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Seagate Technology (NASDAQ:STX)

F2Q07 Earnings Call

January 17, 2008 5:30 pm ET

Executives

William D. Watkins - President, Chief Executive Officer, Director

Brian S. Dexheimer - Executive Vice President, Chief Sales and Marketing Officer

David A. Wickersham - President, Chief Operating Officer

Charles C. Pope - Chief Financial Officer, Executive Vice President

Analysts

Katy Huberty - Morgan Stanley

Richard Kugele - Needham & Company

David Bailey - Goldman Sachs

Aaron Rakers - Wachovia

Andrew Neff - Bear Stearns

Jeff Brickman - UBS

Steven Fox - Merrill Lynch

Keith Bachman - BMO Capital Markets

Mark Moskowitz - JP Morgan

Sherri Scribner - Deutsche Bank

Mark S. Miller - Brean Murry & Co.

Tom Curlin - RBC Capital Markets

Christian Schwab - Craig-Hallum Capital

Shaw Wu - American Technology Research

Daniel Renouard - Robert Baird

Operator

Good afternoon, ladies and gentlemen. Thank you for standing by. Welcome to Seagate Technology’s fiscal second quarter 2008 financial results conference call. (Operator Instructions)

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 but are subject to a number of risks, uncertainties, and other factors that could cause actual results to differ materially from those anticipated by these forward-looking statements.

Information concerning additional factors that could cause results to differ materially from those projected in the forward-looking statements is contained in the company’s annual report on Form 10-K as filed with the U.S. Securities and Exchange Commission on August 27, 2007, and in the company’s quarterly on Form 10-Q as filed with the U.S. Securities and Exchange Commission on October 29, 2007.

These forward-looking statements should not be relied upon as representing the company’s views as of any subsequent date and Seagate undertakes no obligation to update forward-looking statements to reflect events or circumstances after the date they were made.

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

William D. Watkins

Thank you, Dustin. Welcome, everyone and thank you for joining us. On the phone with me are Dave Wickersham, President and Chief Operating Officer; Charles Pope, Executive Vice President and Chief Financial Officer; and Brian Dexheimer, Executive Vice President, Chief Sales and Marketing Officer. Brian is actually offline on a phone here so he will be kind of from a remote position.

As announced earlier today, we reported another quarter of double-digit revenue and profitability growth year over year. These results were driven by the continued strong demand for storage and the breadth and depth of our portfolio and our expanded customer base, which enables us to benefit from demand across virtually every market for digital content from the home to the enterprise.

I’ll start the call today by spending a few minutes reviewing our second quarter numbers with you and sharing with you some additional perspective on our business trends and the industry landscape. I’ll then 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’ll then ask Brian, Dave, and Charles to discuss details of our market, operating, and financial results.

Our results for the quarter continue to show overall strength in Seagate's business model and the fact that technology trends continue to create strong demand for digital storage. At Seagate, we surpassed our first quarter with record demand that resulted in capacity constraints. For the quarter, revenue grew 14% year over year to a record $3.4 billion on shipments of 50 million units, representing a 20% increase over units shipped in the second quarter of last year.

We maintain our overall industry leadership position, shipping 35% of the total industry volume and retained our leading position in the enterprise, desktop, and consumer electronic markets.

Profitability improved with gross margins increasing to 26% in what was then a benign pricing environment. We continued to demonstrate that Seagate is a powerful generator of cash with $724 million in cash generated from operations and $512 million in free cash flow in the quarter.

Through the first half of the fiscal year, we have generated approximately $1.5 billion in cash from operations and over $1 billion in free cash flow, and we have returned approximately $600 million in cash to shareholders through dividends and stock repurchases.

Clearly we remain enthusiastic of what we see as a very strong future for the industry and expect Seagate will continue to leverage our technological and operational strength into a competitive advantage.

Given the seasonality of our business, we expect an historical 5% decrease in unit demand for the March quarter from the December, but we expect demand will be approximately 20% up from the March quarter of last year.

Longer term, we see demand trends continuing to shift towards higher capacity storage, indicating that the global appetite for digital storage in both the consumer and commercial markets remain robust.

Looking ahead, we see a continuation of a strong overall demand trends with normal seasonality in the current quarter. We expect to report solid third quarter results with a revenue in the $3.2 billion to $3.3 billion range, representing a 15% revenue growth year over year at the midpoint.

Now I’d 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 S. Dexheimer

Thanks, Bill. Calendar 2007 ended on a strong note for Seagate and the industry. Year-over-year demand increased significantly, delivering record units and revenue for the industry. Once again, supply and demand appeared to be well-balanced, contributing to a healthy operating environment.

Seagate and the industry continue to benefit from the dramatic growth in digital content creation and distribution and the increasing build-up of Web 2.0 applications. Specific to the December quarter, we believe the overall industry TAM was approximately 144 million units, up 21% year over year. Seagate maintained its overall industry leadership, shipping 35% of the industry’s volume and growing its shipments to 49.6 million units. Seagate retained share leadership in the enterprise, desktop, and CE markets.

Looking toward the March quarter, we expect seasonality will bring the overall TAM down 4% to 6% quarter over quarter to $134 million to $138 million units, representing a continued strong year-over-year growth of 20% to 22%.

Now I’ll give some detail on the individual markets.

The mission critical enterprise TAM in the December quarter grew faster than originally predicted at the beginning of the quarter, reaching approximately 8.3 million units, representing 13% quarter-on-quarter growth and 16% year-on-year growth. Seagate maintained its leadership position in this market, shipping a record 5.3 million units.

Server virtualization resulted in strong demand from customers deploying SAN architectures, leading to dramatic growth in our 15,000 RPM 3.5-inch high capacity products. Also, small form factory enterprise drives continued to be in high demand as Seagate shipments were 1.7 million units during the December quarter. These products offer a powerful combination of reduced power and physical footprint while providing industry-leading performance.

Also within the enterprise space, we are seeing continued growth in the high capacity enterprise class SATA products. Growth for these products is driven by the build-out of Web 2.0 data centers and continued adoption of drive-to-drive back-up solutions at the expense of tape.

These products are being widely adopted for digital content aggregation and distribution over the Internet infrastructure. We believe we are the leader in this portion of the enterprise market.

Additionally, we achieved solid qualification starts during the quarter with several first tier customers for our 1-terabyte product. We expect shipments of this product to be material in the March quarter and beyond and further strengthen our leadership in this space.

Looking forward to the March quarter, for the enterprise market we expect mission critical class drives to be flat to slightly down seasonally, which high-capacity SATA products are likely to be slightly higher sequentially.

In consumer electronics applications, we believe the industry TAM exceeded 22 million units during the quarter. DVR growth of nearly 30% year-on-year was a key driver in this space. Seagate also experienced strong growth in this market, maintaining its leadership position by shipping 8.1 million units. This represents our largest quarter ever in consumer electronics applications.

Additional key sources of growth for Seagate in this space continued to be surveillance equipment and gaming, each of which experienced substantial growth in the quarter.

We are planning that the CE TAM for the March quarter will follow normal seasonal patterns and be approximately 15% to 17% lower than that of the December quarter.

We believe the mobile compute TAM grew 10% sequentially and 48% year-on-year to approximately 44 million units. Seagate shipped 6.4 million units into this market during the quarter, an increase of 46% year-on-year. Capacities continue to trend higher in this space as the notebook displaces the desktop as the platform of choice in the digital home.

We believe our 250 gigabyte notebook product, now shipping in volume, will provide additional opportunity for Seagate beginning in the March quarter. This product has been qualified by eight OEMs to date, with several more imminent.

We expect the March quarter for the mobile compute market to exhibit normal seasonality and be slightly down from the December quarter.

The TAM in the desktop compute market grew 5% sequentially to approximately 69 million units. Seagate shipments grew to a record 29.9 million units in fiscal Q2. we continued to see strong movement to higher capacity 3.5-inch ATA products during the quarter and believe that the industry exited the quarter with some unmet demand in capacity to 500 gigabytes and greater. We believe channel inventory of 3.5-inch ATA products for the industry exiting the December quarter was less than five weeks and Seagate's inventories were at four weeks.

For the March quarter, we expect that the desktop computer TAM to be seasonally down approximately 4% to 5% sequentially, yet still reflecting healthy year-on-year growth of slightly more than 10%.

Finally, we saw sequential growth in our branded solutions business that was greater than that of the core business. During the December quarter, we were challenged to meet increasing demands of our customers in several product configurations. We are seeing strong adoption of our new Maxtor OneTouch 4 products and expect this to continue as we see the creation and distribution of digital content proliferate globally.

Looking into the March quarter, we expect this market will be flat compared to the December quarter.

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

David A. Wickersham

Thank you, Brian. I’ll start with a few comments regarding our inventory performance in the December quarter, provide a quick update in regard to our capital spending plans for fiscal 2008, and conclude with some comments regarding our new product execution.

Seagate's inventory increased $67 million quarter over quarter from $763 million to $830 million. An increase of $76 million in finished goods inventory was partially offset by a $9 million reduction in work-in-process and raw materials. As highlighted in our October conference call, during the December quarter we expected to continue to fully utilize our available capacity and also replenish our OEM JIT hubs to required inventory levels.

To put this in perspective, on a year-over-year basis finished goods inventory decreased by $70 million while revenue increased by over $400 million. Inventory turnover was slightly higher than 12 turns in the December quarter, which was better than our projection of 11 turns.

As discussed in previous calls, we align our capacity expansions with customer demand. In light of the normal seasonal demand patterns in the March and June quarters, we do not expect to increase our fiscal 2008 capital spending plans. Consequently, the fiscal 2008 capital investment outlook remains unchanged at approximately $900 million and continues to include the expansion of our finished media and substrate factories in Asia. Over the next couple of months as we meet with our major customers, we will determine how much additional capacity will be required to support expected demand for the fiscal 2009 September and December quarters.

New product introductions continue to be a critical aspect of Seagate's ability to grow revenue and sustain margins. For example, Seagate has shipped more 250 gigabyte per disk 3.5-inch ATA drives than any of our competitors. However, we need to significantly improve our time-to-market results in the notebook market, where Seagate was late to productize the equivalent areal density, which is the 125 gigabyte per product disk that is now shipping in volume that Brian mentioned earlier.

Seagate remains committed to delivering new products that lead the industry in time-to-market, quality and reliability, and lowest cost. We are very disappointed with our time-to-market execution in the notebook market and we are addressing these issues.

While there is still much work to do, we are on track with the introduction of new products required to support our financial performance for the March quarter and beyond.

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

Charles C. Pope

Thanks, Dave. You will find the company’s press release, 8-K, and additional financial information related to Seagate's financial performance, along with a reconciliation of GAAP to non-GAAP financial results and other supplemental information in the investor relations section of Seagate's website at Seagate.com.

For the December quarter, Seagate reported revenue of $3.4 billion and unit shipments of approximately 50 million, which reflects year-over-year growth of 14% and 20% respectively.

GAAP net income and diluted earnings per share for the December quarter are $403 million and $0.73 respectively. Included in the GAAP results are approximately $31 million of purchased intangibles amortization and other charges associated with recently completed acquisitions, including MetaLINCs, as well as a net gain from asset sales of approximately $15 million. Without these items and the associated tax effects, non-GAAP net income and diluted earnings per share was $419 million and $0.76 respectively.

Included in both the GAAP and non-GAAP results is approximately $27 million of restructuring charges, which reduced diluted earnings per share by about $0.05.

GAAP gross margin for the December quarter was 26%. Excluding approximately $11 million of acquisition related costs, non-GAAP gross margin was 26.3%. Gross margin increased approximately 140 basis points from the prior quarter, due primarily to the pricing environment that was prevalent during the quarter.

GAAP R&D and selling, general, and administrative costs were $429 million for the December quarter. Excluding costs related to recent acquisitions including MetaLINCs, non-GAAP expenses were $422 million, slightly higher than what we had expected.

The roughly $30 million increase in R&D and SG&A expenses compared to the prior quarter is primarily due to annual salary adjustments, non-recurring engineering costs related to new product introductions, and increased legal expenses.

Cash flow from operations was $724 million for the December quarter, while free cash flow, defined as net cash provided by operating activities less capital expenditures, was $512 million.

For the first six months of fiscal 2008, Seagate generated approximately $1.5 billion in cash from operations and $1.1 billion in free cash flow. Cash, cash equivalents and marketable securities ended the quarter at $1.75 billion, up $252 million from the previous quarter.

During the December quarter, Seagate returned $300 million of cash to its shareholders, consisting of $50 million for the quarterly dividend and $250 million of share repurchase.

Seagate's ability to generate cash is one of the strengths of our business model and this quarter’s results again underscore that point.

Capital investment in the December quarter was $212 million and for the first six months totaled $362 million. As Dave previously indicated, we continue to plan for approximately $900 million of capital investment for fiscal 2008.

Depreciation and amortization for the December quarter was $215 million, up slightly from the prior quarter. Amortization of purchased intangibles totaled approximately $24 million.

You can find our fiscal year 2008 estimate for amortization of purchased intangibles on slide nine of the supplemental information package.

During the December quarter, the company purchased 9.3 million shares related to its share repurchase plan with an average price of $27. Cumulatively, under the current share repurchase authorization, we have repurchase 81.5 million shares with an average cost of $24.86. The company has authorization to purchase approximately $474 million of additional shares under the current stock repurchase program.

As indicated in the press release, we anticipate completing the balance of the current share repurchase authorization during the March quarter. I’d like to point out that when we closed the Maxtor acquisition in May of 2006, we issued just over 100 million shares. Our objective all along was to make the Maxtor acquisition a virtual cash transaction. Since that time, we have repurchased approximately 98 million shares. To the extent Seagate is able to fully utilize the existing share repurchase authorization in the March quarter, we will have repurchased more shares than originally issued through the Maxtor acquisition.

Additionally, we expect to request a new share repurchase authorization at an upcoming board meeting that would allow Seagate to continue repurchasing its stock beyond the March quarter.

Now I’d like to provide further detail on our outlook for the March quarter.

As Brian mentioned, for the March quarter we are expecting industry unit demand to be seasonally down around 5% quarter over quarter. Keep in mind that on a year-over-year basis, this equates to approximately 20% unit growth, similar to what the industry experienced during the last six months.

Consequently, Seagate expects revenue to be in the range of $3.2 billion to $3.3 billion.

GAAP diluted earnings per share is expected to be $0.57 to $0.61, and includes approximately $27 million of purchased intangible amortization and other charges associated with recently completed acquisitions, including MetaLINCs. Accordingly, non-GAAP diluted earnings per share excluding acquisition related costs is expected to be $0.62 to $0.66. At the midpoint, this outlook for the March quarter equates to top line year-over-year growth of 15% and non-GAAP earnings per share growth of 36%.

In providing this guidance, we recognize the current uncertainty of the U.S. economy. We believe our global market position and the breadth of our portfolio are strengths that may temper the effects of any cooling in the U.S. economy.

Demand for our products continues to be very strong, particularly among our content aggregator and Internet infrastructure customers. With ongoing input from our customers, we will continue to watch the U.S. economy closely and monitor its condition for any potential impacts that would cause deviation from the normal seasonal trends reflected in the company’s guidance.

GAAP, R&D, and SG&A expenses are expected to be approximately $438 million to $443 million for the March 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 $435 million to $440 million.

The increase over the prior quarter reflects modest incremental investments in technology leadership and continued increases in our legal expenses as previously discussed.

Other income and expense is expected to be a net expense of approximately $12 million and the tax rate is expected to be near the low end of the 5% to 10% range, similar to the December quarter.

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

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

William D. Watkins

Thanks, Charles. Clearly Seagate operational and financial performance position the company well in what has become one of the world’s most important and exciting industries. On behalf of the management team, I would like to thank and congratulate our employees around the world for another quarter of outstanding results.

So with that, let’s open up the call.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Katy Huberty with Morgan Stanley.

Katy Huberty - Morgan Stanley

Given your comment on unmet demand, it sounds like manufacturing utilization was near 100% in December. Where does that stand to date in the month of January?

William D. Watkins

Dave, do you want to take it?

David A. Wickersham

Where does it stand to date through the month of January?

Katy Huberty - Morgan Stanley

Yeah.

David A. Wickersham

Well, again, we are 100% utilized to the December quarter. The vast majority of our investments for the remainder of the quarter will be to continue to facilitize the media expansion in Asia along with the substrate expansion. So we have the ability and we’ll continue to monitor customer demand to try to keep our utilization very, very high but the roughly two-thirds of our capital investments, of the $900 million in 2009, or for 2008, pardon me, is really to position us to start to ramp those facilities in the June quarter but really prepare us for the September and December capacity needs for internal components.

William D. Watkins

I think one way to think about it, if you look at we are really forecasting about a 5% drop in units on a sequential quarter on quarter, so you can see we are going to run pretty close to capacity, even now. We are not putting in a lot of capacity, as Dave said, unless it’s reducing our costs on medium substrates.

Katy Huberty - Morgan Stanley

And then with the greater adoption of 1.8-inch drives in the notebook market, how quickly do you think you can come to market with a drive with appropriate capacity?

William D. Watkins

Brian, do you want to talk about that?

Brian S. Dexheimer

Well, I think first of all it may be a little presumptuous to think that there’s going to be wide adoption of 1.8-inch in the notebook. They have been there for quite some time and in products very much like the one that we saw yesterday being announced, or a few days ago, and they’ve continued to be less than 5% of the overall part of the notebook market.

So while that may change a little bit, it doesn’t -- any announcements in the last week doesn’t cause us to revisit our plans. The short answer to your question is we could be in a 1.8-inch product within 15 to 18 months after we decide we wanted to have one in our roadmap.

Katy Huberty - Morgan Stanley

Okay, great. Thanks.

Operator

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

Richard Kugele - Needham & Company

Thank you. Just a couple of quick questions -- first, on the gross margin, obviously an impressive number but due to the demand being as strong as it was, you likely had to expedite much of the quarter, which usually means by air then, right? So if we were just to take a step back and look at what the earnings power and the margin potential, the model actually was, what do you think it would have been if you didn’t have to do that? If you actually had the inventory and the capacity? Is there a way of figuring that out?

Brian S. Dexheimer

I’m not terribly sure that it’s worthwhile speculating about that. If you are meeting all the demand, who knows what the mix of product are and everything else. There’s a lot of different moving parts, Rich.

William D. Watkins

We’re very happy with where it stands right now. We like to exactly where we are at.

Richard Kugele - Needham & Company

Okay, and then just secondly, Dave, as you look at the manufacturing capacity, where do you think the greatest bottlenecks are in the system that need to be dealt with as you move throughout the year to meet the second half demand?

David A. Wickersham

Well first, Rich, I would say that we had some unique challenges within Seagate that I’ve referred to, which is a good challenge to have and that is, we’ve seen some very, very strong demand of our high capacity drives in particular, and so that is what has created some unique issues for Seagate that we’ve worked through and we’ve talked about publicly through December and we continue to see that strong and rich mix moving forward.

So we continue to have our media and slider demands underpinned but there are continuing linearity issues. As Brian mentioned, we exited the quarter with some pent-up demand and so from a Seagate perspective we like you said are constrained on some of those components but we think that’s a nice problem to have.

For the industry, I think that most folks have been aligning their capacity to customer demand similar to Seagate. However, I don’t see any industry component or drive capacity constraints. I think it’s again well managed but I can’t see anything that would prevent either Seagate or the industry from delivering in March.

William D. Watkins

Rich, the bottleneck is me. I’m just not going to let a lot of capital go out there. We are very happy with the way the state of the industry is right now and we are going to be very, very conservative. We are watching the TAMs. We are growing with the TAMs and we think we have a nice business for the next three years if we manage our business smart.

Richard Kugele - Needham & Company

Nothing wrong with leaving a little on the table and making --

William D. Watkins

I don’t mind leaving it. We’re really happy with what we got here and we -- the ideal is to keep this going for the next three years.

Richard Kugele - Needham & Company

Okay, and then just the last question is on the CE side -- sometimes you guys do actually break out CE, since the gross margins are so different between the various segments. Is there any color you can give on DVR versus gaming versus surveillance, just understanding how it breaks down?

William D. Watkins

Brian, do you want to try to take that?

Brian S. Dexheimer

I guess what I would tell you is this; that the -- of the 8.1 million units, over half of those were DVR.

Richard Kugele - Needham & Company

Okay. All right. Thank you very much.

Operator

Our next question comes from the line of David Bailey with Goldman Sachs.

David Bailey - Goldman Sachs

Thank you very much. Could you comment on where you are in meeting your JIT hub inventory targets and what you expect your internal inventory levels to be at the end of March?

David A. Wickersham

I would say that we are still a little bit short, particularly as I said earlier, in the higher capacity drives. Our overall finished goods level I would say is pretty close to our profile with the exception of what I think Rich was hinting at, is trying to use ocean modes of transportation rather than air. We are still short. Our customers would tell you that Seagate is short to them on the high capacity, near line, a lot of the drives that Brian talked about earlier, enterprise and so forth, so it’s a nice problem but we are clearly under profile, working very, very hard to try to put more inventory in front of our OEMs because that’s what they want us to do, that’s what they need us to do. But it is clearly lower than they would like.

David Bailey - Goldman Sachs

And can you talk about pricing trends so far this quarter, or maybe since the middle of December?

Brian S. Dexheimer

Pricing since the middle of December has followed pretty much the pattern we expected, so at least at this point through almost now three weeks in January, we haven’t seen anything unusual.

David Bailey - Goldman Sachs

And then finally, do you expect any restructuring charges in the March quarter?

Charles C. Pope

I’m not currently aware of any but as we go through the quarter and evaluate things, we will look at that.

I would make one comment relative to pricing, the pricing comment that Brian made indicated that we haven’t seen anything that we wouldn’t expect. We would expect pricing in the March quarter to be somewhat more aggressive than it was in a quite benign December quarter and that’s reflected in the plans that we have laid out.

David Bailey - Goldman Sachs

That’s at the higher or lower end of normal declines?

Charles C. Pope

Kind of the midpoint.

David Bailey - Goldman Sachs

Thank you.

Operator

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

Aaron Rakers - Wachovia

Thanks for taking my questions, a couple of them if I can; so I want to dig a little bit into the seasonal decline going into the March quarter. We’ve heard you talk about capacity constraints and even the extent of you are not where you want to be yet in terms of the OEM JIT inventory level, so why guide a seasonal quarter? Is that erring on the side of conservatism and therefore a little bit of, you know, there is an upside potential here going into the quarter if the industry overall is typical seasonal for you guys?

William D. Watkins

You know, the problem we have is we’ve been down this path numerous times and a lot of things look good in January and February and in March don’t turn up like we all think. Obviously with a lot of the noise about recession, I think we are just trying to be prudent here in the face of what looks like to be good strong demand. Again, we did this last year and we watched the market fall apart on us.

I think we’re just trying to do the right thing. It looks like a normal season. We’re projecting it to be that way.

Aaron Rakers - Wachovia

Fair enough. A follow-up, if I can then, on the mobile business -- pretty sharp decline sequentially on a unit basis. Just curious in terms of you getting to parity with your competitors on the areal density curve. I think Western Digital with their 320-gig drive is somewhere 160 gigs per square inch. You guys at 125 -- when do you expect to be on par with them in the industry and maybe start to recapture some share in the notebook market?

David A. Wickersham

Let me first clarify in terms of -- it’s not an areal density efficiency. That’s why I pointed out that the same areal density on the 3.5-inch versus the 125 and 2.5-inch notebook that you described is in fact the one that Seagate was first to market in very, very high volume. I would say I think we’ve been fairly forthright in defining that as somewhat of a -- when you have finite resources and you set your priorities and then change those roadmaps, it is a little bit disruptive. So that’s was the issue on the 125 that Brian mentioned where we have eight OEMs, we’re ramping that to volume.

To answer your specific question then, when do we follow-up on that to the 160 2.5-inch notebook capacity point, we will begin to ship CTU units this quarter and ramp that to production next quarter.

Aaron Rakers - Wachovia

Thank you. And then final question, if I can, I heard you bring up a couple of times the idea within the OpEx line some one-time items around R&D efforts, as well as legal expenses. It would be very helpful if you could kind of quantify them or give us any color to what those were this quarter and looking into the March quarter.

David A. Wickersham

Well, I don’t know what color I could give you. Virtually all of the increase is associated with variable R&D spending when you are dealing with prototypes and prototype materials and other things, and then we do periodically have ebbs and flows in terms of legal costs and that really represents the entire increase in the below-the-line spending.

Aaron Rakers - Wachovia

Okay, fair enough. Thank you.

Operator

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

Andrew Neff - Bear Stearns

I just wonder if you could talk about some of the time-to-market issues. Is there something structural that is leading to those sort of issues? And what are you doing to resolve that? And I guess the other side of that, is it a capacity issue or is it a design issue? Can you sort of go through -- you mentioned this last quarter and for a couple of quarters now. Can you talk about other processes you are dealing with?

William D. Watkins

Let me do it before Dave falls on this -- here’s the problem, and we’re big in this company on being honest about things and the issue really started, we came off of last year’s March quarter -- and I’ve got no one to blame but myself here -- is I went into full cut-back mode. We killed the 250 program. We felt that we had enough areal density leadership. We didn’t need it so we killed it and we spent a lot of churn during that April/May/June really looking at a whole different plan and cutting back, thinking that we are going to be in a significant price war.

That did not materialize but the effect on the organization was pretty big. We put a lot of churn and we spent a lot of time doing things that were probably a waste of our time and we should have been much more focused on making sure that these products got out.

And so as July came about, Dave and team put a lot of resources into this and you can see in the extra spending in R&D, get the people there and get the thing caught up.

But at the end of the day, I mean, this is one of these issues where I’ve got no one to blame but myself and how we were kind of addressing and the churn we created in this organization.

Again, it’s not an areal density. We’ve got -- there’s areal density there. I mean, we’ve been doing better than that in other products but we just kind of -- I pulled this thing back way too far and I’m paying the consequences and really thankful to the team that they really got their act together and are catching up two notebook programs simultaneously.

And that’s it. I mean, there’s nothing more. And I mean, that’s the upside because we think this is our problem, we know what it is, and we know how to fix it.

David A. Wickersham

Let me just add, I think Bill just gave you his view of the background. It’s very similar to what I was trying to describe earlier. As far as your question about go-forward, as I mentioned we will be clearly behind on the 160 per platter on the notebook and the 125 and the 160, I would view those as if you look at our history, some pretty significant exceptions to our time-to-market leadership across all market segments, I would say it’s going to be competitive for the next platform on the notebook but we expect to be there and be time-to-market, if not very, very close.

We think the issue is behind us for the reasons Bill described but it is disruptive to try to add a product back on the roadmap within lead time, and so we are dealing with that and we are working hard to get back and retain our consistency on time-to-market leadership.

Andrew Neff - Bear Stearns

Thank you.

Operator

Our next question comes from the line of Jeff Brickman with UBS.

Jeff Brickman - UBS

Thanks, just a couple of questions -- could you just talk about the linearity you saw in the quarter? Did anything drop off at all or did it relatively stay constant throughout the new year?

William D. Watkins

I don’t know. I got beat up all quarter along. I’ll let Brian take the question.

Brian S. Dexheimer

From a shipment standpoint, Jeff, it was probably one of the more linear quarters we have see, so demand was pretty steady throughout the quarter.

Jeff Brickman - UBS

Okay, thanks, and then just recently we saw EMC come out with some of their new high-end product line utilizing some Flash drives. What’s your thought on this? Do you think the sales could be material and would this possibly be the kind of product that maybe we could see an initial entry point for you guys when you decide, if you decide to head into Flash?

William D. Watkins

We believe -- obviously we’ve talked about solid state. We do believe this is the application set that will be best served by solid state and it’s obviously a focus of our engineering, and so again I think it just kind of prevails what we think is the right direction for us to go as a solid state.

Brian, do you want to add something?

Brian S. Dexheimer

I think it’s helpful to note even how EMC positioned it, as another tier of storage. So I think to that extent, it’s going to not be corrosive to the drive business that we see today -- certainly not in a significant way. At the price premium you pay on a cost-per-gigabyte level, even a high performance application like that one is going to be difficult to displace disks, so I think we are viewing it that way. I think we are viewing it as one of the first spots we might want to enter with something but I also think we are viewing it as something that’s going to take a little time to come to fruition.

I don’t expect any immediate impacts whatsoever.

Jeff Brickman - UBS

Thanks, guys.

Operator

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

Steven Fox - Merrill Lynch

Good afternoon. Bill, your comments about what happened last March were kind of interesting -- I’m just curious, given what you did last year and obviously no one’s expecting you to predict the economy, what kind of contingency plans would you expect to put into place this year if things got worse than you are thinking about right now?

William D. Watkins

Well, I’d cut spending. You know, we’d take a hard look at spending. We’d look at programs and we’d do a lot of the things that we did.

That’s not our expectation. I think we overreacted to a price war, not a demand which is probably the mistake I made, thinking about it more in hindsight. But again, we’re a pretty reactive group. I’m a very reactive guy and sometimes it works, sometimes it doesn’t. That this turned out to be obviously a great year and we should have been more focused on that.

Steven Fox - Merrill Lynch

And then just as a follow-up on the DVR market, I was just curious -- how sensitive do you think that’s going to turn out to be to any kind of economic pressures? It can tend to be lumpy, I guess. What are the service providers saying? What are your equipment customers saying about just production of DVRs at this point?

Brian S. Dexheimer

It’s probably one of the areas I worry least about in any kind of economic downturn. I think that’s something that’s going to be a personal preference and people aren’t necessarily going to see a purchase price impact of that as they walk down to the store, because as we all know, that comes in the form of subscription.

So to date, we haven’t seen anything and frankly, that would be one of the last places I’d expect to see something, if in fact we do see something and the economy turns south.

Steven Fox - Merrill Lynch

Great. Thanks so much.

William D. Watkins

If you can’t go out to dinner, you might as well stay at home and play on the Internet and watch content on TV.

Steven Fox - Merrill Lynch

Exactly.

Operator

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

Keith Bachman - BMO Capital Markets

I have two, if I could; first for you, Bill, if you aggregated where you thought not only your distribution channels are but included your OEMs as well, where do you think that combined inventory level is and how much cushion, if you looked out through March? Is that in aggregate maybe a week of cushion? Or is there any way to aggregate those two to think about the levels of inventory that are currently out there?

William D. Watkins

I’m going to let Charles take it.

Charles C. Pope

Of the distribution channel, we would normally target somewhere between four and six weeks and probably more realistically in the five to six week range. And certainly on the PS side, which is 50% distribution, being at four weeks that would give us at least a week under what we would target and depending on where you fall in that range, a little more than that.

And as Dave indicated within the OEMs, the JIT hubs, we made some progress in terms of getting inventory in front of them. We would normally expect to have two weeks of inventory in the JIT hubs and then transit inventory. We don’t believe we are at the two weeks yet. We believe that we are over the week, which is where we spent most of last quarter, just around a week. And so I would guess that we probably have somewhere between three quarters and a week aggregated that is represented in terms of very lean inventory levels in front of the OEMs and the distribution customers.

Keith Bachman - BMO Capital Markets

And so obviously -- everybody on this call and it seems the investment world is convinced we’re heading into recession, so isn’t that the way to think about it, is if you guys are giving normal seasonal patterns, but if we get some recession, the cushion would be some of that inventory that is represented by both the channel as well as the OEM? Is that the way to think about it?

David A. Wickersham

I don’t think it’s a wrong way to look at it, Keith. I guess the way that we look at it in the company is that December is always the wrong quarter to exit with high inventory levels, either with OEMs or distribution because you are going into a seasonally weaker period and so we would always try to manage the business in such a way that we exited the December quarter with lean inventories. That gives you a little bit of cushion against additional seasonality or any other perturbations that you might see in the economy or market.

Keith Bachman - BMO Capital Markets

Okay, well let me try one for Brian then, if I could -- Brian, a previous caller mentioned your sequential growth in mobile is obviously not that great. How would you expect the market to shake out here in the March quarter as it relates to mobile in terms of if you could just refresh on what you said about the TAM but more importantly in terms of share distribution of that TAM, given that you are now in the 250s?

Brian S. Dexheimer

Well, we’d expect to do better. The thing I would point out about December is some of that was conscious as well in that with a finite amount of 2.5-inch capacity, we chose to split that maybe a little bit differently between some of our consumer electronics applications and pure notebook, so that was part of last quarter’s story. Although the lack of the 250 was certainly part of that story as well, so net is I think in the March quarter, you’d expect our share to come up a little bit with better participation and better volume availability.

Keith Bachman - BMO Capital Markets

Could you just refresh on what you think the TAM does sequentially?

Brian S. Dexheimer

We said that it’s going to be down. We didn’t try and quantify it but I would put it in that 5% range.

Keith Bachman - BMO Capital Markets

Okay. Thanks very much.

Operator

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

Mark Moskowitz - JP Morgan

Good afternoon. A few questions -- I want to get back to the blended ASP for the December quarter, just given the strength in mission critical enterprise, also the strength in TV DVRs and also the commentary around [inaudible] cap -- one would think that the blended ASP would nudge up as we’ve seen in Decembers past. Is this more a function of some of your lower end CE taking a bigger piece of the pie now or what’s going on there?

David A. Wickersham

There certainly is the impact of more gaming in the December quarter, Mark. And then I’d have to go through and be a little more granular in terms of all of the mixes but it is purely a product mix issue and the top of mind would be the gaming participation in the December quarter.

Mark Moskowitz - JP Morgan

And then you would expect gaming to fall off somewhat in the March quarter, perhaps giving you a little buffer there on the blended ASPs?

David A. Wickersham

A little buffer on the blended ASPs, but being offset by the fact that you are in a typically more aggressive pricing environment.

William D. Watkins

We probably had a little bit higher percentage in the channel. I mean, there was obviously some big channel opportunities we probably missed in the quarter --

Mark Moskowitz - JP Morgan

Okay, so you could have some upside potentially as you go through the first half of this year, as you kind of right-size the [inaudible] potentially, as far as distribution?

William D. Watkins

Well, it’s something we’re obviously taking a look at, where the right mix should be.

Mark Moskowitz - JP Morgan

Okay, and then maybe this is more for Brian -- any thoughts in terms of what Seagate is doing with respect to the industrial design of some of the FreeAgent retail drives versus your peers, just in terms of making it a little more sexy? Should we expect some more announcements down the road?

Brian S. Dexheimer

Well, that’s one vector differentiation and yeah, I think the answer is yes, so expect to see some different things. We’ve just announced a new form factor around the Black Armor product we announced at CES. There’s a different industrial design around that.

But that is one vector of differentiation that we think is potentially important to a certain set of customers. I think there’s others and we’re concentrating on all of them.

Mark Moskowitz - JP Morgan

And then just lastly, Charles, you talked earlier about the legal expenses in terms of the incremental for March -- is that related to the appeals ruling that went against Seagate recently regarding [inaudible] valve?

Charles C. Pope

No, it isn’t specifically associated with that and there’s probably a couple of things that I’d like to comment on relative to the note that came out today.

First of all, there was a misleading quote in the note that indicated that the patent office had ruled against and had ruled that Seagate's patent was derived from an invention from [Kon] Vault. That is not accurate. They did not rule that Seagate's patent was derived from [Kon] Vault and Seagate's patent is still issued and effective.

And then secondly, I really don’t understand the underlying motivation for even issuing a press release about this decision today. The patent office decision that was referred to in that release was issued on August 24, 2007 and the time for appealing that decision ended in late October 2007. And that ruling really has no impact on the underlying litigation between the two parties.

And so I am a little baffled about what the motivation was to even have a release there, so --

Mark Moskowitz - JP Morgan

Okay, so it’s nothing we should really worry about then as far as our model? Thanks for that clarification. I appreciate it. Thank you.

Operator

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

Sherri Scribner - Deutsche Bank

Thank you. I was just curious in terms of the gross margin upside we saw this quarter. Obviously you had a much better enterprise quarter. You mentioned pricing as part of the gross margin upside but how much of the better enterprise helped your gross margin in the quarter?

Charles C. Pope

I think that for practical purposes, you need to consider all of the improved gross margin to be pricing based because offsetting the improvement in the mix of high capacity, we also had a greater mix of gaming. And so you start putting the mixes together and the benign environment was a large part of the margin improvement.

Sherri Scribner - Deutsche Bank

Okay, so you are saying the gaming and enterprise maybe offset each other on the gross margin?

Charles C. Pope

Substantially.

Sherri Scribner - Deutsche Bank

Okay and just in terms of the guidance, and if I look at the midpoint of the revenue guidance, it looks like revenue down 5% and you also commented it sounds like units to be down 5%, which suggest to me flat ASPs. Can you maybe help us understand -- I mean, that seems a little bit aggressive in a March quarter. Can you maybe help us understand where you are getting that from?

Charles C. Pope

Sure. As we sat and looked at it, again the March quarter we would expect gaming and some of the other CE applications to be down at a greater rate than the 5%, giving us a little better mix in products. And then Dave’s already mentioned the fact that the area that is in tightest demand is the high capacity ATA drives, and so we would expect to have a little richer mix of the high capacity ATA drives during the March quarter also.

Sherri Scribner - Deutsche Bank

Okay, so better high capacity, and then also it sounds like enterprise down just a little bit, so is it also a better enterprise?

Charles C. Pope

Certainly of the total mix, it would be.

Sherri Scribner - Deutsche Bank

Okay, great. Thank you.

Operator

Our next question comes from the line of Mark Miller with Brean Murry.

Mark S. Miller - Brean Murry & Co.

Just a couple of questions here -- first of all, can you break out for us last quarter your percent of sales in terms of OEM, distribution, retail?

Charles C. Pope

Yeah. Give me one second -- the distribution -- the OEM was 67%, distribution was 33%. That 33 includes the retail. Retail was 7%.

Mark S. Miller - Brean Murry & Co.

So 26 and 7, okay -- could you also, and I haven’t asked you about this for a long time, but with the concerns about the U.S. economy, how are your sales breaking out internationally?

Charles C. Pope

North America is 29%, which was flat with the September quarter; Europe is 28%, which is up one percentage point from the September quarter; and Asia-Pacific was 43%, down 1% from the September quarter.

Mark S. Miller - Brean Murry & Co.

And then just, you’ve discussed this I think previously but it seems like to me you could have a better product mix next quarter or do you think the product mix will be the same with, you know, because of the gaming exclusion and maybe some of your shipments in the mobile space.

Charles C. Pope

We currently have in our projections a little richer mix of products for the two reasons that you’ve mentioned.

Mark S. Miller - Brean Murry & Co.

Thank you.

Operator

Our next question comes from the line of Tom Curlin with RBC.

Tom Curlin - RBC Capital Markets

Actually, I’m good. My questions have been answered. Thank you.

Operator

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

Christian Schwab - Craig-Hallum Capital

On the consumer applications, Brian, in September -- when we gave September quarter we expected that TAM to be flat and it was up 16% sequentially. What specifically drove that? Was that gaming or DVR being much better than you expected then?

Brian S. Dexheimer

DVR was a little stronger than we thought.

Christian Schwab - Craig-Hallum Capital

And then, how would you categorize the start in the first few weeks of January versus historical starts? Has it been in line with a typical March quarter -- has it been weaker, softer, stronger?

Brian S. Dexheimer

I would say for the first two-and-a-half weeks it’s pretty much as we predicted, if not a little bit on the strong side. Remember, as we mentioned there were a couple of categories of product where we thought we left last quarter under-serving them, so I think a little bit of that is catching up.

Christian Schwab - Craig-Hallum Capital

There’s some current investor fear that some of the leading OEM customers may begin to cancel orders, given the weakening U.S. economy. Historically, when in a March quarter and then maybe even you could comment on a June quarter, if there were going to be OEM cancellations, when would you see them?

Brian S. Dexheimer

I don’t know that there’s any historical pattern to cancellations, particularly for the reasons that you described. If economic concerns are going to be the driver of that, I think it could be anywhere, any time.

Christian Schwab - Craig-Hallum Capital

Okay, so you’re not seeing that yet?

William D. Watkins

No, we’re spending a lot of time talking to people and we are just not seeing it.

Christian Schwab - Craig-Hallum Capital

Great, and then my last question on the competitive environment, would you categorize Hitachi and Samsung’s remaining fairly rational? I’ll start with that.

Brian S. Dexheimer

We haven’t seen anything. It’s probably a little early to tell, but we haven’t seen anything at least for this period of time that demonstrates behavior any different than we’ve seen for the last three or four months.

Christian Schwab - Craig-Hallum Capital

Okay, so focusing more on product and quality versus market share?

Brian S. Dexheimer

Yes.

Christian Schwab - Craig-Hallum Capital

Great. That’s it. Thank you.

Operator

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

Shaw Wu - American Technology Research

I just have two quick questions; just on R&D, it looked like it grew a bit sequentially. I am just wondering if there is anything unusual there and should we expect those spending levels to remain at this rate?

And then second, just on the margin profile of notebook drives, historically they’ve been below the corporate average. I’m just wondering if that’s changed. And also, with your new notebooks, can that -- I mean, can the notebook business be above corporate margins? Thanks.

David A. Wickersham

Let me take those. The R&D increases that you have seen, as we’ve indicated represent variable R&D spending associated with prototype materials and other things as we kind of have a bunch of products here that are in the process of being launched and ramped, and so we would expect to see that plus actually a little bit of increase in the guidance that we gave relative to the R&D spending. And it’s all associated with the variable R&D material requirement.

Relative to notebooks, let me start at a high level and just back up with a little bit of history -- if you go to the middle of 2006, notebook margins on average were in the mid to high 20s. During a year-and-a-half of very aggressive pricing, the margins dropped to the low teens. Since that period of time, they’ve been slowly working their way back up towards the desktop type margins and recognize that desktop is below the corporate average. You have other markets that we serve that have higher margins than the average desktop. And notebook was still running below the desktop margins, even though it is improving quarter on quarter during the last several quarters.

We don’t ever really see the margins getting up to the levels that they were in in 2006, which would have put them slightly above corporate average margins. We do see them, a path to them improving up to desktop type margins as we continue to go through successive generations of products. But probably never even really at the corporate average margins again.

Shaw Wu - American Technology Research

Okay. Thanks for the color.

William D. Watkins

We’ll take one more call, Dustin.

Operator

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

Daniel Renouard - Robert Baird

Can you just give us some sort of guidance or some sort of sense of as you look at your CapEx budget, you’ve had a few investments you’ve been making this year into moving parts. If you were to look forward, what would be reasonable for investors to assume in terms of a maintenance CapEx or what you would need just in terms of a replacement cycle versus any capacity expansion? Could we assume something close to half if the economy falls into a recession? Or maybe just give us a framework for what would be reasonable if you really had to tighten your belt? What would be the minimum you might have to spend on a CapEx front? Thank you.

Charles C. Pope

I hate going down that path because if you sit and look at most of the problems that have come up with competitors in this industry over time, it’s been by not funding capital and R&D during difficult periods of times and we have always maintained the position that says we need to maintain a balance sheet and everything that will allow us to fund capital and R&D during any difficult periods of time.

We are turning over our entire capital base every four years and if you don’t do it on a pretty steady basis, you get behind and can’t catch up. And so I’ve always said, and I don’t mean to be flippant about this, that the $900 million that we are dealing with is really maintenance capital because while you are adding capacity, it is usually at new technology points and everything else that are going through there.

I know we have proven in the past that we can tighten up some and we have, but I think for planning purposes, thinking about it in the $900 million range and anything that is below that, if there was an ugly economy -- which again, we are not seeing -- would be gravy versus planning on it.

Daniel Renouard - Robert Baird

Okay. That’s helpful. Thank you.

William D. Watkins

Thank you for joining us on the call today and again, we look forward to speaking to everyone next quarter. Travel safe.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Seagate Technology F2Q07 (Qtr End 12/28/07) Earnings Call Transcript
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