Seagate Technology Holdings - Earnings Call - Q4 2011

Transcript

Speaker 6

Good afternoon, ladies and gentlemen, and welcome to the Seagate Technology fiscal fourth quarter and year-end 2011 financial results conference call. My name is Catherine, and I'll be your coordinator for today. At this time, all participants are on a listen-only mode. Following your prepared remarks, there will be a question-and-answer session. If you would like to participate in this portion of the call, please press star followed by one at any time during the conference. If assistance is needed at any time during the call, please press star followed by zero, and a coordinator will be happy to assist you. As a reminder, this conference is being recorded for replay purposes.

This conference call contains forward-looking statements, including but not limited to statements related to the company's future operating and financial performance in the September 2011 quarter and thereafter, and includes statements regarding customer demands for disk drives and general market conditions. These forward-looking statements are based on information available to Seagate as of the date of this conference call, but are subject to a number of risks, uncertainties, and other factors that could cause actual results to differ materially from those anticipated by these forward-looking statements. Information concerning additional factors that could cause results to differ materially from those projected in the forward-looking statements is contained in the company's annual report on Form 10-K, Form 10-K/A, and quarterly reports on Form 10-Q as filed with the U.S. Securities and Exchange Commission on August 20, 2010, October 6, 2010, November 3, 2010, February 3, 2011, and May 3, 2011, respectively.

These forward-looking statements should not be relied upon as representing the company's views as of any subsequent date, and Seagate undertakes no obligation to update forward-looking statements to reflect events or circumstances after the date they were made. I would now like to turn the conference over to our host, Mr. Steve Luczo, CEO. Please go ahead, sir.

Speaker 5

Thank you, Catherine. Good afternoon, everyone, and thank you for joining us today. On the call with me from Seagate are Pat O'Malley, our Chief Financial Officer, Bob Whitmore, our Chief Technology Officer, Dave Mosley, EVP of Operations, and Rocky Pimentel, Chief Sales and Marketing Officer. We have provided detailed supplemental information about our fiscal fourth quarter and fiscal year-end results on our investor relations site at seagate.com. During this call, I will review the results for the fourth quarter, then provide a brief update on the Samsung transaction, and then discuss the outlook for the September quarter. After that, we'll open up the call for Q&A. On our earnings call in April, we indicated that we were expecting component constraints related to the damage caused by the Japan earthquake and tsunami to continue to impact the disk drive industry in our fiscal fourth quarter.

We believe the supply chain impact would result in the industry TAM being flat to slightly down quarter over quarter at approximately 160 million units. We also expected Seagate's revenue to be roughly flat sequentially at approximately $2.7 billion and non-GAAP diluted earnings per share of $0.19 to $0.23. Seagate delivered solid financial results in the June quarter with revenue of $2.9 billion. We believe the upside revenue was the result of stronger than anticipated demand, and we were able to respond because of the benefits of Seagate's robust supply chain. On a non-GAAP basis, the company reported gross margins of 18.8%, diluted earnings per share of $0.28, and net income of $126 million.

The industry TAM for the June quarter was approximately 166 million units, an increase of approximately 4% from the prior quarter, which is essentially equal to the industry's record shipment of 167 million units in the fourth calendar quarter of 2010. In addition, the average capacity per drive shipped by the industry continued to increase during the quarter and reached approximately 560 gigabytes per unit. For the fiscal year, storage capacity shipped grew approximately 40% to 330 million terabytes. Seagate shipped a record 52 million units during the quarter, representing approximately 32% market share and averaged approximately 590 gigabytes per unit. We believe that this continued increase in the amount of digital storage shipped is directly related to the broadening geographical footprint of IT systems and services, as well as the impact of a highly mobile and connected user base that is demanding real-time access to rich data and content.

We also believe these trends will continue as computing architectures evolve to serve the growing commercial and consumer user base throughout the world. In the enterprise market, Seagate shipped 5.1 million drives for mission-critical applications and 2.7 million drives for business-critical applications, representing year-over-year increases of 8% and 46%, respectively. The company shipped a total of 35.5 million client compute drives in the June quarter, consisting of 14.7 million mobile drives, up 21% year-over-year, and 20.7 million desktop drives, up 6% year-over-year. Demand for Seagate branded storage products remains strong, with solid year-over-year growth of 36% to 3.5 million units, while consumer electronics products totaled 5.4 million units. While there has been some commentary in the market about customers potentially building inventory due to real or perceived supply constraints, we believe the June quarter's TAM reflected true end demand.

For example, distribution channel inventory of Seagate's 3.5-inch ATA desktop drives at the end of the quarter was 3.5 weeks, which was again below the targeted range of four to six weeks. We think it's important to note that this is well below levels typical for a June quarter, which is historically the quarter with the greatest risk of excess inventory during the year. Given our ability to sustain weeks on hand below five weeks for the last two years, we are now targeting four to five weeks on hand for our distribution channel inventory levels. Our gross margin in the quarter was slightly better than planned and was positively impacted by the relatively balanced supply environment in the quarter, as well as higher volume. Historically, our gross margins improved more significantly in this type of environment. However, this quarter's accretion was limited by the following factors.

First, since we had completed price negotiations with our OEMs prior to the mid-quarter increases in demand, we did not increase OEM pricing within the quarter. OEMs constitute approximately 70% of our revenue. Second, we did not achieve our time-to-maturity targets for products announced in fiscal year 2011, which resulted in higher scrap costs and inefficiently utilized manufacturing resources. Third, as we most recently discussed on our fiscal second quarter financial results call, commodity prices that directly impact our company and the industry have continued to rise. Fourth, we were able to service upside demand consisting primarily of lower margin notebook products. We continue to focus on actively managing the balance sheet to maximize shareholder returns while maintaining the flexibility to invest in a broad range of storage technologies to serve our customers.

During the quarter, Seagate completed a $600 million offering of senior unsecured notes, returned $77 million to shareholders in the form of a dividend, and repurchased $112 million of Seagate ordinary shares. Our strategic relationship with Samsung progressed as expected during the quarter, and we continue to believe the transaction will close by the end of calendar 2011. Once completed, this relationship will enable the companies to better align current and future product development efforts and roadmaps, accelerate time to market for new products, and position the companies to better address rapidly evolving opportunities in mobile computing, cloud computing, solid-state storage, and other markets. We remain confident about the benefits of this strategic relationship to our customers and our shareholders.

With regard to our outlook for the September quarter, I want to emphasize that the outlook is influenced by significant uncertainty concerning global macroeconomic conditions, including the outcome of negotiations around the U.S. debt limit and the impact of issues related to European sovereign debt. For the September quarter, we expect the industry TAM to be 165 to 170 million units and believe the industry will maintain a well-balanced supply and demand environment. Specifically for Seagate, revenue is expected to be approximately $2.9 billion. We do not anticipate significant market share shifts from the June quarter, primarily due to a longer life cycle of current generation products throughout the industry. Closing margins for the September quarter is expected to be up slightly compared to the June quarter. We expect to benefit from relatively benign price erosion already negotiated with our OEM and continued tight supply in the distribution channel.

We do, however, expect the positive margin impact of a more stable pricing environment to be offset by the following factors: the cost of many upstream materials, especially rare earth elements, which have increased significantly. These costs are expected to adversely impact gross margins by at least 200 basis points. As previously mentioned, the delay in achieving time to maturity of new products is resulting in inefficiently utilized manufacturing resources with higher costs. Currently, we expect meaningful cost reductions and resulting margin accretion associated with these new products to be realized in the second half of fiscal 2012. In regards to the increasing cost of upstream materials, Seagate has historically been able to absorb these cost increases and insulate our customers.

However, the recent dramatic increase in the cost of rare earth elements, combined with a preexisting upward trend for a broad base of other commodities, far exceeds our ability to find offsetting cost reductions. While we are exploring opportunities to reduce the content of certain rare earth elements that are used in the manufacture of hard disk drive components, we will be discussing with our customers passing through what we hope are temporary surcharges related to upstream earth-based commodities. It's important to note that for the relevant rare earth materials, there does not appear to be a significant supply constraint. While we have a short-term concern over margin impact, we do not currently have a long-term concern. The tax provision is expected to be between 3% and 10%.

R&D and FT&A is planned to increase to $350 million, and we expect capital investments to be at or below the low end of our targeted range of 6% to 8% of revenue. Excluding certain expenses, such as restructuring and acquisition-related costs totaling approximately $10 million, non-GAAP diluted earnings per share is expected to be in the range of $0.29 to $0.33 per share. Catherine, we're now ready to open up the call to questions.

Speaker 6

Thank you, sir. Ladies and gentlemen, if you have a question, please press star followed by one on your phone. If your question has been answered or you would like to withdraw that question, press star two. Questions will be taken in the order received. As a reminder, please press star one to begin. Our first question comes from the line of Rich Cougley of Nehat & Company. Please proceed.

Speaker 2

Thank you. Good afternoon. A couple of questions. First, on the rare earth side, can you give us a sense on what % of your disk drive might be affected by rare earth element pricing, for example? I mean, are we just talking about the motor, or is it much more broad than that? I have a follow-up.

Speaker 5

Percentage in parts to be indicated in percentage in terms of basis points, which is 2%. You mean where is it used throughout the drive, Rich?

Speaker 2

Yes.

Speaker 5

It's largely the DCM magnet, Rich, and then inside the motor itself as well, the center motor itself as well.

Speaker 2

Okay. Because rare earth pricing has been increasing for some time, has it just been the supply chain that's been absorbing it up until now?

Speaker 5

That's partially true, but I think if you look over the last month or two months, it's been dramatically increasing as well. I'm sorry, I should also mention probably cerium oxide, which is used in these polished blasts as well. There are a lot of different variants of rare earth that are actually increasing. It's been increasing for, I mean, I think we first identified this actually last summer. We emphasized it again in the January call. I think the acceleration, Rich, in the last 60 days is dramatically greater than the average before that.

Speaker 2

Okay. In terms of your comment about the technology transitions, your yield and not being able to hit the type of volume you wanted, can you be a little bit more specific about, is it just the products that you mentioned in the comparative marks, or is it a specific aerial density? When do you expect those issues specifically to go away, or is it just that the component count will change in the second half and so you get the margin benefit that way?

Speaker 5

Yeah, let me just touch on it, and then I'll turn it over to Dave or Bob. I think we're going through, as I think you know, and we've indicated to the investor base, it's a fairly significant transition that's occurring through this calendar year and in the next calendar year. It's related to aerial density, as well as different capacity points across almost our entire product line. For Seagate, I think it's at least eight products that we're transitioning over the course of this fiscal year. Ultimately, it's lower component cost at higher capacity, and you have to get through the transition to drive yield. I'll let Dave and Bob talk to some more of those. I think the gross margin implications, all things being equal, are pretty significant in terms of once we get through the transition.

Speaker 2

I think the other thing, Rich, that I would add is, you know, to the component cost reduction, which are component count coming down, which when you get through the transitions, it's very meaningful. It's also, as you push out the product transition, you end up changing the configuration quite a bit, which ends up in materials that they're not utilizing properly. They're either ending up in scrap or, you know, something somewhere else that wasn't optimal. That's what we're suffering through as we go through these transitions right now, and that's what we got to do. To the best of your knowledge, is the competition facing similar challenges? Do you think that Seagate's still retaining its aerial density lead even with the delay?

Speaker 5

I think it depends market segment by market segment exactly how it breaks down. I think we've got fierce competition in certain areas, and then there's other areas where we're doing quite well.

Speaker 2

Okay, thank you very much.

Speaker 5

I think that you had that, okay?

Speaker 2

Yes.

Speaker 5

I realized that maybe Dave couldn't be heard as well. I think the other thing is there's none of the competition transitioning the portfolio that what we are, right? No one has the breadth of the portfolio yet. No one even, you know, with across all segments and within the service segment as well. I think it's a different animal probably for our competition. I think in general, we feel good about where we are in aerial density transition, though, across the portfolio.

Speaker 2

Okay, thank you, Steve.

Speaker 6

Our next question comes from the line of Keith Bachman of BMO. Please proceed.

Speaker 0

Hi. Thank you very much. Steve, I wondered if you could just talk about if the TAMs in the range that you've identified for September, just any thoughts on what at least directionally the TAM would look like in December? Also, speak to, if you could, I think you said supply-demand was relatively balanced, but if you could speak to what are the constraints out there that you're seeing from your competition, particularly Hitachi, within that overall market environment? I have a follow-up if I could, please.

Speaker 5

Yeah, I think let me just, on the first question, I think we expect the summer quarter to be greater than the September quarter. You know, my guess is probably in the same kind of growth range of maybe 4 to 5%. Right. I think that's probably, you know, if you think about what our capital allocation and, again, big product transitions. I think there's big component challenges as well at those levels, even though they may feel lower than people thought the industry could be at a year ago. That was at much different component counts per drive and things like that. With the average capacity increasing to the extent that we talked about, 40% growth year over year, that's obviously chewing up a lot of heads and disks. The capital is getting pretty tight there.

Us, for one, you know, we told you we're going to be probably at or even below the low end of our capital investment range. We're trying to manage it to what we see as decent growth and probably establishing a record quarter for the industry and certainly a record quarter in petabyte shift. It's not robust, firing on all cylinders. I think until the macroeconomy is settled down globally, right? I think with respect to Hitachi, I don't want to talk to, you know, specifically a competitor. What I'd rather talk to, I guess, is my observations of living in Asia for four months and getting there three days before the earthquake happened and being pretty intimately involved with that on multiple levels, both personally as well as professionally.

I just think that the disruptions on the supply chain side are still going to be probably more difficult than maybe expected. Every day we still hear about things that are worse than we thought they were. It's human nature to, I think, be optimistic. I think it's also these are very complex systems that have been severely disturbed. With respect to our industry, obviously, it's around fabs and fab capacity and when fabs are coming online, and if they do, what yield and how much power are they going to have? I just think it's still very tenuous. Therefore, we still see a fair amount of tightness in certain segments, mostly around notebook, as some of our competitors have shifted their more certain production to probably higher margin opportunities.

Speaker 0

Right. If you look at the opportunity today, Steve, collectively with the industry, the industry can produce that, say, TAM of 165 to 170 million units in the September quarter?

Speaker 5

I think it can. I think it's tight, but I think it can. I think it's going to be relatively balanced, like I said.

Speaker 0

Okay. Thanks very much. That's it for me, guys. Good luck.

Speaker 5

Yeah, thanks.

Speaker 6

Our next question comes on the line of Katy Huberty of Morgan Stanley. Please proceed.

Speaker 1

Thanks. Good afternoon. Given the demand upside in the June quarter, can you just talk about why the guidance for September is subseasonal? Which product categories are you seeing weaker than seasonal demand? Were there trends at the end of the quarter that drove a more conservative outlook?

Speaker 5

Probably a better question for the IT, you know, for the computer companies of the world probably than us. I mean, we're obviously responding to what we think customer demand is, and keeping our channel inventories at reasonable levels. I think that's probably better directed towards the PC companies in terms of the growth that we're getting from them, whether or not it's at the server level or at the client level or at the high enterprise system level. It's really our reflection of what our customers are telling us, in general.

Speaker 1

Does your TAM outlook assume that you get inventory back into the four to five-week range?

Speaker 5

No, I don't think we said that. I think we said that we have consistently been under four to six weeks, and therefore, we're reducing our targets to four to five weeks. We still continue to manage our inventories as lean as we can and as lean as is also acceptable for our customers.

Speaker 1

Okay. Lastly, did any of the yield issues impact your ability to negotiate for more favorable pricing with the OEMs?

Speaker 2

Pat, I'll let Dave comment on this as well. We were able to hit supply. I mean, we hit the time-to-market metric of getting the products out there, but the yield was somewhat costly. We didn't impact our customers' schedules significantly, as much as it manifests itself into our P&L for this quarter and probably next.

Speaker 5

Yeah. I think OEM pricing for the September quarter, and actually, you know, with some of our OEMs, we've actually negotiated pricing through the December quarter, has been the most favorable it's probably been in the 20 years I've been in the industry if I think about percentage changes quarter to quarter. I think there was nothing with respect to ramping our new products that impacted our ability to deliver to our customers because we can obviously deliver old products. It's more of an internal challenge for us. The opportunity of getting into these transitions at the yields that we want obviously drives a lot more margin for us. It wasn't a pricing issue at all. In fact, pricing relative to historical norms has been quite favorable just given the supply-demand challenges that are, as I mentioned in the first question, I think that are still somewhat tenuous.

Speaker 1

Okay, thank you.

Speaker 6

Our next question comes on the line of Mark Miller of JPMorgan. Please proceed.

Speaker 4

Yes, thank you. Good afternoon.

Speaker 5

Good afternoon.

Speaker 4

Maybe if I could follow up on that last point you made, Steve, in terms of OEM pricing as negotiated through December, I think you said, and some of the most favorable terms in years. Does that, is that assumed then you've kind of already been able to pass through some of these rare earth elements increases, or is that still a wild card?

Speaker 5

That's still a wild card.

Speaker 4

Okay. How should we think about the distribution channel? Typically, you get a nice benefit when you do put a product in there. Are they going to have to bear the cost of these rare earth elements even at a higher rate?

Speaker 5

Again, I don't know that I can answer to any even a higher rate because our negotiations with their OEMs, like I said, some of them are out one, some of them are out two quarters, and some OEMs aren't. Depending on what you signed up for in terms of volume and commitments on both ends, it had different implications for pricing. As you point out, the channel is more of a spot market. If there are shortages that are either related to increases in demand or shortages in supply, or pressures from other areas like rare earth elements, then the spot market would tend to bear that more. Obviously, we have to take into account that our channel partners are working on very thin margins as well.

We have to work together in terms of determining what's the right balance in order to continue to drive demand as we deliver more and more storage for less money, while not getting squeezed on the margin side where we can't invest in R&D and capital.

Speaker 4

Sure. Understood. Maybe just to come back to it, though, I guess historically, have there been instances whereby once you kind of negotiate prices with the OEMs, you can come back and renegotiate?

Speaker 5

Yes.

Speaker 4

Do we need to see some sort of major demand exceeding the supply situation for you to be able to pass on these rare earth elements pricing?

Speaker 5

We tend not to do that. It's happened in the industry, and, you know, for us, as you know, we have more OEM market share than any of our competitors, I think. Maybe not Hitachi. They're pretty OEM-centric as well. For us, we try and take the longer-term view, and we try not to raise prices in our OEMs in quarter if we've made commitments because, obviously, they plan their business around that as well. On the other hand, when disruptions happen, we try and work together in terms of cushioning that for both sides so that we can pursue our business opportunities. I would say that for those customers that have committed, it would be less likely that we would have to come back to them with any sort of increase.

If it got absolutely crazy, I think they would be understanding and saying, "Yeah, we understand what the problem is, and we have to work it together.

Speaker 4

Okay. My other question is, just getting back to the TAM, I guess we're kind of all perplexed here by the below seasonal trends for September. Was there something that happened in the first half of the June quarter where maybe that was abnormal or artificially inflated, i.e., hoarding, and that's why you're kind of being cautious here with the outlook?

Speaker 5

No. Again, I don't know that the outlook is all that cautious relative to what a lot of the computer companies are saying, but maybe you have different data.

Speaker 4

Okay.

Speaker 2

Mark, we did expect the June quarter to even be flat, even some signal down, and it was up. I mean.

Speaker 5

I think you have to remember what my initial comments were, that this is also heavily influenced by a lot of uncertainty around global economic conditions. I think it's very dangerous to talk about a very robust September when a week and a half from now, you may have some real or perceived issue with the U.S. government that might shatter people's confidences or not. We are putting a forecast out there that we think is reasonable given a lot of uncertainty in the world with respect to macroeconomic interlinks. I don't think it's that inconsistent with what most of the IT industry is saying. Like I said, I don't know what Intel has said or is going to say, but I don't know that 170 million units is really all that short to what the industry is saying.

If it is, you can kind of give me the data that says it isn't, and we'll visit it. It's our best guess right now.

Speaker 4

Sounds good. Thank you.

Speaker 6

Our next question comes from the line of Aaron Rakers of Stifel Nicolaus. Please proceed.

Speaker 0

Yeah. Thanks, guys. A couple of questions as well. First, in looking at the results over the last couple of quarters, you guys have consistently provided a guidance of basically flat sequential operating expenses. However, we've seen that surpassed here for two quarters in a row by a decent amount. Can you talk to us about why we should think flat or what's going on in the OpEx line that drove the upside this last quarter and just thinking about that, the quarter prior to that even?

Speaker 2

Yeah, this is Pat. The OpEx in the first half of the year did not have a variable comp plan. We did not hit our financial targets. The second half did, and we're planning on the objectives of the first half next year to have that. That is probably the biggest variant. There are other variants of some level of increased investment either in sales and marketing for penetration of a few areas that we see some opportunistic views that we'll go after and see how we can harvest those. There are just some other G&A costs, whether it's a litigation load. If you want to read our footnotes, we have quite a big load next year that may not manifest itself, but we are certainly planning for that level as laid out. The $350 is pretty solidly on the pen as we see it today.

Speaker 5

Yeah, I think that the increase is $5 to $6 million, and it's coming from five different types of directions. We'd love to be able to say it's increased investment for geographic expansion. There was a piece of that. The reality is when we split apart $6 million over a $3 billion revenue, it kind of gets, it's hard to kind of give you a list of stuff, but we've tried to give you a flavor. Probably, the litigation expense may be the, if I had to point to the one single largest piece, it might be related to that. It's also hard to tell for us whether or not somebody's easier to sell or not. I think.

Speaker 0

Okay. Fair enough. On the product transitional points, can you remind us again of where you were at, how you were making these aerial density transitions? Were you predominantly leading with your own head technology? I just want to understand, kind of going back to the question of whether this might be a little bit more Seagate-specific relative to the overall industry, if there's any differential being driven by internal versus external usage of heads or other components for that matter.

Speaker 5

Yeah. No, I don't think so. I mean, other than I think, you know, I think in our portfolio on the Delta and the NanoPlugs, we're ahead of the competition, significantly in some cases. Yeah, we're, you know, it's not just aerial density, right? There's performance. It's the past. It's in rotational speed issues. If you want to boil it all down to aerial density, I suppose we could at some point. I think for the most part, those are, you know, we utilize TDK and Seagate heads, and we don't see any competitive differences, you know, across the board to kind of say Seagate's better or worse. We feel good about where we're at on our head technology, and we feel very good about where TDK is. I think in those two segments, it's primarily, we're ahead of the game.

Because we're ahead of the game, we're probably paying a little bit of a price of what it means to get through that transition. Obviously, the benefit of that is pretty significant once we can get off the yield curve. On notebook, I would say that that's not the case. We're certainly probably not ahead of the competition, and we're probably not executing as well. That's certainly still an area of opportunity for it. Again, I wouldn't point it towards TDK heads versus RHO heads. I think it's just an execution issue that we need to address. Part of it is a portfolio that is significantly more complex than our competition in terms of 7 millimeter and 9.5 millimeter, 5400 and 7200. It's a broader portfolio where you're trying to leverage the technology.

Obviously, we have our hybrid technology that, you know, is another, you know, differentiation, but it's also more complexity.

Speaker 0

I was just going to actually ask that, and it'll be my final question. Just update us on where you're at or where your thinking's at with regard to what you've said in the past on hybrid, when we should expect, you know, volumes ramping and how we should think about that opportunity or that move from the company.

Speaker 5

Yeah. We're still optimistic about it. I still kind of put my five-year view out there that, you know, I believe for a variety of reasons, the vast majority of our products will be hybrid. Whether or not that's NAND flash related, or whether or not that's aerial density related, or whether or not that's performance related at the device level or at the system level, I think there's many reasons why hybrid technology is going to be more and more relevant and prevalent. I think more specifically, we continue to have excellent traction with a broader and broader base of OEMs. I think you'll see systems launching over the course of the next year that are going to incorporate the hybrid technology, especially as we get closer to deploying MLC-based technologies at the client level.

That's obviously going to be a price point breakthrough that's going to be very significant in terms of the ramp on the product. You know, we feel that we're there.

Speaker 0

Okay, thank you.

Speaker 5

Yep.

Speaker 6

Our next question comes on the line of Sherri Scribner at Deutsche Bank. Please proceed.

Speaker 1

Hi. Thank you. Just a quick clarification to begin with. The TAM guidance of 165 to 170, is that based on what you think the industry can supply, or is that based on your expectations for demand in the calendar third quarter?

Speaker 5

Yeah, I'm glad you answered the question. About the same. I mean, I think it's, you know, again, we'll see what our competition says tomorrow and what, you know, our best guess is that's the TAM. I wanted to clarify that. I also think that's about what the industry can supply. If it's higher than that, which if we're wrong and it's 175 or 180 because that's what the magic, you know, 8.8% growth rate says on what the June quarter shift, then I think the industry is going to be very constrained. It will show up, and it'll show up in September.

I think the other thing I'd really like to emphasize, and I'm sorry I didn't in my comments or in the previous question, is the demand is unusual in terms of how it's profiling out this quarter in that it's very strong in July and August and less visibility in September. Yet, if you look at, you know, the last five years of shipments by the industry, it's obviously the inverse of that, that, you know, July is weaker than August, and August and July are weaker than September, you know, by a fair degree. The fact that it's so front-end loaded can either talk to, you know, lack of visibility or, you know, other strategies at our customers or could talk to that, yes, the 165 to 170 is conservative and that pop is going to happen in September.

I think the industry will struggle to meet a lot of that upside. That would just result in a situation in September that could be, you know, certainly challenging from a supply-demand perspective.

Speaker 1

Okay. That's extremely helpful. Just talking about the product transition issues, I know that you gave a number for the impact to gross margin from the raw material costs, 200 basis points. Can you give us a sense of what type of impact the product transition cost was to gross margin? I mean, you're at 18.8% now. Your long-term target is 22% to 26%. Would you have been in your long-term targets, or do you think you'll be in your long-term targets by the second quarter?

Speaker 5

Yeah, we'll be in our long-term targets. It's, I mean, all things else being equal, but it's another couple hundred basis points. Right.

Speaker 1

Another couple hundred basis points. Okay. Just.

Speaker 2

We'd be in our target margin range as we signaled earlier, you know, without the rare earth in. If we ramped historical, it's not that we're late to market, just ramping is the issue, but if we ramped historical, we'd be there. We clearly see a path to get there. It's just been a little longer than we want to get there.

Speaker 1

Okay. Finally, on the notebook products, you mentioned the mix was somewhat negative to the gross margins also. In the past, you talked about your notebook gross margins being lower than your desktop gross margins. That was a couple of years ago. Is that still the case, or would you say they're at parity? You know.

Speaker 5

It's very specific to current market conditions. I mean, we've had periods where our desktop, our notebook margins are very attractive, and other times when they're less so, and it's mostly pricing related. I think if you look over the last four quarters, rare earth price of low as you have seen the most aggressive has been in the notebook space. Some of our competitors were very aggressive at certain capacity points and drove margins that were in the mid-20%. If you can actually measure margins that way, which we can get into a longer discussion about how real that is. If you were to use some consistent application of accounting and said margins were in the mid-20%, those were driven down to certainly sub-double digits.

Getting recovery on that as we have in the supply-demand imbalance has been good, but there's still margin levels that are less than the average for the company. Because Seagate was able to respond to upside at those capacity points, mostly 500 gigabytes, it was a good opportunity for a revenue upside that certainly was impressive. From a margin perspective, it squeezed margins a bit, but adding that income. I think, I'm not apologizing for it, but it's just a part of the description of why the gross margins were impacted more as a result of that upside response.

Speaker 1

Okay. Great. Thank you very much.

Speaker 6

Our next question comes from the line of Ananda Baruah of Baird. Please proceed.

Speaker 3

Thanks, guys, for taking the question. Steve, I guess just for a bit of a clarification on TAM, sounds like you might be suggesting if we've got the 4 to 5% industry demand increase from the December quarter, that in fact might be, you know, and if the September quarter came in as you're forecasting, that might be a challenge to meet from a supply perspective.

Speaker 5

Yeah, I believe that's true.

Speaker 3

Okay. Great. Is there anything, any update you can give us regarding European Trade Commission communication? Is there anything you have incrementally reached out to them with since they decided to take a deeper look or request more information from you? Maybe if you can just give us a sense of what your message to them has been through this whole process.

Speaker 5

We've obviously been actively cooperating with them throughout the entire process. I don't think that there's been any surprises in that process with respect to either the request, reaction to response, timing, or engaging with either suppliers, customers, competitors, or internally at Seagate. I think for us, this has been going as expected. It's a healthy process for everyone. Right now, we anticipate that we'll continue to proceed in a healthy, positive manner and get the transaction closed by the end of the year.

Speaker 3

Okay. Great. Just one last clarification, if I could. You said the expectations for more normalized yields on the new product transitions are second half of fiscal year 2012. That's the first half of, you know, I guess, like the March, June, quarter of next year.

Speaker 5

That's right. I mean, we're obviously working our transition yields and performance issues right now. I think in terms of our opportunity to have those contribute in the way that Pat mentioned, where we can start to gain benefit at the margin level to get into our targeted range, we'd expect it to start at the second half of the year or so, starting in the March quarter.

Speaker 3

Got it. Great.

Speaker 5

Obviously, we'll aggressively push to continue.

Speaker 3

Thanks a lot.

Speaker 6

Our next question comes on the line of Scott Quaith, Bank of America. Please proceed.

Speaker 4

Yeah. Thanks. Good afternoon. Hey, Steve, can you give us maybe an update on the SSDs in the enterprise, sort of what you're seeing there from your customers and the transition from fiber channel to SATA drives there as well? Secondly, you guys have made a lot of product announcements recently on the SSD side in the enterprise. Maybe just give us your thoughts on how you expect that business to ramp and when we should start seeing a meaningful contribution. Thanks.

Speaker 5

Yeah. I mean, I think on the customer side, the reality is it's a very limited customer base who's using SSDs in the enterprise segment. I'll let our customers identify who they are, but I think we know who the majority one is and what their success has been. They've been probably leading the charge in terms of defining an architecture, presenting it to the customers, and getting good traction. That's an account that we're not engaged with with the fiber channel drive. We feel good about our technology. We feel good about where we're at on our SATA drive. Obviously, with the relationship with Samsung, we believe that the NAND sourcing and cost side of that is going to be very attractive.

Our engagement with our customers certainly has accelerated, both with that agreement as well as getting further down the path on the joint technology development that we have with them, which is this flash management engine chip. In terms of meaningful revenue, I would say that once MLC starts getting incorporated into the devices, which we do feel very confident about the approach that we're taking, I think that's when you're going to start seeing it be significant. I'll stick to what I've been saying for a year, which is, to me, it's a 2015-2016 thing where you could look at that and say there's hundreds of millions of dollars of revenues or somewhere between 5% and 15% of incremental enterprise business that is associated with SSDs. I think that's the important point. There's not a disk drive in the world, let's say, that could do what an SSD does.

It's not replacing disk drives. It's basically opening up new applications other than group drives, which I think happened three years ago. I feel good about where we're at. I still think it's an opportunity that Seagate, and I guess I'll now characterize it as Seagate and Samsung jointly, are going to pursue in a way that's going to be very tough to have a better product than.

Speaker 4

Okay. Thanks. Just to follow up on the CapEx, it sounds like you're going to drop it here below the sort of normal targeted range. How long do you think that goes on? Where are the priorities when you're looking at the CapEx over the next couple of quarters? That's it for me. Thanks.

Speaker 5

I think for us, as we get to a, I did a big, we did a big reorganization a few months ago. One of the big focuses on the New York was to split the R&D function from the operating function. Within those areas, we started to be rethinking how we deploy capital throughout the manufacturing side as opposed to buy components, either the heads or disk or drives. Through that, I think that we've seen that we have some efficiencies that can be had. Some basically say that adversely, that maybe we have overinvested in some capital historically that maybe wasn't being as efficiently utilized as we think it can be now. I think it's a decent amount. Call it 5%, call it 10%. I think there's that amount of capital efficiency there that we can go attack. Dave's off doing that. I'll have him talk more to it.

A lot of it is also this issue around complexity of the portfolio and then complexity of what we're doing in terms of how we're running our products in our factories that will basically ultimately yield a lot better capital improvement. I think it's a big opportunity for us to basically reduce that capital on a sustained basis and drive a lot more output with a smaller capital footprint. Where I worry about constraints, historically, I probably would have said heads, depending, again, if aerial density keeps, petabyte shipments continue to grow at 40% year over year. I think most people in the industry would say that aerial density is somewhere in the 25% range right now. Until you get a HAMR deployment or whatever the next big generation is to boost aerial density, the only way you can solve that problem is with more heads than disks.

I would historically have said probably heads. I'm starting to think probably more disks now. I'll let Dave talk to that as well. Certainly, it's the component level, not the drive level. I think that's probably the bigger message, right? We can argue at the margin if the constraint first going to happen at wafer or slider or HSA, but I think it's at the component level. If there's a marginal shift in my thinking, it's probably away from heads and towards media. I think, look, at 40% aerial density growth, I mean, 40% petabyte growth and 25% aerial density growth, if you throw some macroeconomic coverage on top of that, there's going to be some challenges on the component side. Those are 9 to 12-month lead times on capital. It's not something that'll get resolved overnight.

I don't think it's something that the industry is going to lean into because all of us are operating at margin structures below our targeted range.

Speaker 2

One more question.

Speaker 6

Our next question comes on the line of Asiya Merchant of Baird. Please proceed.

Speaker 4

Okay. Thank you. Steve, just a clarification. I'm not sure if I understood the comment on earth-based commodity costs being more of a short-term concern than a long-term concern.

Speaker 5

I think, you know, we'll see how this thing plays out. There's obviously a lot of dynamics going on that are certainly not in the conversation set I'm involved with, right? The reality is it doesn't appear that there's a true supply constraint here. There are a lot of dynamics around owners of rare earth materials and profitors of rare earth materials and who is controlling inventories at what level, as opposed to there being fundamentally, you know, some shortage. If there was fundamentally a shortage, then I would think that the fact that price is supposedly representing supply and demand, if you effectively reduce supply or enormously increase demand, that would mean that there's a sustained increase in price. I think this feels a little bit like a bubble.

We went through it with lithium, I guess, in 2006, where there was a massive spike, and it lasted six months, and it settled down. Now, did it settle down at levels higher than maybe it was originally? Yes, but certainly, it wasn't anywhere near the spike levels. I think it's a factor of 10 is what the spike level was. Our point is that right now, since it doesn't feel like there's a fundamental supply issue, this probably works itself out. Oh, by the way, if these prices stay high, guess what? There's a bunch of U.S.-based mines that are going to come online again, and it'll solve itself. It's not like this stuff doesn't exist. I should say that a lot of mines were closed down when the prices fell below $75 or whatever the magic price is, and we're well above that right now.

I don't think it's a long-term issue. On the other hand, having a piece of something go up that's hitting your margins by 200 basis points in a relatively short period of time is not a lot of fun either. We need to figure out how to address that.

Speaker 4

Okay, a question on Samsung also. Have you been able to do anything from a pre-integration planning perspective so far?

Speaker 5

Not a lot. I mean, obviously, we're under regulatory review, and that regulatory process has lots of conditions around what we can and can't do. There's some limited planning that you can do, and there's some more limited due diligence that you can do. All I want to comment is that to the extent that we have been able to get people once into the resources or the technology or the products, we've really been favorably impressed. I think this is going to be really significant for Seagate.

Speaker 4

Okay. Last question from me on Toshiba. Maybe this is too early to ask given supply chain constraints, but I'm wondering if you have or if you think you'll see actions from your PC OEM customers that would indicate a willingness to make Toshiba a stronger player in the industry eventually.

Speaker 5

I think our customers care about supply, but I don't think they're going to try and make Toshiba stronger. I think, look, if the WD Hitachi merger is approved, that's going to be an extremely powerful competitor that has a lot of revenue and deep technology, and they're going to drive aerial density and product performance. We all know the cost curves that we need to hit to deploy demand. Seagate has obviously been in that position for a while, and we continue to make our company better, we hope. It takes a lot of capital and a lot of R&D. If the Toshiba Corporation decides that this drive is an area to allocate capital and expense to, then there'll be another supplier. I don't think our customers are going to do that. It's going to come from our competitors, whether or not you have competitive technology and products.

This isn't an easy science. It's a science that's getting tougher, and therefore, capital and R&D is a competitive advantage, and we're at scale. Hitachi and WD, if that merger goes through, will be at scale as well, and Toshiba will be less so. If you had a look at that scenario, I think it would tend to say that they'll have a tougher go of it. Could they decide they want to invest $5 billion and get serious in the drive business? I don't know if I know enough about Toshiba Corporation to know if that's the reality or not, but I got nothing to worry about with Seagate and Yonta and stuff.

Speaker 4

Thanks. Thanks for taking the question, Steve.

Speaker 5

All right. I just want to thank everyone for joining us on the call today. We do look forward to speaking with you next quarter. I want to make sure to thank all of our employees, our customers, and our suppliers for another good quarter. Thanks very much, everyone.

Speaker 6

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. Please disconnect and have a great day.