Seagate Technology Holdings plc (NASDAQ:STX) Goldman Sachs 2023 Communacopia & Technology Conference September 5, 2023 1:00 PM ET

Company Participants

Gianluca Romano - EVP & CFO

Conference Call Participants

Toshiya Hari - Goldman Sachs

Toshiya Hari

Okay. Great. We'd like to get started. Thank you so much for coming. I'm Toshiya Hari. I cover the semiconductor space at Goldman Sachs. Very excited, very honored to have Gianluca Romano, Executive Vice President and CFO from Seagate with us this morning. I will kick off with questions, and I failed the last fireside chat, but I will try to leave room at the end for questions from the audience as well. Gianluca, first of all, thank you so much for coming.

Gianluca Romano

Thank you, Toshi.

Question-and-Answer Session

Q - Toshiya Hari

I wanted to spend most of our time on longer-term strategic topics, but I did want to kick off with a near-term question. I think you guided September quarter revenue down 3% sequentially after posting June quarter that came in below the midpoint of your guidance. What were some of the puts and takes you considered when constructing your calendar Q3 outlook and how has the quarter progressed so far?

Gianluca Romano

Thank you. Before we start, as usual, I will be making forward-looking statements today, and you can learn more about the risk associated with those statements on our website. Yes. So when we guided for the calendar Q3, what we said is we expect mass capacity to start to improve and that will offset the decline in legacy that was expected for the calendar quarter. So we were expecting hard disk drive revenue more or less flat. And we were also expecting a decline in the system business. So outside our hard disk drive revenue. And we guided basically $50 million sequentially lower revenue.

At this point in the quarter, I would say, mass capacity is slightly improving. Legacy is going to be worse (ph) than what we were expecting, mainly because of the situation in China. China, I'd say, we have basically all the segments in China, from China cloud, China enterprise, video-image application, mission-critical, consumer client.

I would say video and image application is doing fairly good. So it's sequentially improving as we were expecting. And this is a major driver of mass capacity, not (ph) slightly improving sequentially. But all the other segments are actually very slow. And the expected revenue at this point is less than what we were expecting at the time of the guidance.

So I would say, we are probably going to overpay (ph) low end of our guidance range for revenue and probably also for EPS. At the same time, we are very encouraged with discussion we are having with the cloud customers. It looks like the situation is improving in the cloud space. And we are also encouraged by the action that are going to be taken by the Chinese government to support the local economy.

So hopefully, this will also result in a faster economy in the next quarter or two. So between the cloud and hopefully a better recovery in China, we think will be -- this will be positive for our December and March quarters. But as I said, in the short term, probably no calendar Q3 towards the low end of the guide range.

Toshiya Hari

Okay. And just to clarify, Gianluca, so mass capacity improving sequentially, largely in-line with what you were contemplating, but the legacy portion of your business is tracking below.

Gianluca Romano

Yeah. I would say, mass capacity, except for the China enterprise OEM that is also a little bit impacted by the slow economy in China. The other segments are actually evolving as we were expecting, including video and image application, but it is a little bit an exception for the business we have in Asia and China, in particular.

Toshiya Hari

Okay. And then again, just to clarify, revenue and EPS tracking toward the low end is kind of the message.

Gianluca Romano

Yeah. This is what we expect now. Of course, we're still a month to go through the end of the quarter. So it could be maybe a little bit higher, but right now, this is what we expect.

Toshiya Hari

Got it. Very clear. Thank you. In terms of how to think about nearline demand going forward, obviously, it's going through a pretty big correction as we speak. I think it was down more than 50% year-over-year in the June quarter. To what extent do you feel like you're under shipping vis-a-vis end demand. And do you think the current correction is purely a cyclical dynamic where customers are digesting inventory? Maybe a little bit of budget sort of shifts with AI becoming a big theme, or should we be worried about this being more of a permanent shift in how customers think and spend on storage?

Gianluca Romano

Yeah. I’d say, right now, it looks like we are under-shipping. We see inventory consumption in the cloud space, in the enterprise OEM space, I would say enterprise started earlier. So there is less inventory to really consume. Cloud started probably in the June quarter, the big inventory correction. So we did already a good step in the June quarter. I think we are doing another good step in the September quarter. And as I said, we think starting December situation will start to improve.

In terms of overall dynamics in the business, this cycle is different than what we have seen before. The main reason is but it's not only one factor that is driving the down cycle. It's not just an inventory correction. We had many different factors. We have inflation. We have a war in Ukraine. We have COVID-19. We had a force phase of recovery out of COVID-19, which is still strongly impacting China, and we had the inventory correction. So in general, no technology business has always different phases. We have phase of expansion and phase of consumption.

Of course, we are in a big phase of consumption, but there are also all those other factors that are keeping this down-cycle longer than usual. So as every cycle will end and we think it's starting to end already in the December quarter and March quarter, as I said before, we see improvement coming, but it lasted many, many quarters, probably double in normal cycle. And this says brought some different actions now that companies had to take during this prolonged down cycle. But again, we are -- we think we are coming out from that cycle fairly soon and we will enjoy the up cycle in the next two or three quarters.

Toshiya Hari

Got it. And Gianluca (ph), can you maybe talk about the visibility you have into customer inventory? Is that something that you have a pretty good kind of pulse on or is it extremely difficult to tell how to utilize or not utilize your drives are particularly at the cloud?

Gianluca Romano

Yes. I'll say is -- it's not difficult because we have visibility on -- a little bit of visibility on their inventory. The most difficult part is understanding the utilization because a lot of what we call inventory digestion is actually not hard disk that have not been already implemented in various data centers. They're already there, but they are not fully utilized. So for us, it's very difficult to understand if a specific data center has hard disk utilization at 40% or 70% or 90%. So that is a difficult part for us to estimate. What has been shipped and still not installed, that we have a little bit of visibility, of course, talking to our customers.

Toshiya Hari

Okay. But to your point, you see the December quarter for your near-line business improving.

Gianluca Romano

Yeah. And I said before, enterprise OEM started earlier. So it's more of a gradual improvement that already started. But cloud really declined the exabyte need in the June quarter. We are keeping that low in September quarter, but our good conversation, I think December quarter will start to improve.

Toshiya Hari

Okay. Got it. I mean you talked about VIA in China being pretty healthy within an overall China that's still relatively challenged. I guess September quarter and beyond, what are your expectations for the overall VIA business within mass capacity?

Gianluca Romano

Yeah. We said in the past, and I think but also external company analyzing that business, I think that is a fairly good consensus on a CAGR -- exabyte CAGR in the mid-teens. So it's not growing as fast as cloud, but it's still a very healthy growth. So it will be one of the segments that we really focus on for the present and for the future. So cloud enterprise, video and image application, those are the three major segments that we will continue to focus and serve also with the new drives not based on the HAMR technology.

Toshiya Hari

Got it. We'll definitely get to HAMR. So historically, you've said that exabytes and your mass capacity business should grow at a CAGR of roughly 30%, give or take, I believe. Is this still the relevant long-term through cycle target or given what you've gone through over the past six to eight quarters, is that number a little bit lower or little bit higher. How do you think about the through cycle growth rate of your mass capacity business and gigabytes?

Gianluca Romano

Yeah. I would say, no, you always need to take a certain number of years to identify the right CAGR. So you need to go through the phase of expansion and the phase of digestion. And in the past, we had a year where we were growing 50% or 60%. And of course, we had last fiscal year, where actually the growth was negative. So when you put altogether, the up-cycle and the down-cycle.

Now what we expect is probably in the mid-20%’s. And so a little bit lower than what we were saying before, that it's not maybe 30%, it's more 25%, but it's still a very, very healthy growth. And again, don't expect a linear growth of 25% every year. You will have years, especially at the beginning of the up-cycle, where we grow much more, and then we will have series of consumptions where the growth will be much lower.

Toshiya Hari

Yeah. Makes sense. AI is a big focus for investors. I think the compute segment tends to get a lot of the mind share. Based on what you're seeing, what you're hearing from customers, what are your thoughts on AI's impact on storage? Do you expect it to drive an acceleration in your revenue growth and if so, around what time frame?

Gianluca Romano

Yeah, absolutely. So AI has two main phases, the training part where AI just access data that is already available. So it's not creating new data, but is accessing data that is available in order to then create something new. Because AI needs information is data, data becomes more valuable. So data that maybe today could be deleted in the future. Now people and companies will probably keep it for longer, but AI will have to access all that data to create something that is even more valuable.

And then the second phase that is the one that will impact the most storage that is what AI will create from accessing all bad data. So with access and create something new. If there's something new is something valuable for individuals, for companies that will be stored. And that is the new data that needs to be stored and of course, consume data storage and create an additional need for data storage. Now AI today is still in the fourth phase. It's just assessing the data is not really creating a lot of new things. People are still learning how to use it. Companies are still learning how to use it. I would say, in one or two years, AI will be a normal tool for companies to improve their performance. And so they will have to store much more of what AI is creating. So I think it's very positive for storage.

Of course, in the short term, it's more positive for companies that are selling different components because the big cloud had to get ready to use AI. And so you need different components and to create the infrastructure. But once infrastructure is ready and AI get up to speed, the result is more storage and more data to get stored in the cloud.

Toshiya Hari

Got it. So when you're deploying models, when the inference is going on, that's when you start to see an impact on storage.

Gianluca Romano

Yeah, absolutely.

Toshiya Hari

Okay. Makes sense. The competitive sort of situation vis-a-vis flash is a topic that we get questions on there, I guess, or a couple of storage OEMs who are very vocal, very adamant about this transition away from hard disk drives to enterprise SSDs. I know it's been ongoing for a very long time. And I guess it's encouraging to see hard disk drives you're going through a correction. But I think on a relative basis, you're actually holding up better than SSDs despite NAND flash being at a price level that is frankly, unsustainable. So I guess that's encouraging, but how do you internally at Seagate think about kind of the push?

Gianluca Romano

Yeah. I agree with you. I would say, first of all, now you have seen different trends between the two technologies in hard disk despite this major down cycle company are still generating a decent gross margins. If you look at the NAND business, that margin is negative. So there's a huge difference on how the two businesses are managed and the results they can provide not only in the up-cycle, but even in the down-cycle. Of course, this is a matter of consolidation and how the companies in the industry are driving those businesses.

Second is, as you said, even if the NAND price is very, very low today, and they generate negative margin, but there's been no change in the structure of the data center. 90% of data was stored in hard disk before the down cycle and is still 90% today. So no change there. I think it's a confirmation of what we are saying before in the data center NAND and hard disk are used for different parts of the application. So they will both continue to grow, but they will not overlap. Data center is separating the storage that is hard disk and the support to analytics and compute that is an end part.

So two different parts of the big data center. Hopefully, they will both be very successful. But we don't see any overlaps there. There is, of course, overlap in low capacity. So if you look at the consumer, the clients, the mission critical, so where you have hard disk that are 1 terabyte, 2 terabyte, maybe 4 terabyte, that is for sure overlaps there. And no, we have been very clear since several years. We know that part of the business that we call legacy is going to decline year-after-year. And what is the part that can be replaced by the end longer term.

Toshiya Hari

Got it. On your most recent earnings call, you talked a little bit about raising pricing in select markets. I was hoping you could expand on that. What catalyzed this shift in, I guess, it's not a really shift in strategy, but what led to this decision to raise pricing? Are you seeing good traction with your price changes and how should we think about the risk around market share to the extent your competitors don't follow suit?

Gianluca Romano

Yeah. I don't know if that is a fair assumption. I think the industry has the same view and the same need to generate a certain level of profit, a minimum level of profit. So I think it's not only our desire to generate that level of profitability. So the need of increasing pricing, I think, will be more an industry need. We will know fairly soon in the next quarter or two, but this is my expectation.

Our customers need to understand the -- the customer base is fairly concentrated in storage, especially in the cloud space, but the supply base is even more concentrated. If you look at the nearline, there are basically two companies, Toshiba is very small in the nearline space, less than 10% of market share. So it's very consolidated.

And as I said before, we need to generate a certain level of profit because supply chain, our supply chain is also in a need to be supported. There are many companies that need to generate a certain level of cash flow. And of course, we need to help them with that cash flow. And at the same time, our customers need to help us.

And we think we arrived at a time where it was necessary to increase a little bit our pricing, especially right now because we see the end of the cycle coming, and we want to be ready at the end of the down cycle with the pricing a little bit stronger. So we can generate better cash flow when we go into the up cycle and volume will be higher of what it is today.

Toshiya Hari

Your message about supporting the supply chain certainly makes sense. And we talk to a bunch of companies that make up that ecosystem. Does that message resonate with your customers when you go to your customers and say, hey, we need to support our small suppliers in Southeast Asia, give us a break. Do they say understood, let's take the pricing a little bit or is it tough in to combine that?

Gianluca Romano

I would say the reaction is not always the same where our customers we have worked with Seagate for 10, 20, 30 years, and they probably understand that. Customers that are more new into the space, they probably need to understand that it will be better. So again, in the short term, you always have a little bit of pushback when you raise price, but you need to keep the position. And as I said before, industry is concentrated, it's consolidated. I think it's the right thing to do for us, for the industry and for our suppliers.

Toshiya Hari

Got it. Makes sense. You also talked about this concept of build to order on the earnings call. I think from wafer to shipment, we're talking months, sometimes quarters in terms of lead times for hard disk drives, right? We're not talking days, we're not talking weeks. When you say build to order, what's the starting point? And if I'm a customer and place an order today, when would I get my set of drives under that

Gianluca Romano

Yeah. Well, if we really start from the wafer, the cycle time is at least six months, and depending from what drive you want to buy, it can be even longer. So this is another improvement we want to have. Now we want to have a little bit more certitude on what we need to start. Of course, when you are in an up-cycle and you see volumes going up, you can build more into your inventory and then define the right mix through the end of the quarter.

Right now, it's more difficult because we don't want to create inventory ourselves. We want to preserve cash. So we need to have a good understanding of what we need to start. What is the product that the customer want in three, six months from now. And in the past, it's been a little bit difficult. And a real order confirmation always arrived a little bit late. So we had to build based on the forecast, but was not in order. And if the forecast change, we need to manage with inventory, and if at quarter end, you have excess inventory, you need to move the inventory that, of course, not helping the pricing situation. So we need to change.

And as many other technology industry, we need to get orders. And when we get the order, we will deliver exactly what the customer wants at the times they want. But it's not the time right now for us to speculate on what they will want in three or six months from now, we need to have a little bit more visibility.

Toshiya Hari

Okay. So is it fair to say that you've sort of introduced this long-term order kind of concept or am I interpreting the wrong way?

Gianluca Romano

No, I think it's correct.

Toshiya Hari

Okay. And again, customers is it resonating with…

Gianluca Romano

This is a new concept, even if it doesn't seems to be not very difficult to implement. You always get some pushback when you ask for a longer-term commitment. And it's a little bit like the pricing. There was a bit of pushback at the beginning, but then it's just the right way of working. It's a good partnership. They tell us what they need, we will produce what they need and deliver what they need when they want. But always the same thing, Seagate or in general, they are risk industry to build wafers and build media in way to assemble until the last moment, I don't think is a good way to manage this industry long term.

Toshiya Hari

All right. Makes sense. Before we take questions from the audience, I just wanted to hit on HAMR, obviously, another topic that comes up a lot in conversations. Your engagements with customers seem to be broadening. I think a quarter ago or two quarters ago, you had talked about one specific U.S -based cloud titan being qualified. Can you give us an update as to how things are going with HAMR? How should we think about the ramp of the '24?

Gianluca Romano

So qualification is progressing well. So far, we have not encountered any issue with the core. So it's progressing well. We will qualify other customers after this first one. And as we said in the earnings release, we will start ramp volume in -- at the beginning of calendar 2024. So it's just four months from now. So we are very close to that time. And no, but a little bit of time needed to ramp it up, but we expect a fairly good revenue already in the calendar Q2, I would say, 2024. So we will have revenue in current Q1, but more volume in calendar Q2.

Toshiya Hari

Got it. Okay. Great. I'll pause here and see if we have any questions from the audience. If not, I can keep going. Okay. So in terms of the supply side response, I think both you and your closest peer have been pretty proactive in taking supply offline. Can you remind us exactly how much manufacturing capacity you've taken offline? And I assume this is permanent, but talk about whether it be transitory or permanent as well.

Gianluca Romano

Yeah. We took out about 25% of capacity. That means compared to the volume we are producing and selling today, there is still capacity available for the fourth part of the up-cycle. But at a certain point, of course, depending on how strong the demand we will have to go back and spend a little bit of CapEx to create more demand if it's necessary. I would say there are two ways to reduce capacity. One is taking out equipment from the manufacturing and one is reducing labor and we did both. So unfortunately, we had to do many restructuring plans in the last few quarters. So our headcount reduced by about 10,000 people. This is about 25% of our headcount.

And we also took out, of course, the equipment from the manufacturing floor. So at a certain point, of course, you can always add back those people and re-increase part of the capacity, but it will take a lot of time to rehire thousands of people. We don't think we will need to rehire exactly the same number of people to go back to the same level of production. We can do it with a lower number of people. Now we are -- we have identified opportunities, of course, for improvement during the down cycle and to be more efficient. So we think the cost structure will be better even at the same level of volume we had before.

And of course, we also did a lot of restructuring in the OpEx. Now if you look at just a few years ago, our OpEx was about $400 million a quarter, and now it's almost 250. So a huge reduction. I don't think we will add OpEx when we go into the up-cycle. But there will be no one change, but it's variable compensation that today is basically zero. So hopefully, that value compensation will come back. But that should be the only major item that will increase in our OpEx, not much more.

Toshiya Hari

Okay. Got it. And then in terms of gross margins for the current quarter, I think you guided profitability to increase modestly from 19.5% in the June quarter, perhaps that's a little off now given some of your earlier comments. But what are some of the near-term puts and takes as you think about gross margins and when do you expect underutilization charges to subside?

Gianluca Romano

Yes. So underutilization charges this quarter will be higher than last quarter. And of course, with latest adjustment in revenue will not particularly help with the gross margin situation. But as I said, mass capacity is starting to slightly improve. In the legacy, we also have a decline in mission critical, that is generally a good gross margin. So that will now be positive overall. But again, I would say the most important is what is our feeling for the next few quarters, and we see that improving.

And of course, gross margin will improve sequentially. We will have the impact of our restructuring plan, some impact already in the current quarter, more in the December quarter is probably where we pick a restructuring level in terms of cost decline, and that will stay with us for a few quarters until we really have to ramp more. So I would say there are positive things, both on the pricing side and on the cost side. So we should see an improvement in gross margin in the next few quarters.

Toshiya Hari

Got it. And specific to some of the pricing actions, is it possible to sort of quantify how much of a tailwind that could bring along over the next couple of quarters or is that difficult?

Gianluca Romano

Well, we are -- we have decided to increase pricing in all the segments. Of course, it takes time and every segment take a different time. So we started, of course, with more as a channel and the distribution. And then we discussed with some of our OEM and cloud customers. And of course, the video and image application customers. So it takes a bit of time. But we have been very clear. No, it's not a one quarter action. This action will continue because we need to bring that profitability that we need for us and for our supply chain. And so until we are there, we need to increase pricing. And we need to continue to reduce our cost because that is, of course, part of how we manage the business.

Toshiya Hari

All right. So you were at 30%, plus or minus, in gross margins, not long ago, right, it was 1.5 years ago, two years ago. You're currently below 20. With the price actions with mass capacity demand improving over time and all the restructuring programs that you implement. Is there a good line of sight back to that sort of 30%-ish level sometime in '24 Or is it a little bit too early to think about [Multiple Speakers]

Gianluca Romano

I think both, I think we will be able to achieve that level of gross margin well before the level of revenue we had six quarters ago. So six quarters ago, we were about $3 billion and a little bit higher than 30% gross margin. I think we can achieve those levels with a much lower revenue because of all the work we have done on the cost that will stay with us and because of the pricing actions we are taking right now, and we need to continue to take in the next few quarters.

Toshiya Hari

Got it. Maybe one last question on the balance sheet and the dividend. I believe you reduced debt on your balance sheet by roughly $500 million in the June quarter. You now have less than 12% of your total debt due in the next two years. So you made a lot of progress. Given the outlook that we've just sort of discussed in terms of the business, how are you thinking about the balance sheet? How you're thinking about the dividend? If you can kind of share your thoughts, that would be helpful.

Gianluca Romano

Yeah, in the last probably three quarters, we have reduced about $800 million in debt and of course, has been a focus of the company during -- going into this down cycle. That was a little bit elevated. So we had to take actions and reduce the debt. Every quarter, we look at opportunity to reduce the debt or improve the structure of the debt. and now pushing out the debt in time. As you said, right now, we only have 10% to 12% of debt, outstanding over the next couple of years. But no, I -- we always do something. Every quarter, we look at opportunity and improve the structure of the debt and repay what is becoming short term and try to take care of the balance sheet and keep it strong balance sheet.

In terms of dividends, even during the down cycle, our fiscal year '23, we generated about $600 million of free cash flow. And so this is above the level of dividend that we pay. So I would say the company has been very, very focused on generating positive free cash flow even in this very tough environment. And right now, that we expect gross margin to start to improve in the next few quarters, I would say, shareholder return has always been a focus of the company. Of course, we had to stop doing share buyback at the beginning of the down cycle. But we are very focused on keeping the dividend, and this is a priority for the company.

Toshiya Hari

Got it. In the last 60 seconds that we have, I know you converse with a lot of investors and analysts. Anything about the Seagate story or anything about the hard disk drive industry more broadly that we collectively overlook or underappreciate in your view?

Gianluca Romano

Well, the only thing I can add is that data is growing. So the need for data storage will continue to grow. There are cycles in this industry. And of course, right now, we are through a fairly big down cycle, but hopefully, through the end of this down cycle. As we discussed before, we're seeing the CAGR for the exabyte growth is very healthy, and we will need to have a lot of focus on how we manage our own business in terms of cost, how we support our supply chain, how are we partner with our customers, but there is no reason why the data growth and the need for data storage will be different in the next year or two or five or 10 years of what has been in the last four or five years, actually probably will be much higher because of AI, because of all the new application that people and company will start to use.

So we are very positive on the long term, I would say, in the medium and long term. And we start to see a sign of improvement already. So we feel more confident. And as usual, we focus on free cash flow, profitability and much less on market share. We focus on our road map and push our road map with our customers because that is what is important. [indiscernible] is a way for us to generate more revenue at a bigger level of profitability and continuous evolution of the industry. And I think this is what we have to do and where we are focusing on.

Toshiya Hari

That's great. Thank you so much, Jon. Really enjoy the conversation. Thank you.

Gianluca Romano

Thank you.