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Western Digital (NASDAQ:WDC)

F3Q 2014 Results Earnings Conference Call

April 30, 2014, 5:00 p.m. ET

Executives

Robert Blair - VP, IR

Stephen Milligan - President and CEO

Timothy Leyden - CFO

Analysts

Aaron Rakers - Stifel

Rich Kugele - Needham & Company

Andrew Nowinski - Piper Jaffray

Rob Cihra - Evercore Partners

Bill Shope - Goldman Sachs

Monica Garg - Pacific Crest Securities

Katie Huberty - Morgan Stanley

Ananda Baruah - Brean Capital

Steven Fox - Cross Research

Keith Bachman - BMO Capital Markets

Amit Daryanani - RBC Capital Markets

Sherri Scribner - Deutsche Bank

Scott Craig - Bank of America Merrill Lynch

Jayson Noland - Robert W. Baird

Nehal Chokshi - Technology Insights Research

Joe Wittine - Longbow Research

Operator

Good afternoon, and thank you for standing by. Welcome to Western Digital's third quarter financial results for fiscal year 2014. [Operator instructions.] Now, I will turn the call over to Mr. Bob Blair. You may begin.

Robert Blair

Thank you. We will be making forward-looking statements in our comments and in response to your questions concerning, among others, our position in the growth of data and storage ecosystem, stabilization of demand in our business, demand trends in the enterprise space, our product offerings and our customers’ responses to our product offerings, and our financial performance, including our financial results and expectations for the June quarter.

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 31, 2014. We undertake no obligation to update our forward-looking statements to reflect new information or events.

In addition, references will be made during the call to non-GAAP financial measures. Reconciliations of the differences between the historical non-GAAP measures we provide during this call to comparable GAAP financial measures are included in the quarterly fact sheet posted in the Investor Relations section of our website.

The forward-looking guidance we provide during this call excludes amortization of intangibles related to the acquisitions of HGST, VeloBit, sTec and Virident; asset impairment and other charges; charges related to litigation; and expense due to the writeoff of debt issuance costs.

Because the amount of these items is not fully known to us at this time, we are unable to provide guidance for, or a reconciliation to, the most directly comparable GAAP financial measures. The impact of these excluded items may cause the estimated non-GAAP financial measures to differ materially from the comparable GAAP financial measures.

We ask that participants limit their comments to a single question and one follow-up question in our Q&A session. I also want to note that copies of remarks from today's call will be available on the Investor's section of Western Digital's website immediately following the conclusion of this call.

I’d now turn the call over to President and Chief Executive Officer of Western Digital Steve Milligan.

Steve Milligan

Good afternoon, and thank you for joining us. After my opening remarks, Tim Leyden will provide additional commentary on our March quarter performance and our outlook for the June quarter.

We achieved solid financial results for the March quarter, with revenue in line with our expectations and gross margin and earnings per share exceeding our guidance. Cash generation remained strong. Our steady financial performance continues to demonstrate an ability to manage the business and deliver ongoing value to our customers and shareholders.

Both of our subsidiaries executed well in the March quarter, as we continue to participate in the ongoing growth of data with an intense focus on helping our customers succeed in a rapidly changing environment.

Our results reflect sustained strength in gaming, anticipated seasonality in client and branded products, and some softness in the enterprise space. The industry TAM was slightly higher than anticipated, driven by the strength in gaming.

We continue to see demand stabilizing in the commercial side of our client business as part of a PC refresh cycle, and we remain positive about the long term demand trends in the enterprise space. The continued strength in gaming is due to consumers’ healthy demand for the newest game console designs, all of which have integrated hard drives. Overall, we believe industry supply and demand remain in balance.

We continue to believe very excited about our unique position in the overall storage ecosystem, enabling a broad-based perspective on the dramatic changes that are underway. Customers are responding positively to a number of new products and technologies we are bringing to market to help them to be successful.

Specifically, our enterprise class SSD business had another strong quarter. We will continue to expand our full range of enterprise SSD products, including SAS, PCIe, and SATA, in a range of form factors and capacity points, as well as grow our software and solution offerings.

Several strategic OEM customers have qualified our 6 TB helium filled drive, and we are shipping to them in volume. The product is generally available on a global basis, resulting in broad adoption in all geographies. It is important to note that our innovative helium technology platform is extendable to higher capacities and additional applications.

We recently began shipping a new family of highest-performance, high capacity 2.5 inch 15K hard drives. Our customers continue to use 15K hard drives with SSDs in tiered pools of storage, and this new product addresses the industry’s shift away from the 3.5 inch form factor to smaller 2.5 inch drives to help manage space requirements.

Customers have responded very positively to our Power of Choice lineup of hard drives, including the WD Red drives that ship primarily to value-added resellers who are configuring mass systems for small and medium businesses. Likewise, the new WD Purple series addresses security surveillance mass systems for the home and small businesses.

Both of these are high-growth segments where storage is a value-added means to an end for the customer, which makes them attractive opportunities for us. We continue to see opportunities with our My Cloud network attached storage solutions in the home and small office segment. Our My Cloud solution provides the opportunity to connect with billions of devices that create, store, and display massive amounts of data.

All of these products reflect our highly focused strategy of helping our customers succeed through collaboration and innovation and are contributing to the favorable mix shift underway in our business to higher growth and higher value-added segments of the market.

Before turning it over to Tim, I wanted to address the topic of our discussions with China’s Ministry of Commerce. Consistent with our prior commentary, we had the opportunity to submit a request in March for MofCom to lift the hold separate restrictions on our business. We have done so and we continue to work with MofCom as they review our submission.

In the meantime, we continue to operate our HGST and WD subsidiaries separately and we will keep you informed of any material developments.

Tim?

Timothy Leyden

Thank you, Steve. Our March quarter performance reflected healthy unit demand and solid execution. The hard drive industry shipped approximately 137 million units during the March quarter, which was higher than the TAM implied in the guidance we provided in January.

In our business, we saw continued strength in gaming, anticipated seasonal declines in client and branded products, and some softness in enterprise. Aggregated channel inventories of Western Digital products remain at the low end of our 4 to 6 week range.

Our revenue for the March quarter was $3.7 billion, including $134 million from enterprise SSDs. Our enterprise SSD revenue was slightly better than we had expected, and some of the single source strengths we saw in the December quarter carried into the March quarter.

We continue to expect that our SSD enterprise business will outpace the market’s revenue growth rate over the long term. Overall, 53% of our revenue came from non-PC applications. We shipped a total of 60.4 million hard drives at an average selling price of $58. The quarter over quarter decline in overall ASP was primarily driven by business mix.

Our gross margin for the quarter was 28.6%. Excluding $39 million of amortization expense for required intangible assets, as well as $16 million of restructuring charges, our non-GAAP gross margin was 30.1%. We exceeded our implied guidance for non-GAAP gross margin by 60 basis points, primarily due to operational efficiencies and better utilization.

R&D and SG&A spending totaled $628 million for the March quarter. SG&A included the following items: $11 million of amortization expense for required intangible assets, and $4 million of restructuring and other charges. R&D included $8 million of restructuring charges. We accrued interest charges of $13 million in the March quarter relating to the Seagate arbitration matter.

Tax expense for the March quarter was $31 million or, or 8% of pretax income. Net interest expense for the March quarter was $13 million, and included $4 million of debt issuance costs that were expensed with the payoff of the prior credit facility.

Our net income for the March quarter totaled $375 million or $1.55 per share. On a non-GAAP basis, net income was $470 million or $1.94 per share.

Turning to the balance sheet, we generated $697 million in cash from operations and our free cash flow totaled $536 million. Our capex for the March quarter totaled $161 million or 4% of revenue. We repurchased 2.8 million shares for $244 million during the March quarter. We also declared a dividend in the amount of $0.30 per share.

We entered Q3 with total cash, cash equivalents, and investments of $5 billion, of which approximately $2.3 billion was in the U.S.

I’ll now provide our guidance for the June quarter. We expect revenue to be seasonally down and in a range of $3.5 billion to $3.6 billion; gross margin approximately at the midpoint of our 27% to 32% model, excluding the amortization of intangibles; R&D and SG&A spending around $600 million, also excluding the amortization of intangibles; a tax rate of approximately 8%; a share count of approximately 242 million.

Accordingly, we estimate non-GAAP earnings per share between $1.65 and $1.75, for the June quarter, which includes the dilution impact of approximately $0.10 of the sTec and Virident acquisitions. As a reminder, we expect the sTec, VeloBit, and Virident acquisitions to be accretive early in calendar year 2015.

Overall, we continue to execute well, and we are well-positioned to succeed in the evolving storage market. In closing, I want to point out to investors and analysts that our fiscal year 2015 will consist of 53 weeks, with the first quarter ending October 3, 2014, consisting of 14 weeks, and the second, third, and fourth quarters at 13 weeks each.

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

Question-and-Answer Session

Operator

[Operator instructions.] And our first question comes from Aaron Rakers of Stifel.

Aaron Rakers - Stifel

First question would be on the enterprise relative weakness. Maybe you can help us understand how the quarter progressed, where maybe in particular you saw the weakness, be it between the traditional enterprise guys, relative to the cloud vendors, and then how we should anticipate that business looking into the current quarter.

Stephen Milligan

The primary area where we saw a bit of weakness in terms of enterprise demand was in capacity enterprise. Not so much traditional performance enterprise in terms of our business. That more or less tracked to our expectations. I think just to kind of put a little bit of context on this, one of the things to keep in mind as a general statement is that one, the volumes for capacity enterprise on a relative basis are not that large in terms of relative to the total TAM.

The other thing is that the number of customers, it tends to be dominated by a relatively few number of customers. So any changes in purchasing behavior on the part of some of those larger customers can have a relatively significant impact on the overall numbers. So that’s just a little bit of context.

With that being said, basically what we saw was increased efficiency from the standpoint of some of our significant hyperscale buyers. And efficiency is coming in the form of really a few things. One, supply chain efficiencies and efficiencies in the way that they deploy capacity from their standpoint through their deployments, and also, in terms of improved utilization, in terms of the overall storage capacity.

So they’re basically working off inventory that they already had in place, because of, if you want to call it, inefficiencies in their deployments. We see that persisting through our current quarter that we’re in, our fiscal Q4, and we expect that demand will pick up in the second half of the year, more in line with what we’ve been seeing in the past. And so it’s a short term dynamic in terms of the first and the second calendar quarter of this year, and we don’t expect to persist longer term.

Aaron Rakers - Stifel

And as a follow up real quickly, I know you’re not giving any updated thoughts around MofCom, but as we look at your business model and look at the utilization rates of your manufacturing, can you help us understand where you stand utilization wise, be it internal versus external on heads and media, and maybe how much opportunity exists to driving more efficiency or utilization out of those key assets?

Stephen Milligan

I’ll take a stab at that and then Tim can add to that as appropriate. First off, we’re very comfortable right now in terms of where we’re at with our internal versus external component purchases, really, on both subs. And frankly, they’re at relatively consistent levels, coincidentally, not through any inappropriate coordination. They just happened to be at very similar levels in terms of the percentage of internal versus external components for both heads and media.

And generally speaking, that’s been fairly consistent over the last few quarters, so we haven’t seen any material change in that. From an overall utilization perspective and expected synergies that we might happen to realize if we are able to combine, we have not provided a specific number on that in terms of cost synergies. We have provided an indication of what we thought it would be on the opex side, but needless to say, it will be meaningful in terms of the reduction in terms of cost that we’ll see on our cost of goods sold if we’re able to combine the two entities.

And so clearly we think that will be a benefit, not only to our shareholders, but in particular to our customers, and will allow us to continue to fund the required innovations that we need to deal with the changing storage ecosystem that we’re dealing with.

Operator

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

Rich Kugele - Needham & Company

Just geographically, Asia was up, EMEA was down. Can you just put any color around that? And then I’ve got a follow up.

Timothy Leyden

It was at the noise level, really. There was some movement in there, but it was relatively insignificant. So there wasn’t anything really that was significant that would cause us to call it out separately.

Stephen Milligan

One thing that I would call out is that obviously we saw strength in the gaming side of our business. That is all attributable to Asia. Because it’s shipped into location, as opposed to where those ultimate systems get deployed. And so that might have something to do with that increase in Asia.

Rich Kugele - Needham & Company

And as a follow up, would you have a similar level of optimism for the second half of the calendar year as your primary competitor, both the PC client side as well as the hyperscale guys, coming back in ordering? I think you commented a little bit about that, but any other color you might have?

Stephen Milligan

In terms of the second half of the year, we are optimistic about the enterprise side of the business, and so in that regard, I would say that we would concur with what our largest competitor has said.

On the PC side, and Rich, you know us well, we probably tend to be a little bit more cautious and a little bit more conservative. We have definitely seen a stabilization in the PC market. Now, it still is declining on a year on year basis. Certainly a lot of that has to do with commercial refresh. The question there is that we don’t know how long the sustainability of that commercial refresh.

We believe that we’ll continue to see some of that activity through the June quarter. The question is, does it persist through the back half of the year. Consumer generally speaking, as far as we can tell, continues to be relatively weak, so we’re not really seeing any particular strength there.

So I would characterize that we’re probably cautiously optimistic regarding PC demand trends, but I think the stabilization is meaningful in the sense that there’s less volatility. And that decreased volatility just makes it a little bit easier for us to manage and plan around that as opposed to chasing the ball around on the pitch trying to figure out which way it’s going to go next.

Rich Kugele - Needham & Company

And just lastly, on ASPs, given the gaming mix, which is presumably a much lower ASP, that going down here in this June quarter, would you expect ASPs to be more firm this quarter, maybe even increase? What should we be expecting here for June?

Timothy Leyden

They’ll be flattish.

Stephen Milligan

Yeah, we’re going to continue to see pretty strong gaming volumes here in the current quarter.

Operator

Our next question comes from Andrew Nowinski with Piper Jaffray.

Andrew Nowinski - Piper Jaffray

Just another follow up on the PC side. So it looks like both notebooks and desktop units underperformed relative to Seagate this quarter. The results are still in line with your normal 10% decline in calendar Q1, so was there anything abnormal in those segments that you noticed regarding pricing or share shift?

Stephen Milligan

I wouldn’t call anything out specifically from our standpoint. The client business from our perspective - and this is kind of at the margins, so it’s not a significant thing - was a little bit stronger than what we expected. Gaming was certainly stronger than what we expected, and then the enterprise side, which I talked about earlier in terms of capacity enterprise, was a bit weaker.

But the stronger PC business that we saw, it was not that significant within the whole grand scheme of things. And competitive behavior was within the norm, I guess you might say. We didn’t see any unusual competitive behavior that would be particularly alarming to us.

Andrew Nowinski - Piper Jaffray

And then if you look at it from a region perspective, were there any large differences between your mature markets and your emerging markets?

Timothy Leyden

I think the consumer business is a bit more impacted by the macroeconomic issues, and as you know, the emerging markets have been challenged really because of the foreign exchange. And so that continues, and we’re seeing that the more mature markets are the stronger ones, and the emerging markets are the weaker ones. And of course the dislocation in Russia didn’t help.

Operator

Our next question comes from Rob Cihra with Evercore.

Rob Cihra - Evercore Partners

On the enterprise SSD side, you’re saying you’re still looking to be accretive from the sTec and Virident acquisitions early calendar 2015. I guess can you just help map out at all - maybe not specifically map out, although it would be awesome - where that’s revenue driven versus cost cutting driven or cost savings driven? Is it all revenue driven, or is it just hopefully like a smooth ramp from here? Or are there kind of milestones that we can be looking for more specifically?

Timothy Leyden

I think it’s a continuing plan. We’re putting together the multiple roadmaps for sTec, Virident, VeloBit, and the JDA. And as we put those together, we will have some efficiencies that will come from cost. We’ll obviously be building up our revenue.

So from where we are right now going towards the end of the year, by the time that we’re exiting December, we will be pretty much at breakeven, or maybe a little bit accretive. And then we’ll be fully accretive in the first quarter. And it will taper between now and then going from the $0.10 to where we are right now, towards that breakeven point in the December quarter, as we exit December.

Stephen Milligan

Just to add to that, the primary driver is revenue and ramping the new businesses. And the new business being those products that relate to the sTec and Virident acquisition. There are some synergies or rationalization from an opex perspective, but the primary driver will be continuing to ramp from a product perspective, from a revenue perspective, from a customer perspective, those new businesses.

Operator

Our next question comes from Bill Shope with Goldman Sachs.

Bill Shope - Goldman Sachs

You were pretty clear on the drivers of the enterprise weakness, particularly within the hyperscale customer base. But could you give us some color on the demand trends you’re seeing within capacity enterprise for traditional server and array OEMs? And how are you thinking about that as we progress through the calendar year?

Stephen Milligan

I don’t know if I would really call anything out, frankly, in terms of that. I mean, it’s a little bit of a challenging question in the sense that we have a number of customers that increasingly are coming more and more direct to the [drive] guys, which is obviously impacting some of the traditional customer base.

And so I don’t think we saw anything in particular that stands out with our traditional customer base in the capacity enterprise market that’s worthy of calling out, other than just ongoing challenges of how to remain relevant with some of the changing purchasing behaviors on behalf of some of our customers.

Bill Shope - Goldman Sachs

And then you had mentioned that you would extend your helium platform to other product lines over time. Can you remind us of how we should think about what this does to your cost structure relative to the competition now and particularly over time as the technology matures?

Stephen Milligan

You mean our cost structure? Or our customer’s cost structure?

Bill Shope - Goldman Sachs

Your cost structure.

Stephen Milligan

Well, the primary impact to our cost structure, which has nothing to do per se with helium, the fact that it’s helium sealed, is that as we are shipping higher and higher capacity drives, whether they be 6 or 8 or 10 or whatever it happens to be as the product extends itself over a period of time, is the test times for these products are significant. And so we’re having to add, or will have to add, as volumes ramp, meaningful amounts of test capacity. But that is not unique per se to the helium platform. It just has to do with the amount of data these things are storing.

Operator

Our next question comes from Monica Garg with Pacific Crest Securities.

Monica Garg - Pacific Crest Securities

The first question is on the enterprise SSD side. Could you maybe talk about do you think in the next quarter you’ll see enterprise demand to be flattish or decline before you see it pick up, as you talked about, in the back half of the year?

Timothy Leyden

Each of the different segments, other than gaming, is likely to be down as you look quarter on quarter.

Monica Garg - Pacific Crest Securities

And the other question I have is on the enterprise SSD. If I look at your June 2013 enterprise revenues, they were about $104 million. And if I add sTec, which was only at about $25 million a quarter, and then you add Virident, VeloBit, and kind of one-time benefit, it seems that revenue is still flattish. Maybe could you talk about kind of when do you expect the pickup in that segment?

Stephen Milligan

I think you’ve got to keep in mind that relative to the sTec side, the momentum there was not exactly positive. So I think you’ve got to consider that really we bought a, I hate to call it this, but a little bit of a distressed asset.

Monica Garg - Pacific Crest Securities

And just a last one on the Xyratex, you were talking recently about the test times increasing on the enterprise side. So maybe can you talk about with Seagate buying Xyratex, does that impact your test strategy somewhat? And kind of how do you see the relationship with the test manufacturers?

Stephen Milligan

We are generally comfortable with where we’re at in terms of our relationship with our test equipment suppliers, including with Xyratex/Seagate. There are contractual provisions that were put in place prior to the closing of that transaction that we believe sufficiently protect us, and will provide for a constructive relationship going forward.

Operator

Our next question comes from Katie Huberty with Morgan Stanley.

Katie Huberty - Morgan Stanley

How were you able to keep gross margins flat in the March quarter given lower volume, lower ASP, and the mix shift away from enterprise to gaming? Was there anything one-time or are whatever positive benefits you saw continuing into the next few quarters?

Stephen Milligan

You know, I want to remain appropriately humble in terms of answering this question, but the reality is that we have a really good team, particularly from a manufacturing perspective, from a cost perspective, on both sides, being WD and HGST, and they are constantly working on eking out every dollar of savings that we can. And so it’s just a matter of sort of scratching and crawling every day, to make sure that we’re realizing appropriate efficiencies and it shows up in our numbers.

That being said, overall, even though the volumes came in the form of, let’s say, gaming primarily, in terms of upside, which didn’t necessarily translate to higher ASPs and that sort of thing, we did get some additional efficiencies from higher volumes that provided some of that uplift as well. But frankly, I have to take my hat off to our operations team in terms of their ability to grind out cost savings all the time.

Katie Huberty - Morgan Stanley

So that should continue?

Stephen Milligan

I certainly hope so.

Katie Huberty - Morgan Stanley

And then just lastly, do you need the $2.5 billion of net cash? And what’s holding you back from stepping up on the buyback, given fairly constructive comments about second half of the calendar year?

Timothy Leyden

We continue to pursue the plan that we outlined in September of 2012, at our analyst day, which is 50% of free cash flow. But obviously as we go forward, we’re in the business of making sure that we maximize the value for the shareholders. So consequently, we are always looking to see what’s best mix, and what’s the best balance between investing in the business for future gain and also making sure that we meet our obligations that we have outlined to shareholders.

So it’s an ongoing process that we’re looking at, and we continue to look at it. But we’re very pleased with the generation of the cash flow and obviously we keep looking at it.

Stephen Milligan

I think another comment to make, and not to in any way message that we have anything planned, but one of the things that we think is important is that we continue to keep our powder dry in terms of looking at additional opportunities, whether that be M&A or otherwise.

There are a lot of dramatic changes going on in the storage world, in the data world. We believe we’ve got our eyes and ears to the ground in terms of trying to understand what’s happening, where we’ can add value from a customer perspective, what we can do from a technology perspective. And so we want to make sure that we’ve got sufficient stock, so to speak, for any other opportunities that might be M&A related.

Operator

Our next question comes from Ananda Baruah from Brean Capital.

Ananda Baruah - Brean Capital

I guess the first one is a question with part clarification. Did I hear correctly that the expectations for blended ASP is to be flat sequentially in the June quarter? And if that’s the case, I guess in the context of the revenue guidance, which is down 5% quarter over quarter, that would sort of put it all on the TAM is the implication, that you’re expecting TAM of $130 million in the June quarter?

Timothy Leyden

Yes, we did indicate that the ASP would be flattish, and in line with the seasonality that we’ve historically seen, generally it’s down somewhere in the region of about 4% or so from a quarter over quarter basis. So that’s really where the expectation and the matching of the flat ASP and the revenue guidance is coming from.

Ananda Baruah - Brean Capital

And then the follow up is with regard to gross margin. I guess given that there’s sort of similar revenue decline in the June quarter relative to the December quarter, and the mix isn’t tremendously changing, why wouldn’t you be able to capture similar efficiencies? Steve, to your comment, hopefully they continue in the June quarter. And why couldn’t margins be more flattish? Or is the volume, the down sequential TAM, really that big of an impact?

Timothy Leyden

Yeah, there would be a little bit of a challenge as far as utilization is concerned, when you compare quarter on quarter. So that’s really where the challenge is. From a viewpoint of component reductions, what we’ve seen is that as the volumes stabilize, the component cost reductions have also flattened out a bit, and they’re not as significant as they used to be historically. They’re probably running somewhere in the region of about a half to a third of where they had been previously. So consequently, the utilization takes on a larger significance in that particular mix.

Operator

Our next question comes from Steven Fox with Cross Research.

Steven Fox - Cross Research

Just getting back to the SSD business, I guess on a year over year basis, including inorganic activity, you were up 45%. Can you sort of flip that to what kind of organic growth the business is experiencing year on year, and maybe some more color around what was driving it in the most recent quarter? And then sort of expectations for the rest of the year? And then I have a quick follow up.

Timothy Leyden

There’s a lot of moving parts, and you’ve got SAS and SATA and PCIe, all as [unintelligible]. From what we can glean out of it, it looks like on a year on year basis, that the growth is somewhere north of about 50% or so. So we’re just slightly behind where the total market growth rate is.

Steven Fox - Cross Research

And in terms of your own success, is there anything you would point to that’s having a better impact on the market than maybe some of your competitors? Because obviously that’s a significant business for you guys.

Stephen Milligan

I don’t know if I would call anything out in particular. I think that in a lot of ways, we were, I’ll call it an early investor in this business, going back to really 2008. And this is on the HGST side initially. And that also corresponds to a lot of the work that we did to improve our position in the broader enterprise market period, and have really developed what we’d like to believe are very tight relationships with a number of enterprise customers, and have broad-based knowledge of the enterprise market and the interaction of storage devices with systems and so on.

And that’s bearing fruit. And the added credibility that we happen to provide, it may not be entirely showing up in the numbers as of yet. There is some ramp, and not only that, ongoing product development that we need to do. But that credibility will translate to either legacy sTec products, which basically will go away. I mean, call it HGST products going forward, and then not only that, it will translate to PCIe or Virident related products as well. So I think it’s really just a reflection of our ongoing investments in credibility in the broader enterprise market.

Steven Fox - Cross Research

And then just one real quick question. I know you’re not providing guidance on the second half of the calendar year, but there has been some talk about a return to normal seasonality. If that was sort of a baseline, are there any markets where you feel like you could see that come back? I know you expressed some conservatism around PCs, but is there anything where you feel like you could get a seasonal lift at least, if we’re looking at the model second half of the calendar year?

Stephen Milligan

I think the one area that we would call out, and I don’t know if it will necessarily be outside of seasonal norms, it’s probably a little bit too early to call that, but obviously we’re expecting a nice rebound in terms of capacity enterprise demand. So there might be a little bit more strength in that market than what we traditionally have seen. And so that’s the indicators that we’re getting “today”. We’ll have to continue to validate that as we move through the balance of the quarter. And then we’ll talk more about that when we have our earnings call in three months.

Operator

Our next question comes from Keith Bachman with BMO.

Keith Bachman - BMO Capital Markets

First off, could you talk about the enterprise pricing trends, both with the web sale companies as well as your traditional enterprise companies? It seems like pricing’s been a bit more aggressive as of late. And that would include the near lines. If you could talk about current pricing trends, and then talk about what you see pricing trends over the next couple of quarters.

Stephen Milligan

The one thing that’s tricky about the enterprise space as an overall comment, is that the margins are richer. And that’s traditionally been the case for quite a long time. Therefore, there’s more margin to give away, just by definition. These are indicative numbers as opposed to real numbers, but if you’re running 20% gross margins, there’s not as much profit to give away, and so people are going to be more cautious.

When you’ve got higher margin products, and you think that there is an opportunity to drive elasticity, you might be compelled to lower those prices more than you otherwise would. And so as a general statement, I would say that probably in the enterprise space, as we begin to see weakness - this is an overall statement, it’s not a statement about us. I’m not pointing the finger. It’s not anything like that. It’s not intended that way.

But, you know, people weren’t entirely sure what was going on from a demand perspective. Maybe there was a little bit of a thought, well, maybe there’s elasticity here. So we’re going to maybe look a little bit more at the pricing lever and maybe things got a little bit more aggressive than what made sense. Because there was not the kind of elasticity that you normally would expect.

And so I think that’s kind of maybe what’s happened over the last few quarters. Going forward, the reality of it is that pricing is always difficult to predict. It just is. And obvious statement, but no one individual or no one individual company controls pricing. And there’s a lot of factors that go into that.

The market continues to be competitive, and we are working very closely with all of our customers to find different ways to continue to help them solve the issues that they’re working on to help them create value, whether that be through innovative products, innovative technology, and also making sure that the products are at a cost point for them that makes sense depending upon the economics that they’re trying to drive in their business.

So there’s a lot of dynamics that go into pricing, but I do think that given the larger margin pool, it’s a little bit more tempting for guys who look at taking price down than maybe other segments of the market.

Keith Bachman - BMO Capital Markets

And my follow up is related to TAM. And I’d like to follow up on Ananda’s question. The seasonal guide for June is a little less than seasonal, and I think [unintelligible] Seagate and WD, that’s what it would suggest. What is driving that? Is it the hangover from [SV], or is it the enterprise [near line drive] that’s causing a little less seasonal in June? And [unintelligible] part of the question is, Seagate talked last night about 140 to 145 for the back half of the year. Is that kind of a range you’re comfortable with in the September and December quarters? [unintelligible]

Stephen Milligan

We’re forecasting revenue generally down 4% on a quarter over quarter basis. That, from our perspective, is pretty consistent with normal seasonality. And so I would not intend that that’s outside of the norms of what we’ve seen historically. And overall, I don’t think that we’re really seeing any particular dynamics in a given market, other than the gaming market continues to be healthy. That’s just a good thing in terms of volume absorption and that kind of thing. So that’s kind of helping us a bit.

So I wouldn’t really call [anything out] there. And then what was the second part of your question? I’m sorry.

Keith Bachman - BMO Capital Markets

The 140 to 145 range in the second half of the year for the TAM. Does that feel reasonable?

Stephen Milligan

I’d prefer not to go there, honestly. I think it’s a little bit too early. We’re certainly expecting a seasonal uptick in our business in the back half of the year. There’s still a fair amount of uncertainty out there, and I don’t want that to come across as an overly negative statement.

It’s more just to be cautious, and that’s kind of the way that we manage our business. There is still a reasonable amount of uncertainty out there. What’s really happening in the PC market? How long is this refresh cycle going to have?

And I’m afraid of saying all this, because I’ll scare everybody. You know, there’s a fair amount of geopolitical things out there. China is still kind of soft overall. Russia provides a little bit of uncertainty, how’s that going to play out.

And I think it’s just a little bit too early to call exactly how calendar Q3 and Q4 are going to look, other than we think we’re reasonably comfortable that it’s going to be seasonally up, pretty much along the lines of what we typically see.

Operator

Your next question comes from Amit Daryanani with RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

One, maybe if you could just touch on the inventory side. A healthy spike in the finished goods inventory on a sequential basis. Could you talk about what’s driving that given the fact that you’re actually looking for a downtick in TAM in the June quarter?

Timothy Leyden

So if you look at our business, and look at the cash flow, we had very good linearity during the course of the quarter. And we used that linearity in order to be able to avoid capital expenditure. Because it means that we’re able to avoid spikes. So that’s one thing.

The second thing is, we’re putting quite a lot of product on the ocean, and from a funding viewpoint, and from an investing viewpoint, and from a return on investment, that is proving to be a very good ROI. We did take something in the region of about $60 million in absolute terms out of the work in process, and our [raw] was almost flat.

So when we look at how we’re executing the business, it’s a mix of making sure that, as we kind of bypass an expenditure through linearity, we can then avoid costs through putting product on the ocean. And as we put it on the ocean, it means that we carry that inventory for something in the region of six to eight weeks or so. So it does have an impact on our finished goods.

Amit Daryanani - RBC Capital Markets

And then a second question, I guess when I look at the total exabytes shipped on a capacity basis, it looks like that number is about 10% both year over year and also on a rolling four quarter basis. That seems to be below kind of what the expectation is, at least I would have had on that number. So how do we think about that as we go into the back half, especially when you’re expecting this enterprise pick up. Does it remain here? Or do you think it gets back to this 20% to 30% range.

Stephen Milligan

So there’s a few things that are impacting that. The first thing that I think is important is that overall growth in data, which is a little bit difficult to get exact numbers on it, but [unintelligible] the analysis that we’ve got is tracking to our expectations. So it’s not an issue, the exabyte growth issue is not reflective of overall content creation, if you want to call it that.

The other thing is that some of the numbers that we have been talking about historically, let’s call it a 25% growth, rounding off to 25% growth, in exabyte volumes. That had certain assumptions related to the PC market, both from a volume perspective as well as from a capacity mix perspective.

What we’re seeing is one, volumes have generally speaking been less than what we had previously assumed. The other thing is that our PC customers are not mixing up to higher capacity points as much as we normally have seen. Really, one, because they’re trying to hit certain cost points, and also, aerial density growth is not progressing as much as what we have historically seen. So that, because of the large volume that the PC market tends to have, has an oversized impact on that 25%, reconciling it back to the 10% number that you’re talking about.

And then on the last factor that I will cite, is that some of these recent changes that we’ve seen in terms of the capacity enterprise market, where we’re seeing more softness than what we previously expected, because of efficiencies that they’re realizing, that’s also had an impact. And we would expect to see that that will begin to improve in the second half of the year.

Operator

Our next question comes from Sherri Scribner with Deutsche Bank.

Sherri Scribner - Deutsche Bank

I just wanted to get some of your thoughts on M&A. You mentioned M&A as a possible use of cash going forward. Obviously you’ve been doing a lot of stuff on the SSD side, but would you look at things like moving up the stack into the storage stack, like Seagate has done with the Xyratex acquisition?

Stephen Milligan

As a general statement, not necessarily speculating on would we do something exactly like what Seagate’s done, but we will continue to look at ways that we can add value throughout the enterprise stack. So it may or may not perpetuate itself potentially as exactly with Xyratex’s acquisition, but yes, that is certainly an area where we’re working with our customers and have active dialog in terms of well, what are different ways that we could add value? And there’s nothing conclusive there. But that is a meaningful opportunity for us from a business perspective.

Operator

Our next question comes from Scott Craig with Bank of America Merrill Lynch.

Scott Craig - Bank of America Merrill Lynch

First, on the hybrid side, you’ve talked about that as being a 2014 story for WD. Can you maybe give us an update on how you’re thinking about that market develop? And then secondly, I’m sorry to keep hitting on the enterprise side, but how much visibility do you have when the capacity guys are coming to you with forecasts? How comfortable are you with looking out with that. You know, I’m asking that around the context of you’re expecting a second half increase, but it’s been a pretty disappointing segment all in all over a few quarters, or some would even argue a year. So just wondering if you could sort of help us understand that dynamic.

Stephen Milligan

On the hybrid side, frankly it hasn’t been as compelling of a product, or has not tracked to our original expectations. And I think that is not only a WD statement, but is also frankly largely an industry statement. One of the things that we’re continuing to focus on is trying to figure out how that value equation translates or sells, not only with our customers, who in this case would be traditional PC OEMs, but also to the end customer.

And so we’re going to continue to work on that. There are different alternatives that we’re looking at, including what should the pricing be, or what does the cost point need to be, what capabilities, etc., and also talking to our customers about how can they package it in such a way that it translates to compelling value from a customer perspective. But the reality is that the sales level, the revenue level, have been disappointing versus our original expectations. And it’s something that we continue to evaluate.

Now, to be honest, our revenue expectations were not that significant anyway, and so it doesn’t have that significant of an impact on our financial results, but it is something that we need to continue to focus on and make decisions on going forward, particularly in terms of investment otherwise.

On the enterprise side, what’s actually happening, to address your question in terms of visibility, what was going on before is that our enterprise customers, or capacity enterprise customers, particularly the hyperscale ones, were either carrying more inventory than they needed, or we were carrying inventory for them, because they didn’t have as much visibility, and so their supply lines or deployment schedules were kind of inefficient.

What’s happened is that they’ve become more efficient, which is actually, other than the short term demand driver that we’ve seen, good for our business in the sense that we believe, and this is something that needs to be tested out as we move forward, that there’s going to be improved visibility, less inventory carried through the entire supply line, and that will be good for our business.

Operator

Our next question comes from Jayson Noland with Robert Baird.

Jayson Noland - Robert W. Baird

Just a follow up to that last topic, Steve. How much does new product, 6 TB and helium, play into elongated test and [unintelligible] cycle? Does that create a pause at all? I wasn’t sure if that was included in your remarks about efficiency.

Stephen Milligan

Are you talking about a pause in terms of demand?

Jayson Noland - Robert W. Baird

That’s right, a quarter or two of delay as those buyers get their arms around how to deploy the product.

Stephen Milligan

Not so much. I mean, maybe at the margins, but not that significantly. It’s still relatively low volume within the whole grand scheme of things. And it’s being worked in in terms of a normal deployment schedule. And frankly, we’ve been talking to our customers about the 6 TB and when it was going to come out for a while, so it’s been worked into their planning cycle. So I wouldn’t say that there’s anything particularly unusual related to that that’s impacting the number of units that our customers are pulling from us in the capacity enterprise space.

Jayson Noland - Robert W. Baird

And as a follow up, on the branded, down with seasonality, as expected. I think there’s a media push there. Are you happy so far with what you see in the network attached personal cloud market?

Stephen Milligan

Yes, we are.

Jayson Noland - Robert W. Baird

Any additional color on the opportunity?

Stephen Milligan

Well, we think it’s a great opportunity for us. We’re going to have to continue to invest. We’re going to have to continue to make the product more and more compelling, I’ll call it from a software perspective. And so it has been a good product for us. We’ve had some service issues. We’ve addressed those. We’re investing in that. We’ve got to make sure that we deliver on the product offering that we’re putting out there. But the initial reactions to it have been very positive. It’s serving a purpose, filling a market need. And so we’re very excited about it, but we’ve also got more work to do in terms of continuing to make the product compelling as we move forward.

Operator

Our next question comes from Nehal Chokshi with Technology Insights Research.

Nehal Chokshi - Technology Insights Research

I’d like to follow up a little bit more on the branded side. It looks like the revenue and units were both down year over year, as well as ASPs. Can you walk through why you’re seeing this trend, especially in the context of the My Cloud seems to be getting good traction here?

Timothy Leyden

As we’ve gone through the years, there’s been more of a concentration on 2.5 inch versus 3.5 inch, and 3.5 inch does have higher price. So from a mix viewpoint, there is an increasing percentage of the total is 2.5 versus 3.5, and that contributes to the dampening of the price. That’s mainly what causes that.

Nehal Chokshi - Technology Insights Research

And can you talk about why you actually saw the year over year declines on the revenue and units?

Timothy Leyden

I don’t think that the growth numbers have been as we would have expected, and I’m talking about total TAM. So consequently, we participated in that. And Toshiba has taken a bit more market share in some parts of the world, primarily through aggressive pricing. And we’re selective in how we compete in there, but the market growth we expect is going to get back as the products become more compelling. What we’ve done is participated selectively and tried to keep the market share that we’ve had.

Nehal Chokshi - Technology Insights Research

Taking into account Toshiba’s aggressiveness, then do you see that the TAM for branded has been expanding for the March quarter? Or was that flat, or could that still contract?

Timothy Leyden

We think there’s a lot of opportunity for external drive attachment as we go forward, particularly as handheld devices and other devices don’t have that much storage integrated into them. So it’s a changing market, but there are lots of opportunities there, and together with direct attach, NAS, and also wireless, I think there’s big opportunity for us to be able to capitalize on the continuing trend towards mobility. But so far, I think it’s been more anemic that we would have expected or liked it to be.

Operator

Our next question comes from Joe Wittine with Longbow Research.

Joe Wittine - Longbow Research

I wanted to ask about gaming. How long does the cycle go? Initially, I think you’d assume you get an initial uptick with the early adopters, then kind of ease. And I think at one point, we said September would be the peak, and December held up, March held up. It sounds like June will be okay. So going forward, does the cycle play out with a long runway, or can this market potentially change on a dime and see orders pulled abruptly if things slow quickly?

Stephen Milligan

That’s a very good question, and the reality is, I don’t know the answer to that. And part of the reason I don’t know the answer to that is because our customers don’t know at this point. I mean, the demand has been very strong. There’s a lot of bullishness there. And so we don’t know exactly how long the cycle is going to go. Now, that being said, just as an example, the models will last for quite a while. It’s just units will continue to be produced. It’s just a matter of at what volume.

And so we’re going to have to continue to monitor that and keep you abreast of how we’re seeing the gaming volumes play out. But right now, there is a fair amount of bullishness on behalf of our customers regarding the new gaming consoles.

Joe Wittine - Longbow Research

And then finally, on the My Cloud, you kind of talked around this, Steve, but the service outages. Do you think you kind of nipped it in the bud quick enough where there’s no near term market dynamics that shake out because of it?

Stephen Milligan

We haven’t seen anything regarding that. It has apparently not had any impact on our sales. That being said, we take these things very seriously, and certainly did our best to respond as quickly as we can, and have attempted to take preventative actions to minimize the risk of that happening again. But so far, knock on wood, we have not seen any direct impact on the units that we’re selling.

Thank you all for joining us, and we look forward to updating you as we go forward. Thank you very much.

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