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Seagate Technology PLC (NASDAQ:STX)

Q4 2011 Earnings Call

July 20, 2011 5:00 pm ET

Executives

Robert Whitmore - Chief Technical Officer and Executive Vice President of Research & Development

Steve Luczo - Chairman, Chief Executive Officer and President

Patrick O’Malley - Chief Financial Officer and Executive Vice President of Finance

Analysts

Richard Kugele - Needham & Company, LLC

Keith Bachman - BMO Capital Markets U.S.

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

Jayson Noland - Robert W. Baird & Co. Incorporated

Sherri Scribner - Deutsche Bank AG

Ananda Baruah - Brean Murray, Carret & Co., LLC

Scott Craig

Mark Moskowitz - JP Morgan Chase & Co

Katy Huberty - Morgan Stanley

Operator

Good afternoon, ladies and gentlemen, and welcome to the Seagate Technology's Fiscal Fourth Quarter and Year-End 2011 Financial Result Conference Call. My name is Katherine. I'll be coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

This conference call contains forward-looking statements, including but not limited to statements related to the company's future operating and financial performance in September 2011 quarter and thereafter, and includes statements regarding customer demand for disk drives and general market conditions. 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, uncertainties and other factors that could cause actual results to differ materially from those anticipated by these forward-looking statements.

Information concerning additional factors that could cause results to differ materially from those projected in the forward-looking statements is contained in the company's annual report on Form 10-K, Form 10-K/A and quarterly reports on Form 10-Q, as filed with the U.S. Securities and Exchange Commission on August 20, 2010; October 6, 2010; November 3, 2010; February 3, 2011; and May 3, 2011, respectively.

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. Steve Luczo, CEO. Please go ahead, sir.

Steve Luczo

Thank you, Katherine. Good afternoon, everyone, and thank you for joining us today. On the call with me from Seagate are Pat O’Malley, our Chief Financial Officer; Bob Whitmore, our Chief Technology Officer; Dave Mosley, EVP of Operations; and Rocky Pimentel, Chief Sales and Marketing Officer.

We have provided detailed supplemental information about our fiscal fourth quarter and fiscal year-end results on our Investor Relations site at www.seagate.com.

During this call, I will review the results for the fourth quarter then provide a brief update on the Samsung transaction and then discuss the outlook for the September quarter. After that, we'll open up the call for Q&A.

On our earnings call in April, we indicated that we were expecting component constraints related to the damage caused by the Japan earthquake and tsunami to continue to impact the disk drive industry in our fiscal fourth quarter. We believe the supply chain impacts would result in the industry TAM being flat to slightly down quarter-over-quarter at approximately 160 million units. We also expected Seagate's revenue to be roughly flat sequentially at approximately $2.7 billion and non-GAAP diluted earnings per share of $0.19 to $0.23.

Seagate delivered solid financial results in the June quarter with revenue of $2.9 billion. We believe the upside revenue was the result of stronger-than-anticipated demand, and we were able to respond because of the benefits of Seagate's robust supply chain.

On a non-GAAP basis, the company reported gross margins of 18.8%, diluted earnings per share of $0.28 and net income of $126 million. The industry TAM for the June quarter was approximately 166 million units, an increase of approximately 4% from the prior quarter, which is essentially equal to the industry's record shipment of 167 million units in the fourth calendar quarter of 2010. In addition, the average capacity per drive shipped by the industry continued to increase during the quarter and reached approximately 560 gigabytes per unit.

For the fiscal year, storage capacity shipped grew approximately 40% to 330 million terabytes. Seagate shipped a record 52 million units during the quarter, representing approximately 32% market share and averaged approximately 590 gigabytes per unit. We believe that this continued increase in the amount of digital storage shipped is directly related to the broadening geographical footprint of IT systems and services, as well as the impact of a highly mobile and connected user base that is demanding real-time access to rich data and content. We also believe these trends will continue as computing architectures evolve to serve this growing commercial and consumer user base throughout the world.

In the enterprise market, Seagate shipped 5.1 million drives for mission-critical applications and 2.7 million drives for business-critical applications, representing year-over-year increases of 8% and 46%, respectively. The company shipped a total of 35.5 million client compute drives in the June quarter, consisting of 14.7 million mobile drives, up 21% year-over-year, and 20.7 million desktop drives, up 6% year-over-year. Demand for Seagate-branded storage products remained strong, with solid year-over-year growth of 36% to 3.5 million units, while consumer electronic products totaled 5.4 million units.

While there has been some commentary in the market about customers potentially building inventory due to real or perceived supply constraints, we believe the June quarter's TAM reflected true end demand. For example, distribution channel inventory of Seagate's 3.5-inch ATA desktop drives at the end of the quarter was 3.5 weeks, which was again below the targeted range of 4 to 6 weeks. We think it's important to note that this is well below levels typical for a June quarter, which is historically the quarter with the greatest risk of excess inventory during the year. Given our ability to sustain weeks on hand below 5 weeks for the last 2 years, we are now targeting 4 to 5 weeks on hand for our distribution channel inventory level.

Our gross margin in the quarter was slightly better than planned and was positively impacted by the relatively balanced supply environment in the quarter as well as higher volume. Historically, our gross margins improved more significantly in this type of environment. However, this quarter's accretion was limited by the following factors: First, since we had completed pricing negotiations with our OEMs prior to the mid-quarter increases in demand, we did not increase OEM pricing within the quarter. OEMs constitute approximately 70% of our revenue.

Second, we did not achieve our time to maturity targets for products announced in fiscal year 2011, which resulted in higher scrap cost and inefficiently utilized manufacturing resources.

Third, as we most recently discussed on our fiscal second quarter financial results call, commodity prices that directly impact our company and the industry have continued to rise.

And fourth, we were able to service upside demand, consisting primarily lower-margin notebook products.

We continue to focus on actively managing the balance sheet to maximize shareholder returns while maintaining the flexibility to invest in a broad range of storage technologies to serve our customers. During the quarter, Seagate completed a $600 million offering of senior unsecured notes, returned $77 million to shareholders in the form of a dividend and repurchased $112 million of Seagate ordinary shares.

Our strategic relationship with Samsung progressed as expected during the quarter, and we continue to believe the transaction will close by the end of calendar 2011. Once completed, this relationship will enable the companies to better align current and future product development efforts and roadmaps, accelerate time-to-market for new products and position the companies to better address rapidly evolving opportunities in mobile computing, cloud computing, solid-state storage and other markets. We remain confident about the benefit of this strategic relationship to our customers and our shareholders.

With regard to our outlook for the September quarter, I want to emphasize that the outlook is influenced by significant uncertainty concerning global macroeconomic conditions, including the outcome of negotiations around the U.S. debt limit and the impact of issues related to European sovereign debt.

For the September quarter, we expect the industry TAM to be 165 million to 170 million units, and believe the industry will maintain a well-balanced supply and demand environment. Specifically for Seagate, revenue is expected to be approximately $2.9 billion. We do not anticipate significant market share shifts from the June quarter, primarily due to a longer life cycle of current-generation products throughout the industry.

Gross margins for the September quarter is expected to be up slightly compared to the June quarter. We expect to benefit from relatively benign price erosion already negotiated with our OEMs and continued tight supply in the distribution channel. We do, however, expect a positive margin impact of a more stable pricing environment to be offset by the following factors: the costs of many upstream materials, especially rare earth elements, which have increased significantly. These costs are expected to adversely impact gross margins by at least 200 basis points. And as previously mentioned, the delay in achieving time to maturity of new products is resulting in inefficiently utilized manufacturing resources with higher cost. Currently, we expect meaningful cost reductions and resulting margin accretion associated with these new products to be realized in the second half of fiscal 2012.

In regards to the increasing cost of upstream materials, Seagate has historically been able to absorb these cost increases and insulate our customers. However, the recent dramatic increase in the cost of rare earth elements, combined with a pre-existing upward trend for a broad base of other commodities, far exceeds our ability to find offsetting cost reductions. While we are exploring opportunities to reduce the content of certain rare earth elements that are used in the manufacture of hard disk drive components, we will be discussing with our customers, passing through what we hope are temporary surcharges related to upstream earth-based commodities. It's important to note that for the relevant rare earth materials, there does not appear to be a significant supply constraint. And while we have a short-term concern over margin impact, we do not currently have a long-term concern.

The tax provision is expected to be between 3% and 10%. R&D and SG&A is planned to increase to $350 million, and we expect capital investments to be at or below the low end of our targeted range of 6% to 8% of revenue. Excluding certain expenses, such as restructuring and acquisition-related costs totaling approximately $10 million, non-GAAP diluted earnings per share is expected to be in the range of $0.29 to $0.33 per share.

Katherine, we're now ready to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Rich Kugele of Needham & Company.

Richard Kugele - Needham & Company, LLC

A couple of questions. First, on the rare earth side, can you give us a sense on what percent of your -- of a disk drive might be affected by rare earth element pricing? For example, I mean, are we just talking about the motor, or is it much more broad than that? And then I have a follow-up.

Steve Luczo

Percentage in parts could be indicated in percentage in terms of basis points, which is 2%. But do you mean where is it used throughout the drive, Rich?

Richard Kugele - Needham & Company, LLC

Yes.

Robert Whitmore

It's particularly the VCM magnet, Rich, and then inside the motor itself as well.

Richard Kugele - Needham & Company, LLC

Okay. Because rare earth pricing has been increasing for some time. So has it just been the supply chain that's been absorbing it up until now?

Robert Whitmore

That's partially true, but I think if you look over the last month or 2 months, it's been dramatically increasing as well. And sorry, I should also mention probably cerium oxide, which is used to polish glass as well. So, there are a lot of different variants of rare earths that are actually integrated.

Steve Luczo

Yes, it's been increasing for -- I mean, I think we first identified this actually last summer, reemphasized it again in the January call. And I think it's been increasing. I think the acceleration, Rich, in the last 60 days is dramatically greater than the average before that.

Richard Kugele - Needham & Company, LLC

Okay. And then in terms of your comment about the technology transitions, your yield and not being able to hit the type of volume you wanted, can you be a little bit more specific about -- is it just the products that you mentioned in the press -- in the prepared remarks, or is it a specific areal density? And when do you expect those issues specifically to go away? Or is it just that the component count will change in the second half and so you get the margin benefit that way?

Steve Luczo

Let me just touch on it and then I'll turn it over to Dave or Bob. But I think we're going through, as I think when we've indicated to the investor base, it's a fairly significant transition that's occurring through this calendar year and into next calendar year. And it's related to areal density nodes as well different capacity points across almost our entire product line. So for Seagate, I think it's at least 8 products that we're transitioning over the course of this fiscal year. And ultimately, yes, it's still a component cost at higher capacity, and you have to get through the transition to drive yield. And then I'll let Dave and Bob talk to some more of those, but I think the gross margin implications, all things being equal, is pretty significant in terms of once we get through the transition.

Robert Whitmore

So I think the other thing, Rich, that I would add is to the component cost reduction, which are component cap coming down, which when you get through this transition, is very meaningful. It's also, as you push out the product transition, you end up changing the configuration quite a bit, which ends up in materials that are not utilized properly. They're either ending up in scrap or somewhere else that wasn't optimal. So that's what we're suffering through as we go through these transitions right now. That's what we've got to take.

Richard Kugele - Needham & Company, LLC

To the best of your knowledge, is the competition facing similar challenges? And do you think that Seagate's still retaining its areal density lead even with the delay?

Steve Luczo

I think that depends market segment by market segment, exactly how it breaks down. I think we've got fierce competition in certain areas, and then there's other areas where we're doing quite well.

[Technical Difficulty]

But I think the other thing is there's -- not only competition is transitioning the portfolio wealth that we are, right. No one has the breadth of the portfolio. Again, no one even, across all segments and within chip segments, so I think it's a different animal probably for our competition. I think in general, we feel good about where we are in areal density transition across the portfolio.

Operator

Our next question comes from the line of Keith Bachman of BMO.

Keith Bachman - BMO Capital Markets U.S.

Steve, I wondered if you could just talk about if the TAM's in the range that you've identified for September, just any thoughts on what, at least directionally, the TAM would look like in December. And then also speak to, if you could, I think you said supply/demand was relatively balanced. But if you could speak to what are the constraints out there that you're seeing from your competition, particularly Hitachi, within that overall market environment. And then I have a follow-up, if I could, please.

Steve Luczo

Yes, I think, let me just -- on the first question, I think we expect December quarter to be greater than September quarter. And my guess is probably in the same kind of growth range of maybe 4% to 5%. And I think that's probably, if you think about what our capital allocation -- and again, big product transition, so I think there's big component challenges as well at those levels even though they may feel lower than people thought the industry could be at a year ago. That was at much different component counts per drives and things like that. So with the average capacity increasing to the extent that we talked about, 40% growth year-over-year, that's obviously chewing up a lot of heads and disks, and the capital was getting pretty tight there and us for one, we told you we're going to be probably at or even below the low end of our capital investment range. So we're trying to manage it to what we see as decent growth and probably establishing a record quarter for the industry and certainly a record quarter in petabytes shipped. But it's not robust, firing on all cylinders. I think until the macroeconomy is settled down globally, right. I think with respect to Hitachi, I don't want to talk too specifically about a competitor. And what I'd rather talk to, I guess, is my observations of living in Asia for 4 months and getting there 3 days before the earthquake happened and pretty -- being pretty intimately involved with that on multiple levels, both personally as well as professionally. I just think that the disruptions on the supply chain side are still going to be probably more difficult than maybe expected. And every day, we still hear about things that are worse than we thought they were. And it's human nature to, I think, be optimistic. And I think it's also -- these are very complex systems that are -- that have been severely disturbed. And with respect to our industry, obviously, it's around fabs and fab capacity and when fabs are coming online and if they do, what yield and how much power are they going to have. And I just think it's still very tenuous and therefore, we still see a fair amount of tightness in certain segments, mostly around notebook, as some of our competitors have shifted their more certain production to probably higher margin opportunities.

Keith Bachman - BMO Capital Markets U.S.

Right. But as you look at the opportunity today, Steve, collectively with the industry, the industry can produce that, say, TAM of 165 million to 170 million units in the September quarter?

Steve Luczo

I think it can. I think it's tight, but I think it can. I guess it's going to be relatively balanced like I said.

Operator

Our next question comes from the line of Katy Huberty of Morgan Stanley.

Katy Huberty - Morgan Stanley

Given the demand upside of the June quarter, can you just talk about why the guidance for September is sub-seasonal? Which product categories are you seeing weaker than seasonal demand? And were there trends at the end of the quarter that drove a more conservative outlook?

Steve Luczo

Probably a better question for the IT -- for the computer companies of the world probably than us. I mean, we're obviously responding to what we think customer demand is and keeping our channel inventories at reasonable levels. So I think that's probably better directed towards the PC companies in terms of the growth that we're getting from them, whether or not it's at the server level or at the client level or at the high enterprise system levels. I mean, it's really a reflection of what our customers are telling us in general.

Katy Huberty - Morgan Stanley

Does your TAM outlook assume that you get inventory back into the 4- to 5-week range?

Steve Luczo

No. I don't think we said that. I think we said that we have consistently been under 4 to 6 weeks, and therefore, we're reducing our targets to 4 to 5 weeks. But we still continue to manage our inventories as lean as we can and as lean as also acceptable for our customers.

Katy Huberty - Morgan Stanley

Okay. And then just lastly, did any of the yield issues impact your ability to negotiate for more favorable pricing with the OEMs?

Patrick O’Malley

This is Pat. I'll let Dave comment as well. We were able to hit supply. I mean, we hit the time-to-market metric and get the products out there, but the yield was somewhat costly but we did impact our customers' schedules significantly as much as manifests itself into our P&L for this quarter and probably next.

Steve Luczo

I think OEM pricing for the September quarter, and actually with some of our OEMs, we've actually negotiated pricing through the December quarter, has been the most favorable it's probably been in the 20 years I've been in the industry, if I think about percentage changes quarter-to-quarter. So I think there was nothing with respect to ramping our new products that impacted our ability to deliver to our customers because we can obviously deliver old products. It's more of an internal challenge for us of the opportunity of getting into these transitions at the yields that we want, obviously drives a lot more margin for us. So wasn't a pricing issue at all. In fact, pricing, relative to historical norms, has been quite favorable just given the supply/demand challenges that are, as I've mentioned in the first question, I think, that are still somewhat tenuous.

Operator

Our next question comes from the line of Mark Markowitz of JPMorgan.

Mark Moskowitz - JP Morgan Chase & Co

Maybe if I could just follow-up on that last point you made, Steve, in terms of OEM pricing has been negotiated through December, I think you said, one the most favorable terms in years. Does that assume then, you've kind of already been able to pass through some of these rare earth metals increases, or is that still a wildcard?

Steve Luczo

That's still a wildcard.

Mark Moskowitz - JP Morgan Chase & Co

Okay. And then how should we think about the distribution channel? Because typically, you get a nice benefit when you do put product in there. Are they going to have to bear the cost of these rare earth metals even at a higher rate?

Steve Luczo

Again, I don't -- I mean, I don't know whether I can answer it, even given a higher rate. Because our negotiations with our OEMs, like I said, some of them are out one, some of them are out 2 quarters and some OEMs aren't. And so depending on what you've signed up for in terms of volume and commitments on both ends, it has different implications for pricing. And as you point out, the channel is more of a spot market. And if therefore, there are shortages that are either related to increases in demand or shortages in supply or pressures from other areas like rare earth elements, then the spot market would tend to bear that more. Obviously, we have to take into account that our channel partners are working on very thin margins as well, and we have to work together in terms of determining what's the right balance in order to continue to drive demand as we deliver more and more storage for less money, as also well as not getting squeezed on the margin side where we can't invest in R&D and capital.

Mark Moskowitz - JP Morgan Chase & Co

Sure, understood. Maybe just to come back to -- I guess, historically, have there been instances whereby once you kind of negotiate prices with the OEMs, you can come back to renegotiate? Do we need to see some sort of major demand exceeding supply situation for you to be able to pass on these rare earth metals price...

Steve Luczo

We tend not to do that. It's happened in the industry. And I guess for us, I mean, as you know, we have more OEM market share than any of our competitors, I think. Well, maybe not Hitachi, they're pretty OEM-centric as well. But for us, we try and take the longer-term view and we try not to raise prices in our OEMs in quarter if we've made commitments because obviously, they plan their business around that as well. On the other hand, when disruptions happen and we try and work together in terms of cushioning that for both sides so that we can pursue our business opportunities. So I would say that for those customers that have committed, it would be less likely that we would have to come back to them with any sort of increase. If it got absolutely crazy, I think they'd be understanding in saying, "Yes, we understand what the problem is, and we have to work it together."

Mark Moskowitz - JP Morgan Chase & Co

Okay. And then my other question is just getting back to the TAM. I guess we're kind of all perplexed here by the low seasonal trends for September. Was there something that happened in the first half of the June quarter where maybe that was abnormal or artificially inflated, i.e. hoarding, and that's why you're kind of being cautious here with the outlook?

Steve Luczo

No. Again, I don't know that the outlook is all that cautious relative to what a lot of the computer companies are saying, but maybe you have different data.

Patrick O’Malley

And the other thing, Mark, we did expect the June quarter evenly flat, even some have signaled down and it was up. So I mean...

Steve Luczo

I think you have to remember what my initial comments were is that this is also heavily influenced by a lot of uncertainty around global economic conditions. I think it's very dangerous to go talk about a very robust September when 1.5 weeks from now, you may have some real or perceived issue with the U.S. government that might shatter people's confidences or not. And so we're putting a forecast out there that we think is reasonable, given a lot of uncertainty in the world with respect to macroeconomic interlinks. But I don't think it's that inconsistent with what most of the IT industry is saying. And like I said, I mean, I don't know what Intel has said or is going to say, but I don't know that 170 million units is really all that short to what the industry is saying. If it is, you can kind of give me the data that says it is and we'll visit it. It's our best guess right now.

Operator

Our next question from comes from the line of Aaron Rakers of Stifel Nicolaus.

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

A couple of questions as well. First in looking at the results over the last couple of quarters, you guys have consistently provided a guidance of basically flat sequential operating expenses. However, we've seen that surpassed here for 2 quarters in a row by a decent amount. Can you talk to us about why we should think flat or what's going on in the OpEx line that drove the upside this last quarter and just thinking about that, the quarter prior to that even?

Patrick O’Malley

This is Pat. The OpEx in the first half of the year was not -- did not have a variable comp plan. We did not hit our financial targets, the second half did. And we're planning on the objectives of the first half next year to have that. So that is probably the biggest variant. There's other variants of some level of increased investment either in sales and marketing for penetration, a few areas where we see some opportunistic views that we'll go after and see how we can harvest those and then just some other G&A costs, whether it's a litigation or, if you want to read our footnotes, we have quite a big load next year that may not manifest itself, but we are certainly planning for that level as laid out. The $350 million's pretty solidly underpinned as we see it today, so...

Steve Luczo

Yes. I think that the increase is $5 million or $6 million, and it's coming from 4 or 5 different directions. So we'd love to be able to say, "Well, it's increased investment for geographic expansion and there was a piece of that." But the reality is, when you split apart $6 million over $3 billion revenue, it kind of gets -- it's hard to kind of give you a list of stuff when we try to give you a flavor. Probably the litigation expense may be the -- if I had to point to the one single largest piece, it might be related to that. But it's also hard to tell for us whether or not some of these are going to settle or not. So I think we feel pretty good about $350 million right now.

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

Okay, fair enough. And then on the product transitional points, can you remind us again of where you're at, how you're making these areal density transitions? Were you predominantly leading with your own head technology? I just want to understand. Again, kind of going back to the question of whether this might be a little bit more Seagate-specific relative to the overall industry, if there's any differential being driven by internal versus external usage of heads or other components for that matter.

Steve Luczo

Yes. I don't think so, I mean, other than I think in our portfolio on the desktop and in the enterprise, we're clearly ahead of the competition significantly in some cases. And so yes, we're -- it's not just areal density, right, there's performance issues and capacity issues and rotational speed issues. But if you want to boil it all down to areal identity, I suppose we could at some point. But I think for the most part, those are we utilize TDK and Seagate heads, and we don't see any competitive differences across the board so you kind of say Seagate's better or worse. We feel good about where we're at in our head technology and we feel very good about where TDK is. So I think in those 2 segments, it's primarily we're ahead of the game. And because we're ahead of the game, we're probably paying a little bit of a price of what it means to get through the transition. Obviously, the benefit of that is pretty significant once we can get off the yield curve. On notebook, I would say that, that's not the case, and we're certainly probably not ahead of the competition and we're probably not executing as well. And that's certainly still a large opportunity for us. And again, I wouldn't point it towards TDK heads versus RHO [ph] heads. I think it's just an execution issue that we need to address. And part of it is a portfolio that is significantly more complex than our competition in terms of 7-millimeter and 9.5-millimeter, 5400 and 7200. So it's a product portfolio where you're trying to leverage the technology. And obviously, we have our hybrid technology that is another differentiation, but it's also more complexity.

Aaron Rakers - Stifel, Nicolaus & Co., Inc.

I was just going actually ask that, and that will be my final question. Just update us on where you're at or where your thinking's at with regard to what you've said in the past on hybrid, when we should expect volumes ramping and how we should think about that opportunity or that move from the company.

Steve Luczo

Yes. We're still optimistic about it. I still kind of put my 5-year view out there, that I believe for a variety of reasons, the vast majority of our products will be hybrid, whether or not that's NAND flash-related or whether or not that's areal density-related or whether or not that's performance related at the device level or at the system level. I think there's many reasons why hybrid technology is going to be more and more relevant and prevalent. I think more specifically, we continue to have excellent traction with a broader and broader base of OEMs, so I think you'll see systems launching over the course of the next year that are going to incorporate the hybrid technology, especially as we get closer to deploying MLC-based technologies at the client level. That's obviously going to be a price point breakthrough that's going to be -- it's very significant in terms of the ramp on the product. And we feel that we're there.

Operator

Our next question comes from the line of Sherri Scribner of Deutsche Bank.

Sherri Scribner - Deutsche Bank AG

Just a quick clarification to begin with. The TAM guidance of 165 million to 170 million, is that based on what you think the industry can supply, or is that based on your expectations for demand in the calendar third quarter?

Steve Luczo

Yes, I'm glad you answered the question, about the same. I mean, I think it's -- again, we'll see what our competition says tomorrow. And our best guess is that's the best TAM. And I wanted to clarify that. And I also think that's about what the industry can supply. If it's higher than that, which if we're wrong and it's 175 million or 180 million because that's what the magic, 8.8% growth rate says on, what, the 2 quarter shipped, then I think the industry is going to be very constrained and it'll show up in September. I think the other thing I'd really like to emphasize, and I'm sorry I didn't in my comments or in the previous question, is the demand is unusual in terms of how it's profiling out this quarter, in that it's very strong in July and August and less visibility in September. And yet, if you look at the last 5 years of shipments by the industry, it's obviously the inverse of that, that July is weaker than August, and August and July are weaker than September by a fair degree. So the fact that it's so front-end loaded can either talk to lack of visibility or other strategies that our customers, or could talk to that yes, the 165 million to 170 million is conservative and that pop is going to happen in September. I think the industry will struggle to feed a lot of that upside, so that would just result in a situation in September that could be certainly challenging from a supply/demand perspective.

Sherri Scribner - Deutsche Bank AG

Okay, that's extremely helpful. And then just talking on the product transition issues. I know that you gave a number for the impact to gross margins from the raw material costs, 200 basis points. But can you give us a sense of what type of impact the product transition cost was to gross margins? I mean, you're at 18.8% now. Your long-term target is 22% to 26%. Would you have been in your long-term targets, or do you think you'll be on your long-term targets by the second half...

Steve Luczo

Yes, we'll be on our long-term targets, I mean, all things else being equal. But it's another couple of hundred basis points.

Patrick O’Malley

We'd be in our target margin range as we signaled earlier without the rare earth and we ramped historical. It's not that the late market just ramping is the issue, but if ramped historical, we'd be there. So we clearly see a path to get there, it's been a little longer than we want to get there.

Sherri Scribner - Deutsche Bank AG

Okay. And then just finally on the notebook products, you mentioned the mix was somewhat negative to the gross margins also. In the past, you talked about your notebook gross margins being lower than your desktop gross margins, that was a couple of years ago. Is that still the case, or would you say they're at parity?

Steve Luczo

It's very specific to current market conditions. I mean, we've had periods where our desktop -- our notebook margins are very attractive and other times when they're less so, and it's mostly pricing-related. I think if you look over the last 4 quarters, where price erosion has been the most aggressive it's been in the notebook space. And some of our competitors were very aggressive at certain capacity points and drove margins that were in the mid-20s. If you can actually measure margins that way, which we can get into a longer discussion about how real that is. But if you were to use some consistent application of accounting and said margins were in the mid-20s, those were driven down to certainly sub-double digit. So getting recovery on that as we have in the supply/demand imbalance has been good, but there's still margin levels that are less than the average for the company. And because Seagate was able to respond to upside at those capacity points, mostly 500 gigabytes, it was a good opportunity for a revenue upside that certainly was impressive. But from a margin perspective, it's squeezed margins a bit but added net income. So I think -- I'm not apologizing for it, but it's just part of the description of why the gross margins were impacted more as a result of that upside response.

Operator

Our next question comes from the line of Ananda Baruah of Brean Murray.

Ananda Baruah - Brean Murray, Carret & Co., LLC

So Steve, I guess just for a bit of a clarification on TAM, sounds like you might be suggesting if we got the 4% to 5% sort of industry demand increase in the December quarter, that, that in fact, might be -- end of September quarter came in as you're forecasting, that might be a challenge to meet from the supply perspective.

Steve Luczo

Yes, I believe that's true.

Ananda Baruah - Brean Murray, Carret & Co., LLC

Okay, great. And there, is there anything, any update you can give us, I guess, regarding sort of European Trade Commission communication? I guess anything you guys have sort of incrementally reached out to them with since they decided to take kind of like a deeper look, I guess, or request more information from you? And just maybe if you can just give us a sense of what your message to them has been through this whole process?

Steve Luczo

I mean, we've obviously been actively cooperating with them throughout the entire process, and I don't think that there's been any surprises in that process with respect to either request, reactions or response, timing or engaging with either suppliers, customers, competitors or internally at Seagate. So I think for us, it's been going as expected. It's a healthy process for everyone. And right now, we anticipate that will continue to proceed in a healthy positive manner and get the transaction closed by the end of the year.

Ananda Baruah - Brean Murray, Carret & Co., LLC

Okay, great. And then just one last clarification, if I could. You said the expectation for more normalized yields on the new product transitions are second half of fiscal year '12. So that's first half of, I guess, like the March, March, June quarter of next year?

Steve Luczo

That's right. I mean, we're obviously working out transition yields and performance issues right now, but I think in terms of our opportunity to have those contribute in the way that, that Pat mentioned, where we can start seeing benefit at the margin level to get into our targeted range, we would expect it to start at the second half of the year. So we mean starting in the March quarter. Obviously, we're aggressively pursuing.

Operator

Our next question comes from the line of Scott Craig, Bank of America Merrill Lynch.

Scott Craig

Steve, can you give us, maybe give us an update on the SSDs in the enterprise, sort of what you're seeing there from your customers, the transition from Fibre Channel to SATA drives there as well? And then secondly, because you made a lot of product announcements recently in the SSD side and the enterprise, maybe you could just give us your thoughts on how you expect that business to ramp and when we should start seeing a meaningful contribution.

Steve Luczo

Yes. I mean, I think on the customer side, the reality is it's for a limited customer base who's using SSDs in the enterprise segment. And I'll let our customers identify who they are, but I think you know who the majority one is and what their success has been. They've been probably leading the charge in terms of defining an architecture, presenting it to their customers and getting good traction. And that's an account that we're not engaged with, with the Fibre Channel drive. We feel good about our technology. We feel good about where we're at on our SAS drives. And obviously, with the relationship with Samsung, we believe that the NAND sourcing and cost side of that is going to be very attractive. So our engagement with our customers certainly has accelerated, both with that agreement as well as getting further down the path on the joint technology development that we have with them, which is this class management engine chip. And in terms of meaningful revenue, I would say that once MLC starts getting incorporated into the devices, which we do feel very confident about the approach that we're taking, I think that's when you're going to start seeing a pretty significant milestone to what I've been saying for a year, which is to me, it's a 2015, 2016 thing, where you could look at that and say there's hundreds of millions of dollars of revenue, sort of somewhere between 5% and 15%, of incremental enterprise business that is associated with SSDs. And I think that's the important point. There's not a disk drive in the world that, say, that can do what an SSD does. So it's not replacing disk drives, it's basically opening up new applications other than group drives, which I think happened 3 years ago. So yes, I feel good about where we're at. I still think it's an opportunity that Seagate, and I guess I'll now characterize it as Seagate and Samsung jointly, are going to pursue in a way that's going to be tough to have a better product than.

Scott Craig

And then just a follow-up on the CapEx. Sounds like you're going to drop it here below the sort of normal targeted range. How long do you think that goes on? And then where are the priorities when you're looking at the CapEx over the next couple of quarters? And that's it for me.

Steve Luczo

Well, I think, for us, as we get to a -- I did a big -- we did a big reorganization a few months ago. And one of the big focuses on the reorg was to split the R&D function from the operating function, and within those areas, start to be rethinking how we deploy capital throughout the manufacturing side as opposed to by component, either with heads or disks or drives. And through that, I think that we've seen that we have some efficiencies that can be had. Maybe you could say that inversely, that maybe we have overinvested in some capital historically that maybe wasn't being as efficiently utilized as we think it can be now. And I think it's a decent amount, call it 5%, call it 10%, I think there's that amount in capital efficiency there that we can go attack. And Dave's off doing that. I'll have him talk more to it. And a lot of it is also this issue around complexity in the portfolio and then complexity of what we're doing in terms of how we're running our products in our factories that will basically ultimately yield a lot better capital improvement. So I think it's a big opportunity for us, to basically reduce that capital on a sustained basis and drive a lot more output with the smaller capital footprint. Where I worry about constraints? Historically, I probably would've said heads, depending again if areal density keeps -- petabyte shipments continue to grow at 40% year-over-year, and I think most people in the industry would say that aerial density is somewhere in the 25% range right now. And until you get a hammer deployment or whatever the next big generation is to boost areal density, the only way you can solve that problem is with more heads in disks. So I would historically have said probably heads. I'm starting to think probably more disks now, and I'll let Dave talk to that as well. But certainly it's the component level, not the drive level. And I think that's probably the bigger message, right. And we can argue at the margin as a constraint, first going to happen at wafer or slider or HSA, but I think it's at the component level. And if there's a marginal shift in my thinking, it's probably away from heads and towards media. But I think with -- at 40% areal density growth -- I mean, 40% petabyte growth and 25% areal density growth, if you show some macroeconomic recovery on top of that, there's going to be some challenges on the component side, and those are 9- to 12-month lead times on capital. So it's not something that will get resolved overnight. And I don't think it's something that the industry is going to lean into because all of us are operating at margin structures below our targeted range.

Operator

Our next question comes from the line of Jayson Noland of Baird.

Jayson Noland - Robert W. Baird & Co. Incorporated

Steve, just a clarification. I'm not sure if I understood the comment on earth-based commodity costs being more of a short-term concern than a long-term concern.

Steve Luczo

Well, I think we'll see how this thing plays out, and there's obviously a lot of dynamics going on that are certainly not in the conversations that I'm involved with, right. But I mean, the reality is it doesn't appear that there's a true supply constraint here. There's a lot of dynamics around owners of rare earth materials and processors of rare earth materials and who is controlling inventories at what level, as opposed to there's fundamentally some shortage. If there was fundamentally a shortage, then I would think that the fact that price is supposedly representing supply and demand. If you effectively reduce supply or enormously increase demand, that would mean that there's a sustained increase in price. I think this feels a little bit like a bubble. We went through it with ruthenium, I guess, in 2006, when there was a massive spike and it lasted 6 months and it settled down. Now did it settle down at levels higher than maybe it was originally? Yes, but it certainly wasn't anywhere near the spike level, like a factor of 10, is what the spike level was. So I think our point is that right now, since it doesn't feel like there's a fundamental supply issue, that it probably works itself out. And by the way, if these prices stay high, guess what, there's a bunch of U.S.-based mines that are going to come online again, and it will solve itself. It's not like the stuff doesn't exist. It's just that a lot of mines were closed down when the prices fell below $75, whatever the magic price is, and we're well above that right now. So I don't think it's a long-term issue. On the other hand, having a piece of something go up that's hitting in your margins by 200 basis points at a relatively short bit of time is not a lot of fun either, and we need to figure out how to address that.

Jayson Noland - Robert W. Baird & Co. Incorporated

Okay. A question on Samsung also. Have you been able to do anything from a pre-integration planning perspective so far?

Steve Luczo

No. I mean, obviously, we're under regulatory review and regulatory process. There's lots of conditions around what we can and can't do, and there's some limited planning that you can do, and there's some limited -- more limited due diligence that you can do. All I want to comment is that to the extent that we have been able to get a deeper look into the resources or the technology or the products, we've really been favorably impressed, and I think this is going to be really significant for Seagate.

Jayson Noland - Robert W. Baird & Co. Incorporated

Okay. Last question for me on Toshiba. And maybe this is too early to ask given supply chain constraints, but I'm wondering if you have or if you think you'll see actions from your PC OEM customers that would indicate a willingness to make Toshiba a stronger player in the industry eventually?

Steve Luczo

No. I mean, I think our customers care about supply, but I mean, I don't think they're going try and make Toshiba stronger. I mean, I think -- look, if the WD-Hitachi merger is approved, that's going to be an extremely powerful competitor that has a lot of revenue and deep technology, and they're going to drive areal density and product performance. And we all know the cost curves that we need to hit to deploy demand. Seagate's obviously been in that position for a while. We continue to make our company better, we hope. And it takes a lot of capital and a lot of R&D. If the Toshiba Corporation decides that disk drives is an area to allocate capital and expense to, then they'll be another supplier. But I don't think our customers are going to do that. It's going to come from our competitors, whether or not you have competitive technology and products. And this isn't an easy science. And it's a science that's getting tougher. And therefore, capital and R&D is a competitive advantage and we're at scale. And Hitachi and WD, if that merger goes through, will be at scale as well and Toshiba will be less so. And if you kind of look at that scenario, I think it would tend to say that they'll have a tougher road. But could they decide they want to invest $5 billion and get serious in the drive business? I don't know enough about Toshiba Corp. to know if that's the reality or not. But I've got enough to worry about with Seagate and [indiscernible]

All right. I just want to thank everyone for joining us on the call today. And we do look forward to speaking with you next quarter. And of course, I want to make sure that we thank all of our employees and our customers and our suppliers for another good quarter. Thanks very much, everyone.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect, and have a great day.

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