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Seagate Technology (STX)

F2Q07 Earnings Call

January 23, 2007 5:00 pm ET

Executives

Bill Watkins - President & CEO

Charles Pope - EVP & CFO

Dave Wickersham - EVP & COO

Brian Dexheimer - EVP of Global Sales & Marketing

Analysts

Harry Blount - Lehman Brothers

Katy Huberty - Morgan Stanley

David Bailey - Goldman Sachs

Steven Fox - Merrill Lynch

Rob Semple - Credit Suisse

Mark Moskowitz - J.P. Morgan

Mark Miller - Brean Murray

Christian Schwab - Craig-Hallum Capital Group

Joel Inman - Robert Baird

Rich Kugele - Needham and Corporate

Sherri Scribner - Deutsche Bank

Brian Alger - [Strata Capital Management]

Shaw Wu - American Technology

Presentation

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to Seagate Technology's fiscal second quarter 2007 financial results conference call. At this time, all lines are in a listen-only mode. Later, there will be an opportunity for questions. Instructions will be given at that time. [Operator Instructions]. This conference is being recorded.

This conference call contains forward-looking, including but not limited to, statements related to the Company's future financial performance. These forward-looking statements are based on information available to Seagate as of the date of this conference call, but are subject to a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. Information concerning the risks and uncertainties that could cause results to differ materially from those projected in the forward-looking statements is contained in the Company's annual reports on Form 10-K, as filed with the US Securities and Exchange Commission on September 11th 2006, and the Company's quarterly report on Form 10-Q, as filed with the US Securities and Exchange Commission on November 7th 2006, and in the Company's Form 8-K, as filed with the US Securities and Exchange Commission on January 23rd 2007. These forward-looking statements should not be relied upon as representing the Company's views as of any subsequent date, and Seagate undertakes no obligation to update forward-looking statements to reflect events or circumstances after the date they were made.

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

Bill Watkins

Thank you, Matthew. Welcome, everyone, and thank you for joining us. On the call with me today are Charles Pope, Executive Vice President and Chief Financial Officer; Dave Wickersham, President and Chief Operating Officer; and Brian Dexheimer, Executive Vice President and Chief Sales and Marketing Officer.

To begin, I'd like to make a few comments on our second quarter performance and then provide a brief outlook for the remainder of fiscal 2007. I will then hand it over to Brian, Dave and Charles to discuss details of our market, operating and financial performance.

I am very pleased to announce that Seagate has achieved a significant new milestone, delivering the industry's first $3 billion quarter, a 30% increase from our year-ago quarter.

These strong results were driven by a number of positive factors: the continued, explosive growth in digital content and the resulting increase in demand for storage; Seagate's ability to deliver a broadening suite of products to a growing set of customers; a better-than-expected pricing environment for desktop products during the period; and the successful transition of Maxtor customers to the more cost-effective Seagate products.

With the Maxtor integration completed and exciting new products hitting the market, we believe that Seagate will continue to increase profitability even as we enter the traditionally slower second half of the fiscal year.

Overall, the industry has completed its fourth consecutive year of annual unit growth in excess of 15%, and Seagate far exceeded that performance. Seagate continues to hold the leadership position in three of the four major markets by remaining committed to constantly improving our technology, investing in our operational infrastructure, and delivering on our financial objectives.

I'd like to give you just a few market highlights. In the mobile computing market, we delivered strong year-over-year growth, with a number of important perpendicular qualifications and an increase in average capacity.

In the consumer electronics, we shipped a record number of units and began qualifications of our new 1.8-inch perpendicular drive. Gaming was particularly strong, and DVRs continue to remain the highest-volume sector of the CE market.

In the enterprise space, we maintained our leading market share position, and have stabilized our position in this market following the Maxtor product transition. Our 2.5-inch small form factor products are gaining significant traction in this market. Specifically, qualifications of the 2.5-inch, 15,000 RPM product, the fastest drive on the market, will help generate future volume.

In the desktop market, we delivered an improvement in product mix, as a number of our drives shipped over 200 gigabytes grew substantially year over year. Entering our third fiscal quarter, we are in a healthy channel inventory position with respect to both Maxtor and Seagate products.

Our branded solutions revenue exhibited strong sequential growth this quarter for both brands. And based on preorders, acceptance of our new product line and our dual-brand positioning has been outstanding. Following the close of the Maxtor acquisition, we have completed the related product transition, and we are now clearly benefiting from the expected manufacturing efficiencies.

For the next six months, our focus will be on launching and ramping new products with lower cost structures across various markets, and we are tracking to plan. We completed the Maxtor integration in just seven months, well ahead of our original schedule. With the transition completed in mid November -- December, we expect this to favorably impact our gross margins and operating results beginning in the March 2007 quarter.

As we enter the traditionally slower half of the fiscal year, we are confident that the Company is on path to continued success and growing profitability for the third and fourth quarters. As we have previously indicated, there are three key factors that will be instrumental in driving profitability in the next two quarters.

The first is the completed Maxtor product transition and the continued improvement in manufacturing utilization rates. The second is the successful customer qualifications and ramp of new products with lower cost structures across the various markets. This effort is tracking to plan and will continue throughout the next six months.

And third, the expansion of market coverage with the new 1.8-inch product, which is currently in qualification at major OEMs. We are pleased with the progress we have made with the 1.8-inch drive, and look forward to providing updates as this product is introduced into the handheld consumer applications.

In summary, Seagate continues to be the industry technology, product and cost leader, with access to virtually every available market in the $30 billion disc drive industry. We remain committed to meeting our financial and operational objectives and providing value for our shareholders, evidenced by our strong performance this quarter.

We are pleased with our recent results and are extremely excited about the opportunities we see in the market, as we are confident the Company is well positioned to capitalize on these prospects.

I now would like to turn it over to Brian for more details on the market highlights of the quarter.

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Brian Dexheimer

Thanks, Bill. Looking back at calendar year 2006, we saw continuing indicators that support the broad global expansion of the creation, aggregation, distribution and consumption of digital content. In 2006, the industry shipped over 430 million units, an increase of more than 15% over calendar year 2005.

Industry revenues surpassed $30 billion for the year and in December reached the first $8 billion quarter in industry history. More specific to the December quarter, the overall industry experienced healthy year-on-year growth of 16% and 6%, sequentially. Seagate performed extremely well in the December quarter, maintaining its leadership in three of the four major markets for storage.

Seagate's growth during the quarter was primarily fueled by the consumer electronics market and seasonal demand increases for desktop and branded businesses. As we look forward into the March quarter, we expect industry unit demand overall to be 116 million to 120 million units, or about 14% to 18% year-on-year growth.

Now, I'll give some detail on the individual markets. In the mobile computing space, we believe, overall market demand grew 32% year on year to 30 million units. Seagate again outpaced the industry's growth, shipping 4.4 million drives, an increase of 52% year on year. During the quarter, unit shipments of our perpendicular notebook drive tripled to over 1.6 million units, and the drive has now been qualified at a total of 21 OEMs.

The average capacity of our products shipped into mobile computing environments increased to 90 gigabytes, an increase of 36% year on year and 13%, sequentially. Looking forward, we expect overall notebook demand for the March quarter to be flat with the December quarter.

In the consumer electronics market, Seagate maintained its leadership position during the quarter, shipping a record 7 million units. In the DVR portion of this market, the average capacity per drive increased during the quarter to just under 200 gigabytes.

Gaming remained one of the primary applications in this market, and we successfully met the strong seasonal demand throughout the December quarter. Average capacity per unit also improved considerably, as new consoles entered the market, emphasizing rich media content experiences.

In handheld applications, our new 5-millimeter-high, 1.8-inch, single-disc, 60-gigabyte drive began qualifications with providers of portable media players and other consumer electronics applications. We expect to realize revenue from this product in the current quarter. We expect demand in the CE market to be flat to slightly down in the March quarter, as seasonality in certain applications produces less demand.

Moving to the enterprise space, Seagate maintained its leadership position, shipping 4.1 million units. As you recall, in September, we stated we were intent on maintaining our share position in this space. With all Maxtor customer transitions completed during the quarter, we believe, we were successful in this regard and have stabilized our share position, going forward.

The adoption of Seagate's 2.5-inch small form factor drives for enterprise-class applications accelerated rapidly during the quarter. Seagate's shipments of 2.5-inch enterprise drives grew 150% sequentially to 800,000 units. More and more, we're seeing enterprise customers look for solutions that can lower power consumption, reduce heat, and address space constraints without sacrificing enterprise-class performance.

As a result, we expect the industry to continue rapid adoption of small form factor drives over the next three to six months. We believe that Seagate is best positioned to serve this market with both our 10k and recently announced 15k small form factor drives. We expect overall enterprise demand in the March quarter to be flat to that of the December quarter.

In the desktop compute market, we maintained our leadership position by shipping 25.7 million units. Consistent with our ramp of perpendicular technology, our product mix continued to improve, as shipments of products 250 gigabytes and greater more than doubled year over year, representing 34% of units shipped during the quarter. The average capacity of desktop products reached 185 gigabytes.

In the global distribution channel, demand remains strong for both Seagate and Maxtor brands, and we exited the quarter with less than five weeks of channel inventory. In addition, during the quarter, we were successful in maintaining levels of sales in and sales out revenue in global distribution channels, subsequent to our decision to terminate our relationship with eSys. For the March quarter, we expect to see seasonal demand that is slightly down in the desktop space.

Finally, Seagate's branded solutions had a strong seasonal quarter and revenue was up sequentially. Earlier this month at CES, we unveiled our dual-brand positioning in the retail channel and a new lineup of Seagate-branded retail products. Both were met with overwhelming acceptance, and we are very excited about the prospects in the retail space. Seagate's new line of Free Agent products will begin shipping in February.

In summary, we are very encouraged by the opportunities presented by the industry throughout the remainder of 2007 and Seagate's unique position to capture revenue share across all markets.

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

Dave Wickersham

Thank you, Brian. The Maxtor integration and product transition to Seagate products was completed in mid-December. Completing this transition is a key factor in our expected improvement in gross margins and operating model beginning in the March 2000 quarter.

As Bill mentioned, we completed this transition in only seven months, well ahead of our original schedule. Beyond a few IT system conversions scheduled to be finished in the coming weeks, the integration of Maxtor is complete.

Regarding finished goods of Maxtor legacy products, as anticipated, there were approximately 200,000 units in inventory at the end of December, which we expect to be consumed this calendar quarter.

I would like to take this opportunity to thank and acknowledge our employees for their continued focus and dedication in achieving the integration of Maxtor ahead of schedule, while at the same time remaining focused on the successful ramp and customer qualifications of Seagate new products.

There has been some speculation recently about the ramp of perpendicular recording based products. So let me provide Seagate's perspective. First, Seagate's yields for perpendicular based products are as good as or better than planned. Second, the yields of our perpendicular products are better when compared against the prior generation products at the same point in their product lifecycles.

Third, customer qualifications of perpendicular based products continue to progress as anticipated, and we see no quality, reliability or perpendicular related issues that will prevent us from achieving our perpendicular shipment plans. In the December quarter we shipped approximately 10 million drives that utilize perpendicular recording, up from the 3.7 million that shipped in the September quarter. We will achieve our internal plan of exiting our fiscal fourth quarter with greater than 50% of all drives shipped in the quarter utilizing perpendicular recording.

Finally, in regards to the supply and cost of precious metals used in the manufacturing process of perpendicular media, Seagate has adequate supply plans in place to support our expected perpendicular product ramp requirements.

While there has been a run-up in the cost of some of these precious metals recently, we're taking actions to mitigate the financial impact going forward, some of which include alternative designs, improvements in material utilization and optimizing our supply chain.

Now, I would like to turn the call over to Charles.

Charles Pope

Thanks, Dave. You will find the Company's press release, 8-K and additional financial information related to Seagate's financial performance, along with a reconciliation of GAAP to non-GAAP financial results and other supplemental information in the Investor Relations section of Seagate's website at seagate.com. Throughout my remarks I will be referring to specific sections of the supplemental financial information by slide number.

Seagate reported December quarter revenue of $3 billion and unit shipments of 41 million. Included are revenue and unit shipments from legacy Maxtor products of approximately $200 million and 2.5 million units respectively. GAAP net income and diluted earnings per share are $140 million and $0.23 respectively.

Included in the GAAP results are approximately $76 million of acquisition-related charges and associated tax effects, as well as a $19 million charge in other income and expense related to the early retirement of our 8% debentures. Without these charges and the associated tax effects, non-GAAP net income and diluted earnings per share was $236 million and $0.39.

Non-GAAP gross margin for the combined company in the December quarter was 19.9%. Slide 6 has the adjustments made to GAAP gross margin. Gross margin percent for legacy Maxtor products was approximately negative 13.7%. Gross margin percent for Seagate products was approximately 22.3%.

In aggregate, price declines were favorable when compared to our plan, due primarily to a more benign pricing environment in the desktop market for much of the quarter. The notebook market continues to be very competitive, and the price declines were slightly more than we had anticipated coming into the December quarter.

For the desktop and notebook markets, the rate of price declines for the March quarter is expected to follow normal seasonal patterns and be marginally more aggressive as compared to the December quarter. However, prices for products in the consumer electronics and enterprise markets are expected to decline at a rate similar to that of the December quarter.

GAAP operating expenses, composed of R&D, SG&A and amortization of intangibles, for the December quarter were $379 million. Excluding acquisition-related costs of $29 million, non-GAAP operating expenses were $350 million. This compares to a non-GAAP equivalent of $388 million in the September quarter, which includes a $40 million charge for the -- to the bad debt reserve related to Seagate's termination of eSys as a customer.

Operating expenses for fiscal 2007, including Maxtor acquisition-related costs and the $40 million bad debt charge, but excluding acquisition integration costs, are expected to be approximately $1.475 billion. Slide 7 has the detail for the adjustments made to GAAP operating expenses for the December quarter. GAAP net other income and expense for the December quarter was $21 million of expense, and includes a $19 million charge related to the early retirement of the 8% debentures.

Cash, cash equivalents and marketable securities ended the quarter at $1.56 billion. During the first two quarters of fiscal 2007, Seagate made capital investments totaling $466 million of which $239 million was invested in the December quarter. We continue to expect capital expenditures for fiscal 2007 to be approximately $1.15 billion. Cash flow from operations was $482 million for the December quarter.

During the December quarter, the Company repurchased approximately 23 million shares. However, the shares were received late in the quarter, and therefore, had minimal impact to the average shares outstanding calculated for the December quarter. So far in the month of January, an additional 13 million shares have been repurchased.

Accordingly, the diluted outstanding share count for fiscal Q3 is modeled at approximately 570 million shares. Since May of 2006, Seagate has repurchased approximately 60 million shares. The Company has authorization to purchase approximately $1.4 billion of additional shares under the current stock repurchase program.

Now, for the business outlook. For fiscal year 2007, the Company's outlook for revenue is $11.5 billion to $11.7 billion, and for non-GAAP diluted earnings per share the outlook is $1.70 to $1.75. Some of the underlying assumptions in the fiscal year financial outlook that have changed since our last conference call are as follows.

First, because of the change to our capital structure and the ongoing stock repurchase program, other income and expense is now expected to be a net expense of approximately $20 million. Second, the $40 million charge we incorporated into our fiscal Q1 results for bad debt is included in both the GAAP and the non-GAAP diluted earnings per share estimates. And third, the expected impact of the higher cost for precious metals used in the perpendicular recording process has been factored into our outlook.

Fiscal 2007 GAAP diluted earnings per share is expected to be $1.27 to $1.32, which includes approximately $234 million directly related to the Maxtor acquisition, $19 million of charges related to the early redemption of the 8% notes, and a favorable adjustment to restructuring reserves of $3 million. For the March quarter revenue is expected to be between $2.9 billion and $3 billion.

Other income and expense is modeled to be a net expense of approximately $10 million. The tax rate is modeled to be approximately 5%. Accordingly, non-GAAP diluted earnings per share for the March quarter is expected to be $0.56 to $0.60. Including acquisition-related costs for Maxtor of approximately $40 million, GAAP diluted earnings per share is expected to be $0.49 to $0.53.

It is important to note that purchase accounting related to charges will be incurred beginning with the March quarter financial results related to the pending EVault acquisition. The purchase accounting allocation for goodwill and intangible assets is not complete, and therefore, amortization and other acquisition-related costs associated with EVault are not included in our GAAP or non-GAAP estimates for the March quarter or fiscal year 2007.

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

Bill Watkins

Thank you, Charles. The December quarter was a tremendous milestone for Seagate in the industry. I'm proud of our employees' continued commitment to excellence in everything we do and congratulate them on an outstanding quarter. Looking ahead to calendar year 2007, I'm very excited about our product, market and operational leadership, and the opportunity in front of us.

So with that we'll open it up for questions, and we can share the Kool-Aid with you guys.

Question-and-Answer-Session

Operator

[Operator Instructions].

Bill Watkins

Let me make a comment, Matthew, right now. We are going to -- due to the fact we have so many people who want to ask questions, we're going to kind of limit it to one question and one follow-up per person.

Operator

Okay. With that said, I'll take our first question from Harry Blount with Lehman Brothers.

Harry Blount - Lehman Brothers

Thank you. You guys made some fairly meaningful progress on the finished good inventory sequentially in the quarter. But I also note that on a percentage growth basis, it's still up year-over-year more than revenue.

Obviously, with you guys growing retail, you'll have to carry a little bit more. But I'd love to get a sense from you, Charles, where you think finished good inventory ought to be on kind of a normalized basis.

Charles Pope

Harry, why don't I have Dave answer that question, but I think he'll answer it on a total turns basis, and kind of help you understand some of the things that are going into the model we have for inventory turns.

Bill Watkins

Yes. Before he does that, one of the things that we have to be careful today, with a lot of product transitions going forward, and as many different market segments we're trying to do product transitions. As we go through these qualifications, we've got to keep enough of the old inventory as we make this transition so we don't jeopardize our customers and their delivery systems, if you have delivered commitments.

So we are going to probably carry more finished goods of products going forward, just because of the massive amount of different market segments and product transitions we're trying to do, and keeping our customers whole as we go through these calls. So with that, Dave, do you want to answer?

Dave Wickersham

Just from an outlook perspective, as well as achievement, as you may note, we did achieve approximately 12 turns, as we anticipated in the December quarter. And we see that we'll probably continue to be in that range going forward.

And as it relates to finished goods, you know, our focus, as we've talked about in the December quarter, was ready to do a couple things. First is to focus on the depletion of the Maxtor finished goods and transition to Seagate going forward. And as discussed, with the approximate $200,000 in finished goods, we think we were successful are there.

Having said that, though, while there's progress, we still think there's opportunities. Yes, we have more configurations, more complexity, more customers. All that is goodness -- does present some challenges on finished goods inventory. But I still believe we've got some opportunity.

So the teams are continuing to work together to try to balance the equation better between supply and demand. At the same time, meet our customer requirements and stay within the balance of 12 turns, and likewise continue to optimize our freight costs at the same time.

Harry Blount - Lehman Brothers

And then the follow-up relates to Brian. On the outlook side of the equation, you were fairly clear, I think, on most segments. But on the desktop segment specifically, was hoping you could provide a little bit of color and any data points you might have on retail desktop inventory of PCs. You talked about your own channel inventories.

Brian Dexheimer

Well, I don't want to get too far ahead of us, Harry, on talking about what we think customers are -- do or don't have downstream in channels. So far we have not been able to determine that it's wildly out of balance with anything else that we've seen in the last couple of years.

And our outlook includes from an industry perspective about a 3% to 4% unit decline sequentially. So I think that's the best way to characterize it for you right now.

Harry Blount - Lehman Brothers

Great. Thanks.

Operator

Our next question is from Katy Huberty with Morgan Stanley.

Katy Huberty - Morgan Stanley

Yes. Thanks. Just quickly going through some of your comments on gross margins, perpendicular, clearly tracking on plan or even a little better; pricing similar, a little bit better this quarter.

And then you have increasing average capacities in the various segments. Are there any headwinds on gross margins as we think about the next couple of quarters that we didn't discuss on this call?

Bill Watkins

Well, I think pricing is still an issue. I mean, I think desktop pricing in the channel was maybe -- probably the only place where we thought it was pretty benign. I think notebook, for example, which is probably one of the highest growth, is actually quite aggressive right now.

So I think what concerns us is our own ability to execute. We've got to stay focused on our ability to execute. And if we do that, we feel pretty good. I think what we can't control sometimes is what our competitors do from pricing. And that's probably the one thing we probably worry about, though. Brian, do you have anything to add?

Brian Dexheimer

Well, Katy, just to address your question a little broader than perhaps Bill did, the items that are going to get us to a step up of roughly 200 basis points in gross margin in the March quarter. And even a little better in the June quarter the way that we've modeled it, is we do have new products with lower capacity -- with lower cost structures coming in, higher volumes of those.

And you know, we do have an increasing mix of products in terms of the capacity and performance. Those are the things that will help lift the margin. The things that you called headwinds are really, as Bill described, a pricing environment that's still a very competitive environment.

And then, as we have talked about, the increase in some of the costs, like ruthenium, that go into perpendicular recording -- those are the headwinds. All of those are factored into the guidance that we have given the world as we see it today. But that's really the kind of core variables that offset each other.

Katy Huberty - Morgan Stanley

So just to be clear, what's the right timeframe to get back to the 24% to 26% long-term goal on gross margins?

Brian Dexheimer

March quarter should be at the low-end of that range, and we should be the midpoint of that range or a little better in the June quarter.

Katy Huberty - Morgan Stanley

Okay. Great. Thank you so much.

Operator

Our next question is from David Bailey with Goldman Sachs.

David Bailey - Goldman Sachs

Yes. Thank you very much. I was wondering if you could just follow-up on that little bit, Bill, and review the pricing outlook by product category for the March quarter? And what you've seen so far in the channel, and on the OEM side, that gives you confidence in those expectations?

Bill Watkins

I'm not allowed to talk about pricing, so I'm going to let Brian do it.

Brian Dexheimer

Let me just rephrase what Charles had said in the outlook. So what he said in the outlook in his comments was notebook and desktop we expected to be marginally more aggressive than they were in the December quarter, and consumer electronics and enterprise to be relatively the same.

Trying to separate that for you by channel at this point is a little bit predictive, and I don't think we want to do that. Last quarter we felt the benefit of predicting something was a little bit more aggressive in the channel. And the results showed something more positive. That could happen again this quarter. It may not.

So we just have to get through more of the quarter to be able to figure that out. What I can tell you is that as we have negotiated through the OEM portions of each of those segments so I just outlined. We haven't seen any positive or negative surprises.

David Bailey - Goldman Sachs

And maybe you could just help us understand a little bit why desktop pricing ended up being a little more favorable?

Brian Dexheimer

Well, I think it's the primary reason -- and it's hard to tell from a 40% perspective, because that's about how much we are of that space -- but I think the primary reason was the fact that you have a high seasonal demand period. And that typically gives us a price environment that's less aggressive, particularly in markets that operate on more short-term behavior, namely the distribution channel.

David Bailey - Goldman Sachs

Great. Thank you.

Operator

Our next question is from Steven Fox with Merrill Lynch.

Steven Fox - Merrill Lynch

Hi, good afternoon. A little confused on the eSys effect. After you released last quarter, you restated the numbers for about $40 million. Did that come back in Q2, or is it expected to come back in the rest of the year?

Bill Watkins

Charles?

Charles Pope

After we released our financial results in the September quarter, we had a subsequent event that required us to take a $40 million bad debt reserve because of terminating our relationship with eSys. That has not come back. We have not recovered any of the receivables.

We are still pursuing all of the avenues available to us to try to recover them. But there is no recovery represented in our December results. And there is no expected recovery that is provided in the guidance that we've given for the fiscal year.

Steven Fox - Merrill Lynch

And then, just on the operating expenses -- so, for the quarter coming up, can you just describe how that would look again versus the last quarter?

Charles Pope

Well, it will show some step-up in terms of the operating expenses. I don't remember the exact number. But in the December quarter, we typically close down all nonessential functions during the week between Christmas and New Year's to give people some time off, which represents a significant savings to the Company as we use up accrued vacation instead of normal payroll.

And then we have our normal step-ups in terms of some of the merit increases and those types of things. So there will be a step-up, and then there's some additional R&D cost because of the new products that are rolling out that consume protype material.

Steven Fox - Merrill Lynch

Thank you.

Operator

Our next question is from Rob Semple with Credit Suisse.

Rob Semple - Credit Suisse

Thanks, guys. On the gross margin side, when you did the deal with Maxtor about a year ago, you talked about some of the incremental drives coming on, once you got all the production on your own equipment, in kind of above that 26% range you have had on the gross margin target. Any update there in terms of where the incremental drives are coming in now?

Charles Pope

Well, as you can sit and look at where we are forecasting, where in the December quarter Maxtor legacy products had an average gross margin of 13.7%, and we're anticipating taking the combined company from 19.9% combined gross margin in December to something like 24% to 24.5% in the March quarter.

You know Seagate's stand-alone margins in December were 22.3%. So, we're getting about 200 basis point lift in terms of Seagate standalone products with the mix and everything. But you can see all the other incremental revenue is coming up to that same level also.

So I would say that we are achieving the incremental 26% to 28% gross margin that we expected from Maxtor. And the reason we're not at the 26% is because in last June, when there was some very aggressive pricing, it just kind of lowered the whole bar a little bit. So we're moving back up into that range with new product introductions with reduced cost structures.

Rob Semple - Credit Suisse

Okay. And then I guess just one follow-up for Brian. Brian, usually for you guys, CE is up sequentially in the March quarter. I understand your comments on the TAM. But wouldn't you expect to see an above-seasonal quarter this time around, given you've got probably better PS3 production lines, Apple iTV, DVR rollouts, etcetera?

Brian Dexheimer

So my comments earlier were about the CE market being down sequentially for the industry. And I think what you've pointed out is Seagate's performance may in fact be a little bit counter to that, and I would agree with that.

Rob Semple - Credit Suisse

Okay. Thanks.

Operator

Our next question comes from Mark Moskowitz with J.P. Morgan.

Mark Moskowitz - J.P. Morgan

Yes. Thank you. This first question is for Charles and Bill. If I sit and look at your truncated guidance for the fiscal '07 as far as the EPS, can you maybe help us understand, if we take the midpoint of your third quarter EPS range, and then we back into the fourth quarter, it looks like you're actually going to have an EPS decrement sequentially.

I'm just trying to understand how that could be if you're talking about gross margin improvements, as well as the impact of a much better flow-through of a reduced share count?

Charles Pope

The modeling that we have and I'm not sure what you did, Mark. The modeling we have, if you just segregate the numbers, it would represent $0.58 for the March quarter and $0.62 for the June quarter.

Mark Moskowitz - J.P. Morgan

Are you not using 20 and 39 then, for September and December, the non-GAAP numbers?

Charles Pope

There's 16 for Q1.

Mark Moskowitz - J.P. Morgan

Okay. I must have had a glitch then in my model. But either way, I'm trying to get a sense as far as how you can only get, I guess, maybe call $0.04 of improvement when you're talking about having some major gross margin uptake here as you leave the Maxtor integration in history?

Charles Pope

If you sit and look at the total guidance revenue and earnings, you'll see that we're expecting some seasonal lessening of demand in the June quarter on revenue. That's reflected in the guidance that we gave. That is historically the case.

And as we sit and look at the June quarter, at this point in time, we don't see any real reason why it would be counter to that so that where you're in fact increasing earnings in a seasonally-lower revenue period of time. Historically in the industry, when the earnings have gone down, so have the -- I mean, when the revenues have gone down, so have earnings. So, I actually think that's a very good outlook.

Mark Moskowitz - J.P. Morgan

Okay. And then the follow-up would be -- the 1.8-inch market; you folks have seemed pretty loud about the prospects that Seagate possesses, and how it's important in terms of -- mentioned that was one of your three factors to really enjoying this margin uptake.

But can you kind of give us some explanation around that market in terms of what is your view of the overall opportunity outside of the iPod? Because there is some concern with the iPhone that there could be some sort of overhang on the iPod, as well as, from what we are gathering, there could be an oversupply of 1.8-inch drives in the market right now, in terms of the drives shipped versus actually consumed.

Brian Dexheimer

Hi, Mark. This is Brian. This market will continue to be more volatile at the margin than most of the traditional markets that we operate in, and we go in with our eyes fully open. You might remember that we entered into the 1-inch space and had some great fortune, and then the backside of that, as this market transitions.

So what I'd tell you is that we believe that the market is broader than one customer, and it continues to demonstrate that. Our experiences at CES here a few weeks ago reinforced that for us. We also believe it's a market that has the ability to routinely deliver 6 to 9 million units a quarter in volume, and it's a market today that only has two fundamental suppliers in it.

I can't speculate where other suppliers might be in terms of their ability to enter the market or announcements around the market. But we think that with our product technology and our supply chain, this is a market we can enter in and be successful.

We don't have extraordinary ambitions in terms of market share in the near-term horizon, but think that bringing a product to market at the highest aerial density and the smallest package gives us an opportunity to penetrate that market in a quality fashion.

Operator

Your next question is from Mark Miller with Brean Murray.

Mark Miller - Brean Murray

Well, since nobody else said it. Congratulations on your progress. At least I'm impressed with it. I just wanted your thoughts about from where you were at a few months ago on Vista and what Vista is going to do in '07.

And also, we've seen a rather large decrease in the price of high-definition TV. I'm just wondering, is there more upside now from either of these than what you thought a couple months ago in your '07 and beyond estimates?

Bill Watkins

Yeah. I'll let Brian to take it.

Brian Dexheimer

Sure. I think both trends, without getting real specific, are generally net positive to our business. One, the high-definition point, which you mentioned. Second, it was encouraging for us, because we think the high-definition displays goes with people's desire to enjoy the high-definition content that would naturally come with that.

And with that comes, obviously, the opportunity and, hopefully, the desire to record in high-definition. And that's a positive effect on our digital video recording business. In Vista, that also is, at the margin, a positive effect.

We haven't baked in either case, either high-def or Vista, significant uptick in volume because of either. But believe that there's some potential upside at the margin in desktop and DVR space because of both.

Mark Miller - Brean Murray

Thanks gentlemen. The final question would be perpendicular. I mean, certainly you guys have been leading in that and you are one of the leader. But we've seen some announcements now from your competitors, especially in the mobile space, and how is that shaping up? Are people starting to catch up, or you still feel you're two to three quarters ahead of them?

Bill Watkins

It's hard for us to know exactly what our competitors -- because we hear a lot of different stuff. My sense is that we have -- still have about a two-quarter lead, maybe more, actually, in certain markets and depending on the competitor. So I don't know. Dave, do you have anything to add? You stay pretty close to that.

Dave Wickersham

I think that's accurate, Bill. I think that, given what we've described as our percent of perpendicular shipments this quarter. We think we are close to twice that of the industry average. And so, and as we look forward to the balance of this calendar year, likewise, with our plans, we think we continue to have a richer mix of perpendicular going forward.

So and then I guess finally, we're the only ones shipping perpendicular applications in all four market segments. So we think we're well positioned. Is it two or three quarters? Not sure.

Certainly, competition is probably seeing the benefits of perpendicular recording, and really just out of gas on longitudinal. So, we expect them to ramp. Whether or not they catch us in the remaining calendar year, we don't think so. So we think we've got a lead. I guess I'd describe it as a quarter or two.

Mark Miller - Brean Murray

Thanks. Thank you very much.

Operator

Our next question is from Christian Schwab with Craig-Hallum Capital Group.

Christian Schwab - Craig-Hallum Capital Group

Great quarter. Brian, could you give us the TAM for the December quarter. The total number of units you expected that shipped in the quarter?

Brian Dexheimer

Not all the returns are in, but my expectation is $120 to $122, somewhere in that range.

Christian Schwab - Craig-Hallum Capital Group

Okay. We previously thought $115 million to $120 million, and kind of thought there might be some push-out in demand, due to Vista. Did Vista or any of that noise impact that? Why was the -- is there anything specific that you can point to that the TAM was greater than you anticipated?

Brian Dexheimer

Sure. I think the primary driver was over performance for, I think, the fourth quarter in a row in the notebook space. It was just stronger than had anticipated coming in. I think the desktop space at the margin maybe a little bit stronger seasonally in December than we had expected going in. But I think those are the two primary factors on the client side.

The CE and enterprise space came in pretty much where we expected. So not altogether that surprising, when the numbers are getting this big, you know, a difference of 3 million units or 4 million units, you know isn't as much as it might sound in absolute terms.

Christian Schwab - Craig-Hallum Capital Group

Right. And then on the 750 gigabyte drive, how are things going there?

Brian Dexheimer

Great. We're encouraged by our penetration of a number of different applications, surveillance and the near line storage space being the two primary ones. We're in qualifications across the board with most of the providers in the near line storage space, and hope to have more news to report there when we have our next call in April about some success in getting those design wins.

Christian Schwab - Craig-Hallum Capital Group

What do you think the market growth of that is?

Brian Dexheimer

Well, it's been the fastest growing segment of the enterprise space, as you know, an absolute terms, it's still a small portion of the overall enterprise space, if you include mission critical. But we believe it's growing quite rapidly and it's erosive to the tape business, and its additive to our enterprise space in SCSI and Fiber, and now SAS, segment of the business. So we're very encouraged by it's hard to tell what the absolute growth numbers are going to be, but it's certainly a high-growth space.

Christian Schwab - Craig-Hallum Capital Group

Congratulations on that, and congratulations on drawing a line in the sand on market share and causing rational pricing. Thanks.

Brian Dexheimer

Thank you.

Operator

Our next question is from Joel Inman with Robert Baird.

Joel Inman - Robert Baird

Hi, thank you. Could you share with us just the ASP in the quarter? And also the mix between distribution channel revenues, retail, OEM?

Charles Pope

I will if you'll give me one second. OEM on a combined basis was 64% with distribution at 36%. If you look at North America -- geographic splits, it was North America 26%, Europe 30% and Asia-Pac 40%. And the blended ASP -- hang on -- $71, basically, no, hold it, $73.

Joel Inman - Robert Baird

Okay. And retail is just folded into distribution?

Charles Pope

Yes.

Joel Inman - Robert Baird

Okay. Thank you.

Charles Pope

Next.

Operator

Our next question is from Rich Kugele with Needham and Corporate.

Rich Kugele - Needham and Corporate

Thank you. Just two quick questions. First, I believe you had intended on end-of-lifing the 10-K SAS that Maxtor had previously been the only one supplying. Is that still your intention today? And what have you been migrating those customers that were interested in it to?

Brian Dexheimer

Rich, this is Brian. Let me take that one. We in fact have end-of-lifed the legacy Maxtor design, as we had indicated. There are a select number of customers that we have engaged with that have a desire to continue that product trajectory. And what we've been successful in doing is moving them onto a Seagate platform.

Rich Kugele - Needham and Corporate

Okay. And then just lastly, you did mention ruthenium, which has been somewhat over-hyped. Can you just comment as to how much of the EPS? Do you think it's really impacting? Are you just being conservative there, based on what's going on today? And how quickly do you expect to see your own actions reducing that impact?

Charles Pope

I'll take a piece of it and then let Dave take the other piece. You know the cost of ruthenium has run up. And without giving you the amount we use per disc or anything else, we believe that we still have the lowest-cost discs in the industry. And the cost of ruthenium is built into the guidance that we have given.

So as I mentioned when Katy had the question, cost of ruthenium is a bit of a headwind in terms of the expanding margins. Now, I'll let Dave answer the rest of it.

Dave Wickersham

Rich, there's not much to add other than what I described in the script. And that is, given the run-up in ruthenium and, clearly, the cost and inventory impact and we're doing everything possible within our control to mitigate it.

And that ranges anywhere from the design team looking at what are the design alternatives, the process team looking at what we can do to improve the material utilization, and of course, the supply chain, just working end-to-end to try to make sure that from an OEE and utilization perspective, we've identified all constraints and improved the overall utilization of ruthenium.

And so beyond that, and what Charles stated in terms of it being in the outlook, you know we're concerned. And that's why we have all hands on deck. We're looking at it across the board. Like you'd expect us to do on any significant cost impact or supply constraint.

So we're attacking it aggressively. It's something that we anticipate we're going to need to continue to do. And we've factored that in not only to our outlook, but in our priorities in the Company.

Rich Kugele - Needham and Corporate

Okay. Thanks very much.

Bill Watkins

Rich, let me add to that. I think it'd be -- I mean, when we think about the biggest issues in the fourth quarter, ruthenium probably wouldn't be there. There's a lot of other issues with our competitor base, and what they do is probably more important to us as we go forward.

Rich Kugele - Needham and Corporate

That's very good. Thank you.

Operator

Our next question is from Sherri Scribner with Deutsche Bank.

Sherri Scribner - Deutsche Bank

Hi. Thank you. Charles, I'm sorry to belabor this point, but in terms of the gross margin, if I model sort of the midpoint of your revenue range and I model operating expenses slightly higher on an absolute basis, I am not getting in my model to a 24% gross margin, I'm getting more like a 23. Am I thinking about this wrong or can you just help me out there in terms of am I wrong on the operating expense number, or -- can you help me?

Charles Pope

I'm not exactly sure what you're using. But the gross margin that we have modeled for the March quarter is about 24.5.

Sherri Scribner - Deutsche Bank

You're modeling 24.5. Okay.

Bill Watkins

And Wickersham is being held accountable to that.

Sherri Scribner - Deutsche Bank

Okay. And then, in terms of the gross margin improvement sequentially from December to March, what percentage of that would you say is the exit of the Maxtor business and what percentage of that would you say, roughly, is the ramping of new lower cost discs?

Charles Pope

There's probably -- if you sit and look at it, there's about, given the 24.5% gross margin I just discussed with you, about 4.6 -- 460 basis points of improvement. And given that Seagate standalone was at 22.3 in December and the combined was 19.9, it was 18.7, or I forget exactly what the other side was.

But you're seeing about 200 basis points improvement just in the Seagate side, which is mix of products, lower cost platforms that are shipping in higher volume, other types of things. So if you talk about an overall 4.6 -- 460 basis points, half of it is just improvement in mix and lower cost products that Seagate is shipping.

Sherri Scribner - Deutsche Bank

And then the other half is roughly exiting the Maxtor facility?

Charles Pope

Correct.

Sherri Scribner - Deutsche Bank

Okay, great. Thank you.

Charles Pope

Yes.

Operator

Our next question is from Brian Alger with [Strata Capital Management].

Brian Alger - Strata Capital Management

Hi guys, good afternoon. Just a quick question on the ruthenium. It seems that you guys have a unique advantage in the industry in that you use the flex capacity of your various suppliers. Do those suppliers have the ability to pass the rising ruthenium costs on to you, or is that something you guys can leverage through your margins?

Dave Wickersham

This is Dave. Let me say, obviously, we're not going to share any specifics in terms of how we work with our suppliers or how we leverage the opportunity, other than to say that, like I said, we've got both the supply underpinned and the cost impacts in our forecast going forward. I don't think, Brian, it's appropriate to go beyond that.

Bill Watkins

The biggest advantage we've had is, we've been in perpendicular for a long time and have understood this issue for a long time.

Brian Alger - Strata Capital Management

Okay. Thanks guys. That's it.

Operator

Our next question is from Shaw Wu with American Technology.

Shaw Wu - American Technology

Thanks. Just a quick question in terms of component availability, is there a change in the environment there, particularly on the media side? And then, if I could squeeze in a second question, it's just a quick update on the Flash, the hybrid drives. Thanks.

Bill Watkins

So Dave, why don't you take the ruthenium, and I'll let Brian take the Flash.

Dave Wickersham

Sure. So Shaw, from a component availability standpoint, I think we have been signaling for some time that we do not see any industry constraints, nor Seagate's constraints on either finished media capacity, glass substrates or aluminum substrates. So that situation really hasn't changed.

You know, we're continuing to monitor it. As Bill said, as we ramp to perpendicular and see how the competitors ramp to perpendicular that could create some tightness, perhaps some spot shortages. But our view is that overall, there's adequate supply in the near-term for both substrates and finished media capacity. So no component constraints, that we're aware of.

Brian Dexheimer

Shaw, this is Brian. Let me take the hybrid question. So we're very encouraged by our position relative to the remaining competitors in the notebook space. As you know, we've announced the product. We're in qualification at a number of OEMs during this quarter. We may get some volume this quarter. It's a little too early to make that commitment.

But certainly over the course of the next six months, we'll see a ramp of volume of hybrid technology, consistent with the release of this, than, to the consumer space. But I think it's really second half of calendar year before you start to see something that's a meaningful revenue impact.

Shaw Wu - American Technology

Okay. And could I squeeze just one more, a quick one? I'm sorry. Dave, where do you think PMR, where do you think the industry is in terms of PMR? I mean your 24% of your shipments are PMR. Where do you think the industry is at?

Dave Wickersham

We thought the industry, including Seagate, is about half of that in the December quarter. And so what I try to say is, whether we're two quarters or more in terms of the lead, we think we'll continue to have that kind of advantage through the balance of the calendar year. So again about 13 or so percent somewhere in that range the total industry December and Seagate, as you just described is about 22-23.

Shaw Wu - American Technology

Okay. Thanks.

Bill Watkins

And Matthew, one more question.

Operator

Okay. Our final question and we have a follow-up from Harry Blount with Lehman Brothers.

Harry Blount - Lehman Brothers

Hi, Charles, on the guidance, want to come back to the midpoint of the EPS. I think maybe part of the confusion -- I want to clarify this myself -- is that the September guidance that you guys provided of the $1.70 to $1.80 was prior to the $0.07 charge for eSys.

And then the new guidance includes it. So in effect, if we do the math, it really looks like you're, in effect, raising the guidance, midpoint of the guidance by about $0.04 to $0.05. Is that the right math?

Charles Pope

It would be easy to just say yes, because your statements relative to eSys are accurate. The $1.70 to $1.80 guidance we gave at the end of September did not include that. The $1.70 to $1.75 we gave now does include that. But it also didn't include the better-than-average performance that we got in the December quarter.

So, you kind of net those two things out. The guidance that we gave for the back half of the year is relatively consistent, once you net everything out that came in and out.

Harry Blount - Lehman Brothers

Okay. Great. And then on the CE side of the equation, Brian, just to clarify the split between gaming and PVR how should we think about that, roughly?

Brian Dexheimer

Well, you can assume that gaming was less than half of that 7 million units.

Harry Blount - Lehman Brothers

Okay. Great. And then the last question. Charles, you indicated on EVault that --

Bill Watkins

Three. No one listens to us. You notice that, Charles?

Charles Pope

I've noticed.

Harry Blount - Lehman Brothers

I figured I had a freebie since I was the follow-up side. The data on the EVault side of equation Charles, you talked about the guidance excludes EVault on the amortization, but anything you'd care to add on either revenue or margin impact?

Charles Pope

The expectation that we have with EVault is that it will have no material effect relative to revenue or earnings after we have taken care of the purchase accounting stuff. I'll give you an update on that when we have those.

Harry Blount - Lehman Brothers

All right. Thank you.

Bill Watkins

Okay. Thank you.

So again, everybody, thank you for joining us for the call today, and we look forward to speaking with you next quarter. Take care. Travel safe.

Operator

This concludes today's teleconference. We thank you for your participation. You may now disconnect.

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