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Western Digital Corp. (NASDAQ:WDC)

F1Q08 Earnings Call

November 1, 2007 5:30 pm ET

Executives

Bob Blair - IR

John Coyne – President and CEO

Timothy Leyden - CFO

Executives

Andrew Neff – Bear Stearns

David Bailey – Goldman Sachs

Rich Kugele – Needham

Mark Miller - Brean Murray Carret

Steve Fox – Merrill Lynch

Mark Moskowitz - JP Morgan

Keith Bachman – Bank of Montreal

Christian Schwab – Craig Hallum

Harry Blount – Lehman Brothers

Shebly Seyrafi – Caris

Aaron Rakers - Wachovia

Jeff Brickman – UBS

Joel Inman – Robert W. Baird

Operator

Welcome to Western Digital's first quarter financial results for fiscal year 2008. (Operator instructions) Now I will turn the call over to Mr. Bob Blair. You may begin.

Bob Blair

Thank you. As we begin, I would like to remind you that we will be making forward-looking statements in our comments and in response to your questions concerning our expectations regarding supply and demand conditions in the hard drives industry; growth in the market for hard drives; and growth opportunities for WD; the effects of strong seasonality in the December quarter; our plans to continue investing in new technologies and product road maps; our beliefs regarding the benefits of a vertically integrated hard drive business; our capital expenditure plans for fiscal 2008; and our current financial outlook for the December quarter.

These forward-looking statements are based on management's current expectations and are subject to risks and uncertainties that could cause actual results to differ materially, including those listed in our Form 10-K filed with the SEC on August 28, 2007, as well as the additional risk factors reported in this press release included as Exhibit 99.1 in the Form 10-K, we furnished to the SEC tonight.

We undertake no obligation to update our forward-looking statements to reflect new information or events, and you should not assume later in the quarter, that the comments we make today are still valid.

In addition, references will be made during this call to non-GAAP financial results. Investors are encouraged to review these non-GAAP financial measures, as well as the reconciliation of these measures to the comparable GAAP results on the last page of our press release, financial statements included as Exhibit 99.1 to the form we furnished to the SEC today, a copy of which can be found under the SEC filings link in the investor relation's section of our website at www.westerndigital.com.

I would now like to turn the call over to Western Digital’s President and Chief Executive Officer John Coyne.

John Coyne

Good afternoon and thank you for joining us. With me today is Tim Leyden, Executive Vice President and Chief Financial Officer. After my remarks, Tim will provide the financial report on our first quarter and our outlook for the second quarter. Our financial results for the first quarter reflect a continuation of our profitable growth in a strong market environment throughout the quarter.

The September quarter was unusual in that we saw strong industry demand emerge early in the quarter, and sustain throughout. This was true in all geographic regions, markets and channels that we serve.

With public reporting of quarterly financials in the hard drive industry now completed, it is clear that the improved demand combined with disciplined production increases allowed more stable pricing, which resulted in an improved industry-wide financial performance.

Through October, industry conditions have been seasonally strong. We believe that growth of 12% to 15% year over year and 4% to 5% quarter over quarter is likely in the December quarter. Distribution and manufacturers inventories combined are down year over year by some of 11% exiting October. Based on current demand and factory build rates, we believe that the industry would be much better positioned entering the January to March quarters than in recent years.

At WD, our capacity is constrained relative to current demand. As a result, we are working diligently to treat all customers fairly in this constrained environment. We expect that we will see allocation on certain capacities continue through out the quarter.

In the first quarter, our investment strategy, product portfolio and execution in all market segments enabled us to address robust demand for mainstream and high capacity hard drives in both consumer and commercial applications.

We posted year-over-year hard drive growth of 37% in revenues and 29% in unit shipments. Combined with our solid performance in the March and June quarters, the WD business model has demonstrated our ability to deliver strong results in both good times and in the periods where we face industry headwinds.

Each of WD's businesses – desktop, consumer electronics, branded products, mobile and enterprise SATA -- turned in strong performances in Q1. As a result of our multi-year diversification strategy, for the first time we derived more than half of our quarterly revenues in the hard drive space from non-desktop applications, 53%, up from 35% in the year-ago quarter.

This greater diversification of our revenue base is a result of the investments made and our execution of the new product plan over the last several years, during which time we have become the world’s second-largest maker of hard drives.

The breadth of applications for hard drives is a major benefit for the industry and especially for those of us who have the ability to continue investing in future technologies and product roadmaps.

The company's unit shipments for the first quarter included approximately 5.9 million 2.5 inch mobile hard drives, up 175% year over year and approximately 3.7 million 3.5 inch hard drives for use in digital video recorders, an increase of 51% year over year. Branded products revenue, which increased 133% year over year, accounted for 18% of the Q1 total, continuing to demonstrate the strength of WD's global brand.

We addressed strong demand for higher capacity points in each of our segments with hard drives based on our own PMR technology. Most notably, our 2.5 inch, 250GB WD Scorpio hard drives and our 3.5 inch WD Green Power 1TB drives. Both of these drive families are based on our industry leading 200GB per square inch PMR technology platforms.

Earlier this week, we began shipping another industry-leading product. Our current generation PMR WD Scorpio mobile drive, based on our own 250GB per square inch PMR technology in capacities of up to 320GB.

Turning to our media acquisition, integration of the media operation is proceeding smoothly, according to plan. We recently completed our first worldwide operations review in Asia, involving the media team along with the rest of the WD operations and engineering teams. We are very excited about our ability to capture the synergies and advantages of a vertically integrated hard drive business, thus enabling us to compete even more effectively on the basis of our quality, reliability, customer service, technology and execution as we address the tremendous opportunities for profitable growth in the storage marketplace.

Tim Leyden will now provide our financial report and outlook.

Timothy Leyden

Thanks, John. Western Digital's execution and revenue diversification strategy, coupled with strong hard drive demand and stable pricing enabled the company to deliver outstanding financial results. Revenue for our first fiscal quarter was $1.766 billion. This includes $40 million of revenue from external sales of media and substrate components, shipped in the period between September 5 and September 28.

Total revenue was up 40% from the prior year, and hard drive shipments total 29.4 million units up 29% from the prior year. Average hard drive selling prices were approximately $59 per unit, up $3 from the year-ago quarter, and $4 from the June quarter as a result of firmer pricing and improved product mix.

We shipped 5.9 million 2.5 inch mobile drives in the September quarter, as compared to 2.2 million in the year-ago quarter and 3.8 million in the June quarter. Our growth in this important segment demonstrates the continued acceptance of our leadership products by notebook PC manufacturers, together with increasing demand in the mobile storage appliance market.

Turning to consumer electronics, we shipped approximately 3.7 million 3.5 inch drives for use in digital video recorder in the September quarter, versus 2.5 million in the year-ago quarter and 2.7 million in the June quarter. This market continues to be a long-term growth opportunity for WD and the industry.

Channel revenue was 51% OEM, 31% distribution and 18% branded products versus 52% OEM, 37% distribution, and 11% branded products in the year-ago quarter. There was 47% OEM, 36% distribution, and 17% branded products in the June quarter.

The Q1 OEM revenue percentage includes $40 million, or 2%, from external sales of media and substrates. Revenue for each of our top five customers increased from the June quarter. However, because of the increased diversification of our revenue base, no single customer comprised more than 10% of the total.

The Q1 geographic split of our business was 33% Americas, 32% Europe, and 35% Asia as compared to 35% Americas, 28% Europe, and 37% Asia in the year-ago quarter. It was 40% Americas, 26% Europe and 34% Asia in the June quarter. Revenue from external sales of media and substrates is included in the Asia percentage.

Our gross margin percentage for the quarter was 18.3% versus 17.3% in the year-ago quarter, and 15% in the June quarter, reflecting improvements in pricing, mix, and costs.

Operating expenses totaled $188 million, including a $49 million charge for in-process research and development related to the Komag acquisition.

Operating income was a $135 million or 7.6% of revenue. Net interest and other income totaled approximately $3 million. Income tax expense was $69 million for the September quarter, including net non-recurring charges of $60 million. Absent these charges, our tax rate was about 6.5% for the quarter.

During the September quarter, we had $3 million favorable resolution of certain foreign tax contingencies. Also during the quarter, we licensed certain intellectual property to one of our international subsidiaries. This resulted in a tax charge of $63 million. We now expect that our future book tax rate will be in the 5% to 7% range. However, I would highlight that our cash tax rate will continue to range between 2% and 3% for the foreseeable future.

During the quarter, we adopted FIN- 48, which prescribes the method by which company should calculate reserves for tax contingencies. The impact of that adoption was not material to net income or shareholders’ equity. However, it did result in balance sheet reclassifications between deferred tax assets and liabilities.

GAAP net income totaled $69 million or $0.31 per share, excluding the $60 million net tax charge, non-GAAP consolidated net income was $129 million or $0.58 per share. Excluding the net tax charge and the combined impacts of the acquisition, non-GAAP HDD net income was a $182 million or $0.81 per share. A reconciliation of non-GAAP to GAAP results is on the last page of our press release, financial statements.

Turning to the balance sheet, our cash and short-term investments at the end of the quarter totaled $851 million as compared to $907 million at end of June. The decrease is primarily the result of the net cash used for the acquisition. As of the end of the quarter, we have drawn down $750 million of our $1.25 billion bridge facility.

Cash generated from operations during the quarter totaled $219 million; capital expenditures for the quarter where $163 million; non-cash charges for depreciation and amortization expense totaled $78 million.

Following a recent review of demand, capacity, technology and efficiency roadmaps, capital expenditures for fiscal 2008 are now expected to be around $700 million, at the lower end of our previously estimated range. This includes about $100 million for our media operations. Depreciation and amortization expense for fiscal 2008 is expected to be about $400 million, including about $100 million for media operations.

We have completed the preliminary purchase price allocation related to our $1 billion acquisition of Komag. We recorded a $49 million cash for in-process research and development. In addition, we increased the book value of the media fixed assets by about $130 million and recorded approximately $100 million in net deferred tax assets; $90 million of amortizable intangibles; and $85 million of goodwill.

The asset valuation assessments indicated longer useful lives than we had initially estimated. As a result, the incremental depreciation and amortization resulting from these fair value adjustments would be about $5 million per quarter. This is included the $100 million fiscal 2008 estimates of media depreciation and amortization referred to above.

During the quarter, we repurchased 841,000 shares of stock at a total cost of about $16 million. Since May 2004, we have repurchased 15.1 million shares at a total cost of $204 million; $46 million remains under our existing stock repurchase authorization.

Our cash conversion cycle was a positive ten days, consisting of 51 days of receivables, 29 days of inventory or 13 turns, and 70 days of payables outstanding. Excluding the impact of the acquisition, our conversion cycle would have been a positive one day, consisting of 48 days of receivables, 17 days of inventory or 21 turns, and 64 days of payables outstanding.

Now I will move on to our expectations for the second quarter 2008. It is our intention to break out revenue from a media sales for the December and March quarters, until our external obligations are complete. All other operating results will be reported on a WD consolidated basis.

As we indicated on our last call, we expect the media acquisition to become accretive in the June 2008 quarter. Longer term, from the end of calendar 2008, we expect that our blended media internal and external supply model will enable us to realize cost improvement at the gross margin line of up to 300 basis points.

We expect demand for the December quarter to be seasonally strong; accordingly, we estimate revenue for the December quarter to be between $1.875 billion and $1.925 billion, including approximately $100 million from external sales of media and substrate.

Gross margin for the December quarter is anticipated to be in the range of 18.5% to 19%. Operating expenses are projected to be approximately $163 million, as we continue to integrate media operations and invest in expanding our product and technology portfolio.

Net interest expense is projected to be about $11 million. We anticipate a tax rate of between 5% and 7%, and our share count will be about 225 million. Accordingly, we estimate earnings per share of between $0.73 and $0.77 for the December quarter.

Operator, we are now open for questions.

Question-and-Answer Session

Operator

Your first question comes from Andrew Neff – Bear Stearns.

Andrew Neff – Bear Stearns

I wanted to take a step back. You had a really nice quarter, things are going well. Why won’t the industry go back to – since things are so strong – over building? You are implying that you think things might be better in January and March. What is different this time? How can it be sustainable, and how can we, as investors, feel comfortable about that?

John Coyne

Andy, there are several positive indicators. One of those is that as we exited the first financial quarter, the September quarter, inventories excluding enterprise -- 3.5 inch and 2.5 inch drives -- inventories were down 8% year-over-year as we exited the September quarter, for the total industry. That is manufacturers inventory, product in transit from the plants, product in the OEM hubs, and distribution owned inventory throughout the world. So that was, in absolute numbers, was 8% lower exiting September this year than the prior year.

As of the end of October, it was 11% lower than it was exiting October last year. So I think we're seeing significant production discipline. I don't think that's an accident. I think it's a reflection of the way the management teams in the large companies are looking at their businesses. I believe that discipline maintained through the balance of this quarter will ensure that we enter January in the best position relative to supply and demand balance and starting inventory that we will have seen in the last five years.

Operator

Your next question comes from David Bailey – Goldman Sachs.

David Bailey – Goldman Sachs

There has been a lot of comment about double ordering from the semi companies into the PC space. Why haven’t we seen this yet in the hard drive space, and what evidence do you have that some of the most egregious prices won’t back off a little bit?

John Coyne

I think my answer to the prior question is part of it. I mean, our inventory positions are low throughout the industry. Our visibility, particularly in the distribution channel, to the movement of product through that channel, the inventories in the channel is very much better than it was years ago. Our visibility into the OEM pulls and build rates is also significantly better than it was some years ago; our view of the market today is that we’re seeing true demand.

David Bailey – Goldman Sachs

A clarification, can you help us understand how much of your CapEx is going toward capacity expansion and how much of it is for maintenance at this point?

Timothy Leyden

Most of our expenditure at the moment is going on component expansion, which is HDS and media, and it is tough to break it out between maintenance and expansion, because when we do any replacements, we tend to get efficiencies also.

John Coyne

I think to elaborate on Tim’s point, as we told you I think in the last call some $200 million of that overall spending relates to our conversion of ‘our wafer fab from 6 inch to 8 inch; that the investment in the initial pilot facility to demonstrate that process technology development. Likewise, a significant portion of the $100 million that we have indicated relative to the media operations is significant equipment technology upgrades that relates to the 100% transition to PMR over the course of the coming year. So I think a substantial amount relates to technology.

Operator

Your next question comes from Rich Kugele – Needham.

Rich Kugele – Needham

In terms of the mobile, a significant increase in your production there. Has there also been an improvement because of the volume on the margins for that product line for you?

John Coyne

Our mobile product, a combination of volumes, our technology leadership in that space have all generated a very good mix and a continuing improvement in margins in that space.

Rich Kugele – Needham

Are we now north of desktop again versus being below?

John Coyne

Let me just say that we are continuing to improve.

Rich Kugele – Needham

Obviously even with Komag, your inventory balances were impressive, but can you give us a sense on some of the other line items on the balance sheet ex Komag?

Timothy Leyden

We didn’t have any real changes in the balance sheet other than the addition of the Komag items. On the inventories in particular and in the conversion cycle, we were at ten days positive on the conversion cycle. When we look at that, there was actually a bit of mismatch there, because we had to count the entire quarter of receivables and also inventory against a very small amount of gross margin, cost of sales, and revenue.

So consequently that was about three days in that ten which will be eliminated when we get down to be able to compare that against the entire quarter. That will bring us down to around seven and we expect that we will go to about five or six in the current quarter.

Rich Kugele – Needham

On your external substrate side, obviously there is a lot of tightness there in the market. Can you talk about what you’re seeing for that piece of the business since you’re the only company that has 100% their needs?

John Coyne

I think on a worldwide basis, I think the supply of both aluminum and glass substrates is reasonably well matched to demand. As we’ve mentioned, we’re continuing to fulfill our external obligations in both media and substrate relative to VPAs that are currently in place.

Operator

Your next question comes from Mark Miller - Brean Murray Carret.

Mark Miller - Brean Murray Carret

Could you give us in terms of weeks of inventory where do you think the industry is at and where you guys are at?

John Coyne

Ending the quarter, Mark, we were in our normal four to six weeks range in distribution. I think inventories are very well situated, as I mentioned, ending October 11% down on the same period last year. I don’t have that translated into weeks but it is a relatively low number, well towards the low end of the range.

Mark Miller - Brean Murray Carret

The second question would be, there’s been talk about component shortages, including disk drives, facing some of the mobile PC builds. I’m just what effect, if any, that’s had on you in the December quarter and possibly if you’re feeling any effect for the March quarter?

John Coyne

I think it’s exhibiting slightly differently, customer to customer. I think most of the issues are being resolved, but not to the extent where there is plenty of availability in the system. I think it’s tight and a little spotty from customer to customer. I think tightness for the whole quarter with timing being an issue from individual customer to individual customer.

Mark Miller - Brean Murray Carret

Seagate indicated at their analyst meeting that they thought Hitachi and possible Samsung had -- well I’m not going to use their words -- but are behaving themselves. Is it basically because we are just short now in terms of supply, or do you thing there is a real change in management from what we’re hearing, Hitachi, a real pressure to make some money there?

John Coyne

I think if you look at the sustained behavior at Samsung over the course of the last year, we have seen a very significant shift in emphasis which we believe is driven by a desire for profitability and a recognition of Samsung’s structural advantages and disadvantages.

So it appears to me that they are playing to the strength of their supply base and becoming, or at least attempting to become, an outlet for the technology that they are head and media suppliers can deliver to them and they are focusing on more niche applications within the overall marketplace.

I think that is very sensible and I think it is very positive for industry. When I look at Hitachi, we saw their results announced yesterday and I think that is also encouraging in that the management there seems to be focusing on addressing some of the cost issues and focusing on profitability and this is also very good to the industry.

Operator

Your next question comes from Steve Fox – Merrill Lynch.

Steve Fox – Merrill Lynch

Just to be clear on the dilution impact from Komag in that quarter just completed, it looks like volumes allowed it to be less diluted. Secondly on that, can you just talk about how much, given the strong volume demand, what kind of dilution are we now looking for, for Komag, in the current quarter?

John Coyne

Well, as you have seen at the addendum to our press announcement, we’ve broken out what the media dilution was for the three weeks of September that we owned the business and we have indicated that we would be accretive in the June quarter. So it will be more or less a straight line between those particular points. We’ve also indicated how much we are spending in OpEx and the other component is the interest rates on the loan that we drew down.

Steve Fox – Merrill Lynch

So off of this higher base, we can assume less dilution than you were probably seeing a month ago, it sounds like.

John Coyne

Secondly, from here through the end of March as we fulfill our external VPA media obligation and substrate obligations, we then have to convert that equipment to WD and there are some inefficiencies related to that in terms of the total utilization of the asset base and the people and some startup costs related to that so I wouldn’t get too ahead of ourselves there.

Steve Fox – Merrill Lynch

When you talk to your PC customers, given the outlook you are talking about and it doesn’t sound like you are that concerned about double ordering, are they taking a more conservative bent in terms of what they expect from sales over the next few months given what’s going on in the economy? Or you are not seeing that from your customer?

John Coyne

I think we are seeing good demand and I think we probably get a lot more information and a lot more focus on the shape of the US economy and the issues in the US economy.

One of the things that we noticed in terms of a strength, which was across all geographies but particularly strong in Q1 in Europe. If you look at the movement in relative exchange rate to the US dollar relative to the European economies, and then you factor in the fact that all IT-related products -- hard drives, PCs, all IT-related products -- are costed and sold essentially in US dollars.

European customers, European consumers have 30% more buying power than they had at this time last year relative to any discretionary spending on IT. That, I believe, is one of the key drivers of the strength of European demand for PCs and for storage appliances and DVR type products.

I think to a degree that’s also true in Asia, although the Asia Pacific region growth is probably more driven just by total economic growth in those areas, but again, currencies have strengthened relative to US dollar cost.

Operator

Your next question comes from Mark Moskowitz – JP Morgan.

Mark Moskowitz - JP Morgan

Maybe we can build off of that last question, obviously you were talking about the currency benefits, I just wanted to get a sense in terms of the underlying trends. What in Europe or Asia is really helping hard disk drives? Is it more the PVR/DVR, the external backup piece?

John Coyne

I think we’ve seen strong growth across our entire product line. I think there are two elements of play here relative to WD specifically, as distinct from the strength in the industry generically. Our ability to grow revenues 37% year over year relative to industry growth in the high-teens is attributable to WD’s focus on product quality, reliability, availability and flexibility. What you see is customers responding to those values and preferring WD and that’s a worldwide phenomenon and a multi-channel phenomenon.

Mark Moskowitz - JP Morgan

Do you feel you are outgrowing your peers in both Europe and Asia from a hard disk drive perspective?

John Coyne

I think we are outgrowing our peers everywhere.

Mark Moskowitz - JP Morgan

Can you maybe talk about the overall blend of the ASP improvement, how much of it was really driven by mix or just better improvement on market share opportunities for WD?

Timothy Leyden

I think we had a number of factors, I think we had a better segment mix. We had high capacity mix and we had strength in the enterprise and branded products, which contributes to the higher segment mix.

Mark Moskowitz - JP Morgan

I want to go back to the commentary on the industry discipline as far as inventories. It doesn’t really appear that channel inventories or OEM inventories with respect to hard disk drives has really been an issue since Maxtor faded away, and clearly WD has had a sterling execution record in terms of what you guys have done with your business model and your inventories over the past few years.

Are you trying to send a cannonball off the bow to the rest of the industry in terms of say, hey, we have a buffer here, don’t mess it up as you go into the first part of next year?

John Coyne

I don’t think there’s any buffers. I think the point I’m trying to make is that the industry as a whole is leaner going into January and consequently I don’t expect the same overhang of inventory to affect the dynamics of supply and demand as severely as they have in prior years.

Operator

Your next question comes from Keith Bachman – Bank of Montreal.

Keith Bachman – Bank of Montreal

The area of out performance was certainly in the mobile side, as I think Rich was alluding to. Could you talk a little bit more, you mentioned some spot shortages. Why was there so much share gain on the mobile side? Related, where at the spot shortages that you are seeing either at OEM or channel? Where is the most tightness today?

John Coyne

I think where we are seeing tightness is essentially in mid cap range of both mobile and desktop. I think our strength in mobile has been the fact that we are leading the market in terms of volume in the 250GB capacity, where I believe in the last quarter we shipped more 250GB into the market than any other supplier and I think more than all other suppliers combined. This week, we announced our 320GB, again, we will lead on time to volume at that capacity. If you look at the mobile marketplace, there is a very high demand for high-capacity drives in the mobile space, 320GB being the largest drive available. Having that capacity in our portfolio makes us a preferred solution for the customer base.

Keith Bachman – Bank of Montreal

Would you expect in the December quarter in terms of your year-over-year growth rates, would be expect that to likewise be certainly the area of out performance for December and perhaps even March?

John Coyne

We see strength in the mobile demand. We see mobile growth rates on an industry basis continuing to outpace other segments. So it’s reasonable to assume that mobile would be a significant contributor to our guidance of 12 to 15 points of year-over-year growth.

Keith Bachman – Bank of Montreal

What was the like-for-like ASP changes either sequentially year-over-year?

Timothy Leyden

We covered that. I believe it was --.

Keith Bachman – Bank of Montreal

I know what the absolute was, just what was the like-for-like?

Timothy Leyden

We don’t normally on that.

John Coyne

We don’t give out that information.

Keith Bachman – Bank of Montreal

Then the final one from me is, you mentioned that you bought back some stock this quarter; that surprised me a little bit. Was that pre the Komag deal or taking down the term debt? I’m assuming that the buyback is with the debt on your balance sheet that you won’t go after that, but if you could just provide some color on how you intend to treat the buyback going forward?

Timothy Leyden

Yes, it was pre us drawing down the loan, and in the future, though, we will be opportunistic. We keep our options open on that front because if there are favorable conditions, we may continue to do so.

Operator

Your next question comes from Christian Schwab – Craig Hallum.

Christian Schwab – Craig Hallum

The OEM growth of 34% excluding Komag, tremendous growth there. Is that due more to market share gains or due to the fact that you are capacity constrained, and you ship to them before you ship to the distribution channel?

John Coyne

Well, our hard drive growth was 37% year-over-year in revenues and 29% in unit volume, that was across all segments. It wasn’t an OEM statement.

Christian Schwab – Craig Hallum

Right, I am just looking at your OEM revenue quarter over quarter, sequentially which grew 40%, $900 million minus the $40 million that you threw into Komag which would make it roughly 34%. The question is do you think you are gaining share at the OEM level?

John Coyne

Yes and the reason, the primary contributor there is if you look at the desktop it is a roughly 50% OEM, 50% distribution business. However if you look at mobile it is 80% to 90% OEM business. Therefore growth in mobile, a lot of it falls into the OEM bucket.

Christian Schwab – Craig Hallum

Perfect. That is the same math I had, just confirming. On the gross margin side the 300 basis point of improvement, what would be a long-term goal on gross margins should industry conditions remains like are today, stable and well-behaved?

Timothy Leyden

Well, our current long-term range for gross margins is 15% to 20% and that reflects the mix, the maturity of the products and the seasonality. We are early in the media integration timing and that is a definite cost opportunity for 300 basis points depending on rational competitor behavior and pricing. We will reach that point at the end of calendar 2008. So at that stage, we should be able to reflect that change in the margin but it is to earlier at this particular point.

Christian Schwab – Craig Hallum

So in essence, longer term should things remain rational, we can have 20% plus gross margins, correct?

Timothy Leyden

Yes.

Operator

Your next question comes from Harry Blount – Lehman Brothers.

Harry Blount – Lehman Brothers

I wanted to come back to a couple of questions on the contribution on both the ASP increase sequentially as well as gross margins sequentially. If you can maybe help us out in thinking about how much of that did come from mix, how much of that was pricing? How much was other factors such as the economy on the Komag side?

Timothy Leyden

I would say that on a ranking you find the mix contributed the most, cost contributed and pricing contributed.

Harry Blount – Lehman Brothers

If we take a look at the December quarter and your ability to blend up, are you constrained on any of the components that will prevent you from being able to blend up a similar amount in the December quarter?

John Coyne

We believe we will be able to continue to execute our management style to optimize our business around any demand profile by having the most responsive, most flexible manufacturing and supply chain system in the industry. So I think we will continue to attempt to best optimize the business relative to the sales opportunities that present themselves.

Harry Blount – Lehman Brothers

So definitely, you don’t feel like if you had a chance or you need to blend up your capacity, your platters per drive, you don’t see either platters, heads or suspension being limiting factors at this point?

John Coyne

No.

Harry Blount – Lehman Brothers

You do disclose the Komag results separately, could you give us a sense of what the intra-company eliminations are either on the revenue and/or gross profit line?

Timothy Leyden

We haven’t got that information.

Operator

Your next question comes from Shebly Seyrafi – Caris.

Shebly Seyrafi – Caris

I just want to make sure I heard you right, did you say that net interest income or expense will be $11 million in the December quarter?

Timothy Leyden

Expense.

Shebly Seyrafi – Caris

In terms of the ASP change you expect in the December quarter, do you expect it to be flat sequentially or down a few ticks?

Timothy Leyden

It will be flat sequentially.

Shebly Seyrafi – Caris

You’re projecting media revenue at $100 million in December. Do you have an idea how that should proceed after the December quarter? When does it go to effectively zero?

Timothy Leyden

We will be without completed or external obligations by the end of March, but we will continue to have some immaterial amounts of substrates going forward after that.

Shebly Seyrafi – Caris

Substrates for modeling purposes in June just maybe 5 million to 10 million or something like that?

Timothy Leyden

Something in that region. Yes.

Shebly Seyrafi – Caris

I was surprised you included the in-process R&D charge in your non-GAAP consolidated EPS. I would normally eliminate that and get like a $0.79 number versus your $0.58 number. Tell me why you included that?

Timothy Leyden

Well, we actually just called that out separately to show it as a one-time charge. On an apples-to-apples basis going forward, you are right. The media operations will continue, so it would be the non-GAAP WD HDD plus the media, which would amount to about 178.

John Coyne

We did this because in our guidance, in the refresh call that we did at the beginning of September when we closed the Komag deal, we had not envisaged the IP licensing transaction which is why did the separate column with the $60 million. So that you could tie it back to the guidance we had given you for the combined WD Komag activity.

Operator

Your next question comes from Aaron Rakers – Wachovia.

Aaron Rakers - Wachovia

Building on Shebly’s question here, if you look at your gross margin guidance for the December quarter and you look at that on a standalone basis, can you help us understand what gross margin excluding the Komag impact would be at the high-end of your long-term guidance range of 15% to 20%?

Timothy Leyden

Well, as we indicated, we’re going to give the amounts on a consolidated basis going forward, so the margin indication that we’ve given includes the impact of the media operation in that number.

Aaron Rakers - Wachovia

Is it fair to assume that obviously given the accretive impact that still is going to be a negative impact on the gross margin line, is that fair?

Timothy Leyden

Well, I think if you look at the current situation and look at what we provided as the addendum for those three weeks, it would be fair to assume if you look at that just maybe quarterize that as John indicated. We’re going through the transition whereby we are providing product externally, and then we’ll be tapering down in the January quarter and completely out at the end of March other than for the substrate.

Aaron Rakers - Wachovia

I’m interested in the comments looking out now into March quarter, and one of the areas of notable strength was on the OEM side of business. Have you seen a change with regard to OEM order patterns in the notebook market in particular, given the recent, I think one of your peers explicitly stated that they were not able to meet all of their demand. Have you seen a lengthening in terms of the OEM forecast that you guys are receiving and that’s what is giving you better visibility?

John Coyne

I’ve been addressing this I think in the last few calls. As the industry has consolidated and as only a few people have been generating the necessary revenues -- well, not revenues, generating the necessary profitability -- to be able to reinvest in significant technology and product breadth and in capacity, I think customers are beginning to understand what that means strategically and are beginning to view hard drive availability as a significant enabler of their businesses, and are taking appropriate actions to ensure that they have that availability.

So, yes, we’re seeing a much more realistic view emerging than perhaps in years gone by when it was an assumption that there was going to be access available at any time.

Aaron Rakers - Wachovia

Cash flow generation had a pretty solid quarter, but once we bake in a full quarter of Komag, maybe you could help us understand how we should think about quarterly cash flow generation?

Last question for me would be, a couple of quarters ago you had talked about moving into adjacent market opportunities, any update with regard to that in terms of new product segments that you might go after? Thank you.

Timothy Leyden

On the cash flow, we anticipate that the free cash flow for the current quarter will be around $100 million.

John Coyne

On growth and adjacent markets, we continue to invest in breadth of product and we continue to a value opportunity in segments in which we don’t participate whether they be hard drives or other solutions to storage demand, and as we evaluate those markets and our potential to make a significant return and leverage our core engineering capability, then those things that pass the standards we will act on them, but as you know we only announce products and product families when we’re shipping.

Operator

Your next question comes from Jeff Brickman – UBS.

Jeff Brickman – UBS

DVR growth was very solid in the quarter. Is this a function of the customer preferring [inaudible] hit in the quarter and should we expect the line to continue to be lumpy going forward?

John Coyne

Yes I think so. The DVR business is very much a project driven business, the demand is very concentrated in large customers such as the cable companies and the direct satellite TV companies. So it tends to be lumpy but some very positive traction, some very good plans in the offering relative to the transition to HD, all of which is good for storage. On the mid to long-term basis, I see this as a very solid application for our technology.

Operator

Your next question comes from Joel Inman – Robert W. Baird.

Joel Inman – Robert W. Baird

You have had a lot of success in retail driving that as a high percentage of your business. Can you give us a sense of where you think that could go in terms of mix and the dynamics between share gain and market growth?

John Coyne

I think the branded segment continues to be a significant growth opportunity for the industry; we’re seeing that the driver of that growth is all of the non-computing content that people now are generating, whether it is with digital cameras or a collection of audio or video content. This is a whole new market application. I think consumers are becoming educated about the value and the need for backup storage, they are also becoming very mobile in terms of seeking the means to carry their data memories and photos with them wherever they go; all of these things are very positive for that space. So I think we’ll continue to grow there.

Our timing, our product design, our product feature set, our reputation for quality and reliability, our relationships with the channel in both retail and direct marketing seem all very positive and all of that across the board has contributed to our success with the My Book and Passport brands. We would certainly hope to continue that and we have a very high focus on ensuring that we do.

Joel Inman – Robert W. Baird

But do you see it being 40% of your mix at some point?

John Coyne

I think we’ve made the major strides, I think the opportunity for us is to, in the developed markets, to grow with the market demand and in some emerging markets which really don’t buy these kinds of products today, the emerging market tends to be very much a do-it-yourself market in the very early days. As average incomes rise then people begin to buy the complete branded finished solution. So emerging markets offer a significant opportunity in the years to come.

Operator

Your next question comes from Andrew Neff – Bear Stearns.

Andrew Neff – Bear Stearns

I just want to go back to something, as you let the customers know that you’re in allocation, how do you avoid or measure or factor in double ordering? There has to be that going on, because they all know the shortages and they need get what they want.

Can you talk about any pricing trend changes in the notebook area?

John Coyne

Let me address the orders first. We have a very high degree of visibility on inventory levels throughout the channel. Therefore, we can judge and base allocation on replenishment of inventory levels to what we believe is appropriate.

In the OEM space, if you look at the large OEM companies, they run very similar models to ourselves; very tight asset turn models. Therefore, we see what’s in the hubs, we see what’s being pulled. We see reporting of what their shipments are. I’m not concerned on lack of visibility of true demand.

On pricing in mobile, I mean it continues to be competitive.

Andrew Neff – Bear Stearns

Are you in allocation mostly in mobile as well, or is it mostly in the other areas?

John Coyne

As I mentioned, mid-cap in both 2.5 inch and 3.5 inch, we’re seeing tightness in the market.

Operator

I would now like to turn the call over to Mr. John Coyne.

John Coyne

Well thank you everyone for participating in today’s call. I look forward to updating you on our progress in the months and years ahead. Thank you.

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Source: Western Digital F1Q08 (Qtr End 9/28/07) Earnings Call Transcript
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