Western Digital Corp (WDC) — Q3 2021 Earnings Call Transcript

Thank you, and good afternoon, everyone. Joining me today are David Goeckeler, Chief Executive Officer; and Bob Eulau, Chief Financial Officer. Before we begin, let me remind everyone that today's discussion contains forward-looking statements, including product portfolio expectations, business plans, trends and financial outlook based on management's current assumptions and expectations and, as such, does include risks and uncertainties. We assume no obligation to update these statements. Please refer to our most recent report on Form 10-K filed with the SEC for more information on the risks and uncertainties that could cause actual results to differ materially. We will also make references to non-GAAP financial measures today. Reconciliations between the non-GAAP and comparable GAAP financial measures are included in the press release and other materials that are being posted in the Investor Relations section of our website. With that, I will now turn the call over to David.

Thank you, Peter. Good afternoon, everyone, and thanks for joining the call today. We reported solid third quarter results above the guidance range provided in January, with revenue of $4.1 billion, non-GAAP gross margin of 27.7% and non-GAAP earnings per share of $1.02. Sequential revenue growth was driven by increasing momentum of our high capacity energy-assisted drives and our second-generation NVMe enterprise SSDs, improving NAND flash pricing trends, along with the continued accelerated digital transformation across end markets. As we continue to manage the impact of the pandemic, we know that the world is not only more technology-enabled, but also more technology-dependent than ever before. From the intelligent edge to the cloud, data storage is a fundamental component underpinning the global technology architecture. Western Digital's strengths in technology and cost leadership, expansive product portfolio and broad routes to market are providing a foundation upon which we are solidifying our position as an essential building block of the digital economy. These strengths, combined with our increased operational and strategic focus enabled by our new business unit structure, are driving results. As we continue to face a dynamic environment, we are seeing the benefits of the synergistic value in the breadth of Western Digital's portfolio, and our unique ability to deliver both hard drives and flash solutions to our diverse end markets and customer base. Let me now provide a recap of our Flash and HDD businesses. Within Flash, the depth and breadth of our product line, distribution channels, cost leadership and customer base are significant differentiators. Our ability to act swiftly and shift bits to meet customer demand in various end markets, ranging from data centers to retail, enabled us to grow both revenue and gross margin in the third quarter. Within Data Center Devices and Solutions, we experienced significant growth in the quarter with our second-generation NVMe enterprise SSD in a cloud titan. In addition, we are seeing many cloud customers also utilize NAND flash for their consumer product lines. This creates many opportunities for us as a strategic partner as we continue to diversify and balance the end markets we serve. We are already achieving significant progress in VR headsets, game consoles and other at-home entertainment devices where we have experienced over 10x bit growth last calendar year and expect to double again this calendar year. In Client Devices, continued strength in PC demand, along with the new game console ramps drove sequential revenue growth above typical seasonal trends. Retail remained a high-performing end market as our brand recognition, broad product portfolio and extensive distribution channels continue to distinguish Western Digital from our competitors. In particular, it was a solid quarter for gaming with our WD Black product line having maintained strong levels of interest as gamers have gravitated towards more customized solutions. By delivering reliable performance, expansive storage capabilities and a hyper-realistic gaming experience, our industry-leading WD Black portfolio is trusted by gamers to perform their best. We are also excited about the future as Western Digital's technology roadmap and cost leadership will continue to drive our ability to meet customers' needs. BiCS5 is in the midst of a significant ramp, exceeding customers' expectations and delivering the reliability and performance our customers depend upon. Moreover, the technology advancements we made with BiCS5 have allowed us to achieve the scale, efficiency and bit growth needed while using a lower number of layers resulting in lower costs and lower capital intensity. We continue to expect BiCS5 bit crossover later in 2021. Finally, in February, we revealed BiCS6, our next-generation flash device, based on 162 layer and CuA technology, developed in partnership with Kioxia as part of our long-standing successful joint venture. BiCS6 features numerous architectural advancements, including improved lateral scaling, which allows us to deliver this high-performing product at an optimal cost. This marks another major milestone in our 20-year relationship with Kioxia. And together, we will continue to drive innovation to meet the needs of our respective customers in their diverse applications. In HDD, revenue growth was led by capacity enterprise drives, a trend that tilts the overall HDD market to growth as demand for capacity enterprise drives will more than offset the decline in client drives. Meanwhile, retail HDD demand was better than expected, supported by continued work from home, distance learning and at-home entertainment trends. We continue to see enterprise demand stabilizing and expect to pick up as employees return to work. We have completed qualifications for our energy-assisted drives with nearly all our cloud and enterprise customers, including all the cloud titans and expect an aggressive ramp of our 18-terabyte hard drives. Building on this success, we've entered into long-term agreements with a number of our cloud titans for 18-terabyte drives. These commitments underscore our product leadership and the importance of capacity enterprise drives to our data center customers. As we continue to navigate challenges brought on by COVID-19, we know that the world is not only more technology-enabled, but also more technology-dependent. We believe this is a fundamental and sustainable trend, highlighting the importance of Western Digital's broad portfolio of storage solutions, and we're encouraged by what's ahead. In flash, improving pricing trends in the retail and transactional portions of the market are translating to better pricing in a negotiated portions of the market, and we expect this trend to continue in the fiscal fourth quarter. Our unique ability to provide high volumes of flash and hard drive solutions through extensive distribution channels and to diversified end markets provides us with broad demand visibility, enabling our team to optimize product mix and profitability. In the cloud, we remain uniquely positioned to benefit from the strong growth in this sector, where NAND flash and hard drives are complementary solutions. We expect the strength to build as we progress through the calendar year, led by the ramp of our 18-terabyte hard drives as well as broad-based growth in flash. And while we are excited about these drivers, we are also keeping close watch on some headwinds. To date, we have been able to largely mitigate the impact of the industry-wide semiconductor component shortages through proactive supply chain management. We are, however, experiencing tightness in controllers as well as flash, which could limit potential upside in the future. We also recognize that while the pandemic effects are lessening in some regions, others are unfortunately experiencing another wave of cases. We are actively managing through this environment, which continues to have ongoing impacts to our business. I'll now turn the call over to Bob to share details on our financial results.

Thanks, Dave, and good afternoon, everyone. As Dave mentioned, overall results for the third fiscal quarter were above the upper end of the guidance ranges provided in January. Flash revenue and gross margin improvement were the primary contributors to the upside versus guidance. Total revenue was $4.1 billion, up 5% sequentially and down 1% year-over-year. Looking at our end markets, client Devices revenue was $2 billion, down 6% sequentially and up 10% year-over-year. On a sequential basis, client SSD revenue was flat and notebook and desktop PC hard drive revenue was down, though it decreased less than what we're used to seeing based on typical seasonality. Gaming revenue grew, while mobile revenue was down on a sequential basis. Moving on to Data Center Devices and Solutions. Revenue was $1.2 billion, up 53% sequentially, but down 19% from a year ago. Revenue from both capacity enterprise hard drives and enterprise SSDs grew sequentially. We were encouraged to see the sequential growth driven by our new energy-assisted hard drives at the 16- and 18-terabyte capacity points and our second-generation NVMe enterprise SSD products, both targeted for the cloud and large-scale enterprise OEMs. Lastly, Client Solutions revenue was $888 million, down 12% sequentially and up 8% from a year ago. Turning to revenue by technology. Flash revenue was $2.2 billion, up 7% sequentially and up 6% year-over-year. Flash ASPs were down 2% sequentially on a blended basis and flat on a like-for-like basis. Flash bit shipments increased 8% sequentially. Hard drive revenue was $2 billion, up 3% sequentially and down 7% year-over-year. On a sequential basis, total hard drive exabyte shipments increased by 7%, while the average price per hard drive increased 14% to $82. As we move to costs and expenses, please note that my comments will be related to non-GAAP results, unless stated otherwise. Gross margin for the third quarter was 27.7%, up 1.3 percentage points sequentially. This was above the upper end of the guidance range provided in January. Continued success in driving down costs, coupled with an improving pricing environment and our ability to shift bits to more attractive end markets, drove our flash gross margin up 2.9 percentage points sequentially to 30.0%. Our hard drive gross margin was 25%, down 0.5 percentage points sequentially. As noted last quarter, production ramp costs of our new energy-assisted drives and a planned reduction in overall units shipped pressured gross margin. This also includes COVID-19-related impact of $31 million or approximately 1.6 percentage points. Operating expenses of $732 million were higher than guidance due to a larger-than-expected variable compensation accrual tied to our improved profitability. With our improving profitability, our tax rate in the fiscal third quarter was 8%, which was well below our prior expectations and directly resulted in a $0.17 benefit to our earnings per share. We now expect our tax rate to be 17% for fiscal year 2021. Earnings per share was $1.02. Excluding the tax benefit, earnings per share was still well above guidance. Operating cash flow for the third quarter was $116 million and free cash flow was negative $11 million. Capital expenditures, which include the purchase of property, plant and equipment and activity related to flash joint ventures on our cash flow statement was a cash outflow of $127 million. In the fiscal third quarter, we paid off $212 million in debt, including an optional debt paydown of $150 million. We'll also be making an additional optional debt payment of $150 million this Friday, highlighting the confidence we have in our cash flow generation for the fourth quarter. Our liquidity position continues to be strong. At the end of the quarter, we had $2.7 billion in cash and cash equivalents, and our gross debt outstanding was $9 billion. Our adjusted EBITDA, as defined in our credit agreement, was $3.5 billion, resulting in a gross leverage of 2.6x. As a reminder, our credit agreement includes a $1 billion add-back of depreciation associated with the joint ventures. This is not reflected in our cash flow statement. Please refer to the earnings presentation on the Investor Relations website for further details. Moving on to our outlook. Our fiscal fourth quarter non-GAAP guidance is as follows. We expect revenues to be in the range of $4.4 billion to $4.6 billion, and we expect both hard drive and flash revenue to be up sequentially. We expect gross margin to be between 30% and 32%. We expect both flash and hard drive gross margin to improve sequentially as well. We expect operating expenses to be between $760 million and $790 million. Interest and other expense is expected to be between $68 million and $73 million. The tax rate is expected to be approximately 17% in the fourth quarter and the fiscal year. We expect earnings per share to be between $1.30 and $1.60 in the fourth quarter, assuming approximately 317 million fully diluted shares outstanding. Now I'll turn it back over to Dave.

Thanks, Bob. As technology continues to advance, our powerful portfolio will remain centered on developing solutions to our customers' evolving storage needs. Western Digital's unique ability to offer complementary flash and hard drive products benefits the industry, our customers and our company as a whole. While market conditions continue improving, I believe the organization and leadership changes made over the last year are now delivering more agility, better execution and a stronger portfolio and collectively are driving results and unlocking the underlying strengths of Western Digital. We are in a unique leadership position and feel confident that we can continue to drive innovation, while delivering value for all of our stakeholders. We will now begin the Q&A session.

Congratulations on the execution in the quarter. I guess the first question I have is, you mentioned in your prepared remarks about establishing long-term purchase agreements with some of the cloud customers or cloud titans. Can you help us appreciate that a little bit more? Can you give us any context of how those agreements are structured? Are they volume-related? Are they take and pay? Just any kind of clarity on that. And how that would compare to kind of prior engagements with those customers on product cycles?

Yes. Aaron, thank you. Yes, it's something we've been working on for a while, I guess. I mean when I got here a year ago, it kind of struck me that it was a big business and it was very transactional. And the more certainty we could put around it, the better for all of us, especially going into a world where we're going to be investing capital in this business. We're trying to judge supply and demand and get that right as the market shifts to capacity enterprise. So there are multi-quarter agreements, as you would imagine. And we talk about the amount of demand they are going to have, and we set a price for that period. So as opposed to just going quarter-by-quarter, we're extending that out to multi-quarter agreements to give us both more visibility around the business.

Okay. And I guess, maybe somewhat related to that, just thinking about the hard disk drive business as my follow-up is, I guess, a simple question is, how do we go from a 25% gross margin back to what I think is still probably the target of at least 30%, if not higher gross margin in hard disk drives? How do we think about the variables to bring us back to that 30% plus level?

I believe the first factor is moving past COVID, which has impacted our gross margin by 1.6%. We all hope for continued improvement in that area. Additionally, the mix of clients working from home presents its own challenges, leading to a different margin profile. We need to achieve scale in capacity to keep driving down costs. While we can't control market prices, we remain focused on providing a strong total cost of ownership for our customers. We are confident in our roadmap for ongoing improvements in density and aerial density for hard disk drives, which serve as a key storage component in the cloud. We are addressing these challenges from multiple perspectives.

Yes. I guess first question I was hoping to discuss just overall gross margins. So very nice uplift there. And in particular, your cost sales on the NAND side in the March quarter were fairly spectacular and clearly better than what we saw across most other NAND players. So can that 20% improvement year-on-year continue as we go through the year? And what other kind of drivers should we be thinking about impacting gross margins into June?

We are pleased with the current state of our technology. Our target remains at 15%, and while there may be some fluctuations in performance each quarter, we are in a strong position. A significant portion of our portfolio utilizes BiCS4, which is performing exceptionally well for us. We're excited about the cost reductions we've achieved. I hope you had a chance to listen to Dr. Sivaram's insights on NAND technology and the factors influencing our progress. We have a strong belief in our technology roadmap with Kioxia, and as the largest investor in NAND, we are confident in our ability to maintain this trajectory. Looking ahead to the next quarter, we anticipate a favorable pricing environment, which should allow us to continue achieving cost reductions in our portfolio, ultimately enhancing our gross margin.

Okay. Very helpful.

And we're beginning to ramp our BiCS5 112-layer technology as well, which will continue to help bring the cost down.

Great. And then, I guess, can you speak a bit to the rebound you saw in the enterprise HDD side, pretty strong, up 16% sequential units? Can you share with us how to think about 16-, 18-terabyte ramp and the prospect for faster growth as we go through the year?

Yes. We anticipate growth in that market. This quarter, we had a well-balanced shipment of our capacity enterprise across 14, 16, and 18 terabytes, and we expect a significant shift towards 18 terabytes in the coming periods. We foresee continuous exabyte growth and improvements in gross margin for our portfolio as we progress.

Could you discuss the progress you've made with enterprise NVMe? You mentioned a major cloud customer. Are there opportunities for additional clients? Given that you had a late start in the enterprise NVMe segment, what would you estimate your market share to be? Is it possible for your share in enterprise to align more closely with your overall NAND share?

We are currently engaging with major enterprise OEMs, which is an ongoing process. As I mentioned previously, this is a multi-quarter effort and it's progressing well. We are observing strong demand in the channel for our product, which is encouraging. In terms of market share, we are maintaining a balanced portfolio across various markets, including client SSD, mobility, and enterprise SSD. A key focus for us is to achieve enterprise SSD qualification and begin shipping at scale. However, we will continue to support a balanced portfolio across our major markets, which also includes retail and the rapidly approaching gaming sector. We feel positive about our product's trajectory, and securing a deal with a cloud titan last quarter was a significant achievement that yielded benefits this past quarter.

Great. And then my follow-up on 330 basis points of gross margin improvement is pretty significant. Can you give us a qualitative sense of how much of that is coming from NAND versus drives?

Gross margins increased on the flash side, although they are down sequentially.

Yes. I mean more in the June quarter, your guidance.

In the June quarter. Yes. Sequentially, will be up in both businesses, probably driven a little bit more on the flash side.

Congrats on the strong results and outlook. David, you talked about shortages in your NAND business as it relates to controllers and perhaps raw NAND as well. Can you talk a little bit about the actual impact you saw in the quarter? What's embedded in your June quarter guidance and when you'd expect some of these issues to be resolved?

Yes. We're working to maximize our supply. In the past quarter, we experienced shortages in controllers, especially for Chromebooks, which limited our ability to ship as many as we would have liked. However, we have been able to reallocate our existing supply to achieve the highest returns, whether that means shifting controllers between retail and channel products. The team's agility in managing our various go-to-market strategies has been quite beneficial over the last couple of quarters, and I anticipate that will continue. While we can't fully eliminate the shortages, we will keep striving to secure as much supply as possible. We are aware of the forecasts and they align with our available supply, so we do not anticipate any unexpected issues.

Got it. And then as a quick follow-up. I just wanted to get your thoughts on NAND supply/demand going forward. Clearly, the near term is looking really good, and you spoke to that in your prepared remarks. But as you start to plan for fiscal '22, what are your thoughts on the overall market supply/demand and your intentions from a CapEx perspective? You obviously want to make the transitions and maintain share, but at the same time, you don't want to flood the market with too much supply. So what's sort of the debate internally?

Yes, you got it right. We plan to invest to maintain our market share. We're optimistic about the demand situation. While 2022 is still a way off, we keep our guidance on a quarterly basis. We continue to see strong demand for the second half of this year, both in the PC market and the cloud infrastructure market. We'll manage our efforts through the end of the year and be disciplined with our capital expenditures, taking it one quarter at a time.

Dave, I want to go back to the long-term agreements on 18 TB. Is there any share basis for those agreements? And if not, how much share are you targeting at these customers?

We don't provide detailed information on a customer-by-customer basis. However, it's accurate to say that we have strong, long-standing relationships with these customers, especially considering our presence in their data centers and the fact that 90% of cloud storage relies on hard drives. Our focus is on gaining better insights into their plans to ensure alignment between our business and theirs. This approach will help us to better predict the next few quarters and facilitate a transition from a transactional focus to a more strategic long-term planning perspective.

Okay. And as a follow-up, on the ACD gross margins improving in the June quarter, is that more mix related or lower cost headwinds? Can you just help us think through what you think are more transitory maybe in the cost headwind side versus an improving mix here?

A big part of it is mix. I think we've been talking for a long time that 18 capacity point is a better point for us. And as I said, this quarter, we shipped pretty balanced number of 14s, 16s and 18s, and we'll see that tilt strongly to 18s next quarter.

And I think the costs will get better quarter-to-quarter as well. We slowed down production a little bit in the March quarter, and we're back at full production here in the June quarter.

David, it's been about a year or so since you joined the company. And remember, when you first joined, you were doing somewhere around $250 million of annualized earnings. And fast forward 12 months, you're almost at a $6 annualized earning. Great improvement, but still well below 2017, 2018, when the company was doing north of $10 of earnings. And I'm not asking you to give me forecast or guide for 1 or 2 years out. But I think it would be very helpful if you could articulate your views as to how earnings are going to improve here, assuming that you just continue to execute? And I have a follow-up.

Yes, I believe you are beginning to see improved execution. On the flash side, we are expanding our portfolio across various end markets, and establishing ourselves with major cloud providers has played a significant role. We have a robust client SSD portfolio, a strong retail offering, and we are well qualified with leading vendors in the mobility sector, though our presence is somewhat smaller compared to others. Additionally, we have numerous new products in development for gaming and smart home devices, and our strong relationships with major cloud customers allow us to be closely involved in those developments. Our goal is to enhance our portfolio and utilize our market channels to achieve the best possible returns despite the current pricing environment. This quarter, we've successfully balanced our flash portfolio across all markets and incorporated agility in our operations to optimize outcomes. Compared to a year ago, we have significantly improved our agility and execution. On the hard drive side, we aim to enhance aerial density and regain our leadership position, a trend we began with our 18 drives. The market remains favorable, and we have maintained a strong presence there. Furthermore, we are seeing synergy between our client SSD and hard drive portfolios, as these technologies have traditionally been substitutes for one another. Our longstanding relationships with customers allow us to manage transitions effectively, and in the data center space, these technologies complement each other. I believe we have the opportunity to execute on this synergy moving forward.

Okay. And just a quick follow-up on HDD. I believe you're still are restricted with shipment to certain customers, but your primary competitor has continued to ship. How do you see that geography and specific customers there playing to your disadvantage? And I'm assuming that you're still restricted.

Yes. Since the commerce rules were introduced back in September, we have ceased shipping in accordance with those regulations. We maintain regular communication with the commerce department and have both in-house and external legal teams to support our position, which we believe is the correct one. The licenses are currently pending with commerce, and we will monitor how that develops. There hasn't been any recent progress in that area. Regarding our competitors, I can't comment on their actions. My focus is solely on our compliance, and we are unequivocally not shipping to areas that are prohibited by commerce department regulations.

My first question is on the 18-terabyte drives. First of all, congrats on all the qualification. But in terms of the ramp, do you expect your 18-terabyte drives to cross over the 14-terabyte drives exiting this calendar year? And will 18 terabyte be margin accretive right off the bat? Maybe a follow-up to that is, how are you thinking about strategy in terms of ramping 16 versus 18?

Yes, we anticipate that 18 terabytes will be our primary and highest volume product shipped this quarter. Additionally, we expect it to contribute positively to our margins and see a sequential improvement in HDD gross margin. Could you remind me what the second question was?

The second part, it's 16 versus 18. Are you putting all your eggs into the 18-terabyte basket and 16 is just its whatever the customers are asking for?

Yes. I believe it's really about what the customer needs. Each customer is at a different stage in their data center development and deployment. Some are still implementing 14-terabyte systems at scale, some have quickly moved to 18, and others are working on adopting either 16 or 18. We aim to align with our customers' current processes. However, we anticipate that 18 will become the most common option moving forward due to its superior total cost of ownership. Therefore, we expect customers to transition to it as their internal architectures evolve.

Got it. As a follow-up regarding the nearline aspect, considering the improvement on the enterprise side that you are observing and the strong performance in the cloud, what do you anticipate for the industry-wide exabyte growth for nearline drives this year? Additionally, how do you believe you will perform in comparison to that this year?

Yes. We anticipate a quarter of strong growth ahead. I believe we're still on track for around 35% exabyte growth for the year. As the market transitions to 18, I see us in a notably stronger position. That's how I expect the remainder of the year to unfold.

Congrats on the really nice results. My first question was around end markets. You guys gave some helpful color on the HDD and flash side. Could you talk to what you guys see Client Devices, Data Center Devices and Client Solutions kind of doing into the June quarter? Just any general color would be helpful there.

In the data center, we anticipate improvement. I'm considering the modular seasonality. Device performance is quite strong, particularly in PC and client areas. Although we observed a decline in the last quarter, it was better than the usual seasonal decline, and we expect this trend to continue. Our customers indicate that the market remains robust, and we've seen an increase in the number of units shipped, which supports a positive outlook. The data center is ramping up significantly, and we expect growth in that area. In retail, we anticipate sequential growth, although it may be slightly smaller than in other sectors, but still reflects very good performance.

That's helpful. My follow-up was really around the cadence of gross margins. You guys indicated that you should see some HDD gross margins that are improving sequentially. But can you talk to the cadence for the year? I think that the target longer term is $30 million and even above that. But obviously, with nearline drives becoming a bigger part of the mix and some of this COVID headwinds coming off, can you talk to the progression that you guys are expecting internally? And just kind of the progression from here to the 30s?

Yes, I believe we will forecast one quarter at a time, and our teams are diligently working to address what they need to in the storage market, which has been consistently lowering costs. As we scale our products, we will also reduce costs. Overall, the industry is pushing towards achieving 30% gross margins. We will get there gradually, focusing on ensuring a good balance between supply and demand in the market. We also discussed multi-quarter supply agreements, which help create some certainty, and we are working on the cost side as well. Each quarter, we will concentrate on all these aspects and keep pushing forward. It starts with providing a valuable proposition for our customers and enhancing the total cost of ownership as we increase aerial densities. We have a long roadmap for improving aerial density, which is significantly supported by our introduction of energy assist technology. This was an important development with our 16 and 18 products, and as we begin to ramp up the 18, energy assist is now in the market. Our research over more than a decade has culminated in this commercialization, giving us multiple generations of technology to enhance aerial density, which will improve the total cost of ownership for our customers.

I'm just curious with regard to your cloud customers. If you believe they're pretty much through the digestion period of the excess capacity? I know we've seen some on a couple of weeks over that they're starting to ramp up CapEx again. But I'm curious what you're hearing from them? And then I have a follow-up.

Yes. I think the word I used last time was cloud digestion abating when we talked about this. But they're all in a slightly different spot, but we're into an ingestion phase for the most part.

Okay. And then I was curious in terms of the tightness in components in overall market. What kind of impact is that having on your working capital? We're looking at some of the movements in AP and inventory.

Yes. No, that's a good question. And we definitely are carrying a little more inventory than we normally would, particularly on the hard drive side because of the tightness on controllers. And also, frankly, because of the logistics costs associated with COVID-19, we're putting more products on the ocean and not in the air. So it's definitely having an impact in terms of working capital in that respect. Our accounts payable did go down this quarter. I mean that really was a result of a slowing down on the production in the March quarter, and I think it will come back up again this quarter.

Just following up on the earlier question about supply/demand. We've had some peers talk about their concern around seeing some excess capacity coming in NAND. I know it's too early to pull out an outlook for the next fiscal year, but is capacity in that industry-wide a concern in your view? Or do you see a path that ultimately could get you back to the type of peak gross margin that you reported in earlier back in the 2018 timeframe?

Yes, we are not overly concerned about it at this time. The industry has been quite disciplined for the past few years, and there is now strong demand in the market. We feel confident about the balance of supply and demand moving forward. Everyone is trying to assess the long-term demand for technology post-pandemic, which is a unique situation, but we are closely monitoring it. Overall, our perspective is that the industry has maintained a balanced approach regarding supply and demand.

And I'll ask both my questions at the same time, and you can answer in any order you want. But the data center softness, is the visibility there getting better, the digestion phase? And are we a long ways to go or kind of mostly through the worst part? Or is demand coming back for that kind of on the data center? And then you mentioned longer-term relationships and contracts with cloud titans and hyperscalers. Do they allow for flexibility in pricing? The reason why I ask is recent NAND pricing came out and it was quite positive. And we just want to make sure that you're not missing the opportunity for better economics from pricing. And so I was just kind of wondering without any specific some of your relationships of quantity and volumes and pricing, are there some abilities to adjust it? Or do you get locked in and maybe pricing will or won't help you?

I think the second issue you mentioned is not a concern for us. Regarding the first issue, we experienced very strong sequential growth in our data center segment this quarter, with a 53% increase, although it was down year-over-year. However, compared to last year, we had robust exabyte shipments. We anticipate sequential growth in exabyte shipments for drives, and also some growth in flash, though not as strong as the anticipated growth in hard drives as 18 becomes a significant factor in the industry. Overall, we see an upward trend there, Jim.

Congrats on the strong results. I guess just going back to the flash gross margin and the balance that you guys are seeing right now, do you feel like you're sort of to 30% sooner than expected, which is a positive thing? And if so, how would you like us to think about if supply/demand remains balanced on the flash side? How to think about margins going through the second half of the calendar year? And then I have a quick follow-up.

Yes. One way to view this is that we performed better than our guidance. We're ahead of our expectations for the market. A significant factor is our strong presence in various transactional markets, especially in retail. As prices tighten, we can adjust pricing in these large markets more quickly than in OEM markets, which require quarterly negotiations. The market has worked in our favor, and our go-to-market and business unit teams have been quite agile in reallocating our supply for the best returns in the quarter. Looking ahead, we are expecting sequential improvement in flash gross margins. We're witnessing pricing strength in transactional markets carry over into negotiated markets. Last quarter, we were uncertain if this would happen, but we are now seeing it moving into Q4. Therefore, we are forecasting stronger flash margins for the current quarter.

Okay. And it sounds like just structurally, it feels like maybe that could actually follow through just because it feels like the dynamics are more at the beginning as well. I guess my follow-up is, it seems like on your CapEx, it seems like you've lowered the CapEx expectation just slightly for fiscal year '21, if I'm seeing that accurately. And I was just wondering if there's any direct reason for that and what would be underpinning that if there is. And that's it for me.

Yes. No, that's a good observation. And we expected CapEx to be around $3 billion this year, pretty much all year. The main delta is we actually sold some real estate this past quarter to the tune of about $100 million.

David, if I heard correctly, you mentioned that cloud giants are beginning to use your client SSD products for their consumer business. This seems to be the first time we have heard about this. Could you elaborate on that? How should we view the opportunity? And are you leveraging your existing portfolio to address this opportunity?

No, not necessarily our client products. There is some of that because the easiest way to think about it is that many of these large cloud companies have significant consumer portfolios. Whether it involves gaming, tablets, or VR headsets, that is what I mean by us engaging in those areas of the market as well. Additionally, in terms of the go-to-market synergy we've discussed, we often limit our focus to HDDs and enterprise SSDs, but it extends far beyond that, given our deep relationship with these customers stemming from the HDD business. Most of them also have extensive consumer portfolios, whether related to home automation or other similar areas. Therefore, our capacity to participate in those market segments for flash is precisely what we are addressing.

On the NAND gross margins as well. I didn't hear you talk about K1 costs. So I'm guessing they came down pretty meaningfully. But I guess my question is, as we look through the next few quarters, you do have additional fabs coming online, either it's K2 or Y7. I'm just wondering how we should think about any potential incremental costs from those new factories.

Yes, I didn't catch all of your initial comments, but you're right that the expenses related to K1 are now insignificant. We've increased to normal volume levels, so those costs are being accounted for in inventory. We're essentially back to a standard operating state. As we bring the New York fabs online, the start-up costs won't be as significant as they were for the K1 greenfield project. While there will be some fixed costs associated with this, we will also be increasing production volumes and spreading those costs over a larger base since we have multiple fabs in one location.

Two questions real quick. First of all, on the taxes, Bob, is the 17% tax rate kind of here to stay? Do you think it can go a little bit lower? And then secondly, I apologize if I missed this, but have you talked about sort of the recent trends in high capacity video HDDs? And what you're expecting going forward?

I handle taxes, and Dave didn't mention video. This has been discussed in previous calls. Over the past couple of years, our operating profits have fallen short of our expectations. We face minimum tax obligations globally, which has led to our tax rate being higher than usual in recent years. As we project for the remainder of this fiscal year, we are quite confident in maintaining a tax rate of 17%. Looking ahead, this rate will depend on our profitability in those future years. For now, I believe 17% is a reasonable estimate for planning purposes.

Yes, Steven, we haven't talked about high-definition video or in particular, but I mean, one way to think about it is just driving more demand for storage. I think all the devices we carry have more and more capability to store higher definition video, which is just driving the need for more storage per device. So if you have something more specific than that, I'm happy to follow-up on and go...

Yes. It's a growing market.

All right, everyone. Look, we really appreciate you spending time with us. We'll follow up with you throughout the quarter. And again, thanks for joining us. Take care.

Yes. Thanks, everyone.