca Romano
So you reduce the debt, the interest rate is a bit higher, but the interest dollar that you pay more or less are fairly well aligned.
Timothy Arcuri
Got it. And can you just maybe speak more broadly to capital return and how committed you are to the dividend and sort of how you think about the liquidity and the free cash flow profile on the capital return in the near-term and looking out?
Gianluca Romano
Yes. As I said before, we are very focused on shareholder return. So this is something that is part of our strategy as a company. So we want to continue to do that. Of course, we want to protect our dividends. We said we think we will have a positive free cash flow every quarter, even during this severe down cycle that I think is a good sign of our ability to create cash from this business even during a very difficult time in terms of revenue.
We are reducing our inventory. That of course is also part of how we generate free cash flow in the current quarter and next quarter, probably more in the next quarter. So again, it’s something we need to manage in the down cycle. We don’t think we’ll be a long-term. We think it will be fairly short-term. The big customers that have already discussed about their CapEx for 2023 were fairly optimistic for sure an improvement compared to 2022. These are fairly big CapEx. We don’t think they can wait only the September and December quarter to spend that level of CapEx. So we think it is not March, at least June would be already a fairly high level of CapEx and are — this is a percentage of that CapEx.
Timothy Arcuri
And just in terms of the inventory, I mean obviously, you don’t need more inventory yet. At this point you reduce utilization in December, very low in October, November throughout this quarter. Do you expect utilization to come back, touch in Q1 or to work down the inventory you’re going to probably keep running underutilized?
Gianluca Romano
Yes, as you said, mid-December is when you really talk to customers and see what is their forecast for the next three to six months. So we need to see what is the level of the inventory at this point and see when they want us to run back production, because finally it’s based on what they want to commit to us in terms of volume. But also very important, as I said before, is the situation in China that is a big part of our volume. China is important for China Cloud, China Enterprise, OEM, China Video and Image applications, consumer, mission critical. All the segments are fairly big in that part of the world.
So when that part starts to improve, we need to ramp up. And of course, when our major cloud customers in the U.S. have consumed their extra inventory, this is when we need to ramp. So right now, as you said, our production level is very low and we want to keep it low until we have those good sign in terms of demand. This is in the short-term creating under utilization charges that are very expensive and impacting the P&L actually not fairly important.
Timothy Arcuri
But you’re — you sound optimistic that China is going to come back maybe toward the end of Q1 into Q2?
Gianluca Romano
Well, of course we have a little bit all the same information. So it looks like we have, there is now a support from the government to go back to a stronger economy. I think they probably want to have a stronger economy in 2023, 2022 is almost over. I don’t think they want to influence the GDP of 2022 at this point. So probably they wait a little bit longer and then when we enter in 2023, hopefully those will relax some of the lockdown conditions and also support and stimulate the economy as I said after the meetings, the big political meetings they had in October.
Timothy Arcuri
Can we actually talk about CapEx for a moment? You said that you’ll be below the target range of 4% to 6% of revenue, but really you’re being very careful to not cut CapEx related to HAMR. So can you talk about that process and maybe hold our hand a little bit, when you have such a critical technology transition, people get a little worried when you start to cut CapEx, are you cutting the right CapEx? Are you potentially damaging the roadmap? Can you kind of talk about that?
Gianluca Romano
Yes, usually in this period of time you don’t need CapEx because you are not producing more than the capacity you have in place actually, you produce much less. But because of HAMR, we still need to invest; we need to even if we spent CapEx that is fungible for HAMR, since at least 2020. So it’s already a couple of years that we are buying equipment that can be used for HAMR, but we need to be more so we are still buying those equipment. We said we will be below our normal range of 4% to 6%, it will be a little bit lower than the 4%, but we still need some investment because we announced the product for early summer and we need to ramp.
Timothy Arcuri
Got it. Also another question that I often get is, one of the large hyperscalers, not just one, but a general trend lately has been to extend the useful lifetime of servers and network equipment and things like that. Do you see signs of real extension of the useful life of the drives or is this more of just an accounting adjustment on your customer’s part?
Gianluca Romano
I would say there is a business reason why they refresh their hard disk is more a capacity. So if you keep or if you think what was the high capacity five years ago is probably out of the capacity you have right now. So it’s not that the hard disk doesn’t work after five years, it can work. Probably a big part of the volume still work, technically work, but for that physical slot, you can replace an hard disk with a new hard disk with double the capacity. So the revenue that our customers generate from that physical slot can be double. That’s why it’s important for them to refresh, because in the same physical slot that is a limitation today, they want to have more revenue and to have more revenue, they need to refresh and replace old hard disks with new hard disks. And this is why HAMR is so important, because you go into a phase where you refresh and you have old hard disk drive, what today we say mid capacity, knowing that maybe 12, 14 terabytes and you can go to 30 terabytes or mid-30 if you use that in SMR. So the benefit for the customers is enormous, not only because of the cost of terabytes, but because of the revenue they generate from that physical slot.
Timothy Arcuri
Great. And I just, I’m going to ask you the question that I get asked a lot, around the Department of Commerce investigation and I know that you can’t say too much about it, but is it, does it change how you run the company at all or is it just a legal matter that’s all?
Gianluca Romano
It is a legal matter. It is not changing how we manage the company and our strategy is a legal litigation. So I cannot say much except that no, we think we have a very solid position. Now our internal legal team, our external legal team, they are very comfortable that we have a solid situation. We need to go through the discussion with VIS [ph] and hopefully solve this matter as soon as possible.
Timothy Arcuri
Great. And then can we talk about free cash flow? I think you’ve committed to generating free cash flow every quarter throughout 2023. Can you kind of talk about the trajectory of free cash flow and maybe any other levers that, I mean obviously you’re pulling the inventory lever, you know, you’re pulling other levers, you’re cutting CapEx, so can you talk about that?
Gianluca Romano
Yes, probably the current quarter is where we generate the lower free cash flow because the revenue is lower and because even if we are starting to reduce our inventory, we are still not paying our accountable for things we have purchased in the September quarter. So there is a bit of time before you realize the decrease in inventory and increase in cash flow. So probably this quarter will be the, hopefully will be the bottom in terms of free cash flow and then you will see an improvement starting in the March.
Timothy Arcuri
Got it. And then we haven’t talked about the VIA market yet. Can you just, can you talk about VIA?
Gianluca Romano
A very important market. So with an image application, no smart cities, smart factories, extremely important. It will be known everywhere in the world. Today our major customers are actually in China, and this is one of the reasons why China is so important to us, but they manage projects everywhere in the world. So it’s not that is a Chinese application, it’s everywhere in the world, but our achievement, our main major customers are in China. So we think also that segment will improve and we’ll go back to where it was before and even better. I think is a part of a, is one of those applications that will continue to grow in the mid-to-long term.
Timothy Arcuri
And you don’t see the risk for any export restriction there running…?
Gianluca Romano
Well, you never know about restriction, EBITDA restriction of course. No, we’ve been impacted as everyone else. In general, if you have a registration a time, the demand is moving to someone that has no restriction, because it’s not that the project disappear, it’s not that you stopped having video camera in New York, you will still have it. So someone else will take care of that application and will become our new customer. So the important is, all those applications are based on hard disks. So whoever is the customer, wherever it is in the world, we can serve the customer. Today, big customers are in China, but if that will change for us it’s not really a major problem.
Timothy Arcuri
And just to kind of level set, China is roughly 30% of revenue, give or take.
Gianluca Romano
Yes, we said yes, we said last year when we were at $3.1 billion, China was about one-third, so about $1 billion.
Timothy Arcuri
Great. And maybe just to wrap up, we’re sort of running out of time. Can you, so we talked about inventory, but can you talk about the risk of inventory obsolescence? Is there any — I get some questions about the potential to have to take a write-down on inventory that doesn’t seem on the cards, but can you kind of talk about that?
Gianluca Romano
Right now, we don’t see that. Again, we are keeping our production very low, so that actually our inventory declined. I don’t think we have part in our inventory that would become obsolete. I don’t think.
Timothy Arcuri
Great. Well, we’re out of time. So thank you Gianluca. Thank you again. Thanks a lot.
Gianluca Romano
Thank you.
Question-and-Answer Session
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