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Western Digital Corporation (NASDAQ:WDC)

F2Q09 (Qtr. End 12/26/08) Earnings Call

January 28, 2009 5:00 pm ET

Executives

Bob Blair - VP, IR

John Coyne - President and CEO

Tim Leyden - EVP and CFO

Analysts

Keith Bachman - Bank of Montreal

Shebly Seyrafi - Calyon

Rich Kugele - Needham & Company

Sherri Scribner - Deutsche Bank

Doug Reid - Thomas Weisel Partners

Christian Schwab - Craig-Hallum Capital

David Bailey - Goldman Sachs

Mark Moskowitz - JPMorgan

Scott Craig - Banc of America

Kevin Rottinghaus - Cleveland Research

Katie Huberty - Morgan Stanley

Joel Inman - Robert W. Baird

Operator

Welcome to Western Digital's second quarter financial results for fiscal year 2009.

(Operator Instructions).

Now I'll turn the call over to Mr. Bob Blair. You may begin.

Bob Blair

Thank you. I want to mention as we begin that we will be making forward-looking statements on our comments and in response to your questions concerning demand in the hard drive industry; reductions in our expense and operation structure; our business restructuring plan and the associated impact on our ability to maintain operating expense, align capacity with demand and improve structural costs and gross margin range; the expected size, type and timing of charges and future original savings associated with our business restructuring plan; our ability to deliver industry-leading performance; market opportunities for high-capacity storage; our future investments; repurchases of our stock and management of our cash; goodwill impairment charges; our gross margin model cost structure and ability to remain profitable and cash flow positive; demand in pricing in the hard drive industry for the March quarter; and our financial results expectations for the March quarter, including revenue and gross margin, expenses, share count, restructuring costs and earnings per share.

These forward-looking statements are based on management's current expectations and are subject to risks and uncertainties that could cause actual results to differ materially, including those listed in our 10-Q filed with the SEC on October 31, 2008, as well as the additional risk factors reported in the press release included as Exhibit 99.1 to the Form 8-K we furnished to the SEC today. We undertake no obligation to update our forward-looking statements to reflect new information or events, and you should not assume later in the quarter that the comments that we make today are still valid.

In addition, references will be made during this call to non-GAAP financial measures. Investors are encouraged to review the reconciliation of the differences between these non-GAAP measure to the comparable GAAP financial measures in our press release included as Exhibit 99.1 to the Form 8-K that we furnished to the SEC today, a copy of which can be found under the SEC filings link in the Investor Relations section of our website at www.westerndigital.com.

I'd also like to note that copies of remarks from today's call by John Coyne and Tim Leyden will be available on the Investor section of Western Digital's website immediately following the conclusion of this call.

And now I will turn the call over to President and CEO of Western Digital, John Coyne.

John Coyne

Thanks, Bob. Good afternoon and thank you for joining us today.

In our last conference call, in October 2008, we were coming off a weak September quarter. And accordingly, in contrast to historical norms of 7% to 10% quarter-on-quarter growth, we provided what we believe was muted guidance for the December quarter of approximately 5% unit growth in our served markets for 3.5-inch and 2.5-inch ATA drives.

However, as the quarter developed, we saw unprecedented macroeconomic conditions depress these already muted expectations with demand actually declining 14% sequentially, transforming the December quarter into one of the most challenging ever for WD and the entire hard drive industry.

Instead of the 138 million units in served market demand which we expected, we saw a decline in industry shipments to 113 million, a negative swing of 25 million hard drives. The timing of this sudden demand shift gave us and others in the hard drive industry just two months to react and adjust. This rapid fall off in demand, amplified by customer inventory adjustments, further intensified the highly competitive pricing environment we experienced throughout calendar 2008.

As we saw demand fall off dramatically in early November, we acted swiftly to align our production volumes and operating expenses, demonstrating the benefits of a well-coordinated, capable and committed team executing to a proven, fast, flexible and responsive business playbook. Our response yielded positive results and comparative profitability, cash generation, asset management and increased customer preference.

While pleased with the performance of the team and the business model and addressing short term conditions, our assessment was that this was not just a one quarter anomaly, but rather a demand level reset, which would become the new base line for demand throughout calendar 2009.

Consequently, we developed and put in motion a plan which resizes our expense and operational structure to a revenue expectation for calendar 2009, some 25% below what we achieved in calendar 2008.

The details of this plan, which involved headcount, compensation, and work hour reductions across all areas of the company. As well as closure of facilities in both our component and hard drive manufacturing operations were outlined in the form 8-K, we filed with the SEC on December 17, 2008.

These actions, which we expect to complete within the March quarter, are designed to maintain our operating expense in the range of 9% to 11% of revenues at the $1.5 billion level.

The resizing of production capacity through work hour and headcount reductions, facility closures and equipment retirement is designed to align capacity more closely with our perception of ongoing demand, improve our structural cost and move our spec towards our business model gross margin range of 18% to 23%.

The hard drive is a high technology commodity. The critical factors for success in this market are consistent high quality and reliability, large scale and low cost, focused asset management, effective technology deployment, product's breadth, and product availability.

WD's consistent and profitable growth over the last seven years demonstrates our understanding of these key factors. And our ability to deliver industry-leading performance across all of them, while executing within the financial model I outlined earlier.

We are focused on continuing to deliver outstanding customer value through consistent execution against this simple yet effective model.

Operating expense averaging 10% of revenue over the last five years has enabled expansion of our worldwide sales and support operations, which has extended our ability to bring outstanding products to customers in every corner of the globe. It has funded the development of industry leading component technologies in heads and media to underpin our customer value proposition.

And it has allowed us to develop a broad and diversified product portfolio serving the majority of the available ATA hard drive and external storage markets, while also funding significant engineering activity in preparation for our entry into the traditional enterprise market.

We continue to demonstrate the effectiveness of these controlled and focused investments through the technology deployments and product shipments we have announced since our last conference call.

In the December quarter, we believe that we shipped more 500 gigabyte, 2.5 inch hard drives than all five of our competitors combined and shipped twice as many as our nearest competitor.

We brought the fundamental technology and system design to market at roughly the same time as key competitors. However, it is the entire recipe of our approach to new product introduction and ramp that is evident in this level of market acceptance and our financial results. The ingredients include our process technology and new product deployment and our refinement of yield, utilization, cost and supply chain logistics as we ramp into production, all the while maintaining the industry's leading quality and reliability metrics and lowest warranty expense.

This week, we began volume shipment of another industry-first, the 2-terabyte WD Caviar Green 3.5-inch hard drive, employing our advanced 400 gigabit per square inch aerial density technology allied to our unique second-generation WD GreenPower energy-saving technology.

This same 2-terabyte drive will also power a new capacity point in our My Book line of personal storage products and enables an 8-terabyte capacity in our WD ShareSpace enhanced product line for home server, media center and small business applications.

In our branded group, we launched several new Mac products during the quarter, including the My Passport Studio with FireWire 800 connectivity, the My Passport for Mac in 320-gigabyte and 500-gigabyte capacities and the My Book Mac edition at 1 terabyte.

We also entered an entirely new branded product category with the launch of the WD TV HD Media Player, a device that allows easy playback from any USB storage device of music, photos and video directly on to televisions in full 1080p HD format. This is the first in a line of WD branded products designed to bring users' media content out of the home office and into the family room with a simple and elegant PC-free interface.

Tim Leyden will now provide our detailed report on the December quarter, our resizing and our outlook. Tim?

Tim Leyden

As John described, unprecedented macroeconomic conditions made the December quarter a challenging one for WD and the entire hard drive industry. Nevertheless, in the face of these challenges, the WD team took swift action to reduce expenses, cut production capacity and minimize working capital investments.

As we enter the quarter, we have expected sequential quarterly unit growth of about 5%, at the low end of historical seasonal trends. Instead, we had to make course corrections during the quarter to respond to a decline in our total served market unit demand of approximately 14%, and desktop and notebook markets each declined about the same percentage.

Our revenue for the second fiscal quarter was $1.8 billion, down 17% from the prior year. Hard drive revenue is down 13% from the prior year and 14% sequentially. Shipments totaled 35.5 million units, up 4% from the prior year, but down 10% sequentially. Average hard drive selling price was approximately $51, down $2 from the September quarter and $10 from the year-ago quarter.

Our Q2 ASP reflects a very competitive pricing environment as a result of all competitors having anticipated more robust demand and consequently having too much supply available for the demand that materialized.

For the December quarter, we saw sequential declines in desktop, notebook and enterprise data unit shipments. We experienced the first Q1 to Q2 decline in 2.5-inch drive market demand since entering the notebook market in September 2004. Our unit shipments of 2.5-inch drives were 13.8 million in the December quarter as compared to 14.6 in the September quarter and 8.7 million in the year-ago quarter.

On the plus side, shipments of consumer electronics and branded products were up sequentially. We shipped 4.1 million 3.5-inch drives for use in digital video recorders in the December quarter as compared to 3.9 in the September quarter and 4.1 million in the year-ago quarter. And revenue from sales of branded products increased 5% from Q1 and 10% from the year-ago quarter to $403 million.

Hard drive channel revenue was 57% OEM, 21% distribution and 22% branded products in the December quarter compared with 56%, 26% and 18% in the September quarter and 48%, 34% and 18% in the year-ago quarter respectively. There was one customer, namely Dell, which comprised more than 10% of total revenue.

The Q2 geographic split of our hard drive revenue was 23% Americas, 29% Europe and 48% Asia as compared to 23%, 29% and 48% in the September quarter and 32%,32% and 36% in the year-ago quarter. Demand strength in Asia continues to be driven by the concentration of global manufacturing in that region.

Our gross margin for the quarter was 15.9% versus 20.1% in the September quarter and 23.3% in the year-ago quarter. Our December gross margin was impacted by the decline in overall market demand and the resulting competitive pricing pressures and factory under utilization.

Our media operations continue to perform as expected. And we have achieved the 300 basis point cost saving objective outlined at the time of our acquisition.

Total operating expense of $274 million included $113 million of charges associated with the restructuring plan announced on December 17. Excluding these restructuring charges, total on R&D and SG&A was $161 million for the December quarter, $29 million less than the September quarter.

Our quarterly operating expense benefited from the reversal of variable compensation incentives amounting to $16 million that had been accrued in the September quarter and the absence of similar accruals in the December quarter and a $6 million insurance recovery.

Our resizing plan includes the closure of one of our hard drive manufacturing facilities in Thailand; one of our substrate manufacturing facilities in Malaysia and headcount reductions throughout the world. We expect the plan to be implemented by the end of March, 2009.

Planned headcount reductions are about 7%, combined with attrition of 6%, should result in total headcount reduction of about 6500 by the end of March. And combined with work hour reductions of about 7%, the result should be about a 20% reduction in total capacity.

The total cost of the restructuring is currently expected to be approximately $140 million, $113 million of which has been recorded in operating expenses for the December quarter.

The total cash utilized by the resizing actions is expected to be approximately $60 million, most of which will be spent in the March quarter.

There were no material cash expenditures related to the restructuring in the December quarter, annual savings from these actions are expected to be approximately $150 million.

Operating income was $16 million or 0.9% of revenue, including the $113 million restructuring charge. Excluding the restructuring charge, operating income on a non-GAAP basis was $129 million or 7.1% of revenue.

Interest and other non-operating expenses were approximately $9 million. This includes about $6 million of unrealized losses on our previously-disclosed investments in auction-rate securities. These investments totaled $19 million at the end of the quarter.

The company recorded a net tax benefit from the December quarter of $7 million. This consists of a tax provision of $6 million offset by a $6 million tax benefit related to the extension of the R&D tax credit, which was enacted into law in October 2008 and a $7 million favorable adjustment of previously recorded tax accruals to reflect the change in the company's outlook for future income before taxes.

Net income totaled $14 million, or $0.06 per share, excluding the $113 million restructuring charge and the related tax benefit of $4 million, non-GAAP net income was $123 million or $0.55 per share.

Turning to the balance sheet, our cash and cash equivalents at the end of the quarter totaled $1.4 billion as compared to $1.2 billion at the end of September. We generated $300 million in cash flow from operations during the December quarter.

Capital expenditures for the December quarter were $140 million and our non-cash charges for depreciation and amortization expense totaled $122 million.

Capital expenditures for fiscal 2009 are expected to be about $500 million. This is consistent with the update we gave on December 17, when we announced the significant reduction from our prior forecast of $750 million.

Depreciation and amortization for fiscal 2009 is expected to be about $480 million. We did not repurchase any shares of stock during the December quarter. We believe that in times of economic uncertainty and tightness of credit, the robust cash balance is an important strength. We will continue to manage our cash accordingly during these certain economic times.

As of the end of December we had 46 days of receivables outstanding, 27 days of inventory or 14 turns and 64 days of payables. This resulted in a cash conversion cycle of 9 days.

In accordance with the accounting rules prescribed by FAS 142, we reviewed the value of our goodwill and concluded that our goodwill was not impaired as of quarter end. This review must be done annually or whenever events or changes and circumstances indicate that goodwill maybe impaired. It is possible that an impairment charge under the FAS 142 rules will occur in future quarters.

Before I discuss the March quarter, I would like to make a few comments about our stated business model.

As John indicated, we continue to believe that an 18% to 23% gross margin model is appropriate given our level of vertical integration, the amount of investments in capital and R&D required continuing to provide the products demanded in the market place and to generate an appropriate return for our shareholders.

As outlined in the restructuring plan, we have resized our cost structure with the objective of remaining profitable and cash flow positive at a $1.5 billion quarterly revenue run rate. The critical remaining pieces of the equation are balanced supply-demand environment and a product and segment mix that will support the revenue level commensurate with the value we are delivering.

I want to once again remind you that WD will have a 14-week quarter in this fiscal year, and we will include that extra week in our fourth fiscal quarter that will end on July 3rd, 2009.

Now I will discuss our expectations for the third quarter of our fiscal year 2009. First, let me outline the market situation as we see it. Historically, the March quarter's sequential unit decline has been in the range of 0 to minus 8%. Global macroeconomic conditions remain challenging and the outlook in our industry and the PC industry narrows that. With demand visibility continuing to be limited, credits continuing to be tight for our customers and inventory rationalization continuing throughout all channels, we envisage that these conditions will continue to render historical demand patterns less meaningful through the rest of this calendar year.

As a result, we are modeling a quarter-on-quarter sequential market unit reduction of approximately 13%. We believe that in a commodity marketplace such as ours, this balancing of supply and demand continues to be critical, and we are still seeking to find that equilibrium as an industry. So we anticipate that pricing will continue to be competitive.

The capacity realignments undertaken by the 3.5-inch industry participants has led to a better balance between supply, demand and inventory holding pattern. However, in the 2.5-inch segment, the willingness of multiple competitors to operate unprofitably continues to depress prices to a level that is insufficient to sustain investment. In the branded products area, competition has intensified as competitors gravitate towards more attractive margins than those provided by comparable products in other segments.

Taking these factors into account, we expect current quarter revenue for WD to be in the range from $1.35 billion to $1.5 billion. For comparative purposes, you should note that our fiscal Q3 revenue numbers last year included $89 million of revenue for external media sales as we fulfilled Komag's pre-acquisition and contractual obligations.

We are modeling gross margin in a range from 14% to 14.5%. R&D and SG&A are expected to total approximately $175 million. Our net interest expense is projected to be about $4 million. We anticipate tax expense of between $5 million and $10 million for the March quarter. We anticipate our share count to be approximately flat with the December quarter. These amounts exclude remaining restructuring charges which we estimate to be about $27 million.

This estimate may change until the date of actual disposal or completion of the restructuring plan. GAAP EPS including the restructuring charges is therefore expected to be between a loss of $0.11 and a profit of $0.02 for the March quarter. Excluding the restructuring charges, we estimate non-GAAP earnings per share between $0.01 and $.14. The non-GAAP earnings per share are calculated using the same share count as the GAAP earnings per share.

Operator, we are now ready to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions).

Our first question comes from Keith Bachman with Bank of Montreal. Your line is open.

Keith Bachman - Bank of Montreal

Hi, guys. Thanks very much. I had two questions if I could. The first, Tim, for you, the $150 savings that you identified in annual savings, could you just give us a little flavor about how and when that shows up, how that unfolds? And then, particularly, how we should be thinking about COGS versus OpEx? And then I have a follow up. Thanks.

Tim Leyden

Yes, we anticipate that we will be at that run rate from the 1st of April and so consequently move right through the June quarter. And we'd be at that new run rate. And then on COGS versus OpEx if we look at the $150 million savings, it's about two-to-one.

Keith Bachman - Bank of Montreal

Two-to-one.

Tim Leyden

Yes, two-to-one, OpEx versus COGS. Now please remember that in the June quarter, it's a 14-week quarter for us.

Keith Bachman - Bank of Montreal

Right, fair enough. Okay. Thanks, Tim. And then my follow-up is: you have identified how much capacity that you anticipate taking out of your system? I just wonder, through your industry analysis, how much you think the industry is looking to take out of total capacity.

John Coyne

I think, Keith, as we indicated, we saw the industry demand come down by some 13%, 14% on a quarter-over-quarter basis into the December quarter. And we are modeling industry demand to go down another 13% into the March quarter.

Now we are talking at ATA 3.5 and 2.5 inch combined, and our view would be that the capacity should come down by the same amount that the demand is predicted to be down if we desire to achieve that supply demand balance which is so critical to the health of this industry.

Keith Bachman - Bank of Montreal

Right, fair enough. Okay. Thanks, guys, I see.

Operator

Our next question comes from Shebly Seyrafi with Calyon. Your line is open.

Shebly Seyrafi - Calyon

Yes, thank you very much. I just want to make sure I understand this math correctly, because your headcount was reduced by 500 and something sequentially already, you targeted 2500 or so. So, I think you have 80% more to go in terms of the headcount target. Should we think about 80% of $150 million divided by four as the quarterly difference between the OpEx in the December quarter and where you going to be at the end of June?

Tim Leyden

Shebly, I am not sure that I understand the question and can you please --.

Shebly Seyrafi - Calyon

You have already reduced your headcount by 20%, I'm sorry, by 20% of the target, right? You want to reduce your headcount by 2500 and you have reduced it by 500 already, correct?

Tim Leyden

Yes.

Shebly Seyrafi - Calyon

Okay, so the $150 million annual savings, 80% of that is left, so to speak, if I look at the headcount side. And then you have divided by four. I was just trying to figure out what kind of OpEx number I should be thinking about in the September quarter of this year?

Tim Leyden

Okay. What we've done is we've indicated that we are citing the business to run at $1.5 billion in revenues. And our business model for OpEx has been in the 9% to 10% region when we were operating at around 2 billion, little above 2 billion, and in revenue.

So we've been operating somewhere in the $180 million to $190 million run rate from an OpEx view point. We are going to try and get back to, as John indicated in his remarks, get back to somewhere in the 9% to 11% range and it's probably ten more towards the 10% rather than 11%. We are going to try and see if we can keep it in at that level, so consequently when you do the math of that, it will be coming somewhere between a $155 million and $165 million.

Shebly Seyrafi - Calyon

By the September quarter?

Tim Leyden

No, by the June quarter. We're going to be at that run rate from the 1st of April.

John Coyne

Well, that's a thirteen week run rate, yes.

Shebly Seyrafi - Calyon

And ask one more?

Tim Leyden

Again there, Shebly, let me remind you that it's a fourteen week quarter in June.

Shebly Seyrafi - Calyon

Yes.

John Coyne

So you have to flex for the fourteenth week.

Shebly Seyrafi - Calyon

Should we think about the March quarter with this 14% or 14.5% gross margin as a low watermark and now we should think about getting back to an 18% gross margin by the end of this year. Is that reasonable kind of expectations?

Tim Leyden

Well, I mean, it's back to what John mentioned about, the critical factor in gross margin, and one of the factor and possibly the most critical factor is pricing. It depends on how the industry sizes itself to match the demand. If it sizes itself to match demand, then yes, it's possible to get back to a reasonable gross margins, but until that's done, we can't forecast when that is going to happen.

Shebly Seyrafi - Calyon

Thank you.

Operator

Rich Kugele with Needham & Company, your line is open.

Rich Kugele - Needham & Company

Thank you and good afternoon, gentlemen. Can you just talk about what you are seeing in terms of channel conditions? Obviously, that segment is primarily 3.5 inch ATA, but it seems people have been acting a little better there. See if you could comment on that?

Tim Leyden

Yes, well that's what I indicated in my comments. We are seeing that the actions that have been taken by the participants and the 3.5 inch segment are tending to firm up the actual situation between inventory, supply and demand and we are beginning to see the firming up of pricing in that particular segment.

Rich Kugele - Needham & Company

There are a lot of indications that overall channel inventories, and even if you look at your own balance sheet and Seagate's balance sheet, the lowest levels I've certainly ever seen. Do you feel that now, after two quarters, I must say, we are down 13%, after two quarters with that type of decline, has the industry gone too far? Will too much capacity be coming offline or is the capacity that is coming offline, primarily 3.5 inch, and it kind of sets the stage for your expansion, more in the 2.5 inch in the second half?

John Coyne

Well, Rich, this is John. Visibility into demand still remains somewhat, okay and cloudy, but the way we're thinking about it, yes, there has been significant reduction in inventories in the channel, particularly in 3.5-inch. In WD's case, we have taken 1.2 million units out of the channel on a quarter-over-quarter basis end of December versus end of September.

As you can see, with our 14 turns, we're managing our internal inventory in the way that we always manage it, very well matched to the demand. However, there are some elements of concern that I have. I look at our own restructuring plan, and one of the outcomes of that is that we have enough unutilized PCs in our business to last us for some considerable time into the future, because we have to let go the users of those PCs.

We therefore are looking at all of the headcount reductions that are happening on a worldwide basis in multiple industries. We believe that those industries are going to have the same kind of condition, and therefore, we see a further depressed demand in the commercial segment as we look forward from a PC-demand perspective. And that's a commercial PC statement, both desktop and notebook.

As we look at the consumer space, we think that's a little less affected. There is some cannibalization effect in the traditional notebook caused by the surging popularity of lower-priced netbook offerings. The good news for us there is that the vast majority of netbooks are shipping with hard drives.

And one of WD's forte´ is design and manufacture of very cost effective solutions to any kind of client system hard drive. So, net-net, we think that that emergence of a lower price point with a reasonable functionality that relies on a hard drive to deliver that functionality is medium to long term a good thing for us and for demand in that segment.

Then we look at the direct external sales of drives in the retail brand of products arena where we see the cleanest demand profile of all. Demand in that segment for us was good in the December quarter. We were modestly up. I think that's a reflection of our great products, great channel partnerships. And while we expect that to diminish somewhat seasonally as it has traditionally done, we believe inventories are very well managed and the demand profile there is immediately visible. And we can react to that.

Rich Kugele - Needham & Company

Very helpful. I guess it's my last question. Just any thoughts on the potential Toshiba-Fujitsu merger and does this in anyway change your timing for the entrance into the enterprise?

John Coyne

Two answers: first, we have a long standing tradition of not commenting on rumor; and second, we continue with our investments in preparing to enter the enterprise space. And we will let you know when we are shipping product in that space.

Rich Kugele - Needham & Company

Okay. Thank you very much.

Operator

Sherri Scribner with Deutsche Bank, your line is open.

Sherri Scribner - Deutsche Bank

Hi. Thank you. Tim, I was just hoping you could go through the tax numbers again really quickly. I am just trying to understand what your normalized tax rate would be without the external, the extra external items. It seems like there was about 10 million of extra items that we won't see again. Just trying to get a number there.

Tim Leyden

Yes, our regular tax expense was $6 million during the course of the quarter.

Sherri Scribner - Deutsche Bank

Okay. $6 million.

Tim Leyden

And we had the benefits of 30.

Sherri Scribner - Deutsche Bank

Okay. $6 million. And then if I look at the mix of your business in the quarter, it looks like there is a lot of retail business. I can understand that from the perspective of the seasonality and the holiday sales. But I think some people would be concerned that maybe there is higher inventory levels in the retail channel. Can you maybe comment on the inventory levels in the branded products business and why that number jumped up so much?

Tim Leyden

Yes, I think our inventory levels in the branded products are very well in line with what we would normally expect; in fact, a little down on the prior quarter. So we're very comfortable with that.

Sherri Scribner - Deutsche Bank

Yes. Do those typically have higher inventory levels?

Tim Leyden

Yes. I think we've noted this on several of the calls, that the pipe there is a little longer than the traditional component distribution numbers. You're probably looking at components that at the end of this quarter were way down at the four-week level, or slightly below, and typically the retail pipeline runs in the eight to nine weeks. I think it is at the low end of that.

Sherri Scribner - Deutsche Bank

Okay. Thank you.

Operator

Doug Reid with Thomas Weisel Partners, your line is open.

Doug Reid - Thomas Weisel Partners

Thanks. Can you comments on pricing trend; in the last three weeks specifically?

Tim Leyden

As we indicated, again that the 3.5 inch has begun to show some signs, the beginnings of some elements are firming up, and 2.5 continues to be extremely competitive. And again, as I noted in my comments, we are seeing competition intensify also in the branded product area.

Doug Reid - Thomas Weisel Partners

Okay. And then I'm wondering if you can give a little more color, where the cuts have been made within SG&A and how quickly you can restore resources you have let go of in the event, or rather when, a recovery happens?

Tim Leyden

Cuts have been made pretty much right across the OpEx and manufacturing areas and in the OpEx area we are dealing with it by cutting out activities and trying to stem down the number of our transactions and activities that people do.

And we are able to operate efficiency at the current level and when we see the signs of more visibility and demand clarity coming back. We would be able to resume normal hiring type of activity. If you review our progress over the last five years, responding to upside opportunity has never been a problem for us.

Doug Reid - Thomas Weisel Partners

Great, thank you.

Operator

Christian Schwab with Craig-Hallum Capital, your line is open.

Christian Schwab - Craig-Hallum Capital Group

Great, thank you, good quarter. My question, what is your capacity then, when you get done with this? Can you share with us, what your total quarterly manufacturing capacity would be?

John Coyne

It will be whatever the market demands from us.

Christian Schwab - Craig-Hallum Capital Group

I thought you said earlier, you'd have a total of a 20% reduction in your total capacity?

John Coyne

That's what we're sizing to support, as Tim mentioned, the focus of our resizing plans was to be appropriately sized to be profitable and cash positive at a $1.5 billion revenue run rate.

Now, around that model target for the baseline of the model, again we have a fundamental business model that is quite flexible around the center line. So what we've done in the restructuring is to take our center line from 2 billion down to the 1.5 billion and then what we will do on a operational tactical basis from week-to-week as we closely monitor demand and market activity, is to respond to that appropriately. Whether that's up or down around that median line and that's how we typically run our business.

If you look at what's different today than this time last year, I'd have to say that we're being a little more conservative and tending to be in a posture of chasing opportunity up once we've verified it, rather than getting in front of it.

Christian Schwab - Craig-Hallum Capital Group

Okay. That's fair. Can you make a comment on what you believe the capacity of the industry is today and where it may be a couple of quarters from now, and the aggregate quarterly volume? Seagate believes the industry, actually in December, before all the restructuring, was about a 160 million units a quarter, which you agree or disagree with that number and where do you think it's headed?

John Coyne

Yes. I think that number is the total industry number; our focus since we participate in the ATA segment, 2.5 inch and 3.5 inch ATA segment tends to be on that segment, which was 131 in September, 113 in December and we are modeling at about a 100 in the March quarter. And so we are looking at our opportunity in that light and in our sizing maintaining our share in light of those expectations for market sides.

Christian Schwab - Craig-Hallum Capital Group

Great, one last question if I may? I'm not going to comment on the rumor, if Toshiba and Fujitsu were to ever happen, but, what do you believe would be the impact to you in the industry if such a merger occurred?

John Coyne

I think we are more focused on how we delight customers with great products that are of high quality and reliability, address their needs, and are available at the right times and frankly, the health of the industry as we see it, relates to how the supply demand balance is managed from a build perspective. And the health of our company is derived from how much better we execute than our competitors.

Christian Schwab - Craig-Hallum Capital Group

Great. Thank you. No further questions.

Operator

David Bailey with Goldman Sachs, your line is open.

David Bailey - Goldman Sachs

Great, thank you very much. Just in follow-up to a comment that you made earlier. How are you thinking about your mix and pricing within product lines this year in light of the shift to lower-end desktops and notebooks as well as sort of the emergence of netbooks? I mean, it definitely helps on the unit side, but doesn't this put more pricing pressure?

John Coyne

It potentially would put some depending on how netbooks get on through the rest of 2009 relative to other PCs and relative to the other products of the market. Potentially, it's an outcome of mixing down the overall average gigabyte shift. And as I mentioned, one of WD's forte´ is the design and manufacture of a very cost effective product. And so here we see that as an opportunity.

Now it does put some pressure on ASPs, but on the other side of that equation, offsetting that is that the branded product retail business is moving in the opposite direction. So, as fast as the PC price point is being moved down to make it accessible to more people, the need for storage doesn't change in the use case for the customer.

And so we expect that the attach rate of external storage to those minimally-serviced products with low-end storage devices, we see that the opportunity to attach to those with high-capacity external storage is greater than the opportunity to attach to high-capacity full-featured PCs.

David Bailey - Goldman Sachs

Great. Thank you.

Operator

Mark Moskowitz with JPMorgan, your line is open.

Mark Moskowitz - JPMorgan

Thank you. Good afternoon. Two questions: More of a technology question; John, just given the macro backdrop and how you talked earlier about the oversupply of even PC, within your own environment, to the corporate PC, as happened to be quite depressible to the consumer, can we see something similar in the enterprise storage environment, where folks decide to shift more to a lower cost solution, such as SATA, a lot quicker than, maybe, a lot of us had anticipated, and move away from fiber channel over the next 12 to 18 months? How do feel positioned there if that was to occur?

John Coyne

Yes, I mean certainly SATA and the enterprise has been an area of significant success for us. It's an area that's been continually growing over the last several years as CIOs and their CEOs and CFOs began to focus more on the value proposition on how to service storage needs with properly-tiered cost solutions relative to performance. And that process has been going on for several years now.

I think current economic environment accelerates more cost effective solutions and typically tiered storage that uses significant levels of enterprise SATA rather than using more expensive SAS SCSI fiber channel drives which typically are higher-price, lower-capacity, because they are primarily a performance device.

Yes, I think we're going to see an acceleration of that deployment of lower-cost drives into the enterprise.

Mark Moskowitz - JPMorgan

And, as a follow-up, if that acceleration does occur, would WD need to spend any more on R&D to really flush out or bolster your SATA platform or you are already there and ready to go?

John Coyne

We're very happy with our positioning in that market.

Mark Moskowitz - JPMorgan

Okay. And then just lastly, I know it's kind of an old type of practice from the old days, but “bundling”; has there been any sort of bundling we're trying, to kind of secure business with some of the OEMs now, where you're trying to package both desktop and the notebook and maybe a low-end server drive?

John Coyne

I think the trends that you are seeing in the industry, and I think on an overall basis, the top three suppliers represented 77% of the industry in the December quarter compared with 73.5% in the September quarter. But I think what you are seeing is a reflection of the value proposition that the large vertically-integrated broad product line companies offer to the customers in terms of value for money, technology roadmap, long-term capability to support their products and satisfy need on into the future. And so, I think that's going to continue.

Mark Moskowitz - JPMorgan

Thank you.

Operator

Scott Craig with Banc of America, your line is open.

Scott Craig - Banc of America

Hi, good afternoon. Tim, can you take a look at the gross margins on a quarter-over-quarter basis and just kind of break out how much of the sequential decline was due to, say, pricing versus volumes versus anything else that you might want it from there?

And then, John, from a 2.5-inch notebook perspective, I think you threw out some numbers there. You had more shipments than outside competitors to your nearest competitor, et cetera. So, what do you estimate your market share was in 2.5-inch from the December quarter? Thanks.

Tim Leyden

Okay. So, on a quarter-to-quarter pricing and margin movement, obviously pricing was by far the largest component. We once again for the fourth consecutive quarter saw prices that were higher than we had seen in comparable quarters.

John Coyne

Tim, sorry. Price decline?

Tim Leyden

Price decline; yes, in a comparable quarter. And the absorption, obviously, as we had to do with much lesser product volumes, was also a significant item and against that we had improvement in mix because our brand had improved from 18% to 22%. So pricing was the biggest item, and the utilization was the second biggest item we had some offsetting benefits from mix.

And to the notebook question, the 2.5 inch product line, my reference related to the 400 gigabyte and 500 gigabyte capacity point and that ability to rapidly ramp reliably in that space and the customer acceptance of our ability to do that, overall, that have the effect, we think, we gained about two points of share in the notebook market.

Scott Craig - Banc of America

Okay. Thank you very much.

Operator

Kevin Rottinghaus with Cleveland Research, your line is open.

Kevin Rottinghaus - Cleveland Research

Thanks. The 13% decline this quarter that you are seeing for the industry. How much that you think is demand is versus inventory?

John Coyne

Still quite hard to separate that, taking on informed stab, probably two-thirds demand, one-third inventory sweeps.

Kevin Rottinghaus - Cleveland Research

Okay. And you've said kind of your inventory at least in the channel and at the retail level you think is okay. Is the inventory correction really just happening at the OEM level or do you think it's just other people in the industry that are kind of seeing an inventory correction happen?

John Coyne

I think it's throughout all channels and it's been driven by a number of things. As the demand ratchets down, the inventory that was appropriate last quarter is no longer appropriate, you need to bring the inventory down and concert with the demand reduction. So that's one item.

The second item is credit availability where customers are looking to squeeze their inventory and turn those sales into cash and use the cash to pay down credit lines or to postpone that cash for the future in fear that they won't be able to renew credit lines and so on.

So there is some impact of those behaviors, also on people changing their business models to run with lighter inventory that, in terms of weeks of inventory, than they would have in the past.

Kevin Rottinghaus - Cleveland Research

Okay, for WDR, are you planning any manufacturing shutdowns this quarter?

John Coyne

We think we're sized to our own opportunity within the market, but we review this on a week-by-week basis as we map our demand profile against our production and our inventory levels and we manage all that on an ongoing basis, at this point, it's too early in the quarter to determine.

Kevin Rottinghaus - Cleveland Research

Okay, and then just one last question. On the 3.5 inch side, is the pricing stabilizing? Do you think that's any indication at all of distress from some of your competitors not being able to go there on price any more? What do you attribute the 3.5 inch kind of price stabilizing here in near-term too?

John Coyne

I think it's a reflection of a more mature market with a smaller supply base. And so the visibility into the demand is a little more predictable and the reaction to that, given that there is a smaller group of people trying to interpret that demand, signals tend to be better.

And I think you see in that market, the predominance of that market supplied by three suppliers, the Seagate, ourselves, and Hitachi, so again, that kind of narrows an improved visibility.

And then, there certainly are indications that there is significant stress in that market place from a price versus cost perspective. And so the behavior we are seeing is to be expected.

Kevin Rottinghaus - Cleveland Research

Thank you very much, appreciate that.

Operator

Katy Huberty with Morgan Stanley, your line is open.

Katy Huberty - Morgan Stanley

Thanks good, afternoon. What do you think your market share is now of notebooks? And as volumes have accelerated over the last couple of quarters, are the gross margin percentages of those lower capacity drive converging towards more mainframe capacities?

John Coyne

I think we have a representative share in that segment relative to our share in other segments. And it is a challenge right now from the margin perspective, because we have not yet developed a purpose design solution for that segment.

Katy Huberty - Morgan Stanley

And does that relate to the planning around $1.5 billion of revenue? Is the model two quarters out to be back to a normalized margin off of $1.5 billion or to just be at least slightly profitable?

John Coyne

Couple of quarters down, we do not anticipate that economic conditions will have returned to normal. So we'll continue to operate, to model for, and to match the demand.

And that again is the key factor. I mean, we need to size our business in order to be able to deal with the market conditions. And it's important that that's understood throughout the industry, because that really is the most critical component in the gross margin equation followed pretty closely by segment mix also.

Katie Huberty - Morgan Stanley

Got you. Thanks.

Operator

Joel Inman with Robert W. Baird, your line is open.

Joel Inman - Robert W. Baird

Hi. Thanks. Nice job on the quarter. So your OpEx guidance, did you say $175 million next quarter?

Tim Leyden

Yes, for OpEx.

Joel Inman - Robert W. Baird

And what's the reason that's going up?

John Coyne

14 weeks.

Joel Inman - Robert W. Baird

All right. Okay.

John Coyne

Q3, it's 175 million. And the reason that's going up relative to Q2, Tim, did call out that a component of the Q2 reduction quarter-to-quarter was a reversal of a bonus accrual from the September quarter.

Tim Leyden

Right. And so, we don't have that pickup in the March quarter. And that was, what, $16 million?

John Coyne

$16 million.

Joel Inman - Robert W. Baird

Okay. And then on the branded side of the business, how do you describe the competitive landscape there? I know you said it's intensifying. But as it pertains to third-party suppliers that don't actually manufacture the products, do you see some consolidation in that space in the near term?

John Coyne

Our observation is that things are becoming more competitive in that space. That will certainly put some pressure on people with marginal structures and marginal market access and so on. We believe we've got a great product line. We've got customer relationships, and we have a very good product roadmap.

So we're very enthused about that market and we're very committed to continue to prosecute that market as the leaders. And we're working on that as we speak.

Joel Inman - Robert W. Baird

Okay. And then just the new product that you announced, is that available today?

John Coyne

Yes. That's been available since mid to end of September, and we're very pleased with the acceptance level on that product and we are very pleased with the excitement it's creating and the demand for incremental storage that that's creating, because it provides a very simple and elegant, straightforward mechanism to take drive content directly to the TV.

Joel Inman - Robert W. Baird

Okay. Thanks very much.

John Coyne

Thank you.

Operator

I would now like to turn the call over to Mr. John Coyne.

John Coyne

Thanks, Holly. In closing, I want to thank the entire WD team. I am greatly appreciative of the loyalty and commitment to WD's success displayed by all of our employees as we resize our business, those who are, unfortunately, leaving us and those who are staying with reduced compensation packages. Their integrity and class, their sustained focus, commitment to success and outstanding execution in these trying times is truly inspiring.

Our results in such challenging market conditions are a testament to their capability and tenacity. Despite the current state of the economy, we remain very encouraged by the long-term market opportunities for high-capacity storage in the years ahead. The applications driving the digitization of massive content are not going away. We are taking what we believe are prudent and appropriate steps to size our business for the new economic environment we expect throughout calendar 2009.

We remain committed to provide the best customer value proposition in the industry to deliver financial results which allow us to make the substantial investments required to continue to lead the industry and providing solutions to customer needs for high capacity, cost effective storage and to generate superior returns for our supply partners, our employees, the communities in which we operate and our shareholders.

I'd like to thank you again for joining us today, and I look forward to keeping you informed of our progress. Thank you.

Operator

Thank you. This does conclude today's conference. You may disconnect at this time.

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Source: Western Digital Corporation F2Q09 (Qtr. End 12/26/08) Earnings Call Transcript
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