Western Digital Corp (WDC) — Q3 2015 Earnings Call Transcript

Thank you, I want to mention as we begin that we’ll be making forward-looking statements in our comments and in response to your questions concerning, among others, our position and opportunities in the growth of data and the storage ecosystem, the growth areas in storage, our management of short-term market dynamics, our focus on long-term value creation, our capital allocation, exit by shipments, macroeconomic conditions, optimization of our infrastructure, regulatory restrictions of MOFCOM, our ability to meet any unexpected increase in our product demand outlook and our financial performance including our financial results expectations for the June quarter. These forward-looking statements are based on management’s current expectations and are subject to risks and uncertainties that could cause actual results to differ materially including those listed in our quarterly report on Form 10 Q filed with the SEC on January 10th, 2015. We undertake no obligation to update our forward-looking statements to reflect new information or events. In addition, references will be made during this call to non-GAAP financial measures. Reconciliations of the differences between the historical non-GAAP measures we provide during this call to the comparable GAAP financial measures are included in the quarterly fact sheet posted in the Investor Relations section of our website. The non-GAAP forward-looking guidance we provide during this call excludes amortization of intangibles related to the acquisitions of HGST, sTec, VeloBit, and Virident data. Because we currently can’t fully quantify future amounts for those excluded items we are unable to provide guidance for or a reconciliation to the most directly comparable GAAP financial measures. The impact of these excluded items may cause the estimated non-GAAP financial measures to differ materially from the comparable GAAP financial measures. We ask that participants today limit their comments to a single question and one follow-up question if they have one. I also want to note that the copies of remarks from today’s call will be available in the investor section of Western Digital’s website immediately following the conclusion of this call. I’ll turn the call over to President and Chief Executive Officer Stephen Milligan.

Good afternoon and thank you for joining us. After my opening remarks, Olivier Leonetti will provide additional commentary on our March quarter performance and our outlook for the June quarter. For the third fiscal quarter we reported revenues of $3.5 billion, non-GAAP gross margins of 31.1% and diluted earnings per share of $1.87. I am satisfied with our execution and results in light of the PC demand challenges that were largely driven by weak macroeconomic conditions. We delivered a solidly profitable quarter with continued strong cash generation, improved average selling price, and healthy gross margins. Overall, our storage shipments for the March quarter were 61 exabytes up 14% year-over-year. We continue to carefully balance the management of short-term market dynamics with a strong focus on long-term value creation. This is reflected in our balanced approach to capital allocation. Fiscal year-to-date we returned $1.1 billion to our shareholders in share repurchases and dividends, while continuing to invest in high-growth market opportunities. We continue to make strong progress on several strategic growth initiatives. Our enterprise SSD business was accretive for the quarter and grew revenues by 67% year-over-year to $224 million. We also launched our new Ultrastar MPME solutions in the enterprise space addressing the industry transition to standards-based PCIe solutions. We surpassed 1 million helium hard drive deployments and are now ramping our new 8 terabyte helium PMR sealed drives. We shipped our first active archive system, a new category of high-value-added archival storage product addressing a market of approximately $15 billion. We completed the acquisition of Amplidata, a key building block of our vertical innovation strategy for active archive systems. We expanded our line of purpose-built drives for the fast-growing surveillance video recording space, and we launched four new models of high-performance NAS systems for the SMB space. These initiatives provide revenue expansion opportunities for our company as we leverage our capabilities and resources in the rapidly changing storage ecosystem. Turning to our outlook, we continue to see growth in exabyte shipments during calendar 2015 and beyond. However, we anticipate that global macroeconomic headwinds will persist in the short term, further impacting PC sales. Given this, we are cautious with regards to our near-term outlook. We believe this is prudent in the current environment and consistent with our focus on long-term value creation. That being said, we are fully prepared to meet any upside in demand that may occur as we progress through the June quarter. We are optimistic that the demand environment will improve in the second half of the year. We will continue to optimize our infrastructure and related investments to the current demand profile. That being said, our ability to respond to changing market dynamics is affected by the MOFCOM hold separate restriction. This is one of the central arguments that I continue to make in our regular interactions with MOFCOM. Lifting the hold separate restriction would be beneficial to consumers and our customers by promoting innovation and enhancing the competitive environment. Olivier will now provide a summary of our March quarter performance and outlook for the June quarter.

Thank you, Steve. Our revenue for the March quarter was $3.5 billion. We shipped a total of 54.5 million hard drives at the average selling price of $61. Our non-GAAP gross margin was 30.1% and operating expenses totaled $591 million. Tax expense for the March quarter was $28 million or 7% of pre-tax income. On a non-GAAP basis, net income was $441 million or $1.87 per share. Turning to the balance sheet, in the March quarter we generated $684 million in cash from operations and our free cash flow totaled $534 million. Our CapEx totaled $150 million, or 4% of revenue. We repurchased 2.2 million shares for $240 million. We also declared a dividend in the amount of $0.50 per share. We closed Q3 with total cash and cash equivalents of $4.8 billion, of which approximately $880 million was held in the U.S. I will now provide our guidance for the June quarter. We expect revenue to be in the range of $3.3 billion to $3.4 billion, excluding the amortization of intangibles, and gross margin percentage to be around the midpoint of our business model of 27% to 32%. Operating expenses of approximately $590 million. Accordingly, we estimate non-GAAP earnings per share of between $1.50 and $1.60 for the June quarter.

Hi, guys. My first question, if you could just review your perspective on the TAM for us in terms of how you see that progressing in the June quarter relative to 125. And any other comments, you said you were optimistic on the second half of the year then how do you foresee that TAM unfolding? And then I’ll ask my follow-up, please.

Certainly, let me provide some insight into the demand environment. For fiscal Q3, we anticipate the total addressable market to be approximately 125 million units. Initially, we expected it to be around 135 million units. The decline we experienced during the quarter was mainly due to weakness in the PC market, which was influenced by broader global economic challenges. As mentioned earlier, we believe these global economic headwinds will continue into the second quarter, impacting PC sales, and we estimate the total addressable market will be around 120 million units. On a different note, demand from the enterprise sector, including both traditional and cloud-related customers, remains robust and aligns with our expectations from both an industry and company perspective. Looking ahead to the second half of the year, we are hopeful for an improvement in the demand environment for several reasons. We anticipate a rebound in PC sales and a seasonal increase in gaming unit sales, in addition to a seasonal uptick in demand for our consumer-oriented branded products, all while maintaining strength in the enterprise market.

Okay. Great. Let me ask my follow-up, then, if I could, Stephen. Your employment levels in Q3 FY12 post-deal were a little over 106,000. The information sheet you put out this afternoon said your total world headcount was about 81,000. How have you managed to significantly reduce headcount during this period? Additionally, could you reiterate the incremental cost reductions you anticipate once MOFCOM relief is granted? Thank you.

Yeah, keep in mind that most of our headcount from a total headcount perspective is concentrated in our factories. We have worked that headcount level down over time primarily through attrition, and so, you know, not replacing workers that decide to move on for further employment. And if we go to the question on MOFCOM, what we have said, and we continue to say is that we expect that from an operating expense perspective, we would realize approximately $100 million of OpEx savings a quarter. We have not quantified the savings that we would anticipate on the cost line item, but we have indicated that we would expect that to be meaningful.

Yeah, thanks for taking the question, I do have a follow-up as well. First looking at the outlook, when we look at the midpoint of your gross margin guidance, and also in the context of your expectation of enterprise remaining relatively healthy, I’m just trying to bridge the expectation of a decline in gross margin down into the 29.5% range. What’s the underlying drivers of that? And why wouldn’t mix shift towards enterprise offset some of the weakness we’re seeing in the PCs and actually be a positive on gross margin?

So let me take this one. The margin decline in the quarter is going to be mainly attributed to absorption impact. That’s the main driver. And as Steve has indicated we expect the margin to pick up in the second half of the calendar year at the back of a bounce back of the PC market and also some increased demand in the enterprise segment.

Okay. And then as a follow-up and related to the enterprise business, it looks like you guys were down a bit more so relative to your closest competitor which I think was flat sequentially. Can you talk about the competitive landscape, whether or not you’ve seen any kind of changes in pricing in the enterprise market or any reasons why maybe you might have underperformed your competitor in that space?

Yeah, so one of the things to keep in mind overall share and in particular enterprises share, things are going to shift a little bit quarter to quarter and particularly in the enterprise space. I hate to use the word 'lumpy' because it tends to be a little bit overused but it tends to come in bigger chunks in terms of we can have a customer that we’re particularly strong with that may provide a little bit of incremental volume or the flip side could be true of our largest competitor and so share can move around a little bit more quarter-to-quarter from an enterprise perspective. But the important thing to keep in mind, there’s a few important things to keep in mind. One is, is that we’re very comfortable with our product positioning in that space and also very comfortable with the positioning from a customer perspective. And then the last comment that I will indicate is that we’ve also got to keep in mind that unit share is one indicator, but it is not the only indicator. You also have to look at revenue share as well as margin share. And in that regard, we’re particularly pleased with how we performed in the past quarter.

Thank you, good afternoon, gentlemen. Just if you could talk a little bit more about the SSD business, strong growth there this quarter, and, Stephen, you had mentioned I think in previous calls that you expected during the first half of calendar 2013 particular growth maybe on the PCIe side in that business so could you elaborate what you’re seeing in SSDs and what that revenue is comprised of?

Most of our revenue today is coming from our enterprise SaaS enterprise SSD offering that we co-developed with Intel. We continue to see strong receptivity to our product and good traction there. As mentioned in my prepared remarks, we’ve recently announced our PCIe/MME offering, and what we’re observing is a shift from proprietary-based PCIe solutions to a standards-based NVMe solution. We expect to see the impact of this on our revenue as we progress through the remainder of 2015, but so far, it hasn't significantly affected our revenue performance in the past quarter.

Yes, thank you. So I guess one quick clarification here, you talked about MOFCOM again in your script and made another strong case for why you should be able to integrate. Is there any update at all on the feedback you’re getting from MOFCOM right now?

Sure. Let me provide a little bit of color on that. We continue, as I alluded to in the prepared remarks, to have frequent communications with MOFCOM. That includes myself and members of the management team. On the positive side, I am encouraged by the frequency of those communications and the substance of those communications. Where I am not pleased is with regards to the pace of decision-making or the transparency of that decision-making. And so one of the things that in a constructive way we continue to push is to help us understand exactly what the decision-making process is going to be and the timeframe associated with that. So that is where the frustration is, just the timing and the nature of the process surrounding that decision-making.

Great, that’s helpful and just a follow-up. You guys have been seeing visibility with hyperscale is getting better. Is that still the case? Do you anticipate you can still see a meaningful uptick in the back half?

Relative to hyperscale demand, we feel comfortable about our visibility right now through the balance of calendar 2015. And, again, as I alluded to in our prepared remarks, we’re expecting to see strong petabyte growth particularly in the hyperscale accounts. The one question which I had talked about on our earnings call last quarter is the question is how will that specifically impact our unit demand which is a function of the deployment of new capacity points as well as the acceptance of those new capacity points on behalf of our customers. So, for example, as we deployed an eight-terabyte drive what will be the take rate on that by our customers and obviously if you ship an eight-terabyte you don’t need a two or four terabytes. So the impact is the one that’s a little bit more variable. But what we do feel very strongly about is continued growth in petabyte growth in hyperscale deployments.

Thanks a lot. Good afternoon guys. I have a question and a follow-up as well. Stephen when I look at your OpEx numbers it appears the long-term target of 10% to 12% you guys have, you’re running at about 16.6% or so right now. I think half of that is attributable to the MOFCOM number you talked about. But I’m curious what do you think helps you realize the other half of the operating margin, is it leverage? Is it mix? And how are you going to achieve the targets as you go forward beyond MOFCOM?

You’re right, a large portion of that delta is due to lack of synergies from related to the whole separate situation. The other thing is, which is don’t mean this to sound as a cop out because it may sound like a copout but keep in mind that our OpEx model was set back in September of 2012. One of the things that we need to do as the composition of our business changes and our investments change accordingly is a resetting of that model appropriately. I’m not suggesting that it is or it is not. It’s just something that we would have to contemplate. But clearly, one of the things that we’re going to have to do as we move forward is look at ways at optimizing our expenditures and, you know, we talk about that in terms of managing short-term dynamics with longer term value creation. And that becomes a bit more challenging as you see, as we did in this past quarter, a faster deceleration in the PC market largely driven by temporal factors.

Thank you. Stephen, I want to ask about inventory levels, if I could. There have been some recent data points suggesting that distributors, especially in Europe and Asia, are excessively bringing down the level of hardware inventory due to currency. What’s your view of inventory in the channel and that the ODMs relatively to normal levels?

So a couple comments on that. Generally speaking, when we look at inventory levels, we think that they are within manageable ranges. That being said, one of the comments that you indicated, when we look at our distribution business, our distribution business was down pretty meaningfully in Europe. And that is largely driven by the effect of a stronger U.S. dollar. And so we’re sensitive to that. We’ve tried to manage our business appropriately and manage those inventory levels. But as our customers in Europe are seeing a compression on their business driven by the U.S. dollar, that clearly puts pressure on our business as well.

Hi, thanks. Stephen, I was hoping you could provide a little more detail on your view as to why the second half will improve from a PC perspective, and also maybe some commentary on the enterprise side. Just wanted to know if you’re hearing anything from customers that suggest they also think demand will improve in the second half, or is that driven by Windows 10 or what that belief is based on. Thanks.

Yeah, so just, Sherri, not to mince words but we’re optimistic that the demand environment will improve. Obviously, we’ll have to continue to keep an eye on that. The reasons that we’re optimistic is we do believe that the PC market will improve or we’re optimistic that it will improve, I should clarify that. We will see seasonal uptick in demand from the gaming segment. And we will continue to see or expect to continue to see strength in the broader enterprise market. I don’t know if I would characterize the enterprise market as being consistent with our expectations. I don’t know if I would say that I’m expecting an acceleration of that in the back half of the year. I think that we’re expecting a continued strong demand environment in the broader enterprise market, including hyperscale.

Okay, great. Thank you. I wanted to follow up on that last question regarding the potential impact of Windows 10. Intel suggested that there was some channel reduction in front of Windows 10 and there’d be a channel fill in the back half. Would that play a role in an optimistic view on the second half?

Yes, Jayson. And we concur with that.

Thanks for taking my question. And going back to your guidance for 120 million TAM units for the June quarter, I’m just curious, what kind of consumer pieces you have built in and are you expecting units to be up, flat, or down in June compared to the March quarter?

We would expect the decline in business to keep declining, putting a number behind that would be a bit difficult. Probably less precipitous than what we have observed in the March quarter but some level of decline.

That’s correct. And that’s why we indicated again in my prepared remarks that if demand ends up being better than we expected we’ll be there to meet it.

Thank you. So the exabyte data gives us the ability to look at price per terabyte which was down a healthy 80% year-over-year on effectively flat gross margins. So this implies that cost production is in line with the price per terabyte reductions and that’s very good. Can you help tease out how much is due to mix shift in your line versus the inherent like-for-like price declines you’re seeing right now? And I will have a follow-up.

Yeah, most of it, more than a lion’s share of that is growth in mix-up is most of that.

It is indeed mostly mix-up.

Absolutely.

Now, the advanced storage consortium which you guys are a part of recently released a ten-year roadmap showing for a 10x increase in aerial density. And I understand there’s going to be an increased unit cost to get there due to HAMR as well as bit pattern media but I would think this still implies a 7x bit price decline over the same timeframe or, basically, a 22% price per bit decline significantly faster than your current trend and potentially faster and further than what the NAND flash camera can accomplish do you have any pushback on that assertion there?

Well, honestly that’s a lot of data to sort of throw out straightaway. It would require a little bit further analysis. But we continue to believe that from a competitive positioning standpoint we will remain particularly in the enterprise space, we will remain cost competitive in terms of any other solution. So generally speaking I would say, yes, I agree with your assertion. Thank you, again, for joining us today. In closing I want to thank all of our employees and suppliers for their commitment and outstanding execution and our customers for their continued business. Thank you so much.