Seagate Technology Holdings plc (NASDAQ:STX) Q2 2023 Earnings Call Transcript

Seagate Technology Holdings plc (NASDAQ:STX) Q2 2023 Earnings Call Transcript January 25, 2023

Operator: Good day, and welcome to the Seagate Technology Fiscal Second Quarter 2023 Conference Call. Please note that this event is being recorded. I would now like to turn the conference over to Shanye Hudson, Senior Vice President, Investor Relations and Treasury. Please go ahead.

Shanye Hudson: Thank you. Good afternoon, everyone, and welcome to today's call. Joining me are Dave Mosley, Seagate's Chief Executive Officer; and Gianluca Romano, our Chief Financial Officer. We posted our earnings press release and detailed supplemental information for our second quarter fiscal 2023 on the Investors section of our website. During today's call, we'll refer to GAAP and non-GAAP measures. Non-GAAP figures are reconciled to GAAP figures in the earnings press release posted on our website and included in our Form 8-K that was filed with the SEC. We've not reconciled certain non-GAAP outlook measures because material items that may impact these measures are out of our control and/or cannot easily be predicted. Therefore, a reconciliation to the corresponding GAAP measures is not available without unreasonable efforts.

Before we begin, I'd like to remind you that today's call contains forward-looking statements that reflect management's current views us and assumptions based on information available to us as of today and should not be relied upon as of any subsequent date. Actual results may differ materially from those by these forward-looking statements as they are subject to risks and uncertainties associated with our business. Regarding the matter raised by the proposed charging letter from the U.S. Commerce Department's Bureau of Industry and Security, or BIS, Seagate maintains that it has complied with all relevant export control laws and regulations. We've been cooperating with BIS and engaging in discussions with BIS to seek a resolution. Please note that we won't be addressing questions regarding this matter on today's call, but we'll provide additional updates as appropriate moving forward.

To learn more about the risks, uncertainties and other factors that may affect our future business results, please refer to the press release issued today and our SEC filings, including our most recent annual report on Form 10-K and quarterly report on Form 10-Q as well as the supplemental information, all of which may be found on the Investors section of our website. As always, following our prepared remarks, we'll open the call up for questions. Let me now turn the call over to you, Dave, for opening remarks.

Dave Mosley : Thanks, Shayne. Good afternoon, everyone, and thanks for joining us today. Seagate delivered on what we set out to do in the December quarter, and I'm proud of our team's accomplishments amid this tough business environment. Revenue and non-GAAP EPS came in slightly above the midpoint of our guidance range and free cash flow generation increased by more than 50% quarter-over-quarter. We are managing well what is in our control and executed on the actions we outlined on our October call. We retired more than $200 million in debt, strengthening our balance sheet. We lowered operational costs by realizing a meaningful portion of the expected savings from our restructuring efforts. We reduced capital expenditures by more than 40% sequentially while still accelerating the launch and development schedules for new mass capacity products, and we adjusted our factory production output to support strong supply discipline as demand recovers.

These actions, we believe, put Seagate on solid footing to weather the near-term industry dynamics while continuing to make the technology investments to meet our customers' evolving needs and thrive over the long term. Relative to market conditions, three primary external factors have been impacting our business over the past several months. The COVID-related economic slowdown in China, the work down of nearline HDD inventories among U.S. cloud and global enterprise customers under a more cautious demand environment and macro-related disruptions primarily impacting our consumer-facing markets. These factors remained at play during the December quarter and weighed heavily on the mass capacity markets, resulting in a 10% sequential decline in mass capacity revenue.

Having said that, we are already seeing some encouraging indicators. Within China, we believe first steps toward recovery are being implemented through government policies aimed at improving economic conditions including the faster-than-expected reversal of zero COVID restrictions and a show of confidence following the policy shift several major banks raised their 2023 outlook for China's GDP. We expect it will take time for consumers and businesses to work through disruptions related to the COVID policy pivot and for the economy to fully reopen. Based on our customer conversations, we anticipate regional sales into the VIA and nearline markets to remain subdued in the March quarter and gradually improve as the calendar year unfolds. We will continue to monitor demand signals and expect to gain a better picture following the Lunar New Year celebrations.

Turning to the U.S. cloud and enterprise markets. Customers have focused on working down the HDD inventory levels that were built up during the pandemic as non-HDD component shortages created inventory imbalances. We believe some progress has been made in recent months supported by an improvement in non-HDD component availability. While inventory adjustments are customer-by-customer event, and ongoing macro uncertainties have led to more cautious near-term buying decisions, we expect nearline sales will improve slightly in the current quarter, particularly for our high-capacity drives. Our view is supported by the ongoing adoption of our 20-plus terabyte family of nearline products, which represented close to 60% of nearline exabyte shipments in the December quarter and is expected to trend even higher in the current quarter.

Relative to our products, we are seeing a wider variety of nearline capacity points and configurations being adopted across our customer base, depending on their specific data center architectures, workloads and application needs. Seagate is well equipped to address these individual unique requirements with our deep customer relationships and broad technology portfolio, spanning traditional perpendicular recording technology or PMR drives to performance-oriented dual actuator products to TCO enhancing SMR technology. In addition to our device portfolio, Seagate's Systems business offers cost-efficient, scalable petabyte solutions for both enterprise and cloud customers. While system sales were down sequentially off of a very strong September quarter, we captured a record number of new customer wins with our CORVAULT products.

CORVAULT offers features such as self-healing, autonomous drive regeneration, which increases productivity while reducing electronic waste. The momentum that we're seeing across the systems business supports revenue to move higher in fiscal 2023. Our strong product pipeline is underpinned by the technology advancements we're bringing to market. We are leveraging our technology leadership to scale drive capacities through aerial density gains rather than additional heads and disks. As a result, we can deliver our trademark TCO advantages to customers with attractive margin opportunities for Seagate. Our 20-terabyte product features 2 terabyte per disk capacities and we have started to ramp the volume of 22 terabyte products deployed on 2.2 terabyte per disk capacities.

The 20-plus terabyte platform is based on traditional PMR technology. And some customers are choosing to enable SMR technology as an additional feature that slightly increases the drives capacity for certain applications. In the December quarter, about 35% of our nearline exabyte shipments were deployed as SMR drives. We are executing plans to deliver another 10% gain in per disk capacity for this PMR platform to offer drives in the mid- to upper 20 terabyte range. However, I'm most excited made on our HAMR technology. It was nearly four years ago to the day that I first shared our lab results demonstrating 3 byte per disk capacity. And today, we have demonstrated capacities of 5 terabytes per disc in our recording physics labs. In the current market environment, we've been taking advantage of our reduced factory utilization to accelerate cycles of learning around HAMR productization.

We are meeting or exceeding all product development milestones and reliability metrics, and we will be shipping prequalification units to key cloud customers in the coming weeks. As a result of this progress, we now expect to launch our 30-plus terabyte platform in the June quarter, slightly ahead of schedule. The speed of the initial HAMR volume ramp will depend on a number of factors, including product yields and customer qualification time lines. However, we plan to use our systems business to quicken the pace of learning and time to yield. Our tremendous progress reinforces my confidence in HAMR products and our ability to execute. These innovations were only possible through the hard work and dedication of our global team, and I would like to thank them for their many efforts.

Our multi-decade focus on HAMR R&D and our innovation across all facets of drive production have resulted in a development advantage that we believe is measured in years, and we're excited by our collaborations with customers on HAMR capabilities. The technology innovations driving aerial density higher will deliver strong and consistent cost reductions at the highest drive capacities and enable future cost-efficient refreshes of our midrange capacity drives. We believe these products serve as the foundation to expand our margin profile back into and possibly beyond the long-term target range. Wrapping up, Seagate is executing with speed and agility through the near-term macro challenges. We've made meaningful improvements to our cost structure and balance sheet while steadily advancing our product and technology road maps.

With signs starting to emerge that market conditions could improve as we progress through the calendar year, Seagate is well positioned with an industry-leading mass capacity portfolio that we believe supports the return to our long-term financial model over time. Thanks, and I'll now turn the call over to Gianluca.

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Gianluca Romano: Thank you, Dave. Seagate is navigating through the near-term macroeconomic cross-currents and executed to plan in the December quarter. We delivered top and bottom line results that came in slightly above the midpoint of our guidance ranges, revenue of $1.89 billion and non-GAAP earnings of $0.16 per share. Our actions to reduce costs, strengthen the balance sheet and improve long-term profitability have yielded desired outcomes, including a continuation of positive free cash flow generation, without sacrificing investment necessary to extend our technology leadership. Total hard disk drive shipments were 113 exabytes in the December quarter, down 5% quarter-over-quarter, with HDD revenue declining 6% sequentially to $1.7 billion.

Multiple factors led to an expected decline in the mass capacity business, including the inventory correction among cloud and enterprise customers, COVID-related disruption in China and Seagate own action to reduce production. Mass capacity sales were offset by a slight seasonal improvement in the legacy market. Shipment into mass capacity markets totaled 97 exabytes, down 7% quarter-over-quarter. Of this total, roughly 82% were derived from nearline products, shifting to cloud and enterprise OEM customers. Nearline shipments of 80 exabytes were down 6% sequentially and roughly 30% of our recent high. We believe the actions we have taken to quickly adjust our production output have aided customers to start making progress in working down their inventory levels.

The degree of progress vary from customer to customer and notwithstanding the current macroeconomic uncertainties, we would expect it will take a few more months to reach more normalized inventory level across the customer base. On a revenue basis, mass capacity sales were down 10% sequentially to $1.2 billion, reflecting the nearline trend that I just described as well as lower demand in the VIA market. As we expected, the prolonged economic slowdown in China continued to impact sales of our VIA products, and we did not see the typical seasonal pickup in sales during the December quarter. As Dave mentioned earlier, the Chinese government is taking action to boost the country economy, including the rapid reversal of COVID policy restriction.

It will take time for these changes to take effect. And while still early, emerging customer dialogue support these encouraging leading indicators. As a result, we anticipate conditions to gradually improve over the next couple of quarters. Within the legacy market, revenue was $421 million, up 8% sequentially, primarily driven by a seasonal uptick in consumer demand, although a more subdued level compared to prior year. Finally, revenue for our non-HDD business was $224 million, down 15% sequentially, reflecting the expected decline in our enterprise system business following a very strong September quarter. Overall, we are making great strides in growing the system business, increasing sales of our branded channel products and building customer momentum with our CORVAULT self-healing technology.

While we are continuing to navigate lingering supply constraint for a couple of system components, we expect non-HDD revenue to improve through the remainder of the fiscal year. Moving to our operational performance. Non-GAAP gross profit in the December quarter was $403 million. Embedded in that figure are the underutilization costs associated with lowering production output to support inventory reduction, both as a customer and on our own balance sheet. Underutilization costs of $79 million were somewhat higher than we had projected at the onset of the December quarter and translated into a 420 basis point of margin headwind. Accounting for risk costs, non-GAAP gross margin was 21.4%, down from 24.5% in the prior quarter. Based on our current outlook, we are planning to begin ramping production output in the March quarter, sometime after the Lunar New Year.

Cost and efficiencies associated with restarting and ramping of production are expected to largely offset the benefit of lower underutilization costs for the March quarter. However, as demand recovers in the coming quarters, we expect both gross profit and gross margin to move higher. We significantly reduced non-GAAP operating expenses to $294 million, down $20 million quarter-over-quarter due to savings associated with our restructuring plans and proactive expense management. We expect quarterly non-GAAP OpEx to remain around the $300 million level through the balance of the fiscal year 2023. Based on the diluted share count of approximately 207 million shares, non-GAAP EPS for the December quarter was $0.16. Moving on to the balance sheet and cash flow.

We executed planning action to strengthen our balance sheet over the near term. We ended the December quarter with a liquidity level of approximately $2.5 billion, including our revolving credit facilities, flat with the prior quarter. We believe these levels are sufficient to support our strategic plans and meet customer demand. We drove a significant reduction in inventory to approximately $1.2 billion, down $400 million from the prior quarter, reflecting our effort to work down strategic inventory and finished goods. We expect inventory to remain around this level over the next couple of quarters, but we'll continue to focus on aligning our supply chain and finished good level to the prevailing demand environment. We reduced capital expenditures to $79 million, down 41% quarter-over-quarter.

CapEx is expected to trend lower through the second half of the fiscal year with total fiscal year expenditure below the long-term target range of 4% to 6% of revenue. Free cash flow generation was $172 million, up 54% sequentially with lower capital expenditure and a $51 million improvement in working capital. We expect free cash flow to remain positive throughout calendar year 2023 and more than sufficient to support our dividend program. We used $145 million for the quarterly dividend. And as previously communicated, we paused our share repurchase program, exiting the quarter with 206 million shares outstanding. We are not currently planning to repurchase any share for the balance of the fiscal year, consistent with our near-term focus on optimizing cash flow through the current macro environment.

Returning capital to shareholders remains an important aspect of our financial model, and we will assess resuming our program in fiscal 2024, depending on business conditions. We lowered overall debt by approximately $220 million, largely through a debt exchange, requiring minimal cash outlay. Additional, we successfully renegotiated our debt covenants to temporarily increase the leverage ratio to 5x. Our debt balance exiting the quarter was $6 billion, and adjusted EBITDA for the last 12 months totaled $1.6 billion, resulting in a gross debt leverage ratio of 3.8x. Interest expense in the December quarter was $77 million and is expected to be approximately $82 million for the March quarter, reflecting higher interest rate associated with the new debt.

We continue to evaluate options related to debt structure and reducing interest expense. Turning to our outlook for the March quarter. The broader macroeconomic and geopolitical uncertainties continue to impact the business environment and shape of recovery. However, as indicated earlier, we are encouraged by the actions being taken to improve economic condition in Asia and the early indication with cloud and enterprise customer inventory levels are trending lower. As a result, we expect March quarter revenue to be in the range of $2 billion, plus or minus $150 million, up about 6% quarter-over-quarter at the midpoint. We project incremental improvement in the mass capacity business from cloud and enterprise customers and higher system sales to offset seasonally decline in the legacy market.

At the midpoint of our revenue guidance, we expect non-GAAP operating margin to be in the mid- to upper single-digit range, which includes both underutilization costs and inefficiencies associated with the resuming production output. And we expect non-GAAP EPS to be in the range of $0.25, plus or minus $0.20. I will now turn the call back to Dave for final comments.

Dave Mosley : Thanks, Gianluca. Seagate continues to demonstrate resilience in the most dynamic of times. We are executing on what is within our control, generating positive free cash flow and advancing our product road map. As I indicated earlier, we expect mass capacity market conditions to gradually improve as we progress through the calendar year, which supports stronger revenue and profitability in the back half of 2023. Longer term, we remain excited by the secular trends driving demand for mass capacity storage, and Seagate unique capabilities to capture these future growth opportunities. We are leveraging our aerial density leadership to increase capacity per disk, which we believe enables the most cost-efficient product solutions for mass capacity storage.

We will begin shipping products based on 3-plus terabyte per disk capacities in the coming months, which is up to 35% more than comparable drive capacities available today. Amid a challenging macro and industry backdrop, I'm incredibly proud of the partnerships and hard work from our suppliers, customers and our employees. Earlier this week, we published our fourth annual diversity, equity and inclusion report, which highlights how Seagate aims to build and support its global team. The principles outlined in this report are foundational to Seagate's technology innovations and long-term success. I encourage you to read the report in full on our website. I will conclude by thanking our shareholders for your ongoing support. Our objective remains taking the decisive steps to best position Seagate for long-term value creation.

Gianluca and I will now take your questions.

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