Western Digital - Q1 2024

Transcript

Operator (participant)

Good morning, ladies and gentlemen, and welcome to the Western Digital First Quarter Fiscal 2024 Earnings Call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star and then one on a touch-tone telephone. To withdraw your questions, you may press star and two. Please also note today's event is being recorded. At this time, I'd like to turn the floor over to Peter Andrew, VP of FP&A and Investor Relations. Sir, please go ahead.

Peter Andrew (VP of FP&A and Investor Relations)

Thank you, and good morning, everyone. Joining me today are David Goeckeler, Chief Executive Officer, and Wissam Jabre, Chief Financial Officer. Before I begin, we have a lot of exciting items to discuss today. In addition to the earnings press release and slides, we also have a press release and slides regarding the conclusion of our strategic review. All of these materials will be posted in the investor relations section of our website shortly. Let me remind everyone that today's discussion contains forward-looking statements based on management's current assumptions and expectations, and as such, does include risks and uncertainties.

These forward-looking statements include expectations for our product portfolio, spending and cost reductions, business plans and performance, market trends, financial results, the outcome of a potential separation of our HDD and Flash businesses, including the form, timing, and tax-free status of the transaction, our ability to complete the transaction, the future performance of our separated businesses, and the creation of shareholder value by separating our businesses. We assume no obligation to update these statements. Please refer to our most recent financial report on Form 10-K and other filings 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 for introductory remarks.

David Goeckeler (CEO)

Thank you, Peter. Good morning, and thank you for joining our call. I will first discuss the completion of the strategic review and then turn to our first quarter results. We're thrilled to announce the completion of our strategic review and plans to form two independent public companies focused on capitalizing on the data storage industry's growth in HDD and Flash. After evaluating a comprehensive range of alternatives, the Western Digital management team and board determined that spinning off its Flash business is the best executable alternative at this time to fully realize value for shareholders. This transaction will allow each franchise to execute on its product and innovation roadmap and capitalize on the unique growth opportunities in their respective end markets. Each company will benefit from streamlined management focus, operational flexibility, and the ability to set its own distinct capital allocation and shareholder return policies.

We are excited for the opportunities this transaction creates to better serve our customers, support our suppliers, partners, and employees, and unlock significant value for our shareholders. Before discussing the details, let me walk you through the journey that brought us to this point. In March 2020, I joined Western Digital with a strong conviction in the company's unique position to accelerate and benefit from the digital transformation that is reshaping every industry, every company, and how all of us live our daily lives. And importantly, I saw an opportunity to create value for a leader in both NAND Flash and hard drives. During my early days at the company, I spent considerable energy into rebuilding and refocusing the company, including the formation of the HDD and Flash business units.

It soon became clear that our focus on driving two distinct technology portfolios was the right strategy, and the new management team that I brought in worked together to transform Western Digital by bolstering business agility and reinvigorating innovation. In addition, we promptly focused on strengthening our balance sheet. We made the tough decision to suspend our dividend, which allowed Western Digital to speed up debt reduction and pay down $2.7 billion of debt over a couple of years following the suspension. We further enhanced our liquidity by bringing in $900 million of strategic investment from Apollo Global Management and Elliott Investment Management, and amended our credit agreements. We also settled a long-standing tax dispute to increase strategic optionality.

The groundwork we laid over the past several years, including the additional actions taken in fiscal year 2023 to rightsize the business, have enabled us to navigate a dynamic environment, all while staying focused on delivering a range of industry-leading products. Each business is now in a strong operational position to succeed on its own, and the actions we are announcing today will further enable each company to drive long-term success in the years to come. The Western Digital team and board completed the strategic review after evaluating a comprehensive range of alternatives and determined that spinning off its flash business is the best executable alternative at this time to fully realize value for shareholders. During our strategic review process, we evaluated material opportunities for each of our businesses.

However, given current constraints, it has become clear to the board in recent weeks that delivering a standalone separation is the right next step in the evolution of Western Digital, and puts the company in the best position to unlock value for our shareholders, while providing strategic optionality for both businesses. Given the confidential nature of the strategic review, we will not be discussing any of the other alternatives that were considered during the process. On page six of the presentation, we present a separation transaction summary. The HDD business will retain the Western Digital name and become an independent publicly traded company. The flash business is expected to be spun off in a tax-free transaction to Western Digital shareholders, and the name of the publicly traded company will be determined at a later time.

We target to complete these plans in the second half of calendar year 2024, subject to the principal closing conditions described in the slide. Page seven provides a bit more visibility into some of the end market exposure for our flash and HDD businesses on a trailing 12-month basis. Moving to the individual businesses on page eight. In HDD, Western Digital is a well-known leader in the mass storage market, with an ability to generate consistent cash flow on a standalone basis. Our ability to lead the industry in bringing new innovations to the hard drive market to enable higher capacity points for mass market adoption, has established Western Digital as a key strategic supplier to the world's global cloud service providers, storage OEM, and distributors. The massive opportunity is driven by the ongoing expansion of the cloud infrastructure, connected to intelligent endpoints and powered by high-speed networks.

Industry analysts estimate the HDD addressable market to grow at approximately 12% compounded annual growth rate to $25 billion over the next three years, with cloud representing over 90% of the total addressable market. The cloud represents an incredibly large and growing end market for Western Digital, and we are well positioned to address customer storage needs. Moving to our flash business on page 10. The Western Digital Flash business is well known for its broad go-to-market channels, enviable premium brand retail franchise, and strong client SSD portfolio. Industry analysts forecast the flash market to grow at approximately 15% compounded annual growth rate over the next three years to $89 billion in calendar year 2025.

We believe content increases in the consumer and client end markets, as well as explosive growth of data created in the cloud by emerging applications such as generative AI, virtual reality, and autonomous driving, are driving a faster growth in flash versus HDD. The highlight of our consumer end market is the strength of our SanDisk brand of retail products and our suite of high-performance SSDs for gaming enthusiasts. The brand recognition and affinity, combined with our unmatched presence across the world, is a great setup for the business on a standalone basis. Our successful 23-year partnership with KIOXIA continues to provide us a reliable source of high-performance, low-cost flash. Together, we have successfully brought to market numerous generations of flash technology with the industry's lowest cost and best capital efficiency.

The joint venture fabs produce over 30% of the world's bits, and our joint memory technology roadmap remains incredibly well positioned, especially as we lead the industry's transition to wafer bonding. We will likely host an investor day closer to the time of the spin-off of our flash business to give investors greater clarity into the historical and future outlook for each of our businesses, along with the intended capital structures for each business. With that, I'd like to turn to first quarter fiscal 2024 earnings review and business update. Western Digital's first quarter results exceeded our expectations as the team's efforts to bolster business agility, drive innovation, and right size the business have enabled us to capitalize on enhanced earning power in an improving environment.

We reported first quarter revenue of $2.75 billion and a non-GAAP loss per share of $1.76. Our ability to develop differentiated and innovative products across a broad range of end markets has resulted in sequential margin improvement across both flash and HDD businesses. In flash, healthy inventory levels on our balance sheet and signs that flash pricing is beginning to inflect, have laid the groundwork for further gross margin improvements. Our broad go-to-market channels, enviable retail franchise, and strong client SSD portfolio have enabled us to shift bits to the most attractive end market categories and achieve 26% sequential bit growth, as well as upside in gross margin.

In HDD, our industry-leading 26 TB UltraSMR drive became the highest nearline volume runner in just two quarters, which demonstrates Western Digital's areal density leadership and ability to deliver high-volume, innovative technologies to data center customers worldwide. During the quarter, demand in consumer and client continued to improve, exceeding our expectations. In consumer, flash revenue has returned to growth on a year-over-year basis, led by strong content increases and unit growth. In client, PC and component demand also exceeded our expectations, and demand for gaming consoles and mobile remained resilient. In cloud, demand for both hard drive and flash products remained subdued. I'll now turn to the business updates, starting with flash.

During the quarter, flash revenue increased sequentially, led by record exabyte shipments and continued content growth in consumer and client end markets, including PCs and all retail products, as we continue to optimize bit placement in an improving environment. WD Black, which is optimized for gaming, continued to perform well, with bit shipments more than doubling and content per unit increasing over 50% year-over-year. We are in an excellent position from both the flash technology and capital efficiency perspective. Today, a majority of products we are shipping are based on BiCS5, the most capital-efficient node in the 3D era, that continues to provide an amazing cost structure and efficient capital spending. As we look into calendar year 2024, we are ramping an array of QLC-based client SSDs based on BiCS6 technology to lead the expected industry transition to QLC.

After BiCS6, we remain on track to introduce a broad range of high-performance products based on BiCS8 technology, with its unique chip bonded on array architecture. Turning to HDD, revenue declined due to lower nearline exabyte shipments, driven by subdued demand from our cloud customers and slower than expected recovery in China. However, demand for consumer and client hard drives was stable. Western Digital has continued to lead the industry in driving innovation within the nearline market. Our ability to bring innovation into mass market drives that are quickly deployed into cloud data centers is reflected in our results as we successfully led the industry's transition to SMR-based nearline drives.

Specifically, our 26 TB UltraSMR drive, which we first announced at our Investor Day, accounted for nearly half of our nearline exabyte shipments, with total SMR shipments exceeding the 40% goal we laid out in the same quarter a year prior. We are on track with our 28 TB UltraSMR drive qualification and have a clear roadmap of ePMR and UltraSMR-based innovations into the 40 TB range. These developments are a result of the choices we have made in the past few years through a combination of product R&D and manufacturing capabilities, and we are proud of how we have been executing against our strategy. Looking ahead to the fiscal second quarter, in flash, we expect both modest bit and ASP improvement and a decline in underutilization charges to drive continued sequential improvement in both revenue and gross margin.

In HDD, we expect higher nearline shipments and seasonal demand in consumer end market to drive sequential revenue growth. We anticipate our value-based pricing efforts and lower underutilization charges will lead to sequential revenue and gross margin improvement in the quarter and through the rest of fiscal year 2024. As we continue to execute against our HDD product roadmap, we are setting the stage for profitable growth for years to come. With that, I'll turn it over to Wissam.

Wissam Jabre (EVP and CFO)

Thank you, and good morning, everyone. As David mentioned, the fiscal first quarter results exceeded the guidance ranges provided in July. Total revenue for the quarter was $2.75 billion, up 3% sequentially and down 26% year-over-year. Non-GAAP loss per share was $1.76. Looking at end markets for the fiscal first quarter, cloud represented 32% of total revenue at $0.9 billion, down 12% sequentially and 52% year-over-year. Sequentially, the decline was primarily due to lower nearline hard drive shipments to data center customers. The year-over-year decrease was primarily due to declines in shipments for both hard drive and flash products. Client represented 42% of total revenue at $1.1 billion, up 11% sequentially and down 7% year-over-year. Sequentially, the increase was due to growth in flash bit shipments.

The year-over-year decrease was primarily due to declines in flash pricing. Consumer represented 26% of revenue at $0.7 billion, up 14% sequentially and 8% year-over-year. On both a sequential and year-over-year basis, the increase was driven by both higher content per unit and increased unit shipments in flash. Turning now to revenue by segment. In the fiscal first quarter, flash revenue was $1.6 billion, up 13% sequentially and down 10% year-over-year. This marks the second consecutive quarter of sequential increase. Sequentially, flash ASPs decreased 10% on a blended basis and 4% on a like-for-like basis. We shipped a record amount of flash bits in the quarter, with shipments increasing 26% sequentially and 49% year-over-year. HDD revenue was $1.2 billion, down 8% sequentially and 41% year-over-year.

Sequentially, total HDD exabyte shipments decreased 5%, and average price per unit increased 13% to $112. On a year-over-year basis, total HDD exabyte shipments decreased 42%, and average price per unit decreased 10%. Moving to gross margin and expenses, please note that my comments will be related to non-GAAP results unless stated otherwise. Gross margin for the first quarter was 4.1%, which was at the higher end of the guidance range provided in July and included $225 million in underutilization expenses and $9 million in other one-time charges. In total, these charges represented an 8.5 percentage point headwind to gross margin. Flash gross margin was negative 10.3%.

Underutilization charges due to reduced manufacturing volumes were $142 million, and flash inventory write-downs were $9 million, resulting in a combined 9.7 percentage points headwind to gross margin. HDD gross margin was 22.9%. Underutilization charges were higher than expected at $83 million, or a seven percentage point headwind to gross margin. We continue to tightly manage our operating expenses, which were down 19% year-over-year to $555 million, well below our guidance range. Operating loss was $443 million, which included underutilization charges and inventory write-downs totaling $234 million. Income tax expense in the fiscal first quarter was $25 million. Net loss per share was $1.76, inclusive of a $15 million dividend associated with the convertible preferred equity.

Operating cash flow for the first quarter was an outflow of $626 million, and free cash flow was an outflow of $544 million. Free cash flow included a payment of $523 million for the IRS settlement and $191 million cash receipt from the sale and leaseback of our facility in Milpitas, California. Inventory declined $201 million sequentially to $3.5 billion. Days of inventory declined 10 days to 120 days. Flash inventory declined by nearly $400 million, driven by record bit shipments in the quarter and proactive actions taken to reduce wafer starts. Days of inventory for flash have reached the lowest level in nearly four years. HDD inventory grew by nearly $200 million due to the timing of certain purchases and lower-than-expected shipments.

Cash capital expenditures, which include the purchase and sale of property, plant, and equipment, including the proceeds from our sale-leaseback of our Milpitas facility and activity related to our flash joint ventures on the cash flow statement, represented a net cash inflow of $82 million. In the fiscal first quarter, we fully drew the $600 million delayed draw term loan facility. Gross debt outstanding was $7.7 billion at the end of the fiscal quarter. At the end of the quarter, total liquidity was $4.3 billion, including cash and cash equivalents of $2 billion and undrawn revolver capacity of $2.25 billion. Before I cover guidance for the fiscal second quarter, I'll discuss the business outlook. For fiscal second quarter, we expect total revenue growth to be led by higher Nearline HDD shipments and improved pricing in flash.

We continue to adjust production into the second quarter to better align supply with demand and anticipate lower underutilization charges in both flash and HDD. For our fiscal second quarter, our non-GAAP guidance is as follows: We expect revenue to be in the range of $2.85 billion-$3.05 billion. We expect gross margin to be between 10%-12%, which includes underutilization charges across flash and HDD, totaling $110 million-$130 million. We expect operating expenses to be between $560 million-$580 million. Interest and other expenses are expected to be approximately $105 million. We expect income tax expenses to be between $20 million and $30 million for fiscal second quarter, and $80 million-$120 million for fiscal year 2024. We expect a preferred dividend of $15 million. We expect a loss per share of -$1.35 to -$1.05, assuming approximately 325 million shares outstanding. I'll now turn the call back over to David.

David Goeckeler (CEO)

Thanks, Wissam. Let me wrap up, and then we'll open up for questions. We are now emerging from a historic storage cyclical downturn, where all of the changes made in the past several years were evident in how well each business performed relative to peers. The first quarter of fiscal 2024 builds upon the improvements we made in fiscal year 2023 around discipline, supply, and capital expenditure management, while executing on our product innovation roadmap. We continued to tightly manage our operating expenses and are closely monitoring demand in our end markets to appropriately manage our inventory in both flash and HDD, all to improve sequential and year-over-year upside in our results. Moving forward, as we progress through fiscal year 2024, we see an improving market environment in both businesses.

With an improved position, the separation of the company unlocks value by creating two independent public companies with market-specific strategic focus, better positions each franchise to execute innovative technology and product development, capitalize on unique growth opportunities, extend respective leadership positions, and operate more efficiently with distinct capital structures. Okay, Peter, let's open up for Q&A.

Operator (participant)

Ladies and gentlemen, we will now begin the question-and-answer portion of today's conference. If you have a question, please press star and then one on your phones. If you'd like to withdraw your questions, you may press star and two. Once again, that is star and then one to join the question queue. One moment please for the first question. Our first question today comes from Joe Moore from Morgan Stanley. Please go ahead with your question.

Joe Moore (Managing Director)

Great, thank you, and congratulations on the decision here. Can you talk through a little bit, anything preliminary in terms of how the OpEx might be apportioned between the two businesses? And you mentioned, you know, maybe you'll give us the capital structure at a later date, but just anything early on, on like, you know, what you think the right amount of debt is to apportion to the two businesses.

Wissam Jabre (EVP and CFO)

Hey, Joe, good morning. Thanks for the question. Look, it's a little bit too premature to talk about details with respect to each side of the business or each company. As we get closer to the separation, we'll be in a better position to talk about much more details with respect to OpEx apportionment as well as capital structures, leverage targets, and capital return policies, et cetera.

David Goeckeler (CEO)

Hey, Joe, this is David. Thanks for the question. Good to hear from you this morning. One thing I will say is we're very happy with the level of efficiency we've driven into the business over the last year, especially during this downturn, and we think has put us in a very good position to go through this transaction. I think, you know, OpEx over two years is down-- over the last two years, is down over $200 million. So, we put ourselves in a position where we've got very efficient business and some flexibility to go through a transaction like this. So as Wissam said, we'll have more to say as we get closer.

Joe Moore (Managing Director)

Okay, great. And then I wonder if I could just ask more tactically, in terms of the need to pay down the convert early next year, you know, how you're thinking about that and whether this, you know, the strategic change here changes anything in terms of your ability to do convert issuance or things like that, pay that down?

Wissam Jabre (EVP and CFO)

Yeah, Joe, the current announcement does not affect our ability to address the convert. As we've said before, our plan is to address the convert that's maturing in February 2024, by the end of this calendar year.

Joe Moore (Managing Director)

Thank you very much.

Wissam Jabre (EVP and CFO)

You're welcome.

Operator (participant)

Our next question comes from Aaron Rakers from Wells Fargo. Please go ahead with your question.

Aaron Rakers (Managing Director and Technology Analyst)

Yeah, thank you for taking the question. Two, if I can as well, real quick. I guess the first question is just thinking about the separation. Appreciating that you're not going to give anything at this point around the capital structure, I'm just curious, though, the relationship with KIOXIA, you know, I know in the past there's been certain attributes of rights as part of the JV. Any kind of context about the dialogue, you know, moving to this separation as it relates to that JV rights? Or, you know, should we be thinking about any approval processes that are involved in that?

David Goeckeler (CEO)

No, I mean. So first off, the relationship with KIOXIA is outstanding, and it has been for a very, very long time. So, we expect that to continue on. Absolutely. It provides a tremendous foundation for our NAND business with both very capital efficient NAND and a tremendous roadmap as we're going into BiCS8 here. But, we can execute this transaction without any other approvals.

Aaron Rakers (Managing Director and Technology Analyst)

Okay. And then as a quick follow-up, I'm just curious on the hard disk drive business. I know the cloud revenue in total is down, you know, consistently, again, quarter-over-quarter. Just how would you characterize what you're seeing from a nearline perspective from the cloud? Have you started to see demand pull again? Just any kind of context of how you're thinking about, you know, the shaping of kind of a recovery here as we move forward.

David Goeckeler (CEO)

Yeah, we think this past quarter was the bottom, Aaron, and we see improving demand as we move throughout the fiscal year on a quarter-over-quarter basis. You know, we've had certain customers that have been on the sidelines for a while, and they're starting to come back and give us visibility into ordering. So, we expect the market to recover from here going forward.

Aaron Rakers (Managing Director and Technology Analyst)

Okay. Thank you.

Operator (participant)

Our next question comes from Krish Sankar from TD Cowen. Please go ahead with your question.

Krish Sankar (Managing Director and Semiconductor Equity Research Analyst)

Yeah, hi. Thanks for taking my question. I have two of them, too. First one, again, sorry to harp on the separation. It makes a lot of sense. I'm just kind of curious, in the past, David, you've spoken about some of the synergies in R&D and how the HDD product line uses some of the BOM from OptiNAND, et cetera. I'm just kind of curious, that would that change post the separation, or there's going to be no strategic shift on that? And then I had a follow-up.

David Goeckeler (CEO)

So the separation doesn't imply any change in strategy for either business, so both of them will continue to go forward. No change in our product roadmaps. We feel very good about what's been built over the last three, four years. We feel like we're in a market-leading position in both franchises, both from a product point of view. If you look at what's happened in the hard drive business, you know, it's very, very clear now the adoption of SMR is the next big step in the cloud data center, and that's progressing very well. Our 26 TB drive just became the highest-shipping drive in the quarter. And we, you know, we announced the next generation of that with the 28 TB as well. So no change there.

You know, OptiNAND's still a big part of that architecture, and the team will be able to procure that and continue to drive that part of the strategy. And on the flash side of the business, the portfolio is also in great shape with both from a product strategy and also the branding strategy. SanDisk, WD Black, these brands continue to perform extremely well. So we think it's a great setup for both businesses, going forward.

Krish Sankar (Managing Director and Semiconductor Equity Research Analyst)

Got it. Thanks for that, David. And then a quick follow-up. Your peers spoke about the HAMR technology getting, like, adopted next year, and your roadmap shows ePMR to extending to 32+ TB. I'm kind of curious how you think about HAMR and your roadmap in case it'll catch up with Seagate?

David Goeckeler (CEO)

Well, look, we, we put a lot of optionality in our roadmap a number of years ago, so that we could extend the, the capacity points with things like OptiNAND, SMR, UltraSMR, ePMR. So that strategy is working very, very well. We're leading the industry in capacity points. We expect to be able to drive this strategy into the 40 TB range on our drives. HAMR is in development. It's going well, and we'll be able to fold that into our roadmap at the appropriate time. But for now, we've got a great roadmap. We've got a market-leading roadmap.

We're leading the adoption of SMR into the cloud data center, and we expect, you know, we have many more generations to go on our current roadmap, and then we'll, we'll move to HAMR at the appropriate time when it's mature, and we can, we can build it at scale. And, it'll be the next leg of growth, into the future.

Krish Sankar (Managing Director and Semiconductor Equity Research Analyst)

Thanks, David.

David Goeckeler (CEO)

Thank you, Krish.

Operator (participant)

Our next question comes from Wamsi Mohan from Bank of America. Please go ahead with your question.

Wamsi Mohan (Managing Director and Technology Hardware Equity Research Analyst)

Hi. Yes, thank you so much. Good morning. Back to the transaction, I guess. Can you maybe talk a little bit about all the actions that you have taken that might be preventing some of the dyssynergies that typically occur in terms of stranded costs when there is separation of the business? Can you maybe, A, address that? And B, on your comments on the roadmap, UltraSMR, ePMR, you have a lot of options. You've noted scaling up to 40 TB. Can you just talk about what the cost of that, how that would compare to, you know, your own future, HAMR roadmap, and give us some sense of how cost-competitive you think these products would be? Thank you.

David Goeckeler (CEO)

Okay. So on the first one, yeah, I mean, Wamsi, I think you kind of laid it out there. We've been going through a whole series of actions that have set us up for this announcement. You know, it was really about execute the business better and give ourselves as much strategic optionality as possible. So, as I talked about in the prepared remarks, you know, we separated ourselves into business units on the product side. That allows us to really get very focused on the portfolio and all the OpEx we spend on building our products, make sure it's ex- we get the best return for it. I think that's worked out well. We then did the same thing in operations. We've now divided those organizations around HDD and Flash. So we've...

Then we've optimized, taken out cost everywhere we can, so that we can operate them independently and also have just the most efficient business possible. As I said, we've focused on our balance sheet. So I think we've put ourselves in a very good position where we can go through this separation, and the organization is as prepared as we possibly can be for it. We've also, as I said earlier, we've taken a lot of OpEx out of the business, so we've driven the OpEx down to a very efficient number, so we believe we can go through the separation and end up with two very well-structured companies that can execute very well, and they come out of the gate with market-leading portfolios on each side and into a recovering market.

So we feel good about that. Cost of the portfolio, look, I mean, as you continue, we feel the road map we have in place, you know, we can produce UltraSMR, ePMR, OptiNAND drives, very high scale, very quickly, very high yields on all the products. So we think the cost position is very advantageous. You see that in our results. You know, so, you know, when HAMR comes, we'll fold that in, and, you know, we want to get to the point where we have the same level of yields, we have the same level of confidence as we do something like a 26 TB drive that we just launched, and now it's, you know, nearly half of our exabytes, a quarter or two in, and that's how we think about launching new products.

You know, when we get there, I think that we'll have that same kind of cost structure on HAMR, and we have a great, very, very strong position to drive very efficient, very high scale, very quickly new drives for many generations on the technology that we put in place over the last three or four years.

Wamsi Mohan (Managing Director and Technology Hardware Equity Research Analyst)

Thanks, Dave.

David Goeckeler (CEO)

Thank you.

Operator (participant)

Our next question comes from Sidney Ho from Deutsche Bank. Please go ahead with your question.

Sidney Ho (Equity Research Analyst)

Thank you. Congrats on the announcement today. Understanding you have amended the debt covenants back in June, given the announced transaction, how are you thinking about the covenants over the next few quarters, specifically related to free cash flow before the transaction is closed? And does that limit the amount of CapEx you could spend in the meantime? And I'll follow up.

Wissam Jabre (EVP and CFO)

Yeah, good morning, Sidney. Thanks for the question. The current announcement does not affect the amended credit agreements. And so, from a free cash flow, from a governance perspective, we're comfortable that we can operate effectively. We have ample liquidity. We do have ample operational flexibility to operate. So I don't see the current announcement as impacting us in any way.

Sidney Ho (Equity Research Analyst)

Okay. My follow-up is, if you look at the fiscal second quarter guidance, if you can walk us through your assumptions that drive seven points of increase in gross margin, that would be great. It looks like underutilization charges coming down. Are there benefits from sales of previously written down inventory? And what are you expecting in terms of price increases in both flash and hard disk drive on a like-for-like basis? Thank you.

Wissam Jabre (EVP and CFO)

Okay, maybe I'll start a little bit on the cost side, and then David could chime in on the top-line side. Look, one of the bigger, obviously, levers is the underutilization. We did in Q1 around $225 million. In total, we had around $234 million-$235 million of other charges. And our guide has an underutilization at a much lower level, and so that's one element. In addition, obviously, we continue to focus on cost reduction. We do have still, we're, we're still, if you exclude the underutilization aspect, we're still taking cost out of the system on both the flash side and the HDD side.

And so that's a key lever to improve the gross margin. And then, if I take it back up to the top line, we see obviously improvement in the on the revenue side, and the improvement is coming from both sides of the house, on both businesses. So that also contributes quite well with respect to the gross margin. And within that revenue, also, we do have a bit of a mix that's helping us as well.

David Goeckeler (CEO)

Yeah, Sidney, I guess what I would add is, if you look at the HDD business, we're ramping new products, right? The 26 TB drive is ramping rapidly. And we also have an improving pricing environment in drives, which is a nice tailwind. And then in flash, we have an improving pricing environment as well, as Wissam said, a better mix. And we expect that business to inflect a positive gross margin next quarter, which is, you know, a great milestone for us as we continue the recovery of the business.

Sidney Ho (Equity Research Analyst)

Thank you.

Operator (participant)

Our next question comes from Tom O'Malley, from Barclays. Please go ahead with your question.

Tom O'Malley (Director and Semiconductor Research Analyst)

Good morning, and thanks for taking my question. I just wanted to ask on your expectations for both market demand on the NAND exabyte side for fiscal year 2024, as well as your view of supply. I mean, you're starting the year up almost 50% year-over-year, obviously off a very low base and sequentially up, you know, mid-20s. Some of your peers have talked about really strong demand here to begin the fiscal year or to begin the recovery in those for those other guys, but kind of some slowing as guys saw the bottom, ordered a bunch, and have kind of slowed down. Can you just give me your comments on if you're seeing any of that, and then your expectations for the exabyte shipments for you for the fiscal year?

David Goeckeler (CEO)

Yeah. So, you know, we have seen an acceleration here at the end of 2023. We've raised our demand number quite a bit into the low-mid teens for 2023. We'll get to 2024. You know, some of that, you know, there has been some strategic buys as part of that. I know that's been a big discussion in the industry, but we've also just see the markets returning to normal inventory levels. So for us, that's been more of what's been happening and a good mix across the businesses. For 2024, we see high teens kind of demand, and we continue to see production significantly below that.

Tom O'Malley (Director and Semiconductor Research Analyst)

Helpful. Then on the other side of the business, you talked about the kind of, you know, varied inventory positions you have, flash going down, HDD actually going up a bit. If you compare your results with Seagate, at least for the last couple of quarters, results have been relatively similar. Could you just talk about when we should start to see that divergence, just given the fact that you're addressing, you know, a higher capacity point in the market today, and theoretically, you should, you should see some outsized benefit. When do you think you'll start to see that divergence in the market? Thank you.

David Goeckeler (CEO)

Divergence in what, what aspect, Tom?

Tom O'Malley (Director and Semiconductor Research Analyst)

In terms of revenue difference.

David Goeckeler (CEO)

So we're managing the business for profitability on HDD. I mean, I think it's, you know, we and I think we are driving a more profitable business. So, that, that's the way we think about the business and driving back to our model, which we expect to get back to here over the next several quarters.

Operator (participant)

Kami? Our next question comes from Srini Pajjuri from Raymond James. Please go ahead with your question.

Srini Pajjuri (Managing Director and Senior Semiconductor Analyst)

Yeah, thank you. Good morning, guys. David, on the HDD comments that, you know, you see growth throughout the fiscal year, just looking for some additional color. You know, just kind of listening to you, some of your customers and the big hyperscalers, I think the CapEx comments have been fairly mixed, and I'm just curious as to how broad-based this recovery that you're seeing is. Is it primarily driven by, you know, the inventory work downs or anything else that's driving it? And also, if you can comment on, you know, by geography. I think you said China was weak in the quarter. If you could talk about, you know, what your expectation for China business is going forward.

David Goeckeler (CEO)

Yeah, I think you got it there in your question. I think you have more broad-based participation in the market by the big hyperscalers as they get to the end of their inventory corrections. So, that's been part of it. Remember, we're coming off very, very, very low numbers. So, you know, we expect improvement throughout the year by more people participating in the market and more consistent participation by the ones that have been in it on a quarter-over-quarter basis. China has been, you know, it's been better, but not as... It hasn't recovered as fast as we expected, so it's still a little bit lumpy and weaker than we would like. So the smart video market has been pretty consistent, and we've seen some good results there. But in the cloud space, it still has a little ways to go.

Srini Pajjuri (Managing Director and Senior Semiconductor Analyst)

Thank you. And then a cash flow question for Wissam. I guess I'm just curious, you know, you had an IRS payment due during the quarter. Did you make that payment? I see, like, a $300 million impact from the tax. And then if you could walk us through some of the puts and takes in terms of free cash flow for next quarter, I think that would be helpful. Thank you.

Wissam Jabre (EVP and CFO)

Yes, sure. On the tax payment in Q1, we made a $523 million payment with respect to the IRS settlement. This covers the years 2008 through 2012. This is why you see, when you look at our free cash flow that we reported for fiscal Q1 at a negative $544 million, in that, we had that $523 million payment. It was partially offset by the sale and lease back of the Milpitas facilities of around $191 million. All in all, we were around negative $200 million for the quarter.

As we look forward, obviously, the key is the continuous improvement of the profitability and of the business, working capital management. You've seen our transition on the inventory side. For instance, in Q1, we continued to manage inventory very, very closely on both flash and HDD. So I expect that inventory to continue to decline gradually in this coming quarter and the next. And then, the continued focus on CapEx for the fiscal year, we did say that for fiscal 2024, we expect our cash CapEx to be significantly lower than fiscal 2023. So, you know, free cash flow is and cash flow is very important to us, big focus, and we will continue to focus on it. And as we look into the second half of fiscal 2024, we're projecting to be cash flow positive on a quarterly basis in the second half of this fiscal year.

Srini Pajjuri (Managing Director and Senior Semiconductor Analyst)

Thank you.

Operator (participant)

Our next question comes from Karl Ackerman from BNP Paribas. Please go ahead with your question.

Karl Ackerman (Managing Director of Equity Research and Semiconductor & IT Hardware)

Yes, thank you. Good morning.

David Goeckeler (CEO)

Morning, Karl.

Karl Ackerman (Managing Director of Equity Research and Semiconductor & IT Hardware)

Hey, good morning. When do you anticipate NAND underutilization charges to abate? And then second, you know, you indicated that NAND and HDD bit shipments will recover in December. I guess for NAND, you know, will that be primarily tied to consumer applications, or do you expect enterprise to be the larger driver over the next couple quarters? Thank you.

David Goeckeler (CEO)

Yeah, I'll take the second part of that, and Wissam can comment on the underutilization charges. Look, we expect bits to be up slightly in the December quarter. It's a strong consumer quarter for us, although we don't really break out by mix. But, I mean, I think that's one way to think about it. We expect an improving price environment and bits to be slightly up.

Wissam Jabre (EVP and CFO)

Yeah, and with respect to underutilization, Karl, we do manage our supply very dynamically, and so, we guided this quarter based on what we see today. We do expect underutilization to continue in the third fiscal quarter, maybe a little bit lower than here, but it's a bit too early to cover the quarters beyond the next one.

Karl Ackerman (Managing Director of Equity Research and Semiconductor & IT Hardware)

Thank you.

David Goeckeler (CEO)

Second fiscal quarter.

Operator (participant)

Our next question comes from Vijay Rakesh from Mizuho. Please go ahead with your question. Actually, the next question comes from Timothy Arcuri from UBS. Please go ahead with your question.

Timothy Arcuri (Managing Director)

Thanks a lot. David, at the bottom of slide four, you did say that the board remains open to considering other alternatives should they become available. So since you put that in the presentation, can you talk about what other options could be available? Is this a, you know, reference to the collapse of the JV that, you know, Hynix commented about or was asked about on its call? Is this in reference to an outright sale of the NAND business? Can you just talk about that a little more?

David Goeckeler (CEO)

No, it's not in reference to any particular thing. It just says that we think this is the best next step for the business to unlock value. We think that, you know, we put the business in a position to go through this right now. So all the reasons we talked about, from the portfolio to where we are on a efficiency point of view to where we are on, you know, the work we've done to retire debt, and also going into an improving market. But, you know, I think any company is always open to other strategic options should they become available, and we'll consider them at that time.

Although I do want to be very clear that the strategic review is completed and any conversations that were going on as a part of that have ended, and we're very excited about this step forward. We think it's the best next step for the business, but you know, I think in any business, you're always going to be open. If there's other strategic options that become available, we will thoroughly consider those at the time.

Timothy Arcuri (Managing Director)

Got it. Then, Wissam, for you. So, the underutilization charges of $120 million at the midpoint, how do they split for December? I would think that more of it's now in the HDD business, but how does that, how does that split? Thanks.

Wissam Jabre (EVP and CFO)

Yeah, the split of the underutilization is 2/3 the flash and 1/3 HDD.

Timothy Arcuri (Managing Director)

Great. Thank you, Wissam.

Wissam Jabre (EVP and CFO)

You're welcome.

Operator (participant)

Our next question does come from Vijay Rakesh from Mizuho. Please go ahead with your question.

Vijay Rakesh (Managing Director)

Yeah, hi, just a quick question, if you went to it already. When you look at the hard disk drive side, wondering if you had what the exabyte growth was for the last two years and what you're seeing as you look forward with this? Seems like a little bit of a bounce coming through. What do you expect for fiscal 2024, fiscal 2025, or calendar 2024, let's say? Yeah.

David Goeckeler (CEO)

So, yeah, I mean, coming off such a high on 2022, 2023 will be down, but then we expect to get back to, you know, we expect a consistent exabyte growth in this business in the mid- to high-20 range on an ongoing basis.

Vijay Rakesh (Managing Director)

Got it. And on the, and the same on the NAND side, with the spin-off, do you see any change in the technology roadmap? How do you see the 218, the BiCS, next generation BiCS coming? And if you can also give us your expectation on the, on NAND bit growth, for 2023 and 2024. Thanks.

David Goeckeler (CEO)

Yeah. No, we don't expect any change in the technology roadmap. That, you know, the JV is very strong, very solid, very productive. Teams work together on a day-by-day basis. We've talked a lot about that. We're very happy with where it's at. The relationship is very strong. The technology roadmap, we think, as we talked about last time with BiCS8 and wafer bonding, we've made a huge step forward there. You know, we've always been able to produce NAND at a better capital intensity than the rest of the industry. Our measures over the last several years are up to a third less capital intensity for the business. So the JV has been strong for 23+ years, and we expect it to be strong for very, very far into the future. We feel very good about that.

Vijay Rakesh (Managing Director)

Got it. Any thought around the bit growth, I guess, for 2024 and 2025... As the next generation, you know, BiCS8 starts to ramp, I guess. Thanks.

David Goeckeler (CEO)

Yeah, we expect demand in 2024 in the NAND business to be high teens. You know, and if it gets really strong, maybe it'll creep over the twenties and low twenties. But, you know, we're thinking about those high teens numbers, and like I said, production will be significantly below that.

Vijay Rakesh (Managing Director)

All right. Thank you.

Operator (participant)

Our next question comes from Harlan Sur from JP Morgan. Please go ahead with your question.

Harlan Sur (Executive Director and Senior Equity Research Analyst of Semiconductors)

Hi, good morning. Congratulations.

David Goeckeler (CEO)

Good morning, Harlan.

Harlan Sur (Executive Director and Senior Equity Research Analyst of Semiconductors)

Yeah, congratulations on the strategic actions announced today.

David Goeckeler (CEO)

Thank you.

Harlan Sur (Executive Director and Senior Equity Research Analyst of Semiconductors)

On the flash tech, on the flash technology side, you know, the JV brings strong synergies in flash manufacturing development and manufacturing scale. Excluding the underutilization charges, you guys have been driving down the underlying cost per bit at around a mid-teens type CAGR and in line with your prior targets, and that's even with the rising capital intensity, right? As you look ahead, BiCS6 transition, move to bonded architecture on BiCS8. Does the team believe it can sustain its mid-teens cost-down profile?

David Goeckeler (CEO)

Yes, we do. We feel very good about that. I mean, I've spoken about this in the past. It's an explicit goal of the technology team to continue to drive those cost downs, and we feel good about our ability to do that. It's been one of the strengths of the JV, and the JV technology team for a very long time.

Harlan Sur (Executive Director and Senior Equity Research Analyst of Semiconductors)

Well, thank you for that. Then on the flash portfolio side, within SSD particularly, the team has been in a very, very strong number two market share position in client SSD, very strong portfolio. In enterprise and cloud, however, you've been consistently in the sort of number five, number six global market share position. So as you think about spinning out the flash business, what is the team doing to improve its competitiveness in its enterprise and cloud SSD portfolio?

David Goeckeler (CEO)

Well, we like the portfolio we have. You know, we qualified our NVMe-based enterprise SSD at multiple cloud providers, and unfortunately, we qualified right into a significant downturn in cloud consumption of enterprise SSD. So, as that starts to come back over the next several quarters, and as we go through 2024, we expect our position to improve as we as those vendors start consuming again. I mean, the reality is there's just not a lot of buying in that market going on right now.

Harlan Sur (Executive Director and Senior Equity Research Analyst of Semiconductors)

Perfect. Thank you.

David Goeckeler (CEO)

Thank you.

Operator (participant)

Our next question comes from Mehdi Hosseini from SIG. Please go ahead with your question.

Mehdi Hosseini (Senior Equity Research Analyst)

Yes, sir. Thank you. David, I just want to go back to your comment you just made regarding enterprise SSD. When I look at the slides from the results of a strategic review, you're highlighting the strength in client SSD and also retail, but I don't see any mention of enterprise SSD. How should I reconcile that with the comment you just made?

David Goeckeler (CEO)

Well, I mean, it's because those are two very, very strong strengths of the portfolio. I think they're very unique. Look, our retail franchise is a real gem. I mean, it's a big part of the portfolio. It provides better through-cycle profitability. You know, we've done a lot of work on building brands over the last several years, and we've already had very, very strong brands in SanDisk. I mean, I think everybody knows SanDisk is a premier brand in the industry. We've built the Black brand around gaming now. That's a significant part of the portfolio. I think we're the preferred provider in gaming. You know, we talked about it this quarter, where, you know, 50% year-over-year content increases in devices and doubling the number of bits in that.

So it's been, you know, it's a very, very key part of the portfolio. We look forward to highlighting it more. The client portfolio has always been a strength of the business. It's something that's been built over the last several years. We've driven several innovations in that, like the DRAM-less client SSD. That's always been a very strong part of the portfolio. I guess, you know, Mehdi, we could have put a whole bunch of stuff on the slide that we're proud of in, in the portfolio, but we picked the, the strongest ones. But we're, we're very bullish on the enterprise SSD market. It's just a market that's depressed right now. You know, we talked a lot about that last year. We, we had qualifications at multiple hyperscalers. Those products are still active.

You know, we're migrating them forward to future nodes, and we expect those to ramp as that market recovers.

Mehdi Hosseini (Senior Equity Research Analyst)

Okay, great. And just a question, a follow-up question for Wissam, and I'm not asking you for a guide on 2024, but if I just look at your cost decline, if I just assume a 10% cost decline, and assume the current ASP trend, your NAND or flash business should become profitable maybe by midyear or sooner than later. The trajectory is very supportive of reaching profitability in the next couple of quarters. Is that a fair assumption?

Wissam Jabre (EVP and CFO)

Well, look, in the current guide for this quarter, it does imply that NAND should be gross margin positive. In terms of the outer quarters, it's a little bit too early for us to comment on them.

Mehdi Hosseini (Senior Equity Research Analyst)

Okay. Thank you.

David Goeckeler (CEO)

Thanks.

Operator (participant)

Our final question today comes from Toshiya Hari from Goldman Sachs. Please go ahead with your question.

Toshiya Hari (Managing Director)

Hi, good morning, and congrats on the announcement.

David Goeckeler (CEO)

Thanks, Toshiya.

Toshiya Hari (Managing Director)

Yeah. Yeah, Dave. So on the NAND side, I think based on a response to a prior question, it looks like you're assuming underutilization charges declined by about $60 million from September to December. Are you guys taking up wafer starts, or what, what's driving the sequential decline in charges in NAND?

David Goeckeler (CEO)

Yeah, I guess what I, Wissam will comment a little bit as well, but I guess what I would say, Toshiya, is we're, you know, we're not putting a broad statement out of there about that. What we're doing is just being very dynamic with how we manage wafer starts, so that we can keep supply and demand matched as best we can without letting inventory get up too high. So as you saw, I mean, our NAND inventory is at the best level since I've been here in the company. I mean, Wissam's team has done a great job, and the operations team just done an unbelievable job of managing that. So we'll, you know, we'll stay very close to where our markets are and, you know, how we're seeing demand, and then we'll, we'll adjust wafer starts appropriately.

Wissam Jabre (EVP and CFO)

Yeah. Thanks, Dave. The only thing I would add, Toshiya, is that when you think of underutilization, just, I know there was an earlier question on this. Yeah, we do expect underutilization further in the second half of the fiscal year. The way to think of it is, we're expecting underutilization to be slightly lower from these levels in the third fiscal quarter. And, as David said, this is very dynamic. We continue to manage the business on a day-to-day, week-to-week basis, and so, obviously, depending on business conditions, this could still change.

Toshiya Hari (Managing Director)

Yeah, that's very helpful. Thank you. Then as a quick follow-up, David, you, you talked about value-based pricing on the hard disk drive side and how that's driving better gross margins into the December quarter. Can you speak to any kind of specific end markets where you're seeing traction? Is it mostly, you know, client and consumer, or are you able to push through some price increases in the cloud segment as well? Thank you.

David Goeckeler (CEO)

I think it's, you know... First of all, in the channel, we're seeing good response to value-based pricing. And then as we bring out new products, you know, as I said, said in the past, I think innovation is what the first part of value-based pricing is, bringing a better value proposition to our customers. As we continue to bring out unique products, 26 TB UltraSMR ramped very fast, you know, nearly half of our exa- our nearline exabytes this quarter, and we're now bringing out 28 TB. I think as we continue to do that, we'll have the opportunity to, you know, have a better conversation with our customers because we're bringing more value to them. I would say it's, you know, we're looking at it across all of our markets.

Toshiya Hari (Managing Director)

Got it. Thank you.

David Goeckeler (CEO)

All right. Hey, thank you, Toshiya. We appreciate that. All right, everybody, we appreciate the time today. Thanks for the discussion, and we look forward to talking to you as we progress throughout the quarter.

Operator (participant)

Ladies and gentlemen, with that, we'll conclude today's conference call. We thank you for joining. You may now disconnect your lines.