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Seagate Technology (STX)

Q4 2006 Earnings Conference Call

August 8, 2006 5:00 pm ET

Executives

William D. Watkins - President and CEO

Brian Dexheimer - Executive Vice President - Worldwide Sales & Marketing

Charles C. Pope - Executive Vice President and CFO

Dave Wickersham - Executive Vice President and COO

Analysts

Harry Blount - Lehman Brothers

Laura Conigliaro - Goldman Sachs

Keith Bachman - Banc of America

Sherri Scribner - Deutsche Bank

Mark Moskowitz - JP Morgan

Steven Fox - Merrill Lynch

Kevin Hunt - Thomas Weisel Partners

Rich Kugele - Needham & Company

Mark Miller - Brean Murray, Carret & Company

Katie Huberty - Morgan Stanley

Presentation

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to Seagate Technology's fiscal fourth quarter and year end 2006 financial results conference call. (Operator Instructions)

This conference call contains forward-looking statements including, but not limited to, statements related to the Company's future financial performance including the expected impacts from the acquisition and integration of Maxtor Corporation.

These forward-looking statements are based on information available to Seagate as of the date of this conference call but are subject to a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements.

Information concerning the risks and uncertainties that could cause results to differ materially from those projected in the forward-looking statements as contained in the Company's annual reports, on Form 10-K as filed with the US Securities and Exchange Commission on August 1st, 2005; in the Company's quarterly report on Form 10-Q as filed with the US Securities and Exchange Commission on April 28th, 2006; in the Company's Form 8-K as filed with the US Securities and Exchange Commission on June 1st, 2006; and in the Company's Form 8-K as filed with the US Securities and Exchange Commission on August 8th, 2006.

These forward-looking statements should not be relied upon as representing the Company's views as of any subsequent dates. Seagate undertakes no obligation to update forward-looking statements to reflect events or circumstances after the date they are made.

I would now like to turn the conference over to our host, Mr. Bill Watkins, President and CEO. Please go ahead, sir.

William D. Watkins

Thanks, Derrick. Welcome and thank you for joining us. On the phone with me today are Charles Pope, Executive Vice President and Chief Financial Officer; Dave Wickersham, Executive Vice President and Chief Operating Officer; and Brian Dexheimer, Executive Vice President, Worldwide Sales and Marketing.

Given the complexity of Seagate's financials, following the Maxtor acquisition, in particular the results of our fourth quarter which reflect six weeks of combined Seagate/Maxtor operations, I'll focus my remarks on what I believe are the most significant aspects of the 2006 fiscal year in total; for the fourth quarter specifically; and then offer a brief discussion of some key factors that will influence fiscal 2007.

Charles will follow with further details on our fiscal Q4 2006 financial performance, and then Brian will discuss products, markets and Maxtor revenue retention. Dave will update new program status and product transition and then Charles will come back to discuss fiscal 2007 and the Q1 outlook.

In connection with the Maxtor acquisition, we incurred a number of accounting charges and other costs which impacted our earnings for the current quarter. During our call today we'll be able to provide additional insight into the components of these expenses to provide a clearer picture of the Company's expected performance in the future.

Let me begin by saying that we're very pleased with our financial growth, operating performance and product execution for fiscal 2006. Another year of product leadership, consistently solid operational execution, and the ongoing escalation and the global demand for mass storage resulted in record annual operating performance for the year with a Seagate standalone annual revenue growth of nearly $1.5 billion and profits of over $1 billion.

In addition to shipping a record 119 million units during the year, we reset the bar for industry-leading capacity in a number of product categories. With the introductions of the first 160 gigabyte notebook drive, the first 750 gigabyte 3 1/2 inch drive, the first 146 gigabyte 2 1/2 inch Enterprise drive and the first 300 gigabyte 15,000 RPM Enterprise drive, and the first 12 gigabyte 1 inch drive.

The records that were broken with those new products have all been set by Seagate. In addition, with our transition to perpendicular recording well underway, products based on this technology were available and delivered across all markets.

Specific to the June quarter of fiscal 2006, our financial performance was very strong despite traditional seasonality and extremely competitive pricing in the low end desktop space that made that particular environment more challenging than we expected, as market share gains became the primary focus of a number of our competitors.

This quarter in particular was transitional as we closed the Maxtor acquisition and accelerated the integration activities that are bringing us closer to achieving the earnings model that will allow us to maximize value for our shareholders.

After the first six weeks of our integration efforts we are confident that we will realize the synergies from our acquisition of Maxtor sooner than we originally anticipated. We're now targeting to have fully integrated Maxtor by the end of calendar year 2006.

Looking to the year ahead, the industry environment remains dynamic. However, given the significant growth forecasts published by the independent market research organizations, we believe that Seagate will deliver very strong fiscal 2000 operating and financial performance consistent with the post acquisition model that we have shared.

Our fiscal 2007 outlook is predicated on a continuing competitive price environment very similar to the June quarter and while we are aggressively restructuring Maxtor operations, Seagate will be impacted in the first half of the fiscal year by the cost of under-utilized capacity as we ramp-down Maxtor designed products and ramp-up Seagate designed products.

We expect the second half of our fiscal year will reflect the significant positive impact of our fully optimized cost structure, new product refreshes that include cost optimized products designed specifically for low cost applications, new market access with the 1.8-inch drives and the completion of the Maxtor integration.

We believe the impact of these factors will result in a very strong second half of the fiscal year and we are managing the Company to increase earnings approximately 20% in fiscal year 2007 with a projection of non-GAAP net income of $1.2 billion, compared to the approximately $1 billion in fiscal 2006.

In summary, fiscal 2006 was an outstanding year for Seagate and I believe our performance will stand out among the best in the technology industry. As we look ahead to fiscal 2007, I'm very encouraged by the current outlook for future growth.

As evidence of our confidence in both the Company's growth prospects and that of the industry as a whole, Seagate today announced that the Company's Board of Directors has approved an additional $2.5 billion, two-year stock repurchase program. During fiscal year 2006 Seagate returned over $500 million to our shareholders through stock repurchases and quarterly dividends. Today's announcement reflects Seagate's continued focus on increasing shareholder returns.

Now I would like to turn the call over to Charles to provide details on our financial performance during the quarter.

Charles C. Pope

Thank you, Bill. You will find the Company's press release, 8-K and additional financial information related to Seagate's financial performance along with a reconciliation of GAAP to non-GAAP financial results and other supplemental information in the Investor Relations section of Seagate's website at Seagate.com.

Throughout my remarks I will be referring to specific sections of that supplemental financial information by slide number.

Before I get into the detail of the financial results for the June quarter, it is important to understand that the reported results include only six weeks of Maxtor product revenue and related expenses. Any references I make in regard to combined Company performance, Maxtor product revenue, unit shipments or gross margins, unless otherwise noted, reflects only the six-week period.

Maxtor unit shipments between April 2 and May 19 need to be taken into account when analyzing the industry's performance and Seagate's revenue retention efforts. This information can be found on Slides 2 and 3 of the supplemental information material that is on our website.

Seagate reported June quarter revenue of $2.53 billion, of which $2.25 billion was from Seagate products and $279 million was from Maxtor products. Unit shipments were 33.6 million, of which 29.3 million were Seagate products and 4.3 million were Maxtor products.

GAAP net income and diluted earnings per share are $7 million and $0.01 respectively. On a pro forma Seagate standalone basis, excluding accounting charges, costs and tax effects directly related to the Maxtor acquisition of $146 million, Seagate's non-cash stock-based compensation of $17 million, and the $72 million loss for Maxtor operations, non-GAAP net income was $241 million for the quarter ended June 30, 2006.

We last provided guidance for non-GAAP diluted earnings per share of $0.46 to $0.49 for the June quarter on April 19th. This outlook did not and could not consider what impact, if any, closing the transaction in mid-quarter would have on Seagate's business or the stock buyback.

While it is difficult to compare our reported results for the June quarter to our guidance, the bottom line is that the Seagate standalone operating results achieved the internal plan. Increased enterprise and gaming shipments and effective operating expense management offset the softness in desktop demand and the more competitive desktop pricing.

Non-GAAP gross margin for the combined Company in the June quarter was 19.4%. Slide 6 has the adjustments made to GAAP gross margin. Gross margin percent for Maxtor products was approximately negative 13%, reflecting an increasingly underutilized manufacturing infrastructure required to build Maxtor products. Gross margin percent for Seagate products was approximately 23.4%. The pricing environment across all markets during the June quarter was very competitive.

The notebook and enterprise markets, while generally in line with expectations, experienced price declines not seen during the previous four to five quarters. The desktop market experienced price declines somewhat more than expected, due to slightly softer demand and the continuing positioning for market share by our competitors attempting to influence the redistribution of Maxtor products market share.

For Seagate products, average price declines on a like-for-like basis across all markets was approximately 7% as compared to approximately 5% in the March quarter.

GAAP operating expenses composed of R&D, SG&A, and amortization of intangibles for the June quarter are $382 million. Excluding purchase accounting charges and other costs directly related to the Maxtor acquisition of $53 million and Seagate non-cash stock-based compensation of $11 million, non-GAAP operating expenses were $318 million.

Further, adjusting out the operating expenses for Maxtor, the pro forma non-GAAP Seagate standalone operating expense would have been $283 million. Slide 7 has the detail for the adjustments made to the GAAP operating expenses.

Other income and expense for the June quarter was $11 million of income compared to the March quarter of $24 million of income. The March quarter contained gains on an equity investment of $7 million and other periodic gains of $6 million.

The fully diluted share count of 563 million reflects the issuance of Seagate's common shares to acquire Maxtor on May 19, 2006 and the offsetting stock buyback activity completed during the quarter.

Cash, cash equivalents and marketable securities ended the quarter at $1.73 billion. On a combined basis, including the losses for Maxtor products and the underutilization of our manufacturing capacity, Seagate still generated cash from operations for the quarter of $162 million, and $1.5 billion for the fiscal year.

Seagate made capital investments during fiscal year 2006 that totaled $1 billion. For fiscal 2007 we expect up to $1.3 billion in capital investment will be required. The capital spending is to support the continued growth and market-leading operating margins Seagate enjoys and to complete the integration of Maxtor into our operations.

When we announced the acquisition of Maxtor, we estimated that up to $500 million of restructuring expenses would be required to fully integrate Maxtor. As we enter fiscal 2007, much of this expense is still in front of us and we are confident that the total cash expenditures related to the Maxtor acquisition will not exceed $500 million.

Reported inventory is $891 million with approximately $637 million related to Seagate products and $254 million for Maxtor products. The Seagate product inventory increased from the prior quarter by $88 million with almost the entire increase reflected in finished goods.

Seagate's standalone inventory turns decreased to 10.9. The management team of Seagate is not satisfied with the recent trend in inventory turns and has specific plans to improve turns into the 12 to 14 range.

That concludes my detailed comments regarding the June quarter's financial results. Now I'll hand the call off to Brian for his comments.

Brian Dexheimer

Thanks, Charles. To help provide a clear year-over-year picture of the market, I want to note that in contrast to the comparisons in Charles' remarks, all sold unit statements and comparisons in my remarks include the full quarter of Maxtor shipments. Detail and unit shipments can be found on Slide 2 and 3 of the supplemental information on Seagate.com.

Echoing some of Bill's statements, fiscal 2006 was an excellent year for Seagate. The industry continued its strong growth trend as the demand for pure capacity in units reached record levels. With the industry shipping over 42,000 pedabytes, a 50% increase over fiscal 2005, all markets benefited from this growth pattern and Seagate's broad participation and product leadership drove record financial performance in unit shipment growth of 24 million units to 122 million for the year. Seagate standalone shipments were a record 114 million units for the year.

In the quarter just ended, the industry experienced typical seasonal patterns across most markets. Seagate retained its overall leadership position shipping over 37 million drives including the full quarter Maxtor results, and maintained our lead in three of the four major markets, while for the first time moving into the number two share spot during the quarter for all 2.5 inch drives shipped.

Now I'll give some more detail on the individual markets. Starting with mobile computing, this space remained a very strong driver of growth for Seagate during the quarter and the fiscal year. There was some seasonality in this space but Seagate continued to grow faster than the market shipping 3.4 million units, an increase of 67% year-over-year.

For the fiscal year, Seagate shipments in this space grew to 12.5 million units from 5.7 million in fiscal '05. Further, our technology leadership in this space allowed Seagate to increase its average gigabyte per drives shipped to over 70 gigabytes, 15% greater than the industry average.

Our industry-leading 5400 RPM 160 gigabyte notebook drive is now qualified as four notebook manufacturers and we expect to complete another ten qualifications during the September quarter as we continue to ramp production. Looking forward, we expect overall notebook demand for the September quarter to be seasonal and better than the June quarter.

In the consumer electronics market, Seagate gained share during the quarter, shipping 6.5 million units, up 10% sequentially with Maxtor March quarter results included. Seagate standalone shipment for the quarter were 5.5 million units.

Particularly strong during the quarter were shipments into the gaming console market. Also shipments into DVR applications grew to 3.4 million drives and we're pleased with our revenue retention in the CE space relative to our goals.

Also in this space, the launch of our 750 gigabyte DB35 platform was well received and is under full qualification for select, high definition recorders planned for later in the year. In addition, demand in 1 inch applications for consumer electronics contributed 400,000 units for the quarter.

On the new product front for consumer electronics, we announced our first 1.8-inch drive during the June quarter, targeted at personal media players, digital video cameras, and other portable devices. There is a tremendous opportunity in this market as we have seen the market for this class of device grow 70% year-over-year and we believe it will grow 40% in the coming year. The drive is on track to begin shipments at the end of the December quarter.

We expect overall growth in the CE space in the September quarter, with particular emphasis on the sequential growth in the game console shipments as manufacturers gear up production for the traditionally strong holiday season.

Demand in the enterprise space was in line with expectations and shipments reached 4.5 million units. Seagate standalone shipments in this space were 3.95 million units and revenue retention in this space was within our targeted levels. Including Maxtor shipments in the June and comparable March quarter, sequential shipments were flat.

Our investments in perpendicular technology are coming closer to harvest in the enterprise segment as this quarter drove significant customer qualification activity on our new products. These products span not only the classic enterprise markets with a 300 gigabyte 15K.5, but also the industry's first 750 gigabyte product designed for the rapidly growing tiered storage market.

Lastly, the market infrastructure continues to evolve nicely to support server consolidation and space optimization around Enterprise class 2.5 inch drives. This was evident in the 20% growth in shipments we saw in this space sequentially. We expect overall enterprise demand in the September quarter to be flat to slightly less than that of June.

In the desktop computer market we maintained our leadership position by shipping 23 million units. CE standalone shipments were 16.5 million units. Revenue retention in this space is slightly below our expectations as throughout the quarter we saw willingness from our competition to secure additional OEM share on aggressive terms, particularly at the low end of the product line.

Our product mix continued to improve as shipments of products 200 gigabytes and greater exceeded the industry average as a percent of volume for the first time. During the quarter, we began shipping in volume the industry's only 750 gigabyte desktop drive which is our first PC drive utilizing perpendicular recording.

In global distribution channels, overall the industry experienced slightly less than planned sell-through demand in the June timeframe due to anticipated price changes in processors. However, inventory levels for Seagate product at the quarter end were at our target five weeks. For the September quarter we expect to see a normal seasonal demand increase in the desktop space.

Finally, in the seasonally lower quarter, our Seagate and Maxtor branded solutions revenue was slightly down sequentially. We're pleased with our revenue retention in this space and believe the Maxtor brand is a valuable asset in this fast growing space and we intend to continue to offer the full range of Maxtor branded products to consumers globally on a long term basis.

Combining the Seagate and Maxtor branded solutions product lines delivers the industry's largest footprint in this space. We see very encouraging trends for growth in attached and networked home and small business storage solutions. We believe this business will continue to be a significant contributor to Company revenue and is a strategic growth area going forward.

In the near term, we're focused on retaining Maxtor revenue and seamlessly transitioning Maxtor customers to Seagate products as quickly as possible. Looking ahead, we see signs of a very strong fiscal 2007 as industry growth trends continue across all markets.

From a product standpoint, we believe we can continue to be the best positioned and with products such as our new 1.8-inch drive, we now have the opportunities in spaces in which we previously did not participate. Additionally, the Maxtor acquisition has opened doors into new customers and more than doubled our branded solutions business.

Now I will like to turn the call over to Dave to provide an update on our operations and the acquisition.

Dave Wickersham

Thank you, Brian. I would like to start by providing an update relative to the Maxtor integration and product transition. Overall, the ramp down of Maxtor products and the transition to Seagate products and processes is proceeding very well. We remain focused on customer requirement, continuity of supply, and the consolidation and optimization of manufacturing capacity.

We are on track to complete the transition from Maxtor-designed products to Seagate products by December 2006, ahead of our original plans. With these product transition plans in place, we are moving quickly to rationalize manufacturing and production capacity.

During this period of transition, operating and financial metrics are challenged due to the inefficient use of the manufacturing infrastructure that is required to support the Maxtor-designed products as they ramp down in volume and the upfront investment needed for capacity additions to support the ramp-up of Seagate designed products.

With regard to staffing, workforce reductions have continued since the transaction closed in late May, as we address the redundancies that exist between the two companies. The balance of the workforce reductions will be implemented based on product transition, customer support and administrative requirement. Keep in mind that the Maxtor acquisition provided us with access to some very talented personnel in branded solutions, R&D and other key functional areas and they are being integrated into Seagate as quickly as possible.

Looking at our transition to perpendicular recording, Seagate's technology leadership is clearly evident in our first-to-market position for perpendicular recording disc drives across all product platforms. During the June quarter, we shipped products based on perpendicular recordings into each of the major markets: desktop, notebook, enterprise and consumer electronics.

To highlight our progress to date, we shipped approximately 700,000 units of perpendicular 3.5-inch, 7200 RPM ATA drive which happens to address applications across multiple markets. Of those 700,000 units, approximately 100,000 were 750 gigabyte capacity points.

While to date the total number of drives shipped with perpendicular recording is relatively small, we are tracking to our internal plan which is to have in excess of 50% of all drives shipped a year from now based on perpendicular recording.

Regarding media supply, based on our recent review of industry capacity and demand, we believe there is adequate finished media capacity planned or in place to meet industry demand. We do continue to see tightness in glass substrate supply through September, and this could result in spot shortages during this quarter. Aluminum substrates remain at very high capacity utilization and appear very tight through December. In Seagate's case, our internal and external supply of substrates and finished media is sufficient to meet our requirements.

We previously indicated that with the combined Seagate and Maxtor external media supply agreement and Seagate's internal manufacturing capacity, we are in a position to relocate the mass media process equipment to Asia at this time. A defined plan is now in place and Seagate will expand media production in Singapore near our current media facility. We expect that we'll require approximately 18 months to relocate the process equipment and initiate production at the new site.

Now I would like to turn the call over to Charles to provide our outlook for the current quarter and the fiscal year.

Charles C. Pope

Thank you, Dave. The outlook for fiscal year 2007 reflects a number of important characteristics. First, the pricing environment is expected to be very competitive, similar to the just-completed June quarter.

Second, during the first half of the fiscal year there will be underutilized manufacturing capacity during the ramp-down of Maxtor products and the corresponding ramp-up of Seagate products. This is a temporary situation which impacts gross margins and operating expenses, and we expect to be at or near the optimum level of capacity utilization and associated supporting operating expenses when we exit the December quarter.

Third, new products at lower cost structures introduced during the fiscal year will improve gross margins and profitability.

Finally, Seagate will access new revenue opportunities, expanding its market coverage to virtually 100% of the global hard drive market with our new 1.8-inch products.

With that backdrop, let me start with the fiscal year 2007 outlook. The Company expects consolidated revenue to be in the range of $11.8 billion to $12.3 billion. Operating expenses, including the ramp-down of Maxtor and excluding purchase accounting charges and other costs directly related to the acquisition of Maxtor, is expected to be $1.5 billion to $1.6 billion.

The tax rate we are using for all of fiscal year 2007 is 10%. The 10% tax rate is an estimate at this time as we are still working through and understanding the impact of the Maxtor acquisition. We expect to have a good idea of where the rate will end up by the time we report our September quarter financial results.

Not including the potential impact of share repurchases, average diluted outstanding shares are expected to be approximately 613 million. Accordingly, non-GAAP diluted earnings per share for fiscal 2007 is expected to be in the range of $1.90 to $2 per share.

Including the estimated purchase accounting charges and other costs directly related to the acquisition and including Maxtor's operations, GAAP diluted earnings per share is expected to be $1.58 to $1.68 per share.

For the September quarter, revenue is expected to be between $2.65 billion and $2.8 billion with approximately $400 million from Maxtor-designed products. As mentioned, gross margins will be impacted by underutilized manufacturing capacity as we accelerate the ramp-down of Maxtor-designed products and invest for the ramp-up of Seagate products. In aggregate, Maxtor-designed products are expected to have zero gross margins, excluding purchase accounting charges and other costs related to the acquisition. Seagate product margins on average are expected to be 21% to 22%, again excluding purchase accounting charges and other related acquisition costs.

Operating expenses excluding purchase accounting charges and other related acquisition costs is expected to be around $400 million. Other income and expense and income taxes are expected to net out to zero.

Diluted outstanding shares are expected to be approximately 610 million. Accordingly, non-GAAP diluted earnings per share for the September quarter is expected to be $0.16 to $0.20.

Including the estimated purchase accounting charges and other acquisition-related costs, and including Maxtor's operations, GAAP diluted earnings per share is expected to be $0.04 to $0.08. Again, none of these estimates include the impact of potential repurchases of common shares during the quarter.

Before I turn the call back over to Bill, I would like to emphasize that the management's view of the accretive impact of the Maxtor acquisition is still the same as when we announced the transaction. While there is certainly short-term dilution associated with the Maxtor acquisition, we are excited about the opportunities this acquisition provides as we complete the transition to Seagate-designed products and we expect to post improving financial results throughout the fiscal year.

That concludes my remarks and I will now turn the call back over to Bill.

William D. Watkins

Thank you, Charles. This was a tremendous year for Seagate and for the industry. I'm proud of our employees around the world for meeting our challenges and achieving our goals. On behalf of the entire management team, I extend our gratitude for their efforts. I would also like to acknowledge the Maxtor team for their hard work, professionalism and support during the integration process. With that, operator, we're willing and ready to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Harry Blount - Lehman Brothers.

Harry Blount - Lehman Brothers

Hi, guys. A couple of questions, if I might. Charles, this is probably mostly for you to start with here. In the current quarter, Maxtor's gross margin was 13%, you guided for zero. Then I look at Seagate's gross margins in the current quarter around 23% and that's down to 21% to 22%. Can you maybe help me bridge that a little bit?

Charles C. Pope

Well, first in the current quarter Maxtor’s was a negative 13%.

Harry Blount - Lehman Brothers

Correct. I'm sorry. The improvement from negative 13% to zero.

Charles C. Pope

Well a large part of the improvement from negative 13% to zero was a purchase accounting impact where at the time that we closed the books we had to restate all the inventories to fair market value; so essentially the cost of the product is what you're selling it for. That's having some effect there.

We, in fact, had to write system of those inventories down in order to accomplish that or they would have been negative again.

Harry Blount - Lehman Brothers

So Charles just to be clear then, excluding that writedown and purchase accounting, Maxtor's gross margins would have been about zero at that point?

Charles C. Pope

No, if we had not written the inventories down in the September quarter the gross margins would have again been negative.

Harry Blount - Lehman Brothers

I see. Okay. Can you help me bridge the gap on Seagate's gross margins going down sequentially 100 to 200 basis points?

Charles C. Pope

Sure, I'll try to do that. If you take a look there's several factors that are going on. One factor is the underutilization that we talked about during the call of ramping up Seagate facilities to increase volume but not being effectively utilized at this point in time. That's under 1% of the gross margin decline. I estimated that at one time and it was 70 basis points of that decline.

If you take a look at another piece of it, we have a higher percentage of our products in the September quarter being consumer electronics gaming units which carry gross margins that are less than the Company average. That's 30 to 50 basis points, and then the rest of it is just continuing to see an aggressive pricing environment that we saw during the June quarter.

Harry Blount - Lehman Brothers

Also trying to bridge the guidance you gave at the Analyst Day to full year guidance for fiscal '07, if memory serves, the 10% tax rate that you're talking about now, I think that's different than what you were talking about at the Analyst Day; is that correct?

Charles C. Pope

Well, at the Analyst Day I used the same 5% estimate that I used through fiscal 2006 and it indicated that we really had not had an opportunity to look at how we might integrate Maxtor and what effect that might have on the ongoing tax rate. We're still in the process of doing that. As we take a look at it we see that there's some decisions that we might be better off making that could have the impact of increasing our tax rate in the short term but giving us a better long-term optimized tax rate. So we still have some decisions that we need to make in that arena between now and the end of September.

Harry Blount - Lehman Brothers

Last question and I'll cede the floor, is coming back to the jump up in finished goods inventory. It's still much higher than I would like to see, so could you help us a little bit with the composition of finished goods in terms of how much of that is demand-related that you held on to, because demand was weaker than expected versus building to bridge transitions? Thanks.

Charles C. Pope

Why don't I have Dave answer that?

Dave Wickersham

The vast majority of it was finished goods that we had positioned for upside that frankly did not materialize and we did not have the opportunity to shut that off. So the vast majority again was related to softness in demand and to some extent positioning for July. But frankly really for upside it did not materialize.

To a much lesser extent there was some mix changes, lower mix at the end of the quarter, that resulted in some of those finished goods even being a higher capacity configuration than what we normally carry.

Operator

Your next question comes from Laura Conigliaro - Goldman Sachs.

Laura Conigliaro - Goldman Sachs

Yes, a few questions. Maybe you can go to over the specifics of exactly what changed point by point since the Analyst Day in June to cause you to change your fiscal '07 earnings expectations by about $0.20, even though you're leaving revenue targets unchanged? Is it primarily pricing? I know you said that you're accelerating the cut over to Maxtor but some of that underutilization was expected and I would assume that the CE business also was expected in the September quarter, so it really comes down to a little bit of the cutover in pricing.

Also, if you can comment on that, it seems like most of the variance in your fiscal '07 earnings targets come in at the September quarter. First of all, is this correct? Second, what has happened in your core business with the acquisition or in a macro environment to make you so much more conservative? Then I have a third question after those two.

Charles C. Pope

Let me start off with the backside, because I think that responding to Harry's question really talked about the factors relative to the September quarter and the 21% to 22% gross margin and what that impact was.

On the Analyst Day, if I remember correctly and I'll try not to sound defensive as answer this, I went to great lengths to indicate that that what we were presenting was a model and that it did not include the impact of any dilution or anything else that we were going through. In fact, I got chided a little bit by a few people for repeating that it was a model, frequently.

So as I tend to look at it, really I do think we have a little more dilution in the first half of the year than what I was anticipating at the June Analyst Day. If we sat and looked at the overhead drag that is associated with the Maxtor ramp-down and then us ramping capacity up to transition the products, there is more dilution than I had expected.

But then also in the first half of the year we're also seeing a little more aggressive pricing than I had anticipated also. Those are the two biggest changes, but the dilution was always expected in the first half of the year and then to have a very strong back half. That’s really what's reflected.

As you sit and look at what we're modeling while we've only given September quarter guidance and annual guidance, it shows meaningful improvement from September to December, but then also a large step-up again in the March quarter and then flattening out in the June quarter so that it does show continuing improvement as we go through the Maxtor transition and get out of under utilized capacity and have some of the new product introductions.

I think I may have missed one of your points.

Laura Conigliaro - Goldman Sachs

I'm not sure which one, I know there was one. I'll get back to it. Your September quarter rev targets are up only 5% to 11% sequentially with a full quarter of Maxtor versus only six weeks in the June quarter, which is less than what we've seen in the past on a standalone basis in the September quarter.

So again, it's really more the standalone business that seems to be somewhat perplexing. It feels like there's a real demand statement being made here too.

Charles C. Pope

Brian, perhaps it would be good for you to address the revenue side.

Brian Dexheimer

Let me give you a little color on what we expect in the September quarter. At this point we're not expecting to see more than about 7% or 8% total unit growth across the entire market. Now, some segments we think will grow faster than others namely consumer electronics and notebooks should be ahead of that rate but we do expect to see relatively minor increases in the pure desktop space. As I noted earlier, the Enterprise to be flat to maybe slightly down on a unit basis. So if we're only going see 7% or 8% unit growth sequentially depending on what price erosion is, it's going to give us a relatively moderate outlook on the base revenue.

So I think that may be what you're trying to get at, and I think given the demand environment we see in front of us right now, that's the best case scenario that we can put together as we look into the September quarter.

Operator

Your next question comes from Keith Bachman with Banc of America.

Keith Bachman - Banc of America

I wanted to touch on a couple of things, to follow Laura, if I could. I did not catch your comment on what you expect in the desktop in the September quarter. Then, also related, what is your sense on -- when you said enterprise is flat to down, that surprised me as well. Could you just add a little color? Then I have a follow-up, please.

Brian Dexheimer

Desktop will be slightly below that 7% or 8%, is what our current expectation is. I think the way to think about that is the transition to notebooks. A lot of the growth you would normally see in the sequential quarter from June to September, as time moves on and the successive years move on, we are seeing more of that growth go to the notebook side.

We do think notebook is going to grow 15% to 20% sequentially but correspondingly, you will not see that kind of growth in the desktop space. We are in the mid-single digits sequentially for June to September on desktop.

On enterprise, I do not want to overstate that one too much. The industry has been quite strong for several quarters in a row. All I am trying to reflect is the fact that for three quarters in a row, we have seen demand be relatively flat on a unit basis, so somewhere between -- let's call it 6.5 million and 6.8 million units a quarter in a classic, mission-critical space, that is sort of the range we see it again -- no great changes.

We have been through seasonality periods in this past year and it does not appear that seasonality is having a big effect on the mission-critical space, so we are just setting our expectations around that.

I do not think there is anymore insight to add for you than that.

Keith Bachman - Banc of America

On the gross margin side, if I go through the various forces that impacted the gross margin commentary around the September quarter for the Seagate standalone business, it seems like most of those are permanent, or at least in this pricing environment would be permanent. Rather, you may have some improvements in the utilization rates, which I think, Charles, you said would maybe move up 70 basis points or so.

Why aren't some of those things -- why won't Seagate be living with those things on a more permanent basis? I have one more, and then I will cede the floor.

William D. Watkins

We got a couple of things here. First, as we said, as we get better utilization of our manufacturing capacity, we will get cost reductions there.

Second point is we actually have a slew of new products, some of which are coming out that have nothing to do but cost reductions, where we think that, with these new products, especially in the desktop and the low-end of the desktop, these new cost-reduction products will again get us back to a better margin in that space.

Then, obviously, the access that we have now to the 1.8 market, later in the year will give us an opportunity to get a better gross margin.

Keith Bachman - Banc of America

So, in other words, would you expect a material increase in gross margin in the December quarter?

William D. Watkins

We would expect in the back-half of the year. I think as we had stated…

Keith Bachman - Banc of America

Well, September is in the back-half of the year, too.

William D. Watkins

Well, for our fiscal year. We would look forward to expand the March-June quarter.

Keith Bachman - Banc of America

Final one I have then is on the $1.3 billion in cap-ex. As I recall, that was a consistent number. Could you just confirm that for us?

Charles C. Pope

That is a consistent number.

Operator

Your next question comes from Sherri Scribner with Deutsche Bank.

Sherri Scribner - Deutsche Bank

Thank you. I just wanted to go a little bit into some of the things you excluded from the number. It looks like, if I look at it, in the non-GAAP number, you are excluding $17 million of stock-based compensation. Is that typical stock compensation that you would normally see, or is that something related to the Maxtor deal?

Charles C. Pope

That is typical. During 2006, since that was our first year to incorporate FAS-123R, we had always given our guidance excluding the stock compensation, and so that was the comparable number to what we have given in each of the previous quarters.

I should note that in our guidance for 2007, we in fact included the stock compensation, because now we have year-over-year comparability on that.

Sherri Scribner - Deutsche Bank

So if I include that number, it looks like the number is not $0.30, it is more like $0.27 including the stock option compensation. Is that right?

Charles C. Pope

I will trust your math.

Sherri Scribner - Deutsche Bank

Okay, and then Brian, when you talked about the 3.4 million PVR drive, does that include Maxtor, and does that include a full quarter of Maxtor, or is that half a quarter of Maxtor?

Brian Dexheimer

It is full quarter of Maxtor.

Sherri Scribner - Deutsche Bank

Do you know what the number is with just six weeks?

Brian Dexheimer

No, I do not, not off the top of my head.

Sherri Scribner - Deutsche Bank

What was the X-Box number, the 2.5 inch CE?

Brian Dexheimer

We have not recorded that separately, but you can kind of get there. I gave you the 1-inch number and the DVR numbers and the total CE numbers, so the math is all there.

Sherri Scribner - Deutsche Bank

Right, okay. That is it. Thank you.

Operator

Your next question comes from Mark Moskowitz with JP Morgan.

Mark Moskowitz - JP Morgan

Thank you. Just a few questions, if I may. First, I want to get back to the inventory build on the finished goods side, if I could. Can you give us a little more color in terms of what the higher capacity mix was that you were planning for up-side on but did not get? Is that for desktop class drives for PC’s or for PVR DVR’s?

Dave Wickersham

Mark, this is Dave, let me take that, just to clarify. The up-side that we anticipated were both on the desktop and the notebook side, so it was a combination of the two segments, and what I meant was that at the end of the quarter, we saw a higher percentage of very low capacity drives, demand for very low capacity drives. Some of the richer mix that we carried in inventory was for the higher capacity desktop and PVR DVR drives.

Mark Moskowitz - JP Morgan

Dave, as follow-up, how should we think about that change going into the September quarter? Is that a function more of what is going on in PCs in terms of a price war where they are trying to save any dollars they can, so they are shipping lower capacity drives, or is that a function more of your competition coming at you with more aggressive pricing from a disc drive perspective?

Dave Wickersham

Mark, I guess I will simplify it and say it is on the inventory turn and the impact of Seagate perspective. We had a lot of variables going on in terms of positioning for potential share shift for Maxtor, but at the end of the day, we did not react quickly enough to reductions in demand.

Those are some of the changes we made, both in terms of process and executive changes and focus going forward.

The other thing I would like to comment on is, as you think about this going forward, Charles mentioned 12 to 14 turnover performance going forward. The difference between those two numbers is simply given the increase in the fuel charges for air shipments, we are looking at where it makes sense to, where we have capacity, there are certainly a large number of drives that we can now afford to use ocean shipment.

To the extent we in a quarter can use those ocean shipments like we expect to do this quarter, our turns will be close to 12 per quarter. If in a quarter where we do not have the ability to use ocean shipments, it will be closer to 14.

Mark Moskowitz - JP Morgan

Just to try to paraphrase, so should we think about an appetite change here from a capacity perspective or not, from the perspective of the PC OEM’s on the capacity side?

Brian Dexheimer

I think the reality is that in the desktop space, we see, and it has been pretty consistent, 50% to 60% of the demand of the pure desktop OEM’s is going to be in that single-disc space. Markedly, right now, it is 80-gigabyte and below fits that parameter.

That is not a change from where it has been historically, so I would not want you to read that we have seen a fundamental shift in PC demand here. I think what we have here is a disconnect between planning and actuals that is relatively unique to Seagate.

Mark Moskowitz - JP Morgan

Thanks for that clarity there. Then I have a question for Charles, getting back to the dilution for the September quarter. I do not want to get too cute here with my loaded question, but at least in my meager model, I was looking for about $0.17 to $0.18 dilution versus the standalone operations, and other folks were plus or minus that.

It looks like your dilution is going to be significantly above what I was expecting, and you are still telegraphing a tailing off of that rather quickly, once you get the ramp down in Maxtor and the ramp up in the Seagate aspects.

Getting back to Laura’s question, can you give us a sense in terms of how we should think of this December quarter in terms of that trailing off? How much of it is still going to be there from pricing versus the integration of Maxtor?

Charles C. Pope

Without going too far down the road, I would expect somewhere between 100 and 150 basis point improvement in the December quarter. Then, the bigger improvements would be in the back-half of our fiscal year, as we see some of the newer cost-optimized products coming out because, as was said earlier by someone on the call, the pricing aspect is not something you get back. The factory under-utilization you can get back, and some of the mix issues where gaming and other, those go away, depending on seasonality, but the pricing does not go way.

We would expect to see something between 100 and 150 basis point improvement in December, basically from asset utilization. Then, as we roll out the cost-optimized products during the year, we feel like we can be strongly back in the model that we have presented historically.

Mark Moskowitz - JP Morgan

Then, just lastly before I cede the floor, I want to get a sense of where you are internally with respect to evaluating your manufacturing yields on some of your advanced technologies, in terms of 160-LMR and the 80-gig PMR, if you could.

Dave Wickersham

Let me take that one. Suffice it to say that both in the case of a longitudinal yield, as well as what we are seeing on perpendicular, we are at or above what we expected in our plan.

Mark Moskowitz - JP Morgan

Thank you.

Operator

Your next question comes from Steven Fox with Merrill Lynch.

Steven Fox - Merrill Lynch

Hi, two questions. First of all, can you give anymore commentary around how you would proceed with the stock buyback, besides obviously you are going to be opportunistic, but is there a consistent plan you plan to use over the next couple of years?

Charles C. Pope

No, I do not think I can give much more color. I would expect to utilize the tools available to us -- 10B51's and other types of tools available to us, but it would more than likely be opportunistic versus a tender, or other type of mechanisms that are available.

Steven Fox - Merrill Lynch

Secondly, I am not quite sure I am clear why, when you look out the next couple of quarters, you are more optimistic about the competitive environment, since it surprised you negatively. It sounds like it is still going to be marginally worse this quarter.

Is there something that you see over the next couple of quarters that will straighten that out, besides just higher unit volumes? What else would we be factoring in there to see pricing ease?

Charles C. Pope

Actually, as I said earlier, we are continuing the competitive pricing that we came out with in June. We actually in our plan are assuming that what happened in June will continue throughout this year. Again, we think on the competitive front, it is going to be very aggressive.

What our plan then is obviously our ability to bring new products that have lower cost structure. We think that will obviously help, and do that faster than the price drops are.

The second point is again, given our capacity, or utilization for capacity, and through the Maxtor acquisition completed, that again gives us the ability to go to a lower cost structure. Obviously, the new markets that we are going to start to see in the 1.8-inch at the end of the year.

Again, I think we look at the competitive factors right now and we think basically in our planning, they are going to be as aggressive over the next four quarters as they were in June. Assuming that, then we are going the take control of our destiny with product cost reductions and utilization.

Steven Fox - Merrill Lynch

Then lastly, on the inventories versus the gross margin -- are you assuming there is some low utilization in this quarter as you work off some excess inventories? How is the utilization going to be affected by the higher inventories at the end of last quarter?

Dave Wickersham

As Charles mentioned, for this quarter we are going to see under-utilization, particularly as we transition out of Maxtor Singapore facility and start to ramp both Maxtor and Seagate in Suzhou, so there is an impact in the September quarter for under-utilization, and Charles talked about that earlier.

Steven Fox - Merrill Lynch

So that includes the inventory impact from last quarter?

Dave Wickersham

Correct.

Charles C. Pope

It really does, because it is all wrapped up in that transition. If you sit and look at Seagate's products, we are continuing the transition to Maxtor, so we are not having to really slow down Seagate production in order to hit the inventory levels.

The transition is taking care of that, so it is the natural ramp-down of Maxtor and ramp-up of Seagate.

Steven Fox - Merrill Lynch

Got it. Thank you.

Operator

Your next question comes from Kevin Hunt with Thomas Weisel Partners.

Kevin Hunt - Thomas Weisel Partners

I have a few questions. I did not hear you say the gross margin target for the full '07 year, so if you could give us that.

Then also, at the analyst day, you had given some kind of fiscal ’08 type of numbers. Any substantial change to the thinking there? It does sound like you are for the most part saying that most of these decreases from '07 are in the first-half of the year. Then I have a follow-up.

Charles C. Pope

If memory serves me correctly, the average for the year is 23% to 24% in the fiscal '07. If you sat and looked at how the Q3, Q4 roll into fiscal '08, it would be very consistent with what the preview was of what the fiscal '08 opportunity was that was presented at the analyst day.

William D. Watkins

Again, I guess the other issue would be, can our competitors sustain this sort of continued price reduction? You know, you look at some of the results of some of our competitors already for June, and my belief is they will not continue that for the next two years.

Kevin Hunt - Thomas Weisel Partners

That was actually my follow-up question. Let me play the other side here, and a lot of the other people asking questions. The June quarter is always your worst pricing quarter. You also had pretty clear land grab, if you will, from your competitors trying to get some of that Maxtor market share, and you had clearly end-of-life in products that are going on now, which is obviously, I would imagine, impacting pricing across the industry.

All those things actually do go away. Why would you expect pricing to stay as aggressive this quarter, given we are going to seasonally stronger periods of the year?

William D. Watkins

Again, first, there was no reason to do what they did last quarter, so it is hard for me to assume.

I do believe some people, profitability is not their concern, and looking obviously at some of the results, you can see that.

Again, I do not believe people are going to do it for two years, but I think it is prudent for us to assume, and we need to prepare ourselves internally at Seagate to be able to meet these cost reductions on a quarter by quarter basis.

Kevin Hunt - Thomas Weisel Partners

One final thing on the share buyback. If you just look at your cash on hand and projected free cash flow, you pretty much get to around $2.5 billion. What expectation will we have that you would do all that? Or would you even consider borrowing money to do share buybacks?

William D. Watkins

As we said, we would look at a number of different financing alternatives, including alternatives to just using cash on hand. Those plans are not in place. As they materialize, we will get back with everyone as to what they are.

Operator

Your next question comes from Rich Kugele with Needham & Company.

Rich Kugele - Needham & Company

Thank you. Just a couple real quick ones.

First, Charles, in terms of the buyback, is this something you actually, if you wanted to, could start tomorrow?

Then secondly, more conceptually about product trips. Historically, players were able to -- whoever was able to get to the next aerial density point first was afforded extra margin, extra profitability, and also a buffer to prevent other competitors who were just going to try and be price aggressive to keep their share.

You had a buffer there on a gross margin side. This does not seem to be the case this time on the 160, and I am just interested as to if that is true and why.

Charles C. Pope

To be honest, on the cost, what is interesting about what is going on, a lot of the pressure is at the 80-gigabyte desktop and below. Actually, one specific part of the 250-gigabyte market, but it is very specific to low-end desktop.

A little bit in the notebook, but that is more of an expected price drop, but it has been very aggressive at these 80-gigabytes and below type markets, which is basically the highest volume part too, so the market share grab for that makes us kind of curious why people want to grab market share at products they cannot make money on.

Dave Wickersham

Rich, to be explicit in answering that question, we have actually had some of the margin lift in the 160. We had expected six months ago to see some plateau-ing of the price reductions in the 80-gigabyte and below capacity points. There has not been that plateau-ing at all. In fact, in the last quarter we saw some accelerated price erosions in that space.

I think your analysis is still basically intact, but it is being offset by some other capacity points and everything.

Back to the share repurchase, I guess in about three days, we typically have 48 to 72 hours to allow markets to digest our news and everything, so theoretically in 72 hours, I could be in the market on the share repurchase, if we chose to.

Rich Kugele - Needham & Company

Then just lastly, Dave, regarding media, you had commented that you are now talking about another Singapore facility. I guess, for lack of a better name, we will just call it Woodlands III or something. Do you still expect that facility to be online in the December '07 timeframe? Then it will be 2008 before you are in this 10% to 15% supply mode?

Dave Wickersham

First on the timing -- and I think Woodlands III is appropriate, given that is one of the reasons we chose it, was to take advantage of some of the synergy and the resources and the talent that we have in Singapore, so thanks for naming that, Rich, it is appropriate.

Timing-wise, what you said also is accurate. We do not anticipate having any production before December of '07. What I said earlier, I referred to sometime in the first-half of the calendar year it would be qualified and in production.

Without pinning me down too specifically, it again will not be before the end of the calendar year, because we have both the ability to continue to add capacity in Woodlands II, both the third and fourth floor, and then with our external partners, we have it covered. We do not need to do anything earlier. First half of calendar '08 is appropriate.

As far as our model in terms of the percentage of external, we continue to look at 10% to 15% is what we believe is appropriate. We are at the high-end of that, just in the June quarter. Looking forward, and for the next couple of years, we continue to look at 10% to 15% on the outside.

Rich Kugele - Needham & Company

The number of tools that you took over from Maxtor of the older 250B’s, do you anticipate rolling all of them into Woodlands III? Or do you think they will be kind of floors? I would imagine the facility will look a lot like Woodlands II.

William D. Watkins

Right. The first question, the answer is yes, we do at this point in time plan on moving all of that sputtering equipment eventually to Singapore. Right now, our plan is that we would not move that into the Woodlands II but would move that into Woodlands III.

Operator

Your next question comes from Mark Miller with Brean Murray, Carret & Company.

Mark Miller - Brean Murray, Carret & Company

I would like to follow-up on what Rich was just talking about. Is there a possibility that you might be retrofitting some of your MP3 decoders for Woodlands III?

William D. Watkins

That is not the plan. Right now, the plan is that we would maintain capacity for the foreseeable future, exactly the capacity it is at. Then, all of the future expansion would be in Woodlands II and then eventually moving the Max media equipment into Woodlands III.

Mark Miller - Brean Murray, Carret & Company

Okay. Shifting gears here, no one talked about that there is some concern about a slow-down at the end of year. You are talking about a 7% or 8% increase in units. That seems to be in the middle of the range. That is not great, that is not terrible. Is there anything now that you did not see three months ago about maybe lowering your unit projections for the second-half of this calendar year?

Brian Dexheimer

Just as to margins, the answer is no, we do not see anything different. We would be accused of having our head in the sand if we did not pay attention to some of the announcements of some of our customers and other technology providers here in the last several weeks.

To some extent, we are reacting to that and believe that they have as good, or maybe in some cases, a better view of the market place, so we are trying to act accordingly as we put our plans together.

I would say, in terms of fundamental shifts, the answer is no.

Mark Miller - Brean Murray, Carret & Company

Finally, is the reduction of Maxtor inventory following your plan? Are you ahead of that or behind that? How is that going in terms of winding down their inventory?

William D. Watkins

Mark, the first piece as far as transitioning to Seagate products, as we mentioned from a build perspective, we are significantly ahead of plan. In terms of winding down the inventory, likewise. We hope to have that completed by the end of this calendar year.

Mark Miller - Brean Murray, Carret & Company

Thank you.

William D. Watkins

Derek, let’s take one more question, okay?

Operator

Yes, sir. Your final question comes from Katie Huberty with Morgan Stanley.

Katie Huberty - Morgan Stanley

Thanks, guys. Dave, you commented that glass would be tight through September. Does that mean we could see some loosening of supply as we go into year-end?

Dave Wickersham

On glass, what we looked at is just the seasonality that we anticipate reductions in March with the planned capacity adds. We think it is tight all through December of this year, and then, based on our predicted capacity from an industry standpoint, we saw some, I will call it, better utilization numbers beginning in March.

Katie Huberty - Morgan Stanley

How far along are you in customer qualifications on the 1.8-inch drive?

Dave Wickersham

We have not started. The 1.8-inch, as mentioned earlier, the initial shipments for volume production will be at the end of this calendar year.

Katie Huberty - Morgan Stanley

Does that mean we could see product with your 1.8-inch drives by December, or does that mean 2007?

Dave Wickersham

That would mean 2007. You would begin to see some benefit of that in the March quarter of 2007.

William D. Watkins

All right. I think that concludes our call. Thank you for joining us today and we look forward to speaking to you next quarter. Thank you.

Operator

This concludes the Seagate Technologies fiscal fourth quarter and year-end 2006 financial results conference call. You may now disconnect.

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Source: Seagate Technology Q4 2006 Earnings Conference Call Transcript (STX)
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