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Western Digital Corporation (NASDAQ:WDC)

F3Q10 Earnings Call

April 22, 2010 5:00 PM ET

Executives

Bob Blair – VP, IR

John Coyne – President and CEO

Timothy Leyden – EVP and CFO

Analysts

Steven Fox – CLSA

Rich Kugele – Needham

Sherri Scribner – Deutsche Bank

Ben Reitzes – Barclays

Ananda Baruah – Brean Murray

Keith Bachman – Bank of Montreal

Mark Moskowitz – JPMC

Aaron Rakers – Stifel Nicolaus

Kevin Hunt – Hapoalim Securities

Jason Nolan – Robert Baird

David Bailey – Goldman Sachs

Robert Cihra – Caris & Company

Kaushik Roy – Wedbush

Nahal Troksey – Technology Insight Research

Operator

Good afternoon and thank you for standing by. Welcome to Western Digital’s Third Quarter Financial Results for Fiscal Year 2010. Presently all participants are in a listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions)

As a reminder this call is being recorded, now I’ll turn the call over to Mr. Bob Blair. You may begin.

Bob Blair

Thank you. I’d like to mention that we will be making forward-looking statements in our comments and in response to your questions concerning industry inventory, pricing and demand, our position in the industry, the impact of our entry into the traditional enterprise market, our investments and technology in capacity, our response to customer needs in existing and new markets, our expected capital expenditures, depreciation and amortization and tax rate for fiscal 2010, our share repurchase plans, our financial results, expectations for the June quarter including revenue, gross margin, expenses, tax rate, share count and earnings per share and the impact of the European air traffic disruptions.

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 January 29, 2010. 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 we make today are still valid.

I also want to note that copies of today’s remarks from the call will be available on the investor section of Western Digital’s website immediately following the conclusion of this call.

I will now turn the call over John Coyne, President and Chief Executive Officer.

John Coyne

Thanks Bob. Good afternoon and thank you joining us today. Overall demand for hard drives in the March quarter was stronger than we anticipated at 163 million units. As we saw a sequential industry time, grow 2% in contrast to a typical seasonal decline of five to 7%. This adds support to the growing body of evidence that in the midst of significant economic uncertainty over the last 12 months, the creation, transmission, consumption and storage of digital content has become much more pervasive in our lives than anyone had previously appreciated.

Over the last year, we have seen increasing levels of demand for high capacity cost effective storage. We believe this demand is at core driven by the ubiquitous role of digital content in every day life. Spared in the consumer segment by increasingly versatile and powerful handheld devices and PCs with new and attractive price points, and in the commercial sector by a drive for growth and efficiency especially in developing markets.

Industry inventory, OEM, distribution and retail combined remains at just over two weeks of sales, reflecting continued strong demand, continuing spotty constraints in the industry supply chain and continued industry discipline in managing the supply demand dynamic. For more than eight years now WD has generated sustained profitable growth and outstanding returns for our shareholders by consistently executing to our customer centric business strategy with passion, focus and perseverance.

Customers continued to demonstrate a strong preference for WD products in the March quarter. And this enabled us to again post record unit shipments and revenue with strong profitability. We’re very pleased that in such a dynamic environment we again helped our customers to succeed in their markets by responding quickly to their changing requirements for volume and mix. A relatively moderate pricing environment combined with our cross segment agility and our focus on cost and efficiency, once again enabled gross margins above the high end of our model range.

Asset management remained crisp resulting in record cash generation. We continued to innovate and lead and multiple markets based on the significant investments we have made in people, products, processes, capacity and technology over the last few years with several recent notable product achievements.

In our client business, we began volume shipment of the industries highest aerial density, Standard 2-Disk, 2.5 inch drive, the 750 gigabyte WD Scorpio Blue Hard Drive for mainstream notebook computers. We doubled the capacity of the WD VelociRaptor, the worlds fastest SATA hard drive to 600 gigabytes delivering high performance and capacity for both enthusiast and enterprise customers.

We launched our first consumer oriented solid state drive family, the WD SiliconEdge Blue in capacities up to 256 gigabytes. In our branded products business, this week we introduced a new app for the iPhone called WD Photos, a photo viewer that gives our customers quick access to all their photos stored on their My Book World Edition or WD Share Space network drives from their iPhone or iPod Touch. Also specifically designed for Mac users, we added a new high speed My Passport Studio Family and a one terabyte Passport SE to our range of popular hard drives.

In the CE market, we launched the WD AV-25 range of 2.5 inch SATA drives engineered specifically for demanding always on multimedia streaming applications such as DVR and surveillance. We also introduced the My Passport AV media drive family optimized for video storage and playback and designed to work directly with select Sony camcorders, Blu-ray players and other popular media players.

In the embedded market, we introduced the WD silicon drive in 1X family of (SLZ) based solid-state drives with capacities up to 128 gigabytes delivering high performance and high reliability for embedded system OEM applications. Our participation in the traditional enterprise market, part of our portfolio diversification and expansion strategy which started with the shipment of our 2.5 inch 10K SAS product line beginning in early November is preceding inline with our measured multiyear plan to establish solid experience and a representative share in this important market segment.

We remain committed to continued investment in the development of our people, technology, product breadth and appropriate capacity while enhancing the advantage business model we have developed over the last several years. In responding to our customers needs and earning their business in the fastest growing markets we provide a critical combination of quality and reliability, portfolio breadth, technology and product availability under pinned by our low cost model, our vertical integration, our rapid inventory turns and our balance sheet strength.

We believe this WD focus represents a sustainable advantage as we continue to respond to customer needs in our existing markets and as move into new markets for WD. We believe that calendar year 2010 will be an extremely strong year for storage and we’re excited about the opportunity to continue to satisfy customer requirements to meet this demand.

Before I pass the call to Tim Leyden, I want to mention that tomorrow Friday April 23, WD will mark its 40th Anniversary spending four decades of innovation, passion, perseverance and success. I want to acknowledge the contributions of our thousands of employees our customers and suppliers in helping us every step of the way. In particular I want to acknowledge the team’s outstanding execution in ceasing the customer opportunities that emerge throughout the most recent quarter which has further strengthened WD in our long term mission of generating sustained profitable growth. Tim?

Timothy Leyden

As John noticed, the overall market was stronger than anticipated during the March quarter. Once again our agile business model allowed us to scale up our supply and adjust our mix to respond to the demand in the more robust segments of the market. This combined with moderate price declines and our low cost focus contributed to growth margin exceeding the upper threshold of all model range and our implied guidance.

Revenue for our third fiscal quarter was $2.6 billion, up 66% from the prior year and 1% sequentially. Hard drive shipments totaled 51.1 million units, up 62% from the prior year period and 3% sequentially. Revenue from sales of WD TV Media Players and solid-state drives totaled approximately $46 million, up 48% from the prior year and essentially flat with the December quarter. Average hard drive selling price was approximately $51 per unit, up $1 from the year ago quarter and down $1 from the December quarter. Growth in emerging markets and recovering commercial segment let the desktop growth being stronger than expected.

Pricing remains stable as a result of the unexpectedly strong demand. We shipped 19.8 million mobile drives in the March quarter, compared to 10.1 in the year ago quarter and 21.2 million in the December quarter. We reduced our mobile volumes in response to the expected seasonality in branded products and to balance the effect of competitors in the mobile market, who diverted their capacity from the gaming segment.

During the March quarter, we shipped 4.6 million drives into the DVR market compared to 3.5 million in the year ago quarter and 4.1 million in the December quarter. Our strong product line up led to revenue gains in both our OEM and channel businesses. Revenue from sales of our branded products including WD TV was $467 million, up 36% from $343 million from the year ago quarter and down 18% sequentially from $569 million in the December quarter, reflecting the typical seasonality of the retail market.

On the enterprise front there was strong sequential demand for our near line storage products and our SAS products are making progress towards our multiyear plan to gain a representative share of the traditional enterprise market. Moving onto our sales channels and geographic results. Revenue by channel was 49% OEM, 33% distribution and 18% branded products in the March quarter, compared with 48%, 30%, and 22% in both the year ago and December quarters.

Relative to the geographic lateral revenue, the Asian market showed continued strength increasing to 52% of revenue in the March quarter from 46% in the year ago quarter and 50% in the December quarter. The Americas and European regions performed as expected at 24% for the Americas and 24% for Europe in the March quarter, compared to 26% and 28% in the year ago quarter and 25% and 25% in the December quarter.

Our gross margin for the quarter was 25.2% up from 15.9% in the year ago quarter and down from 26.2% in the December quarter. Total on the SG&A spending was $224 million or 8.5% of revenue. This compares with $174 million or 10.9% of revenue in the year ago quarter and $214 million or 8.2% of revenue in the December quarter. Our R&D investment is focused on broadening our product offerings in response to customer needs and developing technologies in order to maintain our market competitiveness.

Operating income was $441 million or 16.7% of revenue. This compares with $61 million or 3.8% of revenue in the year ago quarter and $473 million or 18.1% of revenue in the December quarter. Interest and other non-operating expenses were approximately $1 million. Tax expense for the March quarter was $40 million a 9.1% of free tax income, within our model range of seven to 10%. Our cash tax rate is expected to be between one and 2% for the fiscal year.

Our net income totaled $400 million or $1.71 per share. This compares with $50 million or $0.22 per share and $429 million or $1.85 per share in the year ago and December quarters respectively. Turning to the balance sheet for the March quarter, our cash conversion cycle was a negative three days, this consisted of 43 days of receivables, 23 days of inventory or 16 turns and 69 days of payables. We generated $588 in cash flow from operations.

Capital expenditures were $177 million and depreciation and amortization totaled $128 million. We also made our fourth quarterly debt repayment installments of $19 million, reducing our debt balance to $425 million. Cash and cash equivalents increased by $391 million ending at $2.826 billion.

On our January call, we updated our capital expenditure forecast for fiscal 2010 to be between $650 and $750 million. We now expect to be at the high end of that range as we put investments in place to support the expected strength in the market as well as continued customer preference for WD products. Depreciation and amortization for fiscal 2010 is expected to be about $520 million. As we have consistently demonstrated in the past, we remained focused on supply demand equilibrium and ready to adjust capacity utilization in accordance with market needs.

Our strong cash position allows us to maintain an adequate buffer in times of continued global economic uncertainty are still providing the operational flexibility to secure component supply, increase our investments in advanced technology and expand our product breadth through pursuing internal and external opportunities. We have $466 million remaining in our stock repurchase authorization as we continue to evaluate the merits of further repurchases against the internal and external investment alternatives.

Now I will discuss our expectations for the fourth quarter of our fiscal year 2010. Market indicators and customer inputs continued to strengthen our beliefs that demand for hard drives will be strong throughout the calendar year and beyond. WD remains ideally positioned to service these market needs to draw the existing customer and supplier relationships, product line up, operational agility, technology and financial resources.

Historically, June quarter demand has been slight to moderately down when compared to March volumes and we expect that seasonality pattern to continue. Consequently we are forecasting volumes in the 157 to 162 million unit range. We anticipate that pricing will be competitive or will be rational based on advanced technology deployment, supply demand balance and inventory positions in all channels.

I would note that our outlook is based on an assumption that the con disruption of the European air traffic is short lived and that the economic activity is made up during the balance of the quarter. Accordingly we expect current quarter revenue for WD to be in a range from $2.475 billion to $2.575 billion. R&D and SG&A are expected to total approximately $230 million. Our net interest expense is projected to be about $1 million. We expect our tax rate to be about 9%. We anticipate our share counts to be approximately 236 million. We estimate earnings per share between $1.40 and $1.50 for the June quarter. Bob?

Bob Blair

In the interest of time as we begin the Q&A session. We’d like to ask that you limit yourselves to a total of two questions in your initial turn in the queue. That is your initial question and a single follow-up. Thank you and operator, please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) First question comes from Steven Fox with (DLSA). Your line is open.

Steven Fox – CLSA

Hi good afternoon, can you hear me?

John Coyne

Yes we can.

Steven Fox – CLSA

Okay, just a question on (channel) inventories and your own inventories, I guess inventories are still running fairly lean at two weeks according to you said about three weeks. Those stuffs component inventory and during the quarter. Is it possible to ship more to put the channel at a more comfortable level, why your inventory is building up for example and the channel is staying so lean?

Timothy Leyden

Well first of industry inventory is very healthy. It has stayed pretty much constant from where it was at the December – at the end of December and I’m talking about the manufacturing, component and retail which is just above two weeks of sales run rate. Relative to our own inventory, we’re carrying a little bit more width and components inventory in all that accounts that are shortages. But from an inventory viewpoint overall for WD we still have inventory turns that are in the 16, approximately 16 turns which is still the industry leading turns.

In the channel, which it’s within the normal range of four to six weeks and from the December quarter to this quarter, we’ve reduced all inventory in the channel by about half a week.

Steven Fox – CLSA

Great and then just looking forward to the next quarter, do you think you will need to build a component inventory further to be prepared for the second half ramp or do you think its been a planning down?

Timothy Leyden

Yes, we’ll -- I mean we’ll be building up in order to be able to support customer needs for the back half of the year.

Steven Fox – CLSA

Great, thank you.

Operator

The next question comes from Rich Kugele with Needham. Your line is open.

Rich Kugele – Needham

Thank you. Two questions, one on the DRAM side, some of those players have seen the OEMs de-spec some of the PCs as they’ve exceeded more than 15% of the bomb. That traditionally doesn’t happen in drives and I’m just wondering if the tightness or the expected tightness in the second half, if you think that they could go into using lower capacity drives?

John Coyne

Well I think so far the mix in the marketplace continues to rich and we continue to increase the average gigabyte shift quarter-on-quarter. Now we do believe in the back half of the year demand is going to be robust and seasonally robust and we do believe that the supply chain is going to be stretched in order to support that demand in the event total supply chain supply doesn’t meet total natural demand then typically one solution to that is to mix down somewhat to make the components go further.

Rich Kugele – Needham

Okay, and then separately in terms of the buy back, obviously the cash balance is getting quite large and you have certainly the cash flow to go and buy back far more that just $466 million. Are there any tax implications with using more of your cash balance to buy back stock, given some of it’s probably off shore?

John Coyne

We are intimated in – either options are capability to execute our business operationally or structurally. And however I did outlined the intentions of what we intent to use the cash for. We have an operational buyers as far as that’s concerned. However if we ended up doing a large acquisition in the US and determine that it was going to be funded through cash, we would have to take into the account the location of our cash and as you can imagine quite a bit of the cash that we are building up is building up in foreign location.

Rich Kugele – Needham

Okay, thank you very much.

Operator

Sherri Scribner with Deutsche Bank. Your line is open.

Sherri Scribner – Deutsche Bank

Hi thank you. I wanted to ask about your market share this quarter. Clearly based on Seagate’s reported numbers, you guys out shipped Seagate during the quarter and you’re the number one hard disk drive vendor. You’ve continued to gain share over the past couple of years in the notebook market and I’m just curious what your plans are for gaining shares going forward, now that you are the largest hard drive manufacturer?

John Coyne

Well, Sherri, we were obviously very, very pleased that consistently for the last eight years quarter-on-quarter customers have been expressing preference for the value proposition that WD offers and consequently we have grown share on a consistent basis for the last eight years. And we believe that our technology, our manufacturing capability, our supply chain relationships, our agility, all of those values combined with our product breadth allow us to continue to support our customers growth opportunities in an advantages way.

I think in relation to we yes we this quarter shipped the largest number of units in the industry but that was a long way to go relative to the largest revenue generator in the industry.

Sherri Scribner – Deutsche Bank

Okay, that’s helpful. I’ll stop there, I’m going to circle back. Thank you.

Operator

Next question comes from Ben Reitzes with Barclays. Your line is open.

Ben Reitzes – Barclays

Yes thanks. Could you talk a little bit more about the corporate PC commentary and what you saw in particular in that area and I assume you know it whether its going into corporate or consumer but what you saw in terms of the pickup and what you expect for the rest of the year there, the rest of the calendar year?

John Coyne

Yes we saw commercial strength strongest in emerging economies but also some pickup in commercial primarily represented by desktop in all markets in the world. So yes we do believe we’re seeing the beginnings of re-awakening of corporate purchasing in terms of refreshing systems.

Ben Reitzes – Barclays

And with this reawakening, now telling into something you kind of already talked about but I’d like to hear more. Do you feel like the industry is going to be just tight in the back half of the calendar year or do you feel like the HDD industry actually may not be able to meet the demand that pickups seasonally with the consumer with the reawakening corporate.

John Coyne

Well I think the way we’re modeling the back half of the year, we were looking at a range obviously but if you take the actual for the first quarter, first calendar quarter, you take the low side of our expectations for the second quarter and you model the low end of seasonality which is typically 10% in the third quarter and two or 3% in the fourth quarter, then you would come up with a number somewhere $670 million for the full calendar year.

If you model the actual for March the high end of our expectation for TAM in the

June quarter at 162 and then take a 12 or 13% increase into the third quarter and three to 5% in the fourth quarter, you come to 690. We think that range is highly probable and towards the high end of that range. We are working diligently with our supply base to ensure that WD supports the growth opportunities of our customers in relation to that anticipated market size. There is a risk that it will be hotter than that, given that we’re not only are we seeing the strength we’ve seen in the last 12 months in consumer which has been considerable and above everyone’s expectations, now being augmented by the beginnings of a corporate purchasing cycle.

If I had to bet on which end of that range would come up or to be the high end with possible topside opportunity from a TAM perspective. We’re working with a supply base to support that, its going to be a real stretch, as a result of last years economic recession, the level of capital investment that was made during that period was minimal and we’ve been in catch up mode ever since and supply base for capital equipment is pretty stretched. So even we’re the best one in the world, we’re going to have difficulty as an industry I believe across the entire supply chain in fully reaping the benefits of that opportunity.

Ben Reitzes – Barclays

All right, thanks a lot.

Operator

Next question comes from Ananda Baruah with Brean Murray. Your line is open.

Ananda Baruah – Brean Murray

I guess just sort of to piggyback off of that, what – how should we think about or can you help us think about sort of the moving parts around pricing as we go into the second half of the year, what you think about what you’re seeing on mix right now and maybe if you hit the higher end of that range. Is it possible, to see blended pricing actually mix up as we begin the second half of the year from what the levels are now, what you’re expecting in 2Q?

Timothy Leyden

We’re forecasting for Q4 that the ASP will be flat to down based upon branded seasonality for us and the time being down a bit even if only modestly. But with the prospects of very robust demands, there is a possibility that pricing will be firm.

Ananda Baruah – Brean Murray

Okay, great. I guess firm would mean kind of not down to flat potentially increasing.

Timothy Leyden

Yes, I mean segment mix, all of this comes into it, but yes, I mean firming and staying pretty constant.

Ananda Baruah – Brean Murray

Okay, thanks. And just if I could follow up on that, can you talk a little bit about what cost save opportunities you might have going into the second half of the year either from the move to single platter or the use of more internal heads, if that really can be bit of a tailwind as you move forward here.

Timothy Leyden

I mean we constantly strive to improve our cost profile on a quarter-over-quarter, week-over-week, day-by-day basis and we will continue that process.

Ananda Baruah – Brean Murray

Could we expect to see something – I mean could something more than typical show up in the second half of the year from the cost save opportunities or is it just sort of would it be more of the sort of the stuff you guys are always doing ongoingly?

Timothy Leyden

I think we've got a pretty good process of blending technologies relative to overall market needs and continuing to drive cost on a quarter-by-quarter basis and we intend to continue along that path.

Operator

Keith Bachman with Bank of Montreal. Your line is open.

Keith Bachman – Bank of Montreal

Hi, good evening. I have two questions as well. As you look at – you talked a lot about the dynamics of the second half of the year from the demand side. Is there any numbers that you could help us think about what you think the industry is setting up from a supply side, from a capacity side?

John Coyne

I think we're probably pretty confident looking across all the different pinch points in the market and there are many that the low end of the range that I outlined is on a track to be supportive. As we move further into the middle to high end of that range, I think we're going to squeak a bit and we're going to have to work hard to accomplish support for those larger numbers.

Keith Bachman – Bank of Montreal

Okay. Then my follow up question to that would be if we can impute what the growth margin is for your June quarter guidance but it seemed like then under that scenario supply/demand that if we looked at second half of the calendar year, the gross margins that we should be thinking about would be more akin to what you just demonstrated in the March quarter. Is that a reasonable line of thinking?

John Coyne

Yes, I mean we're looking at that, as you say with the prospect of increasing demand and the advantages that we have with all vertically integrated mode and improving segment mix and focus on profits by any other players, and we think that there is an opportunity for us to be able to expand that margin if those conditions come true.

Operator

Mark Moskowitz with JPMC. Your line is open.

Mark Moskowitz – JPMC

Yes, thank you, good afternoon, two quick questions. One is just kind of following on the prior question from Keith; as far as the gross margins are concerned, can you give us a sense in terms of your ability to kind of cherry pick the last quarter (inaudible) serving the higher cap and in your quality and your ability to meet volume commitments. Was that higher in the last quarter too versus in the last year and could that only increase going forward just given that some of your peers still have some technology issues?

John Coyne

The larger we get the more difficult it is to cherry pick the market in the sense that as a broad line supplier to all of the major market players – of necessity on our size and scale, we need to support their total business rather than trying to cherry pick their business. Obviously, as you go to smaller players in the business and we knew how to do this very well when we were smaller, you can pick and chose the business you wish to do. But I think at our size and scale there is a certain obligation to broadly support our customers’ businesses. And again back to the tightness we anticipate in the back half of the year, I'm sure we will work with customers in that environment to support their overall needs, which may involve some mixing to generate increased volumes from a restricted component supply.

Mark Moskowitz – JPMC

Thanks, John. The second question revolves around that tightness that you alluded to earlier in response to Ben's question and I appreciate the detail you provided because it does sound – we take what you said and what your competitors see if that is around CapEx, the folks are being quite disciplined and rational. I'm trying to get a sense in terms of if this tightness really does manifest and to sustain in the back half, given WD’s cash position would you be flexible or creative in terms of maybe pulling out cash upfront of some of your suppliers in the supply chain to make sure you have the necessary supply versus your competitors, whether (inaudible) media?

John Coyne

Well, certainly while we don't talk about specific strategies, I think if you take a look back at WD’s progress over the many, many years now. One of our strengths is to provide availability to our customers and in order to do that and in order to provide the kind of responsiveness that we’ve demonstrated in many occasions of unexpected demand and on other occasions of expected robust demand, you have to have a very good relationship with the supply base and we believe we have that and we work very closely with our suppliers to ensure that we have the ability to support our customers and we are doing that as we speak.

Operator

Aaron Rakers with Stifel Nicolaus. Your line is open.

Aaron Rakers – Stifel Nicolaus

Yes thanks, two questions as well, obviously. You know, first on the notebook business, it looks by my math you guys were also down about 7% or so sequentially I guess the question is, do you endorse Seagate’s comment that the overall industry was more or less flat on a sequential basis and if that’s true, who do think is kind of taking share and do you think that you guys recapture share here as we move forward?

John Coyne

I think the 2.5 inch space was roughly flat quarter-over-quarter. As Tim mentioned in his remarks, I mean we diverted some of our builds capacity and supply chain capacity to 3.5 inch where we saw significant strength in demand and that offered a better business opportunity for us in a overall restricted supply situation. So we focused on those areas, which offered us the best return.

As you go down or go to other competitors particularly those who traditionally have serviced the gaming market, which is as heavy demand for 2.5 inch in the back half of the calendar year, to them the business at least attractive to us in the first couple of quarters of the year looks highly attractive relative to gaming.

So typically they divert their seasonally available capacity that was dedicated to gaming in the back half of the year, they diverted it to the low end of the 2.5 mainstream business in the first couple of quarters that would typically be the component supply into the second tier branded external storage box manufacturers and some diversion into notebook support.

Aaron Rakers – Stifel Nicolaus

Okay, that's helpful. And then the follow-up question understanding that you guys – probably it’s too early to look out to fiscal 2011 at the point but any general thoughts on CapEx and in that I believe in this year you guys have like an incremental $200 million spend related to some wafer upgrades going on, do we kind of think about stripping that completely out as we go into fiscal 2011 in terms of your CapEx?

Timothy Leyden

Now that – well, first of all it's too early for us to talk about FY 2011. But the $200 million that you mentioned that's historical in the sense that a couple of years ago we were indicating that it was going to cost us $400 million (and albeit) be able to bring our capability from 6 inch up to 8 inch wafer. We spent close to half of that, a bit less than half of that in order to prove the capability. And then when the downturn came during the course of last year, we postponed that. So that actually has to come in and will be included in the number that we provide next year.

Aaron Rakers – Stifel Nicolaus

So that's not in the 750 just to be clear?

Timothy Leyden

No, it's not.

Operator

Kevin Hunt with Hapoalim Securities. Your line is open.

Kevin Hunt – Hapoalim Securities

Yes, thank you. I just want to follow up on the distribution piece of your business, that you referred to earlier about the channel inventory. Looking at just the growth numbers that you reported in the terms of the mix and this is the fourth quarter in a row where you had fairly substantial better performance of your distribution relative to your OEM and your channel – I mean, I'm sorry, in your retail. And if I kind of just do some of math, it looks like pretty much all of the incremental units you shipped above your guidance level would have gone into the distribution piece of your business this quarter.

So just kind of what – and trying to tie that to your commentary that inventory is lower than it was last quarter and is there something going on there in terms of like the sell through dynamics of WD versus other players in the industry. That’s it and I have another follow-up.

John Coyne

At the beginning of the quarter we did see a shortage of product in the distribution channel. Well, actually what we saw was a significant demand from the distribution channel in the early part of the quarter. We serviced that demand given our ability to mix rapidly into 3.5 inch. We weren't sure at the beginning of the quarter whether that was a (inaudible) statement being stronger than expectation or whether it was a competitive supply statement relative to the spotty supply chain.

It appears that it was a bit of both and then as we got closer to the end of the quarter, we got into March the overall demand strength was maintained but we saw competitive availability improve as we got towards the back half of the quarter. I don’t know if that helped you.

Kevin Hunt – Hapoalim Securities

Okay. And my follow-up was just on the consumer piece where you had – it would seem seemed like again counter seasonal up growth there in that market and I think that was consistent with what Seagate said, and their DVR business as well. So is there something sort of changing in that business, is that sort of picking up or something? What can you tell us about that market?

John Coyne

Yes, we saw strength in that market both in OEM, which is essentially the DVR piece and in the channel, which tends to be more into the surveillance market and we saw lift in both of those markets.

Kevin Hunt – Hapoalim Securities

Is this economy recovery issue or is there something different going on there or what –

John Coyne

Not a 100% sure, but I think it may be related to the recovery pace post recession and the different model there, where essentially that's a lease, large service providers buy the equipment and then the individual consumer essentially leases it over time in the DVR space. And so, yes, I think that DVR market is behaving more like commercial PC than consumer PC. So I think recovery has kind of got a little bit shifted to the right and has distorted seasonal patterns as a result.

Operator

Jason Nolan with Robert Baird. Your line is open.

Jason Nolan – Robert Baird

Yes, thank you. I wanted to go back to the competitive dynamics question, Hitachi had a very strong Q1, also there’s a couple of other players out there. I guess in the past sometimes there's been oversupply if people get too optimistic but given the situation in the market today it seems unlikely anybody would be able to substantially oversupply the market, maybe John or Timothy could comment on that.

Timothy Leyden

Okay, yes, we were encouraged by Hitachi's results and we think it's the level of transparency they providing is a positive for the industry. And we also think that level of transparency will also be beneficial to the investment community as the behavior of the people now hold somewhere close to around 80% of the total market. And so everybody has got the information available to them in order to make their decisions relative to capacity additions and then once they have the capacity additions in place, they have the information available to them relative to capacity utilization.

So we think that’s a positive, we see the benefits of the large vertically integrated players. We it’s being displayed in the results of the three companies and that’s a positive for the industry we believe.

Jason Nolan – Robert Baird

Thank you. Last question for me on inventory. Tim, what would your expectations be at the end of the June quarter for inventory internally to WD or external?

Timothy Leyden

We always operate our inventory metrics in accordance with our model and we strive to stay within our parameters which are 12 to 16 turns, that’s what our inventory model is and there maybe some opportunity for us depending on the strength of demand and what we see at that time to carry some inventory into Q1. But we – but we do that with an abundance of caution, because the fact that we – we want to make sure that we are servicing customer needs, because that’s what they – that’s what really drives the inventory and the supply demand dynamics.

Jason Nolan – Robert Baird

Thank you.

Operator

David Bailey with Goldman Sachs. Your line is open.

David Bailey – Goldman Sachs

Great, thanks. I just had a question on the SSD product you just announced. Can you talk a little bit about how you are differentiating your offerings from the other that are in the market? And what does the quality cycle looks for these products?

John Coyne

I think the – well, there is two distinct markets that we serve with SSD today. The first of those and the ones that we have five years experience in is the embedded market for industrial, aerospace, Netcom and so on. That is very analogous to the traditional enterprise hard drive space, relatively long qual cycles can take up to six months, nine months, long life cycles, multi-year life cycles.

The other product line that we recently announced in the client PC space targeted at that space, at the enthusiast in that space is essentially a consumer oriented product offering, and there is the qual cycle is internal to the WD development process. And that process has been extremely enlightening as it has been – we also included naturally enough.

Competitive product offerings from the market through the same test regime where we have in developing that produce tested thousands, hundreds of systems for hundreds of thousands of hours. And we believe the differentiation of buying a solid state drive from Western Digital is that it is fully compatible with a broad range of systems and will be highly reliable in those applications. We have made some startling observations relative to our competitive testing of market available drives.

David Bailey – Goldman Sachs

Okay. And then on the internal inventory, it was up a little bit more than revenue was up this quarter sequentially; we have heard a lot about the heads and media shortage. Was there anything else that you have built up components that you are seeing some tightness you are trying to offset?

John Coyne

Yes, I think we are seeing – I mean the major components that gets most of the airtime are substrates, media. The – however there are tightness in many other components, pivots, pivot bearings, all semiconductor components, memory. So there are multiple areas in which we are working with supply base partners to ensure that we have the right support for our customers.

David Bailey – Goldman Sachs

Great, thank you.

Operator

Robert Cihra with Caris & Company, your line is open.

Robert Cihra – Caris & Company

Hi, thanks very much. You mentioned that enterprise SAS product is I guess ramping now. Can you give us any more specifics or updates there and what maybe you are thinking about in terms of broadening that lineup? Thanks.

John Coyne

As you know, we announced products, once we are shipping them in volume, so we will continue to do that. Also in the traditional enterprise space, just as we do in all the other market segments we address. What I can tell you is that we have a significant commitment to success in this space that by definition involves a range of products, not just a single product and is a multi-year endeavor.

Robert Cihra – Caris & Company

Okay, and with that mind, if you look at sort of your – the progress to date, can you – I don’t know sort of tell us if you think it’s been better here or worse there, I mean what have you learned so far in that space?

John Coyne

We have learned that it’s moving along pretty much as we would expect it.

Robert Cihra – Caris & Company

Okay, thank you.

Operator

Kaushik Roy with Wedbush, your line is open.

Kaushik Roy – Wedbush

Thank you. Seems like you have used aluminum in 2.5 inch in the past, so I guess my question is, how much flexibility do you have in using aluminum for notebook or 2.5? And then I have a –

John Coyne

Alright, past, present and future, we have – have and we will continue to ship significant volumes of aluminum in all form factors.

Kaushik Roy – Wedbush

So if there is a strength in glass substrate, can we use aluminum for offset or –

John Coyne

There are certain applications in certain segments of the market where glass is either required or desired. And there are other applications and other segments of the market where aluminum is readily accepted and is appropriate to application. And we are – obviously we are producing product with both glass and aluminum and addressing it to the appropriate segments of the market. And it’s one of the ways in which we are addressing potential tightness in the overall supply chain and ensuring that we have good robust product support for our customers.

Kaushik Roy – Wedbush

(Inaudible) Hitachi, their gross margins actually increased in the March quarter from 25% in December to about 29% in March. Can you comment for us the dynamic there, was it all because of better cost or was it something else? Thanks.

John Coyne

Well, you would have to ask Hitachi for the reasons. I think it’s a – I think when you look at the overall increase in transparency and the increased information they provided yesterday, it’s a very impressive recovery story.

And it demonstrates I think clearly, if you look at Hitachi’s product mix model, it’s much closer to the Seagate model than it is to WD’s. If you look at Seagate, you can see they derive somewhere in the between 25% and 30% of revenue from enterprise, all enterprise that includes traditional and near line storage.

You can see that Hitachi probably derives somewhere in the mid-20 to 25% range and WD derives about 10%. So it’s a – an overall business mix thing, plus my earlier comment about the smaller you are, the more appropriate and able you are to pick your products and cherry pick your overall business.

So – but I think a – a superb recovery story there that that just reinforces I think what we and Seagate have been saying to the investment community for several years now that with the proper business model with which at a scale of this opportunity today is a vertically integrated large scale, efficiently run manufacturing operation with measured marketing and failed activity that this is a highly desirable business.

And when we look at the opportunities and the level of content generation that’s going on around us and the demand level for storage, this properly addressed, this is a fantastic business opportunity.

And I think the fact that Hitachi have now opened the Kimono and being more forthcoming with how they are running the business, I think the investment community should be a lot more prepared to give the HDD industry a little more of its due relative to its opportunity provide significant return on investment.

Kaushik Roy – Wedbush

Thank you.

Operator

Next question comes from Nahal Troksey with Technology Insight Research. Your line is open.

Nahal Troksey – Technology Insight Research

Yes, hi guys, a nice quarter. A little bit more of a longer-term question. Can you talk about indicates that supply does not meet demand in the second half, what do you believe is the risk that PP OEMs would mix towards SSDs? And then on the back of that, because you also talked about what you believe would be effect of ramp-up tablets on the hard drive industry?

John Coyne

I think the risk that they would some SSDs is very minimal for two reasons. One, NAND flash supply is going to be even tighter than the supply chain for the – for hard drives based on the success of highly mobile devices that absolutely have to have NAND flash to make them work. And that represents the vast bulk of the demand profile for NAND flash. And when you look at the level of investment that’s been put in to the flash market, it will be very tight through the back half of the year we believe.

Your follow-up relative – also NAND flash does not address the storage requirements of the vast bulk of those devices that traditionally use hard drives. If it did, I guess the only thing we would be selling is single head single platter.

So then on your tablet question, that makes it even more unlikely that there is going to be an SSD migration in the mainstream PC business, and we see tablets similar to net book that it will create yet another category of device which will initially consume created content which must be stored from where, which will drive requirements for near line storage, cloud support. And as we look at the specs of some of the prospective tablets that are coming along, they will also have content generation capability. And we see it all as positive addition to the total infrastructural demand that’s going to drive our business into the future.

Nahal Troksey – Technology Insight Research

Okay. Can I ask a follow-on to that actually?

John Coyne

Sure.

Nahal Troksey – Technology Insight Research

So do you see an opportunity that you would be able to get in the hard drive within any of these tablet PCs?

John Coyne

Certainly, yes.

Nahal Troksey – Technology Insight Research

Does it require a slim line form factor, or can you do what the regular 2.5 inch form factor.

John Coyne

Probably both, but likely it will be slim line.

Nahal Troksey – Technology Insight Research

Okay, very good, thank you.

John Coyne

You’re welcome. Okay, thank you all for joining us today. I look forward to keeping you informed of our progress in the quarters ahead. Thank you.

Operator

Thank you. This does conclude the conference call. You may disconnect at this time. Have a great day.

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