Seagate Technology's (STX) CEO Steve Luczo on Q1 2017 Results - Earnings Call Transcript

| About: Seagate Technology (STX)

Seagate Technology PLC (NASDAQ:STX)

Q1 2017 Earnings Conference Call

October 19, 2016 11:00 AM ET

Executives

Kate Scolnick – Senior Vice President Investor Relations and Treasury

Steve Luczo – Chairman and Chief Executive Officer

Dave Morton – Executive Vice President and Chief Financial Officer

Analysts

Steven Fox – Cross Research

Sherri Scribner – Deutsche Bank

Ananda Baruah – Brean Capital

Rich Kugele – Needham

Operator

Good morning and welcome to the Seagate Technology Fiscal First-Quarter 2017 Financial Results Conference Call. My name is Nicole and I’ll be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

At this time, I would like to turn the call over to Kate Scolnick, Senior Vice President Investor Relations and Treasury. Please proceed, Kate.

Kate Scolnick

Thank you. Good morning everyone and welcome to today’s call we are hosting from our corporate headquarters in Dublin, Ireland following our successful annual meeting.

Joining me today from Seagate’s executive team are Steve Luczo, our Chairman and CEO and Dave Morton, Executive Vice President and CFO and Phil Brace, President of Cloud Systems and Silicon Group. Dave Mosley, President and COO, is not on today’s call due to travel.

We’ve posted our press release and detailed supplemental information about our first fiscal quarter 2017 on our Investor Relations site at seagate.com. During today’s call we will review the highlights for the September and provide the company outlook for the second fiscal quarter of 2017, and then open the call for questions.

We will refer to non-GAAP measures on this call, which are reconciled to GAAP figures on our supplemental information available on the investor section of our website. We have not reconciled our non-GAAP financial measures guidance to the most directly comparable GAAP measures because material items that impact these measures are out of our control and/or cannot be reasonably predicted. Accordingly, reconciliation of the non-GAAP financial measure guidance to the corresponding GAAP measures is not available without unreasonable effort.

We are planning for the call today to go approximately half an hour and we will do our best to accommodate your questions following our prepared remarks as time permits. As a reminder, this conference call contains forward-looking statements about the Company’s anticipated future operating and financial performance, customer demand, technology and product development advancements, and general market conditions. These forward-looking statements are based on management’s current views and assumptions and should not be relied upon as of any subsequent date. Actual results may vary materially from today’s statements.

Information concerning our risks, uncertainties and other factors that could cause results to differ from these forward-looking statements are contained in the Company’s SEC filings and supplemental information posted on the investor section of the Company’s website at seagate.com.

I would now like to turn the call over to Steve Luczo. Please go ahead, Steve.

Steve Luczo

Thanks, Kate. Good morning everyone and thanks for joining us today. For today’s call, I will cover the high-level trends we are seeing in the business, Dave Morton will then discuss certain financial highlights and I’ll close the call with our outlook for the December quarter.

For the September quarter, Seagate achieved revenues of $2.8 billion, GAAP gross margins of 28.6%, net income of $167 million and diluted earnings per share of $0.55. On a non-GAAP basis, Seagate achieved gross margins of 29.5%, net income of $299 million, and diluted earnings per share of $0.99, up 85% year-over-year. Cash flow from operations for the quarter was $592 million.

We believe Seagate’s September quarter reflects – results are reflective of a generally stable but mixed macroeconomic environment, as well as acceleration in the deployment of cloud-based storage associated with usage shifts of technologies and architectures by end users. Demand from cloud service providers for our nearline high capacity portfolio was stronger than we expected going into the September quarter.

HDD exabyte shipments for the September quarter were up approximately 20% year-over-year, with consecutive record shipments. We shipped 66.7 exabytes of storage in the September quarter. HDD unit shipments were 38.9 million units, with average capacity per drive at a record 1.7 terabytes per drive, up 44% year-over-year and reflecting our tenth quarter of sequential growth in capacity per drive. ASPs of $67 were sequentially flat for the September quarter.

Our customers continue to benefit from our portfolio advancements, and we believe that Seagate is in the leading competitive position as our market shifts from a low capacity unit space demand profile to the future applications which are component rich and require aggressive technology advancement. This is particularly important as the storage market shifts from client server to mobile cloud applications and storage environments.

With respect to our Cloud Systems business, we are on track to launch new converged storage platforms including hybrid and all flash array offerings later this fiscal year, which we believe are equal to or better than our competition and we expect to see continued revenue growth for this business in the December quarter.

We are pleased with Seagate’s execution in the September quarter, both in terms of our ability to maximize the profitability of our technology portfolio and our continued execution on our cost reductions.

I will turn the call over to Dave Morton now to go into more detail on these activities.

Dave Morton

Thanks, Steve. With the shifts taking place in Seagate’s business, there are a few specific areas of our financial performance in the September quarter that I would like to provide further context to Steve’s earlier discussion.

For the September quarter, Seagate’s addressable HDD market was higher than forecast, driving benefit in our revenue and margin results for the quarter. Within this, there were specific HDD product areas where demand was stronger than our expectations, specifically for our nearline enterprise HDD products. Our ATB nearline enterprise products continues to be our leading revenue SKU, as overall HDD enterprise revenue was 41% of total consolidated revenue.

By comparison, our PC client shipments were 24% of total consolidated revenue in the September quarter, reflecting the shift of client server storage environments and our competitive positioning in the higher capacity segments.

From a market demand perspective, we continued to make strategic decisions to not aggressively participate in certain areas of the low capacity client market where the gross margin contribution does not warrant the long-term manufacturing investment. As a result, our future forecast for Seagate’s HDD unit addressable market may have a variance to our competition, and our unit shipment market share may vary as we may not participate in all HDD unit sales demand in any given quarter.

Operating expenses for the September quarter were $580 million on a GAAP basis and $472 million on a non-GAAP basis. The sequential increase in our operating expenses was due to higher variable compensation expense related to the upside in our financial performance.

During the September quarter, we implemented certain cost reduction activities and recognized approximately $82 million in pretax restructuring charges. We continue to drive our non-variable compensation operating expense reduction activities, and our overall expenses will decline on a run rate basis as planned as we move through the fiscal year.

Capital expenditures amounted to $140 million for the September quarter for maintenance capital, supporting the acceleration of the ramp of new products in our portfolio that utilize new tooling and equipment, and the accelerated expansion of our Korat facility to expedite the planned manufacturing footprint reductions across many sites.

As we manage the shifts in our product portfolio, customer demand, and changing nature of our customer base, we are on track to align the operating model of our HDD business to optimize our manufacturing footprint. Our capital expenditures and maintenance capital requirement levels are expected to be less than 5% of our revenue over the next fiscal year and through our manufacturing consolidation activities, Seagate will be operating at or very near full capacity.

Our operating philosophy will then shift to chasing demand upside versus managing excess capacity. While we are still in process of executing many actions, we believe the overall cost alignment activities and the new high capacity and cost advantaged products within our HDD product portfolio refresh will benefit our product gross margins and overall profitability of our business over the course of the fiscal and calendar year of 2017. Given the current demand outlook and assuming a stable macroeconomic environment, we are confident in our ability to remain around the midpoint of our long-term targeted margin range of 27% to 32% and within our operating income targeted range of 13% to 15% for FY2017.

Cash flow from operations in the September quarter was $592 million, and free cash flow was $452 million. Our balance sheet remains healthy, and we ended the September quarter with $1.5 billion in cash and cash equivalents and $299 million ordinary shares outstanding. Our debt structure and level of interest expense is well within our financial capabilities and reflective of our investment grade framework, given our staggered maturities and low interest expense.

For capital allocation in the September quarter, we participated in a third-party block trade transaction in conjunction with ValueAct Capital and deployed $100 million for the redemption of 3 million shares. Due to the confidence in our cash flow generation, our Board has approved our quarterly dividend payment of $0.63 for the September quarter, payable on January 4. There has been no change to our dividend policy, and our dividend payout of $188 million a quarter is supported by our cash flow generation forecast.

I would now like to turn the call back to Steve.

Steve Luczo

Thanks, Dave. As indicated, demand for our high capacity nearline drives has accelerated from earlier in the year as cloud service providers are deploying new systems and/or replacing HDDs that are in service. For the December quarter we expect this demand to remain stable, with overall market exabyte demand to be slightly stronger. We will maintain our focus on high capacity opportunities for our portfolio. As such, we expect relatively flat revenue with improvement in gross margins in the December quarter, and as previously discussed, non-variable compensation operating expenses will trend down sequentially.

We recognize the continued shift from cloud server to mobile cloud and the related infrastructure and application level changes taking place in our industry. These shifts are impacting our traditional product offering and customer base and are creating significant opportunities for core technology providers such as Seagate with an expanding customer base and higher value-add opportunities. The new customer base includes our traditional OEMs and distribution customers as well as significant and growing demand from cloud service providers, surveillance companies, and will likely include corporate demand in the not too distant future.

Thank you for joining us on the call today. And we can now open the call up for questions and answers.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from the line of Steven Fox from Cross Research. Your line is now open.

Steven Fox

Thanks. Good morning. Just first off, I was curious, given how demand is coming in a little bit better than when you sort of started on this rationalization program, has there been any unintentional consequences in how you are dealing with customers or the supply chain that maybe adjusted the strategy going forward a little bit? And if not, can you sort of talk about how the mix maybe improves further like over a 12-month period from here? Thanks.

Steve Luczo

I’m not sure I understand the question, Steven. You want to provide me a little more detail on what you mean by unexpected consequences?

Steven Fox

Yes. Basically is component supply getting tighter than you would have thought just three or six months ago when you sort of set out on this plan? Plan accounts seem to be going up.

Steve Luczo

No. I mean, not than what we expected. I mean, again, our strategy was to take out the capacity that was mostly related to old technology on single disc two head because we’re ramping new technology on single disc two head. And we’re allocating our component technology across our portfolio, I think pretty effectively. We’re balancing between the demands on 2, 4, 6, terabyte as well as the strong demand at 8 terabyte. So I think the factories are – they’re all running hot, but that wasn’t unexpected. So I think at the component level we’re definitely at capacity, which the operations people like as they love kind of chasing upsides and running linearly every month of the quarter. So it was the operational goal that we had in mind when we made the manufacturing adjustments that we made.

Steven Fox

Thanks. And then just as a quick follow-up, just in reference to your nearline demand trend chart, Slide 8, there’s been periods where that has sort of paused sequentially and gone down, I guess mainly related to cloud demand. Can you talk about your expectations for maybe another sort of pullback based on what you’re seeing in terms of data center spend over the next few quarters? Thanks.

Steve Luczo

No. What we pointed out is what we think the demand is for the December quarter, which it looks like it’s going to remain strong. But as you pointed out, the data center growth can have ebbs and flows and they don’t really kind of project out more than a few quarters. And even if they do, the accuracy that they have in that projection is not fantastic. Sometimes they say they’re going to slow down and some big corporation decides to shift to cloud and sometimes they get utilization freeze up. Sometimes a particular customer; we’re strong and may win or lose a big piece of business which then either creates an opportunity or they delay buying.

It’s still I think fairly dynamic with an overall trend that they continue to absorb a massive amount of storage as indicated by the record exabyte shipment that we’ve now delivered two quarters in a row. So I think it’s not going to be perfect quarter to quarter, but I think the 12-month over 12-month trends will continue to be quite favorable as they have been for the last few years as we’ve started this shift to cloud.

Steven Fox

Great. That’s very helpful. Thanks again.

Steve Luczo

Yes.

Operator

Thank you. Our next question comes from the line of Sherri Scribner of Deutsche Bank. Your line is now open.

Sherri Scribner

Hi, thank you. I appreciate the long-term gross margin guidance in the middle of the range for the full year. Just thinking about the gross margin upside this quarter, how much of that was from mixed versus the cost cutting actions that you’ve been taking? Because it seems to me that with more cost cutting to come and some rationalization in December, we should maybe be able to get some margins up into the 30% range, so wanted to see what you thought about that, and also the mix between cost cutting and mix. Thanks.

Steve Luczo

Yes, I don’t really can presume that much, Sherri, I mean the mix was part of the cost cutting, in reference to the prior answer. When we made our operational adjustments it was to drive a higher capacity offering because of our technical lead. That’s the right place for us to be at. We’ll even see that on the client space. Again, it given where we’re at in terms of 1 terabyte per disc notebook and 2 terabyte on desktop transition, we’re going to get a mix advantage even within that space. So again, it’s kind of all related to where we are technically, and as we ramp these products what we think our opportunity is competitively.

In terms of your second comment, we posted 29.5% and we said slight improvement, so I don’t think that’s at odds with what you just concluded.

Sherri Scribner

Okay, great. And then just thinking about the calendar guidance that I think some of us were hoping for an update on this quarter, I mean if you look at the run rate, if you look at the margins, you can easily do $3.50 for calendar 2017. I think some people are thinking $4. Can you maybe give us some thoughts on your calendar expectation? Thanks.

Steve Luczo

Yes. I think Dave gave most of the pieces of it and what we’re thinking for revenue. We’re not going to stay in the business of a calendar projection. We did that when people thought we were going out of business three months ago. But because we did say we’d given update, I think the missing piece to do the model you want to do is where do we think revenues are going to come in.

Right now I would say that we feel that there’s going to be revenue growth year-over-year and it’s probably going to be in the mid-single digits, maybe mid-to-high single digits. That would imply, as you point out, beating that number by 40% to 50% with some head room. So if you landed in the $3.75 to $4 range I think that’s probably right, given what we can see today. But I think the good news is margins near the midpoint of the range, operating margins probably a year ahead of where we thought we were going to be, and revenue growth, which I think we’re feeling more confident that on a year-over-year basis, we’re going to see the revenue growth as well.

Sherri Scribner

Thank you.

Steve Luczo

Yes, thanks.

Operator

Thank you. Our next question comes from the line of Ananda Baruah of Brean Capital. Your line is now open.

Ananda Baruah

Hey guys, good morning. Thanks for taking the question. Congrats on the strong progress, by the way.

Steve Luczo

Thank you.

Ananda Baruah

Yes, you’re welcome. You guys must feel great about that. I guess really a quick clarification and then two from me, which are quick and related. Dave made mention of running a full capacity. I couldn’t get if you guys were already essentially there, and I thought he said something about as you go through these initiatives. So would love any context around are you there now. And then I guess the question, Steve, quickly just on the exabytes, is I would love to get your view on what you see as sort of next 12 months to 24 months, sort of exabyte growth range, any context would be helpful. Seems like there’s been an alteration. I know the comps have been easier. But it feels like there is – through our last two Qs maybe a little bit more high cast demand than you guys thought – well than the industry had been seeing previously.

And then the final thing is to your comment about – collectively you guys comments about being positioned to chase demand, if you can position as you want kind of exiting this, what are the implications of chasing demand and being at basically full capacity utilization? Does it alter the context of the contract conversation? Are there capital implications from that, CapEx implications from that? Anything like that would be helpful. I know that’s a bunch. Thanks, appreciate it.

Steve Luczo

Well. Are we at capacity? As you know, in our business you only need to be at capacity on one element and you’re technically at capacity. So yes, we’re pretty much at capacity. But you got to remember, we’re at capacity with a portfolio that’s just rolling into a lot of new products. So the yield improvement potential is fairly significant. And then how we use that yield improvement in terms of where we use those extra heads and just gets very interesting as well. So where does the biggest marginal contribution occur as we free up capacity, whether or not it’s head related or disc related or test related? So yes, we’re at capacity, but it’s – this is an extremely dynamic business that as you improve yield, you get more capacity, but as you get more capacity you may then decide to use that in more drives that have more heads and discs. So we’re running the business the way we want to.

Let me skip to your third question because they’re related, as you pointed out. What that means is that when we scope a business to, quote, do 40 million units per quarter, then what we go do is we task the ops team to go figure out how in the same footprint and same capital budget how to get to 50 million. So it doesn’t necessarily imply more capital per se. I think more capital would only be a function of was there some significant market opportunity; whether or not that was a spike in demand or a product opportunity from a technical leadership, which would then obviously be reflected in greater revenue growth or expanding gross margin.

So we don’t see any big change in where we run our business, and as you probably can tell we’ve been really lean on capital and we’ll continue to do so, even though we’ve had some fairly significant one-time capital events like what we’re doing in our factories to prepare for the consolidation that we identified. Exabyte growth, again, I think it’s just really important for everyone, whether or not it’s an analyst or an investor, to understand that the exabyte growth feels like it’s going to continue in this kind of 20% to 35% range on an annual basis, but that doesn’t mean every year quarter-over-quarter it’s going to go up 20%. That’s what we’ve witnessed and that’s – as I said before, it’s going to be like this until we get more diversification of the cloud service providers or as corporations start to deploy cloud like architectures that are using these super high capacity drives.

So whether or not you ask me for the next year or two years or 24 months or 18 months, my answer’s kind of the same. It feels to us that the demand is going to continue for utilizing HDDs in the very highest capacity environments, and those are – that’s a great trend for us because it’s absorbing more heads and discs. It’s a way more complicated channel. It’s a way more complicated test, manufacturing tolerances are much more difficult and all of that translates into a product that has a lot higher value add. So we don’t see any shift to that fundamental thesis.

Ananda Baruah

Great. Very helpful. Thank you.

Steve Luczo

Yes. Thanks.

Operator

Thank you. Our next question comes from the line of…

Steve Luczo

And this will be our last one, operator, so we can end before the market opens.

Operator

All right. Our next question comes from the line of Rich Kugele of Needham. Your line is now open.

Rich Kugele

Thank you. Just quickly, Steve, when will the Korat facility be ready to take on the capacity? And should we assume since you’re doing gross margins already in the middle of your target range that once that’s complete you can potentially get to the upper end of that range? Thanks.

Steve Luczo

Yes. I guess I don’t want to necessarily say that right at this second. Again, there’s no reason kind of getting wildly speculative about being at the upper end of the range. There’s a lot of issues that go into that. I’m not sure we’ve disclosed when the Korat facility is going to be fully operational, and I’m not sure we want to from a competitive perspective. So sometime in the next six months we’re rolling into that facility.

Rich Kugele

Okay. Fair enough. Thanks.

Steve Luczo

Okay. All right. Great. So we’re going to end the call here. Just want to thank everybody, certainly all the employees at Seagate, our suppliers, our customers, our investors and then we look forward to talking to everybody on the next quarter call. Thanks very much.

Operator

Thank you. Ladies and gentlemen, thank you for participating in today’s conference. That does conclude today’s call. You may now disconnect.

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