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Seagate Technology plc (STX) Management Presents at Deutsche Bank 2020 Virtual Technology Conference (Transcript)

Seagate Technology plc (NASDAQ:STX) Deutsche Bank 2020 Virtual Technology Conference Call September 14, 2020 5:20 PM ET

Company Participants

Gianluca Romano – Chief Financial Officer

Conference Call Participants

Sidney Ho – Deutsche Bank

Sidney Ho

Hey, good afternoon, everyone. My name is Sidney Ho. I cover semiconductors and semi-cap equipment here at Deutsche Bank. The next company, virtual fireside chat we have Seagate. Seagate supplies hard disk drive for both the enterprise and the consumer markets and is currently the market leader in the fast-growing nearline hard drive market that serves the cloud service providers. Today, we are very pleased to have Seagate’s CFO, Gianluca Romano with us. Welcome, Gianluca.

Gianluca Romano

Hi, Sidney.

Sidney Ho

Sure. Before we start for those investors who are listening to the webcast through our portal, if you want to ask a question, there is a box on the left hand side of the screen I think at the bottom of the left hand side where you can type in your questions. I will ask a question as we go through our discussion. Okay, before we go into Q&A, I think Gianluca wants to make a few comments. Please go ahead, Gianluca.

Gianluca Romano

Thank you, Sidney. Thank you everyone for joining us today. Before starting, a quick reminder that I will be making forward-looking statements today, you can learn more about the risk factors associated with the statements in our SEC filing, which are posted on our website.

So, let me start with a couple of quick comments before we go into the Q&A session. As we have recently shared, the September quarter has continued to align well with our expectations that now we discuss with our earnings release in early August. In particular, the cloud data center demand inside our nearline segment is still demonstrating a very healthy level of demand and also in the video and image application, the surveillance segment is improving and now is sequentially getting stronger as the quarter progressed. At the same time, as we discussed during our earnings release, the part of it is little bit weak is in the enterprise OEM and that has remained soft through the quarter, even if we start looking at some sign of improvement and now we expect that improvement to become even stronger in the near future. We see some indication for our on-prem enterprise investment to improve as we progress through the year, primarily for large businesses, a little bit less strong in the small and medium enterprises. So, net-net, the September quarter is tracking well with our expectation and very important for us. The demand trends are improving in a couple of key end markets. We support our outlook for flattish fiscal year ‘20 revenue compared to fiscal year – sorry fiscal year ‘21 revenue compared to fiscal year ‘20.

I would say probably I will end up talking about the mass capacity EB volume. As you know, our model is for a CAGR of 35% to 40%. We have achieved much better result during fiscal year ‘20 and we have previously disclosed and we want to confirm, but also for calendar year ‘20 we will have an higher volume increase than the 35% to 40% we discussed in different occasions.

Okay. With that, I think we can move to Q&A.

Question-and-Answer Session

Q – Sidney Ho

Okay, great. Thanks for deploying that. I will probably come back for a few questions on your remarks. So first of all, I want to start off with a few near-term questions that we asked every company at the conference. Starting off with Huawei, clearly getting a lot of headlines lately, especially given the new restrictions that were announced last month. First of all, can you remind us what the revenue contribution of Huawei to Seagate is today? Second, can you give us an update how you think those restrictions will impact Seagate in the short-term when I think short-term is calendar Q3, Q4 and maybe in the longer term how does that work out? And that if you want to continue to sell to Huawei, would you be required to get a license approved by the Department of Commerce? Sorry, a few questions here.

Gianluca Romano

Yes. So of course we are still going through the final assessment, but from what I have seen until now, I don’t see any particular restriction for us in term of being able to continue to keep the Huawei or any other customers in China. So, we don’t think we know we need to have a specific license and no, we don’t disclose the level of revenue of specific customers, but as you know we should report if the customer is above 10%. So, you can – you can assume that it’s not at that level.

Sidney Ho

Got it. Got it. With regards to the U.S. China trade, is there a way to think about how much inventory has been built up into supply chain and where do you think the biggest risk of inventory build is?

Gianluca Romano

Well, maybe there was some inventory increase at the beginning of the calendar year, but no, at this point, we don’t see any sign of inventory buildup. So, we think we are in a fairly normal situation in terms of inventory and shipments.

Sidney Ho

Okay. The next question I have again for everybody here is if I think about the COVID impact on supply chain, can you give us an update on your manufacturing network, is it mostly back to normal levels now both within your facilities and the supply chain or were there still bottlenecks that could to be tested and need to be addressed?

Gianluca Romano

All our facilities are fully operational and no, of course, we operate aligned with local guidelines and regulations. I would say we are not at full capacity everywhere, because we cannot have in some location – all the headcount that we need to run at full capacity. But in term of factories operation, we know we are active everywhere. The underutilization cost will decrease sequentially already starting this quarter. So, we are improving, but we are still not at 100%.

Sidney Ho

Okay. Staying with COVID, you talked about both revenue and operating costs being impacted by COVID in the calendar second quarter. Can you talk about how some of these headwinds have trended in the current quarter, when do you see some of these costs kind of come down and do you have – if you are having any success passing along any of these higher costs to your customers?

Gianluca Romano

Yes, I would say the cost is starts to decline. So, the cost impact is mainly on freight charges, labor costs not to support our people in in different location and know to comply with all the safety regulations and underutilization challenges. I would say right now we can have more people at a factory, so the underutilization charges in particular are starting to decline and now hopefully in the next few quarters, you will also see a lower cost on the labor side and probably finally in a few more quarters, you will also see the freight charge decline. So, I would say, it will be a slow decline, but for sure will improve already starting this quarter. In terms of revenue, it is difficult to say now the enterprise OEM segment is for sure impacted. I would say now the enterprise in general so even mission-critical is impacted by COVID. In general, the legacy path is suffering, because of COVID maybe with the exception of consumer, which we see improving and in the mass-capacity segment for sure surveillance is coming back strongly and cloud is still very healthy. Now, we did two quarters, two record quarters, now the March quarter, the June quarter, there were record quarter, so it’s difficult to continue to have record quarter. But we said that that part of the business we see is still very healthy.

Sidney Ho

Great. Which is a good segue into some of the near-term business environment, maybe starting with the nearline side, in your last earnings call, you talked about nearline markets going through some demand softness, you also seem to be pointing to weakness mainly coming from the enterprise and the OEM market rather than the cloud data centers. I think when your competitor seems to be including both sides are weak and today you also – early you also talked about cloud continue to be pretty strong. I am curious why, is there a way that you can help us understand why you guys maybe seeing different kind of trends within the cloud side of things?

Gianluca Romano

Well, I don’t have visibility on how our competitors demand maybe it’s related to product. As you know, about 16 terabyte is really, really strong and in particular, for the cloud is not – is where we sell the majority of the volume. So from our point of view, the cloud is still very healthy. The decline in revenue which we guided sequentially from the June quarter to the September quarter was mainly related to the enterprise OEM part, not too much on cloud. And then I just discussed about the legacy parts of the business, but again, no, we don’t for the current quarter and we don’t expect cloud demand to deteriorate in the next few quarters.

Sidney Ho

Okay, that’s good to know. Maybe on the enterprise and the OEM side of things, you just talk about things have kind of stabilized. I think that’s in line with some of the companies I talked – some of the OEMs I talked about that last week as well. So just remind us, how much visibility do you normally have for the enterprise market, maybe while you are talking about that may as well talk about the cloud customers, how far how can you see the demand profile looks like?

Gianluca Romano

Well, the cycle time to produce an hard disk is about 6 months, in some cases even longer. So that is a visibility that we need to have if a customer wants to have enough supply at a certain point of time. So, I would say we have we start with no very long-term forecasts that are more trained than forecast. And then no, you go with a two-quarter forecast that is much more detailed. And then you have to say one quarter purchase order. So it’s a bit different depending from the time, but no – but we have I would say at least a couple of quarters where we can rely on a fairly good visibility.

Sidney Ho

Got it. I just got a question coming in, it’s a little bit no more near-term. So maybe you can help us out there. Is the calendar third quarter, the current quarter, more back-end loaded just because of all the dynamics you talked about enterprise and OEM stabilizing and nearline continues to be – the cloud side continues to be strong or less back-end loaded them than normal, I should say.

Gianluca Romano

You should define what normal is because it sounds like there is no normal anymore, but I would say if I compare to the last two quarters, I would say it is less back-end loaded. The month of August was actually fairly strong, for sure better than what we had in February or May no I would not say this is a normal trend. We are still not at the linearity that, we had before COVID, probably, but at least we are going in the right direction and then obviously is also giving us confidence in the result of the quarter that we think is still aligned to what we guided, and also in the near term future and the long term for say rest of the fiscal year.

Sidney Ho

Okay. thing with near line, we have seen cycles in near line in the market before I think a couple of years ago, we have a couple of weak quarters, it’s a big cycle up and down. How would you compare the current cycle with those past cycles? And what evidence would you point to support that assessment?

Gianluca Romano

Well, I would say no the think cloud is becoming a bigger part of the of the nearline segment. For sure, if you compare a couple of quarters before COVID between cloud and enterprise it was about 50-50 in terms of volume, right now, cloud is for sure a bigger part. And now we don’t know what we will be in the future. But no, as I said before, cloud is strong is healthy. We don’t believe that what you mean in kind of seasonality in the nearline business this cycle is more the cycle in the individual customers, and how aligned are those customers. If you have, if you have several customers that have the same cycle, so they go through the, through their data center creation and then they need to install all the hard disk. And then so for a period of time, they can have a kind of a digestion period. But right now, no, we are not two or three customer but are now seven, eight customers. And will become more in the future. So I think in the future you will have less of a cycle, you will have maybe a customer increase in demand and another customer that is in a testing phase, but is not a segment cycle is more a customer cycle and hopefully they will not align too well so that we don’t go through peaks that we are very difficult to manage both in the upside and downside.

Sidney Ho

Great. So maybe longer term if we start thinking of a longer term. Obviously, there is some digestion going on right now. And you kind of talk about nearline market as a segment is growing 35% in terms of exabyte that’s kind of your target. Have these expectations change at all over the last few months given what have we seen would be great if we can talk kind of separately about hyperscale guys As far as the enterprise guys and is it one that is more like 50% and more like 25% of our way to think about the relative growth rate going forward.

Gianluca Romano

In general, and we said, a good way to model it for the long term is about 35 to 40% CAGR for the mass capacity part of the business. If you look at our results in fiscal year 20, we achieve a much higher growth, I think it was almost 80%. We also said that for the calendar year 20, no, we have said the volume to increase more than the 35% to 40%. So in the short term, now, as I was saying before, we still see a very, healthy business in the longer term. It’s always difficult to know, of course, I believe that 35% to 40% CAGR is a good CAGR to model in the long-term.

Sidney Ho

Okay. Maybe switching over to the legacy storage, I think you made some comments on legacy market in the near-term. I might have missed this. But can you kind of talk about what the trends you are seeing as such retail stores are reopening in the current quarter? And how do you think about the business – this business whether it’s revenue terms, whether it’s exabyte terms over the longer term?

Gianluca Romano

The legacy in general no, we expect legacy to continue to decline and not to be replaced by SSD technology. If you look at the last 4 or 5 years, the volume as a percentage of the total volume that we said moved from 80% to less than 30% in the last fiscal year. So, it’s for sure a decline in the legacy. There are couple of segments that are performance everywhere. As I said before consumer is now – is recovering from probably calendar Q1 lower quarter and it improved in calendar Q2 and it’s improving again in this quarter. In general, before COVID mission-critical was also doing very well. I think in the December quarter, we had the volume that was the highest volume in the last couple of years. Unfortunately, this is a segment that has been impacted by COVID. So, we need to probably wait for a few more quarters before seeing that level of volume again. And then when you look at maybe desktop and notebook and gaming, DVR, those are the segments where now we expect a sequential decline. And decline in legacy for us means we can move to the capacity, the production capacity to the other segment, so to the mass capacity to nearline and surveillance. So, in a certain way, it’s good, we don’t need to spend too much CapEx to cover the demand for the mass capacity storage of the business. And the volume that we can move in legacy is in general a good contributor to our free cash flow. We don’t spend CapEx for legacy. We have a very little OpEx. So even if the gross margin is lower than knowing the mass capacity storage, it’s still a good contribution for our free cash flow.

Sidney Ho

Okay. Just sort of follow-up on the comment on mission-critical, clearly, it was record and it’s been impacted. When you talk about enterprise and OEM on the nearline test side of things getting better does that benefit the mission-critical as well as it’s kind of two separate dynamics there?

Gianluca Romano

Should be similar. So, we need to wait and see what happened on exports that are in the following quarter, but should be similar.

Sidney Ho

Got it, got it. Another area that you just talked about again is the secular growth areas surveillance and I think earlier you mentioned that it is coming back pretty strongly what kind of dynamics are you seeing there, is it pretty broad based or are they still being impacted by several Chinese companies being put on the entity list? Just trying to understand the long-term opportunity in that market, it seems like we are hitting that inflection point right now?

Gianluca Romano

I would say the majority of our customers are in China. We have a very high market share in China in general. So, with the video and image application customers also, we don’t have any limitation right now in terms of what we can ship to those customers. And it looks like they are recovering from COVID a little bit earlier than other parts of the world and no, this is why we are seeing demand to start to increase again and start to go back to the prior level. And surveillance is also one of those segments that are a little bit seasonal. So in general, you see calendar Q3 and calendar Q4 it would be stronger than calendar Q1 and calendar Q2. So now if you look at the first two quarters of this calendar year, and you add seasonality to the COVID impact, or the total impact was huge. So we know we see that demand coming back. And is an important part for us is important business with a good margin.

Sidney Ho

Okay, that’s great. Maybe switching gears over to the technology part of the questions. You have a very successful ramp of 16 terabytes and so you are just starting to ramp up to your 18 terabyte drives. How do you see this transition when compared to previous capacity transitions? And how should we think about how long it takes for 18 terabyte volume to cross over 16 terabytes?

Gianluca Romano

Probably the transition to 18 terabyte for Seagate will be easier than what is happened in the past, because we will be using the same platform. In the past every time we were moving to an higher capacity, we were generating a new platform and producing a new platform and qualifying a new platform. This time, we use our 16 terabyte in for different capacity levels, not only for the 18 terabytes, but we are also using for 14 terabytes and no and we can also go lower in capacity is a very good platform is good for us to use no a single platform in our manufacturing environment. So we expect the transition to 18 to be fairly easy. Of course you always need to go through a call customer qualification but that should be probably a bit faster than what we did in the past and in terms of volumes. We already sold some of our 18 terabytes in the last quarter. We will sell a few more in this quarter so we start to ramp up. But I would say for the industry in general, we don’t expect 18 terabytes to be I volume in the current quarter for sure. Not even in the next quarter. We think another entire calendar year 20 would be no it will be a 16 terabyte leading story but next calendar year 21 that probably will be an 18 terabyte.

Sidney Ho

Makes sense. Now you lead truck your competition with the 16-terabyte drives and with a very solid share gain, but the timing of your 18 terabyte drives seems to for both companies seem to be quite similar. I noticed that this year is mostly old next year. How do you see the competitive dynamics between you and your competitor going forward?

Gianluca Romano

I don’t know if it will change. And what I mean is before the 16 terabytes now we lost some market share. So with a 16 terabyte success, we basically went back to the prior market share maybe a couple of points higher, but especially if you look at the nearline space, now the two companies are fairly well aligned in terms of market share. Now in a couple of quarters we will have high volume of the same product. So I suppose that now market share will stay fairly similar.

Sidney Ho

Got it. Now, if you take another step forward pass 18 terabyte drive, you have talked about shipping your first HAMR drive by the end of payoff discounted a year. How quickly do you think your customers will switch over to HAMR drives? And how does that shift to HAMR change the margin profile of the business?

Gianluca Romano

HAMR is a technology milestone. And the first generation of HAMR 20 terabyte is a very small capacity for this technology. So what we want to do with the first generation is to know get qualification from our customers, all the big customers so that we can access those customer very quickly with our second generation that will be a listed 24-terabyte. At that point of capacity, we have good decline in cost per terabyte and of course, we will want to give a good TCR to our customers, but now is also an opportunity for us to keep some of that cost saving on our side and start to improve our gross margin. So, this will happen with the second generation and also not with the 20 terabyte that is too small capacity, still not cost optimized, but it’s extremely important, extremely important from a technology point of view. So, we want to have this drive available, we will have it in the next few months. And then now as soon as we have that out we will focus on the second generation and we will ramp up in volume for the second generation.

Sidney Ho

Okay. For the remaining few minutes, I would like to ask a few questions on the financials. On the earnings call, you talked about your expectations on revenue in fiscal ‘21 will be fairly flat versus fiscal ‘20. I think earlier in the prepared remarks, you also talked about that it will be the case. I was hoping you can elaborate what you are assuming to make that projection sounds like the enterprise turning around is one of the factors, it sounds like surveillance coming back it is. But just to try to understand what other assumptions that you are making to get you to flat at least flat for fiscal ‘21?

Gianluca Romano

Yes, you mentioned the right point. I would add that COVID impact. We said at the time of the earnings release our revenue assumption for the fiscal year is assuming a COVID impact for the current quarter, for the next quarter and then we assume now fairly low impact from COVID. So, if this is what is going to happen, we are confident with the revenue to be fairly flat with the prior year. If COVID impact will – now will become even bigger or will last for much longer, we will review that estimate, but now with that assumption that we think is very reasonable with stronger cloud and nearline in general. So, with enterprise OEM coming back and with legacy recovering from this COVID impact, we think is for sure possible that we close the fiscal year at the very similar revenues than the prior year.

Sidney Ho

Got it. On the gross margin side, I think last earnings call you talked about long-term normalized range of 29% to 33%. Just curious what are the main puts and takes to move your gross margin towards the low end of the range versus high end of the range? And frankly longer term why can’t gross margin be higher if there are only two or three suppliers in this market?

Gianluca Romano

Yes, actually, we don’t really have a range for gross margin we have a range for operating margin. As you probably remember, our range is 13% to 16%. We were already at 16% in the December quarter, for example, before COVID. We had another fairly good quarter in calendar Q1 ‘20. And then we had more impact from COVID in the last quarter and of course in the current quarter, but it’s important for now for you to understand that we were already at the top of the range of our range in terms of operating margin. And absent COVID, we were already discussing if that range was still appropriate for us or was it a little bit too low and then COVID arrived. And so we know this discussion for sure is not so important right now, but I expect after COVID, I expect to review that range and possibly to go a little bit higher.

Sidney Ho

Got it. Last question, it’s from a inbound question, on the free cash flow margin, you guys have been around 12% for the past 4 years, are you expecting working capital to be kind of neutral in calendar 2020 and is 12% free cash flow margins kind of the right level to think about fiscal ‘21 or is there room to increase that margin?

Gianluca Romano

In general no, we are very good in generating free cash flow, as you said. I don’t think we ever commented on specific part of the free cash flow, but I think if you look at the long-term of the working capital, it can be positive one quarter and negative the other quarter but in general, when you look at the long-term it’s fairly neutral. So we are now – we have generated almost $1.2 billion of free cash flow in the last few quarters. It’s very important for us to generate free cash flow, because we are very focused on shareholder return and now free cash flow is important for our dividend and for our share buyback program. Of course, we always focus first on business support. So, CapEx is important to support our business and OpEx is important to support our business you need to find the right level based on the capacity that you have already installed and the demand that you are expecting, but free cash flow and profitability are the focus for the management team. And as I said, the free cash flow is usually utilized for shareholder return.

Sidney Ho

Okay. Well, I think we are out of time. Thank you very much for the time, Gianluca and enjoy the rest of the day.

Gianluca Romano

Thank you very much.

Sidney Ho

Thank you.

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