Western Digital Corporation $WDC Q2 2023 Earnings Call

Thank you, Peter. Good afternoon and thank you for joining the call to discuss our 2023 second quarter results. The Western Digital team worked diligently within the dynamic market and delivered revenue at the high end of the guidance range we provided in October. We reported second quarter revenue of $3.1 billion and a non-GAAP operating loss of $119 million. Our non-GAAP loss per share was $0.42. Our ongoing efforts to control expenses, optimize working capital, and deploy capital judiciously helped us manage cash flow in this challenging flash pricing environment and larger than expected HDD underutilization that pressured gross margins. Before we discuss the details of our second quarter results, I wanted to cover two other announcements that we are making today. First, we disclosed that Western Digital has entered into agreements with Apollo Global Management and Elliott Investment Management for convertible preferred equity investments totaling $900 million. In connection with the agreement, Reed Rayman, a partner at Apollo, will join our board starting immediately. On behalf of the board, I am pleased to welcome Reed, a leading technology investor who will provide us with additional financial and strategic expertise, which will be critical as we continue to execute on our business strategy and complete our strategic review. Second, on January 25th, we secured access to $875 million of financing through a delayed draw term loan. When combined with the actions we undertook to structurally lower our cost structure, these financings provide valuable financial optionality and flexibility to Western Digital as we continue our strategic review. Regardless of the outcome of the strategic review, our goal is to ensure the business is in a solid financial position to invest in innovation and create long-term shareholder value. Given the ongoing nature and confidentiality of the process, we will not be answering any questions about the strategic review process or making comments on market rumors. We will provide updates as we have them. Over the past three years, we have worked continuously to reinvigorate innovation and bolster business agility for both our Flash and HDD organizations, which enable the Western Digital team to stay ahead of the market. Over this same period, we paid down $2.7 billion in debt and arranged for settlement of a long-standing tax dispute. Since the beginning of fiscal year 2023, we have taken additional actions to reset the business in response to the post-pandemic environment. These actions include: first, we have further reduced our capital expenditures across Flash and HDD to moderate our supply. As a result, our projected cash capital expenditure for fiscal 2023 has declined nearly 40 percent from six months ago. Second, we have decreased supplied bit growth across both Flash and HDD. In Flash, we reduced wafer starts by 30 percent in January. In HDD, during the fiscal first quarter, we consolidated production lines across our manufacturing facilities and idled certain media production lines in Asia, reducing client hard drive capacity by approximately 40 percent. During the fiscal second quarter, we continued to optimize our capacity enterprise manufacturing footprint to align our supply with the new demand environment. Third, we have reduced our quarterly non-GAAP operating expense by over $100 million since the close of fiscal year 2022, driven by lower headcount, discretionary spending, and variable compensation. We are targeting to reduce quarterly non-GAAP operating expense level to below $600 million by the time we exit the fiscal year. And lastly, in December, we successfully executed an amendment to the existing financial covenants under our credit agreement. Turning to end market demand, during the fiscal second quarter, demand for consumer-oriented products stabilized. As we discussed in October, in consumer, we experienced a seasonal uptick across both Flash and HDD. In client, channel demand for both SSD and HDD have improved. However, commercial PCs are now being impacted by tightening budgets and spending across corporations, which is negatively affecting client SSD shipments. In cloud, we experienced a decline in nearline shipments as our customers were undergoing inventory digestion and ongoing subdued China demand. I'll now turn to business updates. Starting with HDD, during the fiscal second quarter, our HDD revenue declined significantly as cloud inventory digestion intensified, while demand for retail and client HDD improved. We continue to successfully execute on our product roadmap as we completed qualifications and commenced shipments of our latest generation 22 terabyte CMR hard drives at multiple cloud and major OEM customers last quarter. We are aggressively ramping this 22 terabyte CMR product this quarter and expect this drive, along with its SMR variants, to be our growth engine going forward. Qualifications of our 26 terabyte Ultra SMR drives are also progressing well. Our major customers remain committed to adopting SMR drives as the 20 percent capacity gain that Ultra SMR drives over CMR offers multi-generation TCO benefits to the most complex data centers worldwide. We expect sequential growth in revenue and margin into our fiscal third quarter and continued recovery as we move through calendar year 2023. Turning to flash, thanks to our broad portfolio, diverse routes to market, and leading retail franchise combined with strong seasonal demand, bit shipments increased 20 percent sequentially, exceeding our forecast. While we continue to experience pricing pressure in the market, our premium brands including SanDisk, SanDisk Professional, and WD Black continue to deliver strong share and profitability to support the business. Our premium WD Black client SSD, which is optimized for gaming, continues to be well received in the marketplace. It achieved a record in exabyte shipments, unit shipments, and average capacity per drive, resulting in exabyte shipment increase of 73 percent sequentially and 41 percent year over year for this product. On the technology front, BiCS5 represented 70 percent of our flash revenue in the December quarter, while BiCS6 will reach cost crossover in the fiscal third quarter. Our next generation 3D NAND node, BiCS8, has entered productization phase. BiCS8 incorporates several groundbreaking 3D NAND architectural innovations to deliver a major leap in performance and cost-effective solutions to a broad range of exciting products, demonstrating the benefits of Western Digital's strong partnership with Kioxia and our innovation leadership in 3D NAND architecture. As we look into the fiscal third quarter, in hard drives, overall demand in cloud has stabilized and we expect modest improvement in nearline to offset a seasonal decline in client and consumer hard drives. We expect stronger improvements in the second half of this calendar year led by the aggressive ramp of our 22 and 26 terabyte hard drives. In Flash, we expect enterprise SSD product demand for the fiscal third quarter to be sharply reduced as certain large cloud customers have entered a digestion period. In addition, a reduction in commercial PC demand is expected to impact client SSD shipments in the near term. Driven by the lower customer demand forecast in enterprise and client SSDs, we anticipate bit shipments to decline in the fiscal third quarter and return to growth in the fiscal fourth quarter. As I mentioned earlier, Western Digital lowered wafer starts in January and we remain flexible in adjusting the magnitude and duration to restore our flash supply and demand balance. As noted, for calendar year 2023, we expect reduced capital investment and lower utilization in response to the new demand environment. Our initial estimate is for flash demand bit growth to be in the low 20 percent range, with production bit growth to be well below that of demand. With that, let me turn the call over to Wissam, who will discuss our second quarter results in greater detail and provide an outlook for the third quarter.

Thanks, Wissam. Before we open up for questions, I wanted to reiterate our view of the long-term opportunities for both Flash and HDD storage. Importantly, our efforts have enabled us to regain architectural leadership in both Flash and HDD, and we are preparing these technologies to address the meaningful long-term growth for storage from client to edge to cloud. With our diverse portfolio, broad go-to-market engine, an enviable retail franchise, and a lower cost structure, we remain confident in our ability to deliver long-term shareholder value. Okay, Peter, let's open up for Q&A.

Hey CJ, thanks for the question. Good to hear from you. So yeah, that's a balancing act, there's no doubt. One of the things we talked about in the script and we feel really good about is BiCS8. BiCS8 has reached productization. We'll have more to say about BiCS8. We'll do a webinar during the quarter on all the technological innovation there. There's been an enormous amount of R&D going into that, so we feel very good about where we are from a technology roadmap. I'm actually holding a BiCS8 USB in my hand right now, one of the first ones. So we're putting enough capital in the system to move BiCS6 along. BiCS6 will be a shorter node for us. It won't go into all products. We'll be making choices about what we take it into or where we need BiCS6. BiCS5 will service well for the rest of the portfolio, and then we'll move right into BiCS8, which quite frankly is ahead of schedule as far as production, and we feel very good about it. So we'll balance all of that and have enough capital to accelerate BiCS6 where we need it and then accelerate BiCS8 when we see the growth come back. As far as the cost downs, in the second half of the year, cost downs are going to be very difficult because we are far along in BiCS5 and BiCS6 is not ramping that much. We'll return to those as we start to ramp BiCS8, but we'll still have some, but not to the level, especially with the underutilization of the fab. So all of those mixed in, we will have gotten most of our cost downs in the first half of the year and then we'll see them come back as we ramp up BiCS6 and especially BiCS8.

Yeah, hey Aaron. How you doing?

So first of all, let me talk about how we're thinking about it. It is a very dynamic situation. When we were looking at our CQ1, we've seen some demand drops. We're coming off a very strong quarter of bit growth. We just delivered 20 percent sequential bit growth. That's why we didn't cut wafers earlier. When we look at Q3, our fiscal Q3, we're seeing some drop in both client and enterprise. The enterprise SSD side of it is more a digestion issue, so we want to make sure we manage our inventory and we don't get things too built up. That's why we've decided to cut wafer starts in the first quarter. Again, as Wissam said, that's a decision we can make every week about how we load wafers into the fab. Right now, that's a one-quarter decision to make sure we keep our supply and demand balanced as best we can.

Yeah, I think we signaled this a little bit last quarter. We knew there was going to be some variability in demand across the industry and across customers. Quite frankly, when you're at these revenue levels, which are the lowest we've seen in a long time, orders from big customers make a very big difference. So if you go back for the last couple of quarters, the way different big top cloud customers structured their LTAs or the way big orders came in, you're seeing some pretty large share shifts quarter over quarter. But when you look at it on a six-month basis or a 12-month basis, you see pretty consistent share. I think we've gained a little bit, but again, we're managing for profitability. We think share is going to be over a multi-quarter period pretty stable, and that's actually the way it's working out. You're just seeing some pretty big swings here quarter over quarter. So we feel really good about the competitive situation. The 22 terabyte drive shipped in significant volume this quarter. We expect to ramp that throughout the year. We've got big customers very committed to SMR. Our Ultra SMR technology gives us a unique position of an additional 20 percent gain over CMR, and that is in qualification across a number of very large customers. So we feel like as we ramp throughout calendar year '23, we ramp into a stronger and stronger portfolio as we move through the year.

Well, we're always talking to our customers, right? So we have a very good sense of where they're at and what their demand signals are going to be. As we talked about, we expect volume to increase going into our fiscal fourth quarter. So as we get closer to that and we understand what that looks like, we'll make an incremental decision on when and how to ramp back up the fab.

Yeah, again, going back to Wissam's prior comment, that's part of our normal quarterly close process. If there were any adjustments that needed to be made, we would have made them at that time. But of course, you have to re-measure it and take a look at it every quarter.

Yeah, I think the pricing environment has been pretty good in HDD throughout this whole cycle. Anytime you're seeing this kind of underutilization, you're going to see a little bit of pressure on pricing, which is not surprising. I would say we're seeing a little bit more. As we look at exabyte growth, I think it's pretty clear to say it'll be stronger in the second half than the first half. We're going to ramp back off of this very low level. In Q4, we expect growth as we move throughout the calendar year. As we said, we're anticipating modest revenue growth, maybe low to mid single digits quarter over quarter going into calendar Q1, our fiscal Q3. We expect margin improvement as the volume comes back and the underutilization charges drop, and we'll see that continue as we go throughout the calendar year. But we are coming off of very low levels. Exabyte growth in the full calendar year will probably be below 20 percent, something around that. But again, we got to see how it plays out. We've still got big customers going through inventory digestion. Some are coming out of it. We'll know more as we work our way through the calendar quarter. We also have a very dynamic situation in China. The China market has been very subdued for quite a long time now. I would say there are some signs of things getting better. We'll see after we get past the New Year how that progresses. Depending on how that comes back, it will have an impact as well.

Yeah, that's a very difficult question given how dynamic the market is. I think we're coming off of a very strong quarter of bit growth. 20 percent sequential bit growth in our FQ2 was a good result, obviously in a very challenging pricing environment. Going into our fiscal third quarter, we see a drop in both bits and pricing, so that's a pretty significant impact on the business. The current forecast going into our fiscal Q4 sees the volume pick back up. So that's a little bit of how we see the dynamics. The pricing environment will change as supply and demand come more into balance. We're doing everything we can to manage our supply and demand situation so that we keep our inventory situation under control. It's very important in this kind of cycle and will continue to be very dynamic. It literally changes week over week. One of the things I'm very happy about what we've built in the organization over the last several years is a tremendous amount of agility to react. It's important that we react faster than the market is moving, otherwise we just get carried along with the market. I think we are doing a good job of that to get the best result we can out of a difficult market and prepare ourselves from a technology and portfolio position so that when things get more in balance and we get to the inevitable upturn, we are very well positioned. We feel good about that from flash technology. I talked about BiCS8. We'll talk more about that throughout the quarter. I think you're going to be impressed about the innovation that's in that. I certainly was, and also about where we're at in the product volume.

Yeah, it's a number of things. First of all, it is to give us the flexibility to manage through the depths of the downturn. It's important that we have a blend of different kinds of financing, both debt and equity. We can't just take all debt. We've got to watch our debt-to-equity and EBITDA-to-debt ratios and make sure we manage it all as one package. So that's part of it. A big part of it is facilitating the execution of our strategic review. These agreements are very complicated and very well thought through to give us the ability to execute a range of outcomes and make sure that we can be in a good position as we move to that stage of the process. Not putting a timeline on that, but these are set up in a way that give us a lot of optionality and flexibility to facilitate that outcome. And then the third thing, it brings additional capability to our company. Reed Rayman is a very sophisticated technology investor that will join our board. Elliott will have the right to join our board under an amended letter agreement with them when they clear some issues at their choice. So it brings a lot of capability to us as well. We feel good about people investing in the business, about the opportunity to do this, and it puts us in a very strong position to continue to execute the business, invest in innovation, as well as set ourselves up for the next phase of our strategic review.

Yeah, I think one of the things we're seeing is one of our big enterprise SSD customers go through a digestion phase in our FQ3. I think they'll get through that in a quarter and be back to buying, so that should get back to a good guy instead of a bad guy as far as volume. And then this is a very seasonally weak quarter for consumers, so we'll see some stuff up there. Client is a little bit TBD. Commercial and enterprise is a little weaker. The consumer side has stabilized. So I don't want to put too much qualification on it, but again, we feel good about our ability to have a very diverse portfolio and a very diverse go-to-market engine. We've talked about this from the channel to consumer to the big OEMs to the web players. Quite frankly, we saw last quarter that go-to-market engine perform really well, and when we get past a few seasonality things and a few things that are idiosyncratic with big customers, we'll see it kick back in and perform well.

Yeah, I don't think we're that far along to issue that kind of guidance, I guess I would call that. But I think what we're saying is BiCS8 is well along in its technology evolution and its production phase. Like I said, I wish we were on video so I could show you the BiCS8 product I'm holding in my hands and playing with. But the investment doesn't change the way we're thinking about our supply situation. What we're trying to do is match our supply situation to our demand and make sure we can manage our inventory and it doesn't get out of control as we go through this process. We're trying to be very dynamic. Obviously, when you're slowing down the fab, one of the ways to do that is to slow down the node transitions. It brings in this whole question of how long we're going to stay on BiCS6, how fast do we transition to BiCS8. We're working through all of that. Again, that's a bit dynamic. A lot of it depends on what BiCS8 looks like and how it's being productized. I think one of the things we're seeing here today is it has reached the productization stage ahead of schedule. So we'll have more to say about what that fab mix looks like as we go forward. It's clear we're going to have BiCS6 as a shorter node. It won't go into every single product. It'll go into the products that it needs, and then we'll move other products straight to BiCS8.

Yeah, I would say the channel has been pretty good on client SSDs this past quarter. So I don't think there's anything particularly unusual in the channel. The channel performance was actually one of the bright spots last quarter. So I don't think we see anything too unusual there.