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Seagate Technology (NASDAQ:STX)

F1Q08 (Qtr End 09/28/07) Earnings Call

October 16, 2007 5:30 pm ET

Executives

Bill Watkins - CEO

Brian Dexheimer - EVP and Chief Sales and Marketing Officer

Dave Wickersham - President and COO

Charles Pope - EVP and CFO

Analysts

David Bailey - Goldman Sachs

Keith Bachman - Bank of Montreal

Steven Fox - Merrill Lynch

Aaron Rakers - Wachovia

Katherine Huberty - Morgan Stanley

Daniel Renouard - Robert W. Baird

Mark Miller - Brean Murray, Carret

Rich Kugele - Needham & Company

Mark Moskowitz - J.P. Morgan

Christian Schwab - Craig-Hallum Capital Group

Kevin Hunt - Thomas Weisel Partners

Andrew Neff - Bear Stearns

Shaw Wu - American Technology Research

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to Seagate Technology's Fiscal First Quarter 2008 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 statements 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, and 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 additional factors that could cause the results to differ materially from those projected in these forward-looking statements are contained in the company's annual report on Form 10-K, as filed with the U.S. Securities and Exchange Commission on August 27, 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.

Bill Watkins

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

I am pleased to report that we had a very strong quarter, which produced record results in virtually every area of our business.

I will start the call today by spending a few minutes reviewing those numbers with you, and sharing some additional perspective on the industry landscape and the unique characteristics of our platform and business model that enable us to achieve these results.

Then I'll turn to our outlook for the quarter ahead and share with you our view of the key factors that will influence our performance going forward. I will then turn over to Brian, Dave and Charles who will each in turn discuss details of our market, operation and financial results.

Attractive market trends continue to drive robust demand for storage and significant opportunities for growth. In the September quarter, Seagate's revenue grew 18% year-over-year to $3.3 billion. As you know, the first fiscal quarter is typically among our strongest and this year unit demand exceeded even the high-end of our expected range.

We effectively capitalized on this strong demand environment by shipping a record 47 million units this quarter, representing a 21% increase over units shipped in the first quarter of last year and 20% increase over our fiscal fourth quarter of 2007. Clearly, conditions in the industry as a whole have been quite favorable.

Record demand that continues to grow is, of course, a big part of the equation and against that favorable backdrop is Seagate's strategically optimized manufacturing operations and commitment to technology innovations that have enabled us to extend our leadership in the enterprise and desktop markets and maintain our leadership in the consumer electronics market.

We are particularly gratified that our results this quarter underscore the value of the Maxtor acquisition, and the strategic and competitive benefits that have accrued to Seagate as a result. We have already talked about our substantial year-over-year growth in revenue and unit shipped.

In addition, the results from this quarter demonstrate that the cash generation capabilities of Seagate with free cash flow were approximately $604 million generated during the September quarter. This is a dynamic industry that continues to be characterized by robust demand growth, and for Seagate in particular, it is a story of commitment to competitive leadership and a demonstrated agility and vision to create value across all cycles.

In summary, we delivered a very strong quarter, which we believe has reflected not only the strengths of the industry as whole, but equally important is the group positive or the competitive and strategic benefits that we have enjoyed as a result of the Maxtor acquisition. And an integration that has proven to be one of the most successful ever in a disk drive industry.

As we look ahead, we will continue to focus on extending our technology, product, and market leadership, as we grow the business and execute our strategy to generate meaningful value for our shareholders.

Now, I would like to turn the call over to Brian to provide more details of our performance in the different markets and the outlook in each of those markets in the quarter ahead.

Brian Dexheimer

Thanks, Bill. Our fiscal 2008 began with the best quarter of demand in the history of the industry. Clearly, the overall consumption of storage remains very robust. Overall industry demand was extremely strong and all key health indicators for the industry were positive.

Supply and demand were well balanced and price erosion, while in the normal range, was more benign in the previous two quarters. Specific to the September quarter, we believe the overall industry TAM was approximately 132 million units, up 15% year-over-year and 19% sequentially.

Seagate shipped 36% of the industry's volume, maintaining its overall leadership, as well as number one positions in the Enterprise, Desktop, and CE markets. Seagate unit shipments were strong in all segments, growing 21% year-on-year.

Looking towards the December quarter, we expect seasonal growth to bring the overall TAM up 4% to 5% quarter-over-quarter to 137 to 139 million units, representing year-over-year growth of 14% to 16%.

Now I'll give some detail on the individual markets. The enterprise market TAM in the September quarter exhibited the growth pattern we expected at the beginning of the quarter, growing about 6% sequentially to 7.3 million units.

Seagate maintained its leadership position in this market, shipping a record 4.6 million units. Continuing the overall strength in this market, the adoption of small form factor drives continued to accelerate during the quarter, as CE shipments reached approximately 1.8 million units. We are pleased that our delivery of industry leading technology continues to enable important innovations for our customers in the areas of power, performance and physical footprint.

Regarding another area of technology innovation for the enterprise, I also wanted to highlight our collaboration with the storage and security industry to extend our hardware based full-disk encryption technology to our enterprise portfolio.

This week at Storage Networking World, we are demonstrating the performance and security capabilities of enterprise drive-level FDE. Demonstrations underscore the value that FDE technology brings to storage system administrators tasked with protecting against breaches of data that can occur in drives and systems that have been repurposed, decommissioned, disposed of, misplaced or stolen.

Looking forward to December for the enterprise market, we expect similar sequential growth to that of the September quarter.

I'd like to make one final comment on the additional factor of enterprise growth.

As I mentioned last quarter, we're seeing a continuation of strong incremental growth in high-capacity enterprise class SATA products deployed primarily in support of the massive amounts of digital content aggregated and distributed over the Internet.

As a leader in enterprise storage space, we believe we possess the technology, product breadth and customer engagement, and application expertise to take full advantage of this important growth factor.

We believe we saw evidence of this leverage in the September quarter, as we grew share substantially in this space, with significant shipments of our 750-gigabyte product, and we expect strong adoption of our 1-terabyte drive in these applications going forward.

In Consumer Electronics applications, we believe the TAM reached over 19 million units during the quarter, a 19% increase sequentially. We are pleased to see the strong sequential growth in this market as manufacturers built out for the holiday season.

Seagate maintained its leadership position during the quarter, shipping 5.7 million units, driven primarily by shipments into gaming applications and DVRs. Seagate's DVR shipments rose 35% year-over-year.

Given the strong seasonal build out in the September quarter, we are planning for overall TAM for the CE market to be flat in the December quarter.

We believe the mobile compute market TAM grew sequentially by a phenomenal 27% to almost 40 million units. The strength in this market was fueled primarily by consumer demand for back-to-school and holiday purchases.

Seagate shipped a record 7.9 million units into this market during the quarter, an increase of 87% year-on-year. Capacities continue to trend higher in the space as the notebook displaces the desktop as the platform of choice in the digital home. In the September quarter over 50% of our shipments were in capacities 120 gigabytes or greater, and we expect this to continue to rise rapidly.

In addition, during the quarter three major OEMs began shipping notebooks, while our hybrid drive and volume shipments reached approximately 100,000 units. We also saw a strong shift toward our 7200-RPM products up to 200 gigabytes, led by PC gaming and commercial performance applications. We expect another strong December quarter for the mobile compute market and have set expectations around a 5% to 8% sequential TAM growth or approximately 40% year-over-year growth.

The TAM in the desktop compute market grew 16% sequentially to approximately 66 million units, which is higher than we originally predicted.

Seagate shipments grew faster than the industry in the space, increasing 22% sequentially to a record 29 millions units, more than 5 million units higher than that of the June quarter. During the quarter, we were able to react rapidly to build strong overall demand and a higher capacity mix, once again leveraging our leading technology and highly efficient flexible supply chain.

In fact, across all segments, we saw a strong shift to higher capacities for 3.5-inch ATA products, with an 80% sequential increase in industry shipments of 500-gigabyte and greater.

From the technology supply chain perspective, we remained well positioned for this trend and believe we've strengthened our leadership position, with shipments of 750-gigabyte products, reaching 1.5 million units during the quarter.

Additionally, we made a strong move to enter the 1-terabyte category, with almost 60,000 units shipped during the quarter.

Lastly, we ramped significantly volume of the industry's first 3.5-inch, 250-gigabyte per disk product to over 1.5 million units.

We believe channel inventory and 3.5-inch ATA products for the industry, exiting the September quarter, was lower than that of the June quarter, with less than four weeks for the industry and less than three weeks for Seagate.

For the December quarter, we except the desktop compute TAM to be seasonally up, less than 5% sequentially and about 11% year-on-year.

Finally, in our Branded Solutions business, revenue again improved sequentially by about 10%. We're pleased with the initial demand for our newly announced Maxtor OneTouch 4 products that provide innovative security and protection features, in both the PC and Mac markets, along with higher capacity points to meet the growing needs of the digital consumer.

With both the Seagate/Maxtor branded products refreshed and redesigned, we look forward to a strong holiday season. We expect the December quarter to be the strongest sales quarter of the year for this business.

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

Dave Wickersham

Thanks, Brian. Overall, we are very pleased with our development and operational execution in the September quarter, as we continue to focus on extending Seagate's category of leadership as measured by the key factors, valued by our customers: product leadership, quality and reliability, and cost.

I'll start with a few comments regarding our inventory performance in the September quarter and an update of our expected capital investments for fiscal 2008 and conclude with comments regarding the supply chain.

Seagate's inventory in September quarter decreased $31 million from $794 million to $763 million.

Finished goods inventory was reduced by approximately 21% or $90 million as we responded to higher than forecasted customer requirement. The reduction in finished goods inventory more than offset an increase of $59 million in raw material and the working process required to support increased customer demand in the September and December quarter.

Inventory turnover improved to approximately 13 turns in the September quarter and our December quarter inventory turns are expected to be approximately 11 turns, as we replenished customer jet hubs to required level.

As evidenced by the significant reduction in finished goods inventory, Seagate operated at full capacity in the September quarter. Likewise, in the December quarter, we will fully utilize our available capacity, and consequently expect to be supply constrained based on current customer demand for Seagate products.

As discussed in previous calls, we aligned our capacity expansions consistently with customer demand. Considering that the lead time for meaningful capacity expansion is six month or more, we made our capacity decisions for the current quarter back in the March and June calendar quarters of this year based on the demand, and the company’s expected return on investments.

Additionally, considering the projected seasonal demand in the upcoming March and June quarters, we do not plan on increasing our fiscal 2008 capital spending plan. Going forward, we will continue to align our capital investments with customers demand. And by March of next year we will identify what additional capacity will be required for fiscal year 2009. Consequently, the fiscal 2008 capital investment outlook is unchanged, at approximately $900 million and continues to include the investments planned for expansion of our finished media and substrate factories in Asia.

The hard disc drive supply chain continues to experience consolidation at a rapid pace. This past quarter alone, TDK completed its acquisition of the recording head assets of Alps Electric and announced plans to acquire Magnecomp, a suspension supplier. And as most of you know, WD completed their acquisition of Finished Media and aluminum substrate supplier Komag. While the consolidation in the supply chain can sometimes lead to a supply disruption, we do not anticipate any significant supply shortages for the industry in the near term. Specifically for Seagate, we are confident that we have an adequate supply of the internal and external components required to support our production plans.

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 www.seagate.com.

At the beginning of the September quarter, Financial Accounting Standards Board Interpretation Number 48, commonly referred to as FIN 48 was adopted by Seagate. FIN 48 requires an analysis of the company's material tax positions for all open years. The cumulative effect of applying FIN 48 must be reflected as adjustments to the company's balance sheet in the quarter of adoption.

From a financial modeling perspective, we believe that the company's book tax rate will not be materially impacted due to the implementation of FIN 48. Additional details regarding FIN 48 and their impact on the balance sheet will be provided as required when we file the company's 10-Q.

Now, I will provide more specifics on our financial performance for the quarter, and our outlook going forward.

For the September quarter, Seagate reported revenue of $3.3 billion and unit shipments of 47 million, which reflects year-over-year growth of 18% and 21% respectively. The year ago period was the first full quarter Seagate reported after the Maxtor acquisition was completed. Consequently, the non-GAAP results this September quarter are cleanly comparable to the September quarter a year ago.

The highlights of the benefits of the Maxtor acquisition are evident as Seagate continues to grow revenue and earnings and at the same time generates significant amounts of free cash flow.

GAAP net income and diluted earnings per share for the September quarter are $355 million and $0.64 respectively. Included in the GAAP results are approximately $30 million of purchased intangible, amortization, and other charges associated with the Maxtor and EVault acquisitions. Without these charges and the associated tax effect, non-GAAP net income and diluted earnings per share was $385 million and $0.69 respectively.

Included in both the GAAP and non-GAAP results is approximately $5 million related to restructuring charges which reduced diluted earnings per share by about $0.01.

GAAP gross margin in the September quarter was 24.6%. Excluding approximately $20 million of acquisition-related costs, non-GAAP gross margin was 25%. Gross margin increased 300 basis points from the prior quarter due to a more favorable pricing environment than expected and an improved mix of products.

The pricing environment during the September quarter was better than what we had been expecting at the beginning of the quarter, price declines were not at the lowest levels we have seen for a September quarter. In fact, the like-for-like price declines were approximately 4%, which we would describe as normal for a September quarter.

GAAP, R&D and SG&A costs were $395 million for the September quarter. Excluding costs related to the Maxtor and EVault acquisitions, non-GAAP expenses were $390 million. The roughly $30 million increase in R&D and SG&A expenses compared to the prior quarter is primarily due to Seagate's variable compensation plan, which in the prior quarter was zero.

Slide 6 has the details of the adjustments made to GAAP, R&D and SG&A for the September quarter.

Cash flow from operations were $754 million for the September quarter, while free cash flow, defined as net cash provided by operating activities less capital expenditures, were $604 million.

Cash, cash equivalents, and marketable securities ended the quarter at $1.5 billion, up $354 million from the previous quarter. During the September quarter, Seagate returned approximately $300 million of cash to its shareholders through the payment of the quarterly dividend, and approximately $250 million of share repurchases.

Seagate's ability to generate cash was something we highlighted at our Analyst Day last month, and this quarter's results certainly underscores that point.

Days sales outstanding was 42, an improvement of four days, reflecting the linearity of shipments resulting from the strong demand we saw early in the September quarter. Days payable outstanding was 57, an increase of two days and within the normal range.

Capital investment in the September quarter was $150 million, and as Dave previously indicated, we continue to plan for approximately $900 million of capital investment for fiscal 2008.

Depreciation and amortization for the September quarter was $205 million, up slightly from the prior quarter. Approximately $24 million is related to the amortization of purchased intangibles. You will find our fiscal year 2008 estimates for amortization of purchased intangibles on slide 9 of the supplemental information package.

During the September quarter, the company took delivery of 10.3 million shares related to its share repurchase plan, with an average price of $24.27. Cumulatively, under the current share repurchase authorization, we have repurchased 72.2 million shares with an average cost of $24.57. The company has authorization to purchase approximately $725 million of additional shares under the current stock repurchase program.

Now, I'd like to provide further details on our outlook for the December quarter.

As Brian mentioned, for the December quarter, we are expecting industry unit growth to be at the high end of the 10% to 15% year-over-year range we discussed at our Analyst Day.

On a sequential basis, this would be 4% to 5% unit growth for the industry. Seagate expects revenue to be in the range of $3.4 billion to $3.5 billion. GAAP diluted earnings per share is expected to be $0.66 to $0.70 and includes approximately $26 million of purchased intangibles, amortization, and other charges associated with the Maxtor and EVault acquisitions.

Accordingly, non-GAAP diluted earnings per share, excluding these acquisition-related costs is expected to be $0.71 to $0.75. GAAP, R&D and SG&A expenses are expected to be approximately $418 million to $423 million for the December quarter.

On a non-GAAP basis, excluding approximately $3 million of acquisition-related costs, R&D and SG&A costs are expected to be approximately $415 million to $420 million. The increase over the prior quarter reflects the impact of Seagate's annual focal merit increase for the company, variable product launch spending and R&D, and the receipt during the September quarter of a government research grant.

Additionally, other income and expenses are expected to be a net expense of approximately $17 million. Our tax rate is expected to be near the low-end of the 5% to 10% range.

As always, this outlook does not include the impact of any future acquisitions, stock repurchases or restructuring activities that the company may undertake during the quarter.

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

Bill Watkins

Thank you, Charles. The trend towards greater creation and consumption of digital content are clearly driving tremendous growth for Seagate. We see this growth continuing and we are excited about the opportunities in front of us.

On behalf of the entire management team, I would like to thank our employees around the world for their commitment and for delivering an outstanding quarter. And with that, we are ready to open up the call for questions. Justine?

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from David Bailey with Goldman Sachs.

David Bailey - Goldman Sachs

You've already bought up against that higher end of that range. Are there times when you could actually go above the new range and would these factors drive you there?

Bill Watkins

Hey, David.

David Bailey - Goldman Sachs

Yeah.

Bill Watkins

This is Bill. We didn't hear the first part of that question. Could you repeat please?

David Bailey - Goldman Sachs

Sure. At the Analyst Meeting in September, you gave a new gross margin range of 21% to 25%. Well, you are already there. You are already at the high-end of that. So, are there times when you could go above the high-end of the new range? And what would cause you to go above the 25%?

Bill Watkins

I will let Charles answer, but we had pricing declines of 2% that we have been involved in this quarter. Go ahead Charles.

Charles Pope

The range that we gave on our Analyst Day was a long-term range that reflected the product mix changes that are anticipated to occur over the next couple of years. During any given quarter, particularly during the front-end of that period of time, if you have environments like you do today, it may be possible to go beyond the top-end of that range. The range was discussed as a long-term range which includes the structure of the industry and the growth of 2.5 inch in other products which tends to have lower margins in the industry on the relative basis.

David Bailey - Goldman Sachs

And could I just get a follow-up to that. Given the seasonally lower volumes in the March and June quarters, should we expect the gross margin to drop to the lower end of the range or there are specific Seagate items that should keep it sort of at the mid range or above that going forward?

Charles Pope

I don't think we will comment on March and June quarters yet, I think it’s too early to determine what those dynamics are. But, we recognize that those are normally seasonally slower periods of time in the year and given the leverage that is in the company, you would expect to have a decline in profits during those periods.

David Bailey - Goldman Sachs

Okay. Thank you.

Operator

Our next question comes from the line of Keith Bachman with Bank of Montreal.

Keith Bachman - Bank of Montreal

Hi. Can you hear me okay?

Dave Wickersham

Yeah.

Keith Bachman - Bank of Montreal

Just to follow-up on David's question. I think you benefited from the behavior of your competitors during the course of September and it clearly seems like that's going to continue in the December quarter. If you think about some of the issues that Samsung and Fujitsu have had, and perhaps even Hitachi, how should we be thinking about some of the competitive dynamics as we exit December and look to the seasonal period. Is there any kind of color or comments on the way you guys are thinking about it?

Dave Wickersham

Well, again in the September quarter, and as Charles and Brian mentioned it, we had 4% price. That's not what we call a great pricing quarter. Now, that would be normally what we would expect. My sense says that, when I look at the losses that people had last year and historically in this industry we don't tend to go two solid years of price force. I think in our mind that it should be a much better and more stable year, especially with all the demand in front of us. That said, we are preparing for the worst.

Keith Bachman - Bank of Montreal

Okay. Well, let me just try to get a follow up in there. It seems like during the course of this quarter, as we were in the summer, it seems like desktop was a big area of surprise in terms of the sequential growth there. And you guys are forecasting, I think you said 4% to 5% sequential growth in the desktop. Why do you think the desktop market had this seasonal spike during the course of September, even on the back of what was arguably great notebook numbers?

Brian Dexheimer

Yeah. Keith this is Brian, let me take that one. It's a good question. One of the things that's phenomenal. I can tell you that what we did see is a much earlier September quarter than we normally see in terms of linearity, primarily pronounced in Europe, which of all places, is usually slower. So, the reasons behind that are myriad. I think there is some potential exchange rate phenomenon that has crept in there. Remember too that June was not the kind of June that we normally see. It was on the low side of June. So, I think maybe some of that demand rollovered as well.

The last one I gave you is that it is not all through desktop. So, when we talk about growth and 3.5-inch ATA being 4% to 5%, or 15% or 11% year-on-year, there is a lot of applications creeping into that now that are growing at a much faster rate. You've got things like surveillance, you've got things like digital video recorders, you have the branded businesses that both we and some of our competitors have that are putting tremendous amounts of storage into peoples’ homes under various different brands. So, those segments are moving, sort of, at different cadence than the pure desktop market. Clearly, the desktop market is growing particularly in emerging markets. But you certainly have to layer those things at higher growth rates on top of that, so that is some of it as well.

Keith Bachman - Bank of Montreal

Okay. Thanks very much guys.

Operator

Our next question comes from the line of Steven Fox with Merrill Lynch.

Steven Fox - Merrill Lynch

Hi, good afternoon. I’m just going back over a couple of things on the quarter. Can you just sort of dissect the 300 basis point improvement in margins a little bit more, if you broke it up between units, efficiencies, and pricing mix?

And then as a follow-up, if you could, within that answer, highlight what was the most powerful mix effect in the quarter?

Bill Watkins

I will try to do that Steven. If you look at just the order of magnitude of what drove the 300 basis point improvement, it would be pricing first and that's pricing relative to what we had planned and anticipated at the beginning of the quarter.

The second would be the mix of products that we shipped and those really cover the entire margin improvements. Volume had a very nominal, if any impact on the margin expansion, depending on the mix of products that got into it, and so whatever volume was included, it really gets covered in the product mix piece of it.

If you sit and look at some of the areas that really contributed to the margin expansion from the product mix perspective, I think it goes back to Brian's comments in the call where he talked about the very high demand for high capacity ATA drives, 750-gigabyte drives, and the 80% growth rate in ATA drives that are 500 gigabytes and over. And I think that if you sit and look at a mix between product offerings, enterprise, desktop, and mobile, that is not as dramatic of driver as the in-mix, particularly in the ATA products.

Steven Fox - Merrill Lynch

Great. That's very helpful. Thank you.

Operator

Our next question comes from the line of Aaron Rakers with Wachovia.

Aaron Rakers - Wachovia

Yeah, thanks guys. A couple of questions as well, if I can. I guess, the first question is on your free cash flow generation. At the Analyst Day, I believe you gave a framework model guiding basically $840 million to $1.35 billion and you guys just did $604 million. Now, at the time were you thinking that was being rather conservative, or is there something out in front of us that causes you to possibly see some deceleration in the free cash flow?

Brian Dexheimer

Charles is going to take that question.

Charles Pope

Good question though. Good times always look really good and then when you are in the seasonally slow periods, you kind of grind through them. I think that it's a fair question and I do think that it reflects that unless we would anticipate negative cash flows in the back half of the year, which we don't. We expect to still have good revenue, good profitability in the back half of the fiscal year, with positive cash flows in those periods, that it may indicate that during this fiscal year we underestimated the free cash flow that could be generated by the business.

Aaron Rakers - Wachovia

And then if I could follow up on that. The retail business was down modestly as a percentage of your total revenue. Maybe you can touch on the new products coming on board. If we should expect that contribution to start to increase here going forward, and maybe on top of that, highlight if you know possibly what the gross margin implications could be?

Brian Dexheimer

Aaron, this is Brian. Let me take that one. I wouldn't look for any gross margin implications. That's a business that we target to run pretty close to the average of the company gross margins. So, I don't think you are going to see any margin expansion to the retail business. So, on a top line basis, we actually feel pretty good about where we are both year-on-year and sequentially.

It's a little early to tell all the returns earning, yet from the people we compete within that space, we feel good about our position there. We feel good about the cost structure of the products. As I mentioned, both brands have been refreshed and we're moving into a season, that's going to be a high season. So a lot of optimism around the top-line impact of the business going forward.

Aaron Rakers - Wachovia

Thank you. Congratulations.

Operator

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

Katherine Huberty - Morgan Stanley

Yeah. Hi, guys. As it relates to the 4% to 5% sequential unit guidance, that's towards the lower end of what you would typically see in December. How much of that is a function of demand, perhaps being pulled in from September versus just the manufacturing capacity limitations that you've seen in your business for the quarter?

Bill Watkins

Brian?

Brian Dexheimer

Hey, Katherine, this is Brian. I had just a little bit of both. I think part of it's in our planning as well. We were proven wrong last quarter when we forecasted 15% sequential growth. It was stronger than that. You can see by our channel inventories, nobody is sitting on the products. So I don't know that we could say demand was pulled into September, people are using the product that we're putting out there. So, hopefully, we're on the downside again, that would be a good scenario for everyone, but frankly, there is also a capacity utilization limit that we're heading into as well.

As Dave mentioned, we made capacity build-out decisions back in the spring timeframe that we're living with today, and living with quite happily in fact. It's presenting a challenge at some of the product pipelines, at or moving in some allocated stage for periods of time. But, and I think much beyond the 5% range, there is probably, at least at Seagate, if not an industry limitation too in terms of industry capacity. If you just extrapolate that growth rate out, that's going to be an industry unit that's down close to 140 million units and is substantially higher than it's ever been before. So I think we are bumping up against some of the limits, particularly as you get into certain product lines.

Katherine Huberty - Morgan Stanley

And why wouldn't those capacity limitations give you better visibility going into the March quarter then you had, say a year ago?

Brian Dexheimer

Well, Katie, they might. When we are setting in December and January having the conversation with you, they may well. But we need to get through the December quarter, see what the sell-through is in the December quarter, what the channel inventories are as we exit the December quarter and what the OEM sell-through is and if the demand exceeds the 5% and the selling through, it may well give us better visibility, but it's too early to have that look at it yet.

Katherine Huberty - Morgan Stanley

Okay. And then I apologize if I missed it, could you give what channel inventory was at the end of the quarter?

Brian Dexheimer

Yes, for Seagate it was under three weeks, and for the industry excluding Seagate it was four weeks.

Katherine Huberty - Morgan Stanley

Okay, great. Thank you.

Operator

Our next question comes from the line of Daniel Renouard with Robert W. Baird.

Daniel Renouard - Robert W. Baird

I am wondering if you can give us some flavor on profitability. For the last couple of years you have talked about laptop pricing, and that on the PC side it has been more aggressive. Our laptops and desktops on the PC side at roughly comparable profitability levels sort of as much as you can do apples-to-apples or do you think there is more margin pressure not this quarter but say next year on the laptop side.

And then secondly, there has been some conjecture about double ordering etc. with some products on allocation. Would you have any color that you could add to that in terms of what your end customers are actually doing in terms of their demand versus orders in further patterns?

Charles Pope

So Daniel, let me take the first piece. This is Charles. Relative to profitability, and I will answer in two different ways, I wasn't sure how you were asking about it. If you look at in terms of just an absolute profit pool, by the sheer size of the desktop that we shipped versus the notebook, the desktop is by far the largest profit pool that exists. If you look at it on a margin basis, I think we were relatively woken up and open about the fact that during this last year with the pricing pressures on the 2.5 inch product, that margins had slipped below the 3.5 inch ATA margins, and while there may be a path to bring them up comparative at some point in time, they are still somehow below the 3.5 inch ATA margins. And so, we will have to see how these dynamics and product pressures allow that to change overtime.

Brian Dexheimer

Daniel this is Brian, I will take the double ordering question. I think at any time that you have a particular product line that is in short supply you can expect, you are going to see some of that, and I certainly would not deny that we are suspicious that there is some of that going on. I would tell you that anything that we've put in front of you, in terms of an outlook, including the 4% to 5% unit growth, fully contemplates that. And the fact is we have far more demand, then that would represent in front of us today, some of which we don't think is necessarily real in period, that we are not frankly in a position to even react to in order we put that in our outlook. We are also very confident that there is other potential gauge in the supply chains of our customers, both in the desktop and the notebook space, plastics, batteries, panels, processors, you name it. But we feel pretty good about our triangulation around those data points and where we sit within that and consequently the outlook we've given you here for this quarter.

Daniel Renouard - Robert W. Baird

That's helpful. Thank you.

Operator

Our next question comes from the line of Mark Miller with Brean Murray, Carret

Mark Miller - Brean Murray, Carret

Let me congratulate you for having a very strong quarter. It appears very quickly on in your projections for the December quarter that we are seeing somewhat of a more benign pricing environment. It also appears more flattish than what we thought was going to happen in the September quarter. However, we are looking at relatively low inventory levels, we are talking about products on allocation, and we are also talking about a move up in terms of capacity that supported your ASPs to be basically flat last quarter. In the past, when we see an environment like this, we've actually seen price increases or ASP increases in the December quarter. Any feeling about that? You seem to be more conservative here, in terms of your pricing projection for December?

Brian Dexheimer

Mark, this is Brain. Let me take that one. Let me just kind of reset a perception. We've talked about normal pricing ranges on like-for-like across all products being in a 4% to 7% range for sometime now and in fact the 4% we saw in September, you would have to go back about four years before you would find anything lower than that. So, there is a perception that prices actually go up in quarters and periods of tightness. We have seen several of those in the last three to four years, including the period we are in right now and prices just don't go up.

And the large reason for that is about 65% of our business and I think its true in most of the industry, goes to OEM customers who have an expectation of price takedowns on a quarter-on-quarter basis. And those expectations really are set in the previous quarter, and as an industry we have delivered to those expectations with a limited amount of side line in terms of any individual product lines, supply and demand balance over the next 90 day period.

So, by function of that within our model in the industry, we have already have some price declines built in, where we typically get some leverages in more transit markets, either distribution channel, which might be as much as 30% of our business, we have the ability to change price on a more weekly or monthly basis. And so in segments like that, we have sometimes been able to at least keep prices flat in some capacity categories than we do at programs, may be slightly up. But as you mix the sense of the overall, we have not seen any quarters in the last three years that have had less than about a 3% like-for-like overall price decline. And the last point I will make for you, is that all of our products are in allocation now. So, the notebook is tight and some high-capacity desktop products are tight, there are many segments of a product line that aren’t allocated.

Mark Miller - Brean Murray, Carret

But the point I was trying to make is not on a product-for-product basis, but on an ASP basis because of product mix effects.

Bill Watkins

I think you see that in our outlook, where we have said there would be 4% or 5% unit growth for the industry. And if you do the math on the guidance we gave you, you are going to get 4% or 5% revenue growth. So, that implies a flattish ASP.

Mark Miller - Brean Murray, Carret

Right. Next question is that there’s been some reports about mobile component issues. Is it possible that some of that could constrain mobile ships in the December quarter, and shift them into the March quarter? You saw very strong growth this quarter. I am just wondering what you are hearing about, there was a fire at Matsushita plant, also some panel issues?

Bill Watkins

Yeah. That’s a great point. I will try to address that a little bit earlier. Let me tackle it directly. So far, we certainly checked through our engagements with all of our major customers, we are not going to be a constraint for them nor do they feel that the demands they are putting on us right now is in jeopardy because of other component constraints. And so, whether it’s the way they have aligned supply on a specific component -- battery is a great example because of the instance that occurred, we don’t think there is risk there given the outlook that we have put in front of you.

Mark Miller - Brean Murray, Carret

And final question, some people, I know you don’t want guidance, but to refresh my memory, the March quarter really is not that big of quarter. It’s typically, if I recall, and you can correct me, there are 2% to 5% from December typically, will I have to mark there in a typical March quarter following the summer?

Bill Watkins

I will let Charles take that.

Charles Pope

I would stay that it’s more often the 5% range.

Mark Miller - Brean Murray, Carret

Okay. Thank you.

Operator

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

Rich Kugele - Needham & Company

I have a clarification and a question. First, just to understand better your retail, Brian, when you are talking about branded, are you referring to your retail or is branded also a portion of your consumer? I’m just trying to understand the type of growth rate you are talking about relative to the additional color on the website.

Brian Dexheimer

Yeah. Sure, Rich. That is the products that shipped through retail and other channels under the Seagate or Maxtor brand. That’s not any product that we ship or send to the game console or DVR space?

Rich Kugele - Needham & Company

Okay. And then question for Dave, just a little bit more on the supply chain. In particular, aluminum substrates, I know that you have your agreements with your vendors and as well as some internal production. So and as you mentioned, you are fine for your own supply. But are you seeing any constraints from an industry perspective, particularly on high cap perpendicular that maybe impacting maybe some of your Asian guys?

Dave Wickersham

Yeah, Rich. The utilization from an industry perspective is not much different than we talked about at our Analyst Day. It's very similar. So, it's in the high 80s. So, you would expect to see some disruptions, as people shift either their sources, their qualifications or have issues with execution. So, aside from that there is adequate capacity. We think and again other competitors can choose to use those either on the high-end or anywhere else for that matter. So, it's tight, Rich. But again as I mentioned earlier, our view is there is an adequate supply not just for Seagate but for the industry as well.

Rich Kugele - Needham & Company

Okay. And then just lastly, just because we can ask the question, the International Trade Commission investigation into the drive land, is this really an issue or is this just exploratory?

Bill Watkins

I don’t know that I can give any real clarification at this point in time on that, Rich. I don’t have anyone that is close to that topic that can really provide that answer.

Rich Kugele - Needham & Company

Okay. I just wanted to ask. Thank you very much

Operator

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

Mark Moskowitz - J.P. Morgan

Yes. Good afternoon. I have two questions, one for Dave and one for Brian. Dave, could you maybe give us a little more context around the discipline that Seagate is exhibiting with respect to CapEx and the future capacity additions? Is this a sign that the market momentum could slow in the coming year or that potentially market share shifts at peak or maybe there’s one more or, or is it really just to sign that the cycles in terms of the peaks and values have a smaller input to what they are going to be, looks greater a frequent thing?

Dave Wickersham

Well, Mark, Dave. It's obvious. The first part of the question is really what I tried to hit in the scripts and that is we continue to be very, very disciplined. And as we talked about our Analyst Day, we really focused on our overall efficiency, but to not spend any capital before it’s absolutely required. So, one of the things that we try to do every quarter is to make sure that we don't put any unnecessary capital online and that's what you saw here. Frankly, the 150 actual was a little bit less than plan and that's primarily due to some of the facility's expenditures that we planned.

So on a year, the $900 million just for your modeling will be pretty linear roughly half on the first half and half at the second half of '08. But I can speak for Seagate and I think we have seen indications elsewhere that folks are being very mindful about putting capacity online before customer. So, they are either being cautions and I think that's healthy for the industry and certainly we are doing our part.

Mark Moskowitz - J.P. Morgan

Okay. Thank you. Appreciate that. And then, Brian maybe you can just touch really quickly here on the pretty attractive opportunity here that you referenced in terms of high capacity, high margin through ATA business, 500 to 751 terabyte, seems as if Seagate has a pretty lead good followed by Western Digital. What are you seeing from your competitors? Do they have the capacity? Do they have the technology to go out to this market particularly that becomes kind of the coveted profit growth story for the industry over the next couple of years?

Brian Dexheimer

Well, the cynical part of me Mark would say that it close an opportunity to mess up the profit growth story based on behavior. But, with the kind of growth we are seeing, fortunately right now that's not an option for the industry. What I'll tell you is there are two components for the growth. One is through technology, which you are absolutely right, we are well-positioned for. And products like that, they are a high dish, high headcount products, vertical integration helps, and leading technology is even better, and we happen to have both. So, we are well-positioned from technology.

The other vector is application expertise. As I mentioned to one of the previous questions, the growth we are seeing at high capacity really covers a number of different segments, the obvious one being the desktop market that's certainly a component of it. Less obvious being things like commercial surveillance, the branded business that we have and then finally where application expertise is really important and we are well-position the enterprise and this edge of the internet sort of build out. We believe we shipped over 2 million units to edge-to-the-Internet applications and high-capacity SATA, which we consider enterprise applications and part of our enterprise business and the application expertise to pull that off, because it's the same primary custom set of our classic mission-critical business is not trivial. And we think that's a key component of growth there and so from pure technology and application expertise, we think we are really well-positioned.

Mark Moskowitz - J.P. Morgan

Thank you for that. And may be I would squeeze one more question. And Charles could you may be give us little more color behind the government research grant that you talked about earlier.

Charles Pope

Sure. This is a non-US grant. We have operations in countries that we operate in the tax holidays, and some of the benefits that we get are related to research that it goes on in those countries. This grant was about $4 million grant.

Mark Moskowitz - J.P. Morgan

Okay. Thank you.

Operator

Our next question comes from the line of Christian Schwab with Craig-Hallum Capital Group.

Christian Schwab - Craig-Hallum Capital Group

Thanks, Brian. Just a quick question on the tremendous OEM demand. How much benefit do you think you received during the quarter from OEMs, fearful about Hitachi's commitment to the disk drive business versus end demand?

Brian Dexheimer

Yeah, Christian, I would probably hazard to guess on that, it's tough to read minds. What I would tell you is, we believe we've benefited from additional volume both in terms of market growth, but if you're suit and I know you are, you will look at our growth relatively to industry and note that it's higher. So, we grew some share, and we grew that share probably because of our flexibility in our leading technology lineup. We may have also grown it because of some misexecution in part of some competition and/or some of the things you mentioned. But, it's almost impossible for us to tell that specific reason.

Christian Schwab - Craig-Hallum Capital Group

Great. No further questions. Thanks.

Operator

Our next question comes from the line of Kevin Hunt with Thomas Weisel Partners.

Kevin Hunt - Thomas Weisel Partners

Hi. Thanks guys, a couple of questions. First on the OpEx, how much you gave, Charles? What should we be thinking about that if you look beyond the December quarter? Should we be assuming those kind of increased bonuses would continue, i.e. the dollar run rates stays similar or should we think that would come little down as a percent of sales going forward? And I have a follow up.

Charles Pope

If said look in the March and June quarters, we would probably expect them to come back down to the $400 million to $405 million range, because in the spending level that's reflected in the December quarter. It does have some increased variable R&D cost for products that are coming through that stage of it at this point in time.

Kevin Hunt - Thomas Weisel Partners

And do you guys did not talk regarding your options number once in the quarter?

Charles Pope

I do not remember on top of my head what that is. I can certainly have Rod make that available.

Kevin Hunt - Thomas Weisel Partners

Okay. And then one follow-up for Brian as well. Looking at the consumer business again just to make sure I am understanding things, when you are talking the consumer, the branded itself you are including is part of desktop, is that correct?

Brian Dexheimer

No, actually calling our branded separately.

Kevin Hunt - Thomas Weisel Partners

Okay.

Brian Dexheimer

Our branded business are those products that we shipped under the Maxtor and Seagate brands, where we saw (inaudible) consumer electronics business, is that which goes into consumer electronics applications really as it drives them so. Think of handheld, DVR, game consoles, things like that, automotive.

Kevin Hunt - Thomas Weisel Partners

But did you give a number of a brand, I just missed that.

Brian Dexheimer

I didn't give a specific number. I said it was up 10% sequentially on a top line basis.

Kevin Hunt - Thomas Weisel Partners

Okay. So when we're adding up in the units here, is that part of that $29 million desktop fan or what?

Brian Dexheimer

We throw the units when you are looking at the website. If you look at units, it will be in the desktop number.

Kevin Hunt - Thomas Weisel Partners

Okay. Now, then going to the back to the gaming segment again, that was actually based on my numbers here anyway down year-over-year. So could you talk about the dynamics, was that probably just because the real small contractors going way down or what, gaming down or what?

Brian Dexheimer

Right. If you remember last year, it was the launch of the PS3.

Kevin Hunt - Thomas Weisel Partners

Yeah.

Brian Dexheimer

And you remember that launch was delayed, so a lot of volume that might have been in. The similar quarter last year got pushed to the December quarter. So, it makes a difficult year-on-year comp.

Kevin Hunt - Thomas Weisel Partners

Okay.

Brian Dexheimer

Make sense?

Kevin Hunt - Thomas Weisel Partners

Yeah, all right. Thank you.

Operator

Out next question comes from the line of Andrew Neff with Bear Stearns.

Andrew Neff - Bear Stearns

Sure. I just wanted to see if you could elaborate a little more than you get on competition and what you are seeing in that respect in terms of -- talked a lot at the analyst meeting about things you are seeing Hitachi, Fujitsu, is that have you seen any change since the analyst meeting in terms of competitive behavior?

Charles Pope

Not necessarily, so we haven't noticed anything I think at least for now. Again, the pricing was some what benign, more than we thought going to the core, but now we haven't seen anything that we didn't talk about the analyst and it appears that everyone's pretty much got their head down and is kind of focus on the Metro products.

Andrew Neff - Bear Stearns

Okay. Thanks very much.

Charles Pope

Last question please.

Operator

Our last question comes from the line of Shaw Wu with American Technology Research.

Shaw Wu - American Technology Research

Sure. Just a clarification on your hybrid comments, where do you said you shipped 100,000 units, not sure if I heard that correctly, and just related to that, just kind of wondering what's your view on Intel's Robson technology, is that something that's competitive, complementary or where we see notebook products kind of a both forms some with hybrid and some with Robson? Thanks.

Brian Dexheimer

John, first I want to clarify yes, you did hear a 100,000 units. It's early days on hybrid. We got three OEMs that are shipping new products. The market is still quite nascent relative to Robson. We are very confident this technology will perform well versus that alternative architecture for several commercial reasons why, OEMs might not want to align with Robson as an alternative. And we think the hybrid design will provide some additional benefits beyond the performance that Robson promises. So, we feel pretty good about it. We're part of the industry association around hybrid, that's in full support of the hybrid design, and I think we're getting good acceptance from the customer base.

Shaw Wu - American Technology Research

Okay. And just a quick follow-up, in terms of support for the hybrid, the flash portion, is that through the OS layer, through like Windows, or is that your software?

Brian Dexheimer

No, hybrid is really a function of the operating system. So, Vista had a number of changes in it that were to accommodate hybrid in fact. There is number of changes forthcoming in Service Pack 1 that will take more advantage of the features that the hybrid drive provides. But it is within the control of Microsoft.

Shaw Wu - American Technology Research

Okay. Thank you.

Brian Dexheimer

Okay. With that, thank you all for joining us today. We look forward to speaking with you next quarter. Take care.

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Source: Seagate Technology F1Q08 (Qtr End 09/28/07) Earnings Call Transcript
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