Conference Transcript - STX 2026-03-03

Erik Woodring, Analyst — Morgan Stanley

All right, perfect. We are going to get started here. So, again, welcome to day two of the Flagship TMT Conference. My name is Eric Woodring, lead the hardware coverage here at Morgan Stanley. I am delighted to be joined today by Gianluca Romano, CFO of Seagate Technology. Before we get into things, let me just remind everyone to please see the Morgan Stanley Research Disclosure website at www.morganstanley.com slash research disclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. John Luca, thank you for joining us today.

Gianluca Romano, CFO

Thank you, Eric. Now, before we start, we'll be making a follow-looking statement today, and you can learn more about the risk associated with those statements on our website. Perfect. Now we're good to go.

Erik Woodring, Analyst — Morgan Stanley

So let's start in the demand picture. It's clear demand is quite strong. You know, I'd love to better understand exactly how AI is becoming a tailwind for you guys, meaning it's clear the world will need to kind of store, retain, leverage more data in a world of multimodal models, agentic AI, etc. So the broad tailwind is clear, but can you maybe help us understand some of the emerging use cases for HDDs in an AI world just to get some context for what's helping to drive this acceleration behind AI?

Gianluca Romano, CFO

Absolutely. Demand is very strong, as you said. AI is one of the applications that is generating a lot of data and therefore the need for data storage. In our industry, you don't need to produce a different hard disk to store AI data. AI is generating the same kind of data from a storage standpoint that the traditional application we're generating. So we don't have the different mix inside our product where we can say exactly what is coming from an AI application or a non-AI application. So it's a bit more difficult for us to perfectly quantify. But for sure, now in the last year and a half, I would say, AI has been the center of the discussion with our customers in terms of their need to increase storage. And more recently, probably in the last couple of quarters, in particular, video AI has been the reason for that additional increase in demand that maybe came a little bit earlier than what we were expecting when we met in May at our investor day. So there is a little bit more demand than what we were expecting. But again, it's not that we were not counting on video AI for the long term. It's just happening a little bit faster than what we were thinking.

Erik Woodring, Analyst — Morgan Stanley

And maybe just touching on video, the implications are significant when we think about the data requirements for a 30-, 60-second video relative to a text file, is that, and I'm not just trying to focus on the consumer side, but is that maybe the most exciting new application as we think about the potential to, as we think about inferencing and as we think about the potential that AI can bring? Are there any other kind of very focused items that we should be focusing on besides video?

Gianluca Romano, CFO

I think it's very exciting until the next app because that's the reality now. Six months ago, we were talking about something else. Today, we talk about VDI. Six months from now, hopefully, we talk even about something else that will be very important for people and for businesses and something that generates data and needs to be stored. And as you know, 90% of the storage is on hard disk. So everything is important. And as I said before, for us, a data is a data, independently from which application will generate the data. I think you will see a lot of increasing data also from other applications outside AI, like autonomous driving. It started many years ago, but it's not really developed a lot. And there are many cities where you can see autonomous driving being a reality, other cities where you don't see any. And this will continue to evolve, and that needs a lot of data to work. But, of course, no, VDI is something that is taking a volume that is way higher than what we were expecting.

Erik Woodring, Analyst — Morgan Stanley

Let's talk about visibility. Last quarter at Earnings, you talked about calendar 26 near line art orders effectively being covered for the year, that you'd start signing purchase orders into the first half of calendar 27. Can you maybe just give us an update on demand visibility, and maybe more importantly, just beyond that, the sustainability of HDD demand kind of beyond the first half of 27?

Gianluca Romano, CFO

Yes. Now, what we really care is to be sure that when we start a product in our manufacturing, we already have an order for that product. So an order that covers the mix that we are producing, the price for that product, and the time of the delivery. This is why we focus mainly on the next four or five quarters. But customers are very interested in volume. So, of course, they want to discuss about exabyte volume when you go longer. So not only for calendar 26, but also for calendar 27 and even longer. So we have agreement with our customers on exabyte volume for the longer term. And we have very precise orders for calendar 26. And this is why we were able to say in January at our earnings release, based on this visibility, we expect every quarter of calendar 26 to increase in revenue and in profitability. Now, of course, this was more difficult in the past when the industry was working in a different environment. Now we have this visibility, so we can predict and we can make our estimate. I also have to say that now we are beginning of March, so there are, of course, some contracts for the fourth part of calendar 27 that have been translated into POs, and everything is continuing as we have done for the last 11 quarters with that pricing environment that give us opportunity to reasonably increase pricing and take benefit of the cost reduction when we move the mix from a PMR product to the first generation AMR 30 terabytes to the second generation AMR of 40 terabytes.

Erik Woodring, Analyst — Morgan Stanley

As a follow-up on this and speaking to visibility, how are you protecting the company from the risk of over-ordering amidst this demand strength and this elongation of visibility? How do you make sure you ring-fence that risk to limit any future kind of cyclical drawdown?

Gianluca Romano, CFO

Yeah, we are very disciplined on how we deploy our CAPEX. Our CAPEX is not going to be utilized for increasing units. It's all focused on increasing capacity per unit. So technology transition and, of course, the MR production is the focus. We are not going to increase the units because we think through the technology transition we can generate about 25% CAGR in the near-line space that should be enough to cover the short-term need of our customers in terms of data centers that are really building up.

Erik Woodring, Analyst — Morgan Stanley

And maybe just to hit that point again, because I want to be explicit, there has been, at least you guys have talked about leveraging third parties for some head and media content. Some have associated that with greenfield unit additions. We have set the record straight for everyone. You said it once. I just want to make sure you say it again so it's clear. The view on new unit capacity is there is none coming online.

Gianluca Romano, CFO

I don't think there is a need for more units. No, I think us as a company have enough units to serve our customers because we are able to move those units from a certain capacity per unit to a higher capacity per unit. For example, when you go from the first-generation AMR, 30 terabytes, to the second-generation AMR, 40 terabytes, in theory, if you move all your customers from 30 to 40 terabytes, you can increase your exabyte output by more than 30%. So, of course, this doesn't happen in over a year. It takes a little bit longer. But there are opportunities to continue to increase exabyte without the need to increase units that in the past was the problem that then generated oversupply instead of slight undersupply and then generated that volatility and that impact on pricing. I think the industry is way more disciplined today, and this is the benefit of being in this business today.

Erik Woodring, Analyst — Morgan Stanley

Okay, great. I would love for you to touch on maybe the conversations you're having with the major CSP customers. And the question is, you know, we've heard a reference to kind of going from a transactional model to maybe a more partnership model, which allows you to have that visibility. Just can you speak to maybe the permanence of that change? Is that just a function of the supply, demand, and balance as we sit here today? or has something actually changed in which there's a structural importance to HDDs that perhaps didn't fully exist given the need to store and retain and produce more data?

Gianluca Romano, CFO

Yeah, it's probably a little bit of both. Now, of course, the fact that there is a little bit of shortage in storage, in hard disk in particular, is helping that partnership, not that reality. But I also say there is a lot of collaboration with our customers on developing the right product for their storage need. And the right product is the one that has more and more capacity per unit. So as you know, we entered the qualification of our 40 terabyte just a couple of quarters ago. And I'm pleased to announce today that both customers that were in call for the 40 terabyte drive has now qualified the drive. So we start shaping some volume already with quarter, and then more quarter after quarter.

Erik Woodring, Analyst — Morgan Stanley

So I guess you just eliminated one of my questions here. Very good. No, before we get into HAMR, because obviously it's critical, just the point on pricing, right? Supply, demand, and balance right now, clearly kind of insatiable demand. and using aerial density to drive supply or to drive exabytes higher. Talk to us about what's happening with pricing, because you've kind of characterized it as flattish to low single-digit growth. Your competitor has been maybe a little bit more outwardly bullish in talking about mid- to high single-digit year-over-year growth. Is there kind of upside as you see the pricing environment? Is there ability to take more price, not just as we think about calendar 26, but into calendar 27? Absolutely.

Gianluca Romano, CFO

No, I think it depends what is your starting point. Usually, no, I tend to talk about sequential improvement. It's always more a quarter after quarter. Of course, if you go year over year, the increase is substantially higher than what we can do sequentially. So I would say generally, I guess the trend is very similar in terms of pricing. Again, the focus of our customers is more capacity per unit. So now that they can buy the 40 terabytes, at least those two big customers, of course they will focus more and more on getting the volume. They need to give us the time to ramp, a little bit of time to ramp high volume, but it's a huge improvement for them to go from 30 to 40 terabytes. Now if you think about the cost of a slot that they have, a physical slot, if they can put 30 terabytes and monetize the 30 terabyte or for basically the same cost having a 40 terabyte now they monetize 30% more so it's a huge benefit for them to increase in capacity is a huge benefit for us because with a similar cost per unit we generate 10 more terabytes per unit so the cost per terabyte now decline faster than what we have seen in the past and again with the pricing strategy that we have implemented and executed for more than 11 quarters, and what we see for the future, we can reasonably say revenue will be higher and profit will be higher.

Erik Woodring, Analyst — Morgan Stanley

Okay, good. So let's now touch on the comment that you made about Hammer. So you did start, you kicked off qualification on Mosaic 4 products with your first CSP last July. I think the second one started last October, if I'm correct. The comment that you're making today effectively is we have now qualified those two CSPs on Mosaic 4. And just to make sure, again, to make sure we hammer the point home, you're starting to see volume shipments calendar 1Q this quarter. Is that correct? That's correct. Now, how do we think about maybe the pace of the rest of the CSPs out there? Just maybe help us understand the interest level in Mosaic 4 from a qualification standpoint? How do you think about that trajectory it could look like going forward?

Gianluca Romano, CFO

Yeah, I would say the technology is not so important to them anymore. No, they have basically all qualified as a fourth-generation hammer, so they know it's working well in their environment. So technology is not an issue anymore. They just focus on how to get to a bigger drive because that is where they have the best return. So I would say, no, we need to get the time to ramp the first two customers that are really big customers, so they will take a lot of volume. But with the time, we will ramp enough also for other customers to get qualified and then take benefit of the bigger drive.

Erik Woodring, Analyst — Morgan Stanley

Okay. Awesome. Congratulations on that. So you made a comment last earnings. You said the transition from Mosaic 3 to Mosaic 4, so 30 terabytes to 40 terabytes per drive, you'll do that fairly aggressively. You also mentioned it will be a fairly prescriptive ramp. So obviously Mosaic 3 took time to ramp and qualify. You know, what exactly does that look like when we think about that mix shift that you've talked about historically for Hammer? Does that look any different than what you talked about last May in terms of, you know, the 40% mix, the turnover or the crossover, excuse me? Does that look different now that you've had these qualifications?

Gianluca Romano, CFO

No, we were counting on having those qualifications. I would say we are getting those calls maybe a few months earlier, not a few quarters earlier, so it's not that we can ramp a very different number of drive for the 40 terabytes. I would say we are still focusing on achieving those numbers that we said as investor day. If we are at 70% of near-line exabyte sold with an AMER technology by June 27, I think it will be very, very good for us, especially because we start to better optimize our manufacturing. When you start a new technology, you have a period of time where we are not optimized. You have one technology that is new, that somehow competes with the old technology. So what you extract from your manufacturing is not fully optimized. It's very good, but it's not fully optimized. There is a lot of opportunity to improve, and the more and more you ramp up the new technology, you become basically just running one kind of product, and that will help us to get the 25% exabyte or maybe a little bit more in the future.

Erik Woodring, Analyst — Morgan Stanley

I mean, just in terms of the technological volume ramp associated with Mosaic 3 but also Mosaic 4, are there any bottlenecks as you see it, whether it relates to cycle time or components, rare earths, et cetera? Just want to make sure we're kind of triaging any risks that could be associated with that ramp.

Gianluca Romano, CFO

No, I would say the limiting factor is our own ramp. It's not, I would say, any external components that we buy. is our ramp on how much we can... As you know, the cycle time is not short. So we need to start earlier to produce as a media and then to do the assembly and to do the final test. Even the final test gets a little bit longer, not because of the technology, but because of the capacity of the drive. So everything takes a little bit more time. That means to do a ramp of millions of units takes a little bit of time, but every quarter you will see a higher volume and a better contribution of the 40-terabyte drive not only to the revenue but also to the profit link.

Erik Woodring, Analyst — Morgan Stanley

Okay, great. Your competitor had an analyst a few weeks ago. They were talking about adding more heads and platters to a single drive. You've been very focused on aerial density, leading the market on aerial density. Just your perspective as you think about your technology innovation around more platters to a single drive. Is that something that you're focused on or is the focus kind of squarely on aerial density where, again, you're kind of leading the charge there in the market?

Gianluca Romano, CFO

Well, probably when you move to Emmer, the first focus is taking the benefit of this increase of terabytes per disk. Now, when you go from a 3 terabyte per disk to a 4 terabyte per disk, you add 33% of capacity, which is much more than adding one disk. Now, if you add one disk out of 10, you have only 10% of increase. So increasing aerial density per disk gives you a better return. So going to 3 terabyte per disk to 4 terabyte per disk to 5 terabyte per disk to 6 terabyte per disk is probably the best return you can get. Now, at a certain point, it will be interesting and financially, I think, also a good return to start increasing disks. of course in the longer term you want to take benefit of all the space that is inside the box but you need to find the right time right now we get more benefit in increasing the aerial density at a certain point probably will be good for us and I think for the industry in general to take all the space inside the box if you have if you start increasing disk when you are at 5 terabyte or 6 terabyte, the return on the disk and two heads, it's fairly huge.

Erik Woodring, Analyst — Morgan Stanley

Okay, so I think maybe as the CFO, this is, and at least as an analyst, this is one of the most exciting parts of this journey in aerial density is you're not changing the form factor, you're adding more capacity to the box, but you're not adding disks, you're not adding heads. You've talked about insourcing the laser diodes that you've been working on innovating there. What does that translate to when it comes to cost downs? We talked about price per terabyte earlier. You've been able to do something like 15% annual cost per terabyte declines. So now that we're mixing into more Mosaic 3 and in the second half more Mosaic 4, how do we think about the trajectory of cost per terabyte decline?

Gianluca Romano, CFO

It's actually very interesting. Now, the bill of material going from the first-generation AMR to the second-generation AMR to the third-generation AMR is fairly similar. As you said, it's still based on 10 disks and 20 heads. Of course, they are not the same disks and heads. Now, our disks with more capacity and our new heads that need to be developed, also the components that we buy externally need to evolve to support the higher capacity, but it's the same number of components. So the cost per unit is fairly stable, but we add a lot of terabytes per unit. So there is a huge and very important decline in terms of cost per terabyte. Now, when you look at a period of time, it depends how many units you have sold for that new product. So every quarter you will see, you know, we sell millions of units, and we sell PMR units, we sell fourth-generation AMR, we now sell second-generation AMR. where every quarter has a different mix and a different capacity. But the trend, of course, is having a good cost reduction, and the more we can ramp of the 40 terabytes, the more we can take benefit of that decline cost. So this is part of what we said before. An important reason of why we expect a better profitability is the mix moving more and more to the 40 terabyte drive.

Erik Woodring, Analyst — Morgan Stanley

Right. Okay. Okay. Let's take what we've learned maybe on demand and now on the cost side and translate that into financial metrics. So I believe the latest is mid-20% near-line exabyte growth, in line to even stronger revenue growth when we think about the benefits that you can get from pricing that we discussed earlier. A year ago, or almost a year ago, you laid out a target at a 50% plus incremental margins. Clearly, you've been well outperforming that metric. You've been doing 70% plus. Just given what we're talking here about demand, your ability to cost down, your ability to price up, that becomes a very powerful tool. Do we expect in totality kind of growth as we now look into the second half and then margin expansion as we look into the second half? Are those metrics that we think should accelerate just given all of the kind of goodness that is now coming through the model? I know you said we can grow sequentially. Just try to contextualize that growth.

Gianluca Romano, CFO

Yes. When we had our investor day, I said we expect gross margin to increase 50% incrementally, starting a certain level of revenue. And we have done significantly better. The reason why we have done better is mainly because demand is a bit stronger than what we were expecting, now going back to the video AI discussion we had before, and because with those calls that we have achieved, not only the last one that, of course, did not impact the prior P&L, but will impact the future, but the transition to the first generation and also gave us an opportunity to reduce costs a little bit better than what we had in our plan and so to achieve a better margin. I think we are continuing with the same trend. As I said before, the pricing situation has not changed. It's actually now extending for us to the fourth part of calendar 27, so that is very good. That means demand from customers is still very strong because this is a big test now when you go and finally put number in a PO now you can see how real is the demand and this is a confirmation that demand is strong and is real and of course with the mix moving up and up in capacity now we expect continuing improving in in gross margin and finally in in net income because our OPEX is already a very very good point today just very

Erik Woodring, Analyst — Morgan Stanley

quickly touching on OPEX there. You've signaled a ton of leverage that you can drive in the model. Are there, maybe contextualize the added costs, if there are any associated with OPEX as we think about moving into the back half and into calendar year 27, or if there was growth in OPEX, where does that come from?

Gianluca Romano, CFO

I think in terms of resources, we have a very good structure, so I don't expect an increase in the need for resources. so in term of cost should be fairly similar to where it is today usually we have the annual salary increase in the September quarter so we could see a little bit of increase in that quarter and then of course in December but kind of limited so we have seen it this year so part is also variable compensation so every year is a bit different on how much is a variable comp but I would say If you look at calendar 26, I don't really expect a lot of difference in OPEX spending per quarter.

Erik Woodring, Analyst — Morgan Stanley

And then CapEx, you've been very consistent there. It doesn't seem like anything changes. But even as you ramp Mosaic 4 and beyond and testing beyond Mosaic 4, does anything change with that range that we think about CapEx as a percentage revenue?

Gianluca Romano, CFO

I would say 4% to 6% of revenue is a very good model. now give us opportunity to buy the tools that we need to rent more volume of hammer so focusing on the technology transition and moving from lower capacity drive to higher capacity drives and this is what we need of course there is always complex maintenance but our equipment that gets old that you need to replace but again all the focus is on components and transition from one product to the next. Of course, now we don't focus on any increase in units. Okay, perfect.

Erik Woodring, Analyst — Morgan Stanley

I know your analyst day probably feels like it was ages ago. It hasn't even been a year impressively. Can you just remind us how to think about margins and free cash margins on the other side of the equation, right? We're kind of dreaming the dream as we go up and through this cycle. When you talk about your ability to, I think you've guided to 40% plus gross margins, operating margins of 30% plus. Is that signaling kind of those are the floors as we think about the new model, meaning even if we go through a period of digestion at some point in the future, that's, again, notwithstanding certain quarters, but that's where we feel like the floor kind of is in our margin trajectory. I would say we are already above

Gianluca Romano, CFO

those levels, and the trend is to improve. So, honestly, I don't see a reason why we should go in the other direction. We have But all the visibility on calendar 26, I told you about the fourth part of calendar 27. So, again, I see from here I see improvements. I don't see a reason why we should go in the other direction.

Erik Woodring, Analyst — Morgan Stanley

And then maybe last question before we get into kind of capital allocation balance sheet. From the perspective of a kind of new entrance in the market, this is a rational oligopoly right now. and I've long said rational oligopolies can be very powerful. Is there a threat of new entrants? Do you see that? Is that something that is on the horizon? Just would love your perspective as you look out into the market, what you see in terms of this oligopoly structure potentially changing at all.

Gianluca Romano, CFO

Well, from my point of view, the difficult part of this industry is not only manufacturing but also the technology inside the drive. especially now when you move to Hammer, there are way more additional complications and more difficulties. This is where the industry is competing, is in products, in evolving the products so that we can generate more terabytes per unit for our customers. But there's no focus on volume or units or all those things. Those things are actually eventually creating a possible disruption for this industry in the future, so it's not the right focus. The right focus is technology, giving our customers what they need in terms of the product and increase the exabyte so that they can build the data center that they need and have the storage that they need. For a new entrance, it will be very difficult because they need to spend a lot of money, first of all, to set up the manufacturing, second, to develop the technology. At this point it's more complicated than two years ago or three years ago. Now they need to enter and having technology. If you enter and you don't have technology, you're already out of the game. I'll say for the next few years I don't see this happening.

Erik Woodring, Analyst — Morgan Stanley

Okay, good. Let's touch on that capital structure, capital allocation. First, on the structure side, you retired $600 million of your converts last month. Your gross debt is, I think, right around $3.9 billion. That's exactly kind of what you've guided to or at least projected towards. Have you kind of reached the end of that deleveraging just as it relates to your gross debt? Are you kind of done and now you're returning to buying back more stock, or is there a desire to maybe reduce that convert a little bit more? How do we think about balancing that?

Gianluca Romano, CFO

Yeah, to me, reducing the convertible has a double benefit. One is reducing the debt. But second, very important, is to avoid further dilution from the convertible. So it kind of could be assimilated to a little bit of a share by bank. So we have retired 1.1 billion already in the last two quarters. We still have 400 million outstanding. ending, so we will take care of that part of the convertible in the next few quarters. So in terms of debt, I'm fairly happy where we are today. Probably we will go a little bit lower. As you said, the free cash flow will be very strong, so we have the opportunity not only to do a strong return to our shareholders through dividend and share buyback, but also to reduce our debt a little bit more.

Erik Woodring, Analyst — Morgan Stanley

So as we think about maybe the balance of how you've utilized free cash flow, call it over the last two quarters, it has been more levered to delevering. Now it's maybe a little bit more balanced as we look forward, reduce the convert a little bit more, buy back a little bit more, and kind of transition that over towards buyback as we think about a few quarters.

Gianluca Romano, CFO

Yeah, every quarter will be a little bit different, not depending on what kind of treasury activity we are doing in the quarter, but you will have both, and some quarters will have more share by back and less reduction of debt, and some quarters we will maybe focus more on the convertible resources and some other debt reduction and a little bit less share by back. But if you look over a longer period of time, excluding the debt, basically 100% of our free cash flow will return to our shareholders.

Erik Woodring, Analyst — Morgan Stanley

Okay, and I was going to touch on that, but my question was going to be the stated goal is kind of 75% of free cash. Sounds like given how confident you are in the outlook and your margin structure, innovation, all of that stuff, we could and or should be expecting upside to that. That's amazing. Another good insight here. So before we end, you know, last two questions. Just, you know, a CFO just quickly addressing any risks that you think about in terms of things that you want to challenge your team to do better internally things that you see on horizon just making sure and anything is kind of ring-fenced as we all think about potential risks and then one

Gianluca Romano, CFO

question after that please well risk unfortunately is always there now geopolitical risk of course is is high in every industry not only for for us so we control what we can and what we can control is our manufacturing how we address demand how we implement the pricing strategy i'll say where we can extract more value in the next several quarters because demand is above supply is to moving the mix more and more into the higher capacity drive so we can extract a little bit more exabyte from our manufacturing every quarter and of course those exabyte have a very good return for us so that is i think the focus on the quality of the product and the exabyte that we can generate quarter after quarter, and the team is doing an incredible job in extracting the max

Erik Woodring, Analyst — Morgan Stanley

that they can. Amazing. So we've got Mosaic 4 ramping. That's new. We've got more free cash flow returned to shareholders. I'm sure everyone here is happy about that. As you ramp up in kind of the last minute here, just leave everyone with the final word. What maybe is underappreciated? What should people think about the messages that you want to leave as you step off stage here?

Gianluca Romano, CFO

Well, underappreciated could be the state of the industry. Of course, everyone is impacted by the past. I would say the past was a different business. It was based on client business, so on desktop, laptop, different application for the storage. Year after year, this business moves into the big cloud. Now, 80% of our business is data center. So it's all focused on high-capacity drives. And this is a new situation, a new industry, where demand is very strong, where the industry is full in terms of capacity, not adding units, but focusing a lot on technology. I think this will generate a lot of profitability for us and for the industry in general. And this is something that maybe you need a little bit more time for people to get used to it. In the past it was not exactly this. But now it's 11 quarters. We did this already for 11 quarters. We talked about the next four quarters. So this is not a two, three, four quarters cycle. This is a huge change in the industry, in my opinion. That's a great place to enter, Luca. Thank you very much for your time.