Western Digital Corp Q3 FY2020 Earnings Call

Good afternoon. And thank you for standing by. Welcome to Western Digital's Fiscal Third Quarter 2020 Conference Call. As a reminder, this call is being recorded. Now I will turn the call over to Mr. Peter Andrew. You may begin.

Okay. Thank you, and good afternoon, everyone. Joining me today are David Goeckeler, Chief Executive Officer; and Bob Eulau, Chief Financial Officer. Before we begin, let me remind everyone that today's discussion does contain forward-looking statements, including product development expectations, business plans, trends and financial outlook based on management's current assumptions and expectations and as such, does include risks and uncertainties. We assume no obligation to update these statements. Please refer to our most recent financial report on Form 10-Q filed with the SEC for more information on the risks and uncertainties that could cause actual results to differ materially. We will also make references to non-GAAP financial measures today. Reconciliations between the non-GAAP and comparable GAAP financial measures are included in the press release, and other materials that are being posted in the Investor Relations section of our website. With that, I'll now turn the call over to David.

Thanks, Peter. I would like to thank everyone for joining us this afternoon, and I hope that you and your families are well given the COVID-19 pandemic we are all facing. I joined Western Digital a little over a month ago because I have strong conviction in the digital transformation that is reshaping every industry, every company and how all of us live our daily lives. This transition will continue to rapidly increase the amount of data generated, stored and consumed in the world. Western Digital is uniquely positioned to accelerate and benefit from this transformation as the only company providing a broader array of NAND flash, SSD and HDD solutions. We have a strong portfolio, established footprint, operational scale, brand and great customer relationships from the cloud to the edge to the endpoint. On today's call, we'll discuss what we're doing to position the company for continued success and to be best prepared to capture the significant opportunities in front of us. While I couldn't have anticipated the unprecedented series of events that have transpired since I joined the company on March 9, I do believe that the underpinnings of the technology architecture we are all now leveraging on a daily basis has been well established over the past several years. The public cloud rapidly accelerating innovation across a wide array of increasingly intelligent devices, all brought together by high-speed networks. All elements of this architecture are continually upgraded, new cloud APIs, new and more powerful edge and endpoint capabilities and emerging 5G networks. Increased capabilities across any point of this architecture drive incremental opportunity for all that participate in the ecosystem. Data is the critical component that unlocks value across this ecosystem, and our portfolio is well positioned from the cloud to the edge to the endpoint. I'm confident our team's innovation in NAND and HDD technologies will drive significant new opportunity for our customers and value for our shareholders. As you can probably tell, I'm excited to be here and see great opportunities for Western Digital. Before we review our results for the third quarter, I would like to address how we are operating amid the COVID-19 pandemic. First and foremost, our priority is to ensure the health, safety and well-being of our employees, customers and suppliers. We are carefully following precautionary measures and best practices across our global sites and all production facilities remain operational. We encountered some supply disruptions in the quarter. However, due to the efforts of our operations team, we saw supply trends improve as the quarter progressed. We also incurred additional costs associated with logistics and other manufacturing activity. Demand remained strong in the third quarter as expected. Revenue was $4.2 billion, right at the midpoint of the guidance provided in January. We experienced healthy demand from our major cloud customers throughout the quarter and maintained our leading position in the capacity enterprise drive category. The current environment has accelerated the movement to the cloud, transforming the way businesses operate, students learn, and the way friends and families connect. These trends will continue to drive innovation and data storage growth for a number of years, and we are well positioned. High-capacity hard drives are the foundation to enabling the world's essential zettabyte-scale data infrastructure, providing unmatched capacity and TCO efficiency. Our 14-terabyte products continued to perform well, and industry analysts expect this capacity point to remain the industry's highest volume drive, at least through the third quarter of calendar 2020. We are leading the industry in bringing next-generation energy-assisted drives to market as we recognized revenue for our 16- and 18-terabyte drives during the quarter. Customer interest in these products, specifically our 18-terabyte drive is very high and the ramp is on schedule. Customer acceptance of our enterprise SSDs continues to grow. Our latest 96-layer NVMe-based SSDs have completed more than 20 qualifications with well over 100 qualifications in progress at multiple cloud and OEM customers worldwide. Demand for our notebook solutions was greater than expected due to the shift to working from home and e-learning. We experienced record client SSD revenue during the quarter and expect continued growth in the fiscal fourth quarter. Desktop hard drive revenue was down due to normal seasonality and a shift towards mobile notebook solutions. In addition, smart video hard drive demand was softer than expected as a result of COVID-19. Mobile flash bit shipments remained modest in the quarter, as we strategically managed our exposure to this part of the market. Retail was particularly affected by COVID-19 in a typically seasonally weaker quarter. As we approached the end of the quarter, we experienced a decline in demand from traditional brick-and-mortar retailers as they started to temporarily close their stores. While many retailers shifted to curbside pickup and began pushing sales through their online channels, we expect physical store closures will create a headwind in our fiscal fourth quarter. Finally, new game consoles are expected to come to market shortly that are reimagining the next generation of gaming. These new platforms not only utilize nearly one terabyte of internal flash storage, but also empower new cloud-based services for gamers, streamers and content creators that will drive incremental cloud storage demand. We remain on track to ship into this new and growing part of the market in the coming quarter. Turning our outlook for the fourth quarter. Demand remains strong, and we expect growth in revenue and profitability. Of course, the COVID-19 pandemic continues to create a very dynamic environment for us to manage, but our teams are performing well. Bob will go through the details of our Q4 guidance. I am convinced that Western Digital will play an increasingly vital role in the digital transformation underway. The combination of right products, customer engagement and end markets focus provides tremendous opportunities for us. Flash holds the greatest long-term growth opportunity for Western Digital. As I mentioned previously, the migration to flash within gaming consoles is yet another example of flash penetrating deeper into the edge and endpoint. The adoption of 5G and the build-out of the edge to support a new generation of real-time services is another exciting development. We see an expanding TAM for flash that will enable a multiyear growth opportunity. In hard drives, we have already aligned our portfolio to capitalize on long-term growth areas. Our technology and products are indispensable to the growth of the public cloud, the seminal technology trend of our era. We are the first to market with next-generation energy-assisted drives, and we will continue to deliver new innovations to build upon our aerial density leadership. I joined Western Digital to be at the center of this incredible opportunity, innovating in one of the critical building blocks of the digital world, storage. Given the breadth and strength of our portfolio and the attractive markets we operate in, we need to best position the company for ongoing success. As a result, we have made the decision to suspend our dividend in order to reinvest in the business and support our deleveraging efforts. Bob will go into more details on our deleveraging objectives. Before I turn the call over to Bob, I'd like to take a moment to thank the entire Western Digital team, who have come together during this challenging time. It's been incredible to see the support, teamwork and leadership displayed across all levels. Together, I am confident we will get through this and emerge stronger than before. I will now ask Bob to share our financial highlights.

Thanks, Dave, and welcome to Western Digital. As Dave mentioned, the world has changed in the last few months. I'm impressed by how well the Western Digital team has come together and navigated through this challenging quarter. Results in the fiscal third quarter were generally in line with the guidance provided in January as demand held up well in most of our end markets. We had COVID-19-related impacts, which I will detail in a few minutes. Revenue was $4.2 billion, down 1% sequentially and up 14% from a year ago. By end market, Client Devices revenue of $1.8 billion was up 2% on a sequential basis and increased 13% year-over-year. Record client SSD revenue drove most of the sequential and year-over-year growth. As we look into the fiscal fourth quarter, we anticipate client SSD will experience another strong quarter of revenue growth. Notebook and PC-related hard drive revenue declined and now represents under 20% of our total HDD revenue. Smart video was a bit weaker than expected, primarily due to COVID-19. And finally, while mobile was up sequentially and year-over-year, we remain under-indexed to this part of the market. Data center devices and solutions revenue of $1.5 billion was up 2% sequentially and up nearly 22% year-over-year. Capacity enterprise hard drive revenue was flat on a sequential basis, while enterprise SSD revenue grew. Client Solutions revenue was $821 million, down 13% sequentially and up 2% year-over-year. Our retail business was impacted as we approached the end of the quarter due to COVID-19-related lockdown. These lockdowns will have an impact on our fiscal fourth quarter. Demand remains strong in our end markets as we look into the fiscal fourth quarter. Growth in client devices and data center devices and solutions should more than offset the decline in client solutions. By product category, flash revenue was $2.1 billion, up 12% sequentially and up 28% year-over-year. Flash ASPs were up 5% sequentially and bit shipments were up 7% sequentially. As we look into the fiscal fourth quarter demand for our flash-based solutions remains strong, and we anticipate that flash prices will rise on a sequential basis. Hard drive revenue was $2.1 billion, down 12% sequentially and up 2% year-over-year. On a sequential basis, the average price per hard drive increased 5% to $85, and exabyte shipments were down 6%. As we move on to cost and expenses, please note, all of my comments will be related to non-GAAP results unless stated otherwise with COVID-19 impacts detailed where appropriate. Gross margin for the third quarter was up two percentage points sequentially to 27.9%. The start-up costs of our fab in Kitakami, K1, were $62 million and the COVID-19-related costs in the quarter were $13 million. For clarity, both items are included in the reported non-GAAP gross margin. The COVID-19 costs were primarily related to reduced factory utilization and higher logistics and other costs. Our flash gross margin was 26.5%, up seven percentage points from last quarter due to a stronger pricing environment and cost reductions. In the quarter, we began to ship production units out of K1. The hard drive gross margin declined to 29.3% from 30.8% in the prior quarter, mostly due to the COVID-19 impact and mix shifts. Operating expenses were $738 million, slightly lower than expected. Other income and expense was $91 million, higher than expected due to unfavorable foreign exchange rate movements. The tax rate came in at 23.5% in the quarter, which was lower than our prior range of 25% to 27% for the full year. We now estimate our fiscal year 2020 tax rate to be between 24% and 25%. Earnings per share was $0.85. Operating cash flow for the third quarter was $142 million, and free cash flow was $176 million. Our free cash flow was better than expected in a quarter that is usually seasonally low. So far, in fiscal 2020, we have generated $847 million in free cash flow and expect to generate very good cash flow in the fourth quarter. Capital expenditures, which include the purchase of property, plant and equipment and activity related to flash ventures on our cash flow statement, were an inflow of $34 million due to the timing of funds flowing back and forth to the joint venture. For the full fiscal year, we expect cash, capital expenditures to be an inflow of a couple hundred million dollars. Gross capital expenditures, which includes our portion of joint venture leasing and self-operating funding, is expected to be approximately $1.7 billion this fiscal year. We are assessing our fiscal 2021 capital expenditures based on the current economic environment. Our liquidity position continues to be strong. At the end of the quarter, we had $2.9 billion in cash and cash equivalents, and our gross debt outstanding was $9.8 billion. In the fiscal third quarter, we distributed $149 million in dividends to our shareholders and made an optional $150 million debt paydown. Fiscal year-to-date, we've lowered our debt by about $920 million. Our first priority for cash utilization is to reinvest in the business. Since we are suspending our dividend, our second priority is repayment of debt. Our current plan is to reevaluate the dividend and other shareholder return policies, and our total debt is under $6 billion and our net debt is under $3 billion. Our goal through a cycle is to have a gross leverage in the range of one to 3.5 times EBITDA. Our current debt-to-EBITDA leverage was 5.0 times in the third quarter. I want to make it clear, suspending the dividend is not related to our debt covenants. We have substantial room under our covenants. Moving on to non-GAAP guidance for the fiscal fourth quarter. We expect revenue to be in the range of $4.25 billion to $4.45 billion. Gross margin is expected to be between 29% and 31%. This range includes approximately $65 million in costs associated with the K1 fab. We're also anticipating the impact of COVID-19. Operating expenses are expected to be between $740 million and $760 million. The midpoint of the guidance range assumes normal variable compensation expense. Interest and other expense is expected to be between $75 million and $80 million. The tax rate should be between 24% and 25%. As a result of this detailed guidance, we expect earnings per share between $1 and $1.40, assuming approximately $302 million in fully diluted shares. We're using a wider range this quarter, primarily due to the uncertainty in the environment. With that, we will now begin the Q&A session. Operator, we're ready for our first question.

Thank you. Our first question will come from Aaron Rakers with Wells Fargo. Please go ahead.

It's Aaron Rakers from Wells. Maybe I'll start with just asking about it. I think on Slide eight in the prior presentation, you guys gave some commentary around the outlook that you have for the flash business as far as industry supply bit growth, as well as your expectation, I think previously noting that you'd expected mid-30% growth on enterprise, high-capacity nearline drive shipments for the full year. And on the second point, can you just— it looks like you definitely kind of underperformed some of your peers on nearline. Just if you could help us understand what you're seeing in that market relative to the performance we've seen out of your competitors?

So the first question, I missed part of it, but it sounded like that was on aligning supply and demand of bit growth in the second half of the year. Let me start with what we're seeing right now. We saw good demand. As Bob talked about, margins were up this quarter. Next quarter, as we expected and as we guided, margins are up again. Obviously, as we get into the second half of the year, things get a little more difficult to really project. I think we're looking at various recovery scenarios and how we will invest in those, and we'll be prudent about how we do that. On the nearline side, we're happy with where the product performed. The 14-terabyte is still performing well. The 18-terabyte shipped for revenue this quarter, as we talked about. We made that commitment, we delivered on that. The ramp is on schedule. We see great interest. There's no doubt we're in a bit of a product transition in the industry, and that will play out over the next couple of quarters, but we're happy with where the portfolio is. Bob, do you have anything to add?

No, I think that's a good summary. We're ramping as planned.

Okay. And then, Bob, just as a quick follow-up, if I can. I know you mentioned that you've got an ample amount of room as far as your covenants. At 5 times debt-to-adjusted EBITDA, can you just remind us again what those covenants are? What the thresholds look like? I think it was a little bit lower than that. So just refresh us again on the covenants and when maybe covenants change going forward?

Yes. So the covenants are related to an adjusted EBITDA number that we use for compliance purposes. That ratio is well below the five we show as a non-GAAP debt-to-EBITDA number. As you saw, we made progress in the quarter. Our gross leverage went from 5.7 to 5.0 this quarter. So we're definitely trending in the right direction. And as I said, we have plenty of room under the covenant. We just haven't given a lot of specifics on the actual compliance covenant.

Okay, fair enough. That is it. Thanks.

Yeah.

Thank you. Our next question will come from Joe Moore with Morgan Stanley. Please go ahead.

Great. Thank you. If you could talk about the decision around the dividend, and we've highlighted this is something you should consider. But I just curious how much of it is the current environment and the uncertainties around COVID-19 versus just coming in as a new CEO and wanting to get to these leverage targets before you start paying cash out?

Like anything, it's a combination of a lot of things. Certainly, the current situation brings some focus to the desire to deleverage a little faster. But the real issue is I came into the business and the company is really well positioned. When I think about the technology trends that are going on right now—public cloud growth, the ramp in capacity enterprise—it's one of the biggest technology trends we've seen in a very long time. We're very well positioned in that market. We perform in the fourth quarter. The portfolio has been repositioned for the capacity enterprise market, and we actually see that market returning to growth after several years of decline or sideways movement. We're also seeing strong opportunities in flash at the edge and endpoint, for example gaming and the adoption of VR headsets, driving demand on that side of the market as well. So when you put that together, it was the right time to move to a different model. We want to invest in growth and accelerate deleveraging. That influenced the dividend decision.

Great. And then as a follow-up. If you could assess the current environment, we see a fair amount of tightness, particularly on enterprise-grade NAND. How much of that do you think is just tight supply/demand of raw NAND versus tighter supply of PCB controllers, things like that? It seems like it's a combination of both. Do you still think that the underlying NAND market is pretty healthy?

Yes. We're still very bullish on the enterprise SSD market. As you know, Joe, we've got goals to get up to 20% market share there. In the short term, you're right, it's a matter of balancing and making sure we've got the right controllers to go with the NAND for that market. So that's probably the controller side is more of a challenge than the NAND side, but we're very, very optimistic on that business.

Great. Thank you.

Thanks, Joe.

Thank you. Our next question will come from Karl Ackerman with Cowen. Please go ahead.

Hi, good afternoon and welcome to the team, Dave. Two questions if I may.

Thanks, Karl.

Two questions, if I may. I was hoping you could provide a little bit more clarity on when we should expect the volumes of your 16- and 18-terabyte drives to cross over your 14-terabyte drives? I can appreciate your conservatism given limited visibility in the second half, but should we actually see the 18-terabyte timeline accelerate given robust data center demand?

One of the things you're going to see from me is I'm going to really focus on forecasting one quarter at a time. So it's not going to happen next quarter, but you knew that. We're looking several quarters out. Will it accelerate given the increased cloud demand we're seeing? We're already seeing a lot of demand for that product. We have the demand we need to ramp the product. We're looking forward to it being a great launch and the team is very focused on continuing to make supply available. We're excited about the product.

Thanks. And as a follow-up, are you capacity constrained on nearline today? And in NAND, while it's probably difficult to ascertain what your customers' inventory levels are, has NAND inventory on your own balance sheet declined on a days basis in March? Any thoughts on how that could trend in the June quarter?

I would say the balance is what we expected at this point. We continue to see strong demand there.

I can start with the inventory question. Our inventories were up just slightly this quarter. I actually think in the next quarter, you'll see inventories coming down quite a bit because of some of the supply chain challenges. But I'd say everything seems to be in equilibrium in general.

Thank you. Our next question will come from Sidney Ho with Deutsche Bank. Please go ahead.

Great. Thanks for taking my questions. I have two questions. First, on the gross margin guide being 29% to 31% on a non-GAAP basis, I know there are a number of moving parts. You talked about NAND prices going up. Can you help build the bridge between where you were in fiscal Q3 where there were a bunch of expenses included, and how that gets to fiscal Q4?

So Sidney, I'll take that. Actually, we probably have more absorption variance and cost headwinds in the fourth fiscal quarter than we had in the third. We are trying to move prices up where we can in the market as a result of those incremental costs. So it's absorption, logistics costs, other costs and making sure environments are safe around the world. So it's actually a bigger challenge in the fourth quarter.

Okay. Maybe my follow-up question is, you lowered your gross cash CapEx to $1.7 billion from—I think last quarter you said $2 billion to $2.5 billion. Just trying to figure out what has changed there in terms of the CapEx plans? I understand for next year you guys are not ready to give guidance. But qualitatively or directionally, how are you thinking about tech migration, wafer capacity additions, those kinds of things would be great? Thank you.

Without talking too much about the specific number, this was always anticipated to be a low growth CapEx year for us. If you go back a year ago, we were reducing the amount of capacity we had. We actually took some offline about a year ago, as you'll recall. Along with our partner, we had pushed out some of the CapEx expectations. So we'd always expected this to be a light year. I still expect CapEx will be up next year. I'm not ready at this point to say how much that will be.

Thank you.

Thank you. Our next question will come from Mehdi Hosseini with SIG.

Yes. Thanks for taking my question. I want to go back to hard disk drives. It seems like you and your competitor are skipping a node. Your competitor may have gained some market share in 16 terabyte, and now you are aggressively qualifying 18. This has been a pattern for the past two years. How should we think about this looking forward, especially as areal density is going to hit the ceiling? Is there any update on your strategy? And in that context, Dave, this is the first time you have the mic; could you tell us how you see the company moving forward? What are the key strategies you're employing? I understand you've been on board for maybe one or two months, but both NAND and HDD are very dynamic. Things change monthly or quarterly. To the extent you can share your long-term vision and strategy, that would be very helpful. Thank you.

On the first question, you're right, we are in a product transition, and we are excited about the 18-terabyte drive. It's getting harder to drive more density, but we have an enormous amount of R&D in this area and we're going to invest aggressively to make sure we maintain our lead in areal density. You'll hear more from us on that. There's lots of activity in R&D and it is encouraging to see the depth of talent in the organization to drive the roadmap in that critical technology. On strategy more broadly, we'll have more to say in the future. But the company made a pivot to flash and it is positioned well. The cloud is driving enormous change; public cloud is a major transition. We're well positioned in the cloud and have leadership in areal density on the HDD side. On the flash side, edge and endpoints are getting more sophisticated as networks get faster, which drives the flash business. Gaming is an example of a growing market that opens up opportunities. These two sides reinforce each other: more innovation at the edge drives more data, which needs storage and processing. The company is well positioned on both sides. This is a dynamic market, sensitive to supply and demand, but the long-term trajectory is favorable and we are in good TAMs. I'll have more to say as we go forward. I'm happy to be here and believe what the company provides is fundamental for the digital world we all use every day.

Thank you.

Thank you. Our next question will come from C.J. Muse with Evercore. Please go ahead.

Good afternoon. Thanks for taking the question. First, on gross margins: can you repeat what the K1 charges are in the June quarter? How do you see that progressing through the rest of the calendar year? Also, can you share what COVID expenses you're assuming? I'm assuming that's mostly HDD related. Is that something we should think about when modeling the back half of the year?

I'll take that, C.J. The K1 costs were $62 million in the current quarter and we guided to around $65 million next quarter. I think that will be roughly the level through the rest of the calendar year, and then you should start to see it drop off next year as volume ramps. In terms of COVID-19, we aren't going to get specific on the cost. We'll have more absorption variances this quarter, more logistics costs and other expenses. We'll be able to partially offset that with pricing, and customers will share in some of that, but net-net we'll have some headwind for COVID-19. I don't want to get too detailed because it's hard to predict how it will play out.

Sure. Very helpful. My follow-up: how are you thinking about managing your bit inventory on the NAND side with the lack of visibility due to COVID-19? How are you managing wafers? And what visibility do you have to the second half for cloud spending to be sustainable?

We're guiding one quarter out right now. We have multiple scenarios we're evaluating. Inventory is roughly in equilibrium. We'll take it one quarter at a time. So far, demand has held up pretty well and we'll see how it continues through the year. I don't see major changes right now.

Thanks, C.J.

Thank you. Our next question comes from Toshiya Hari with Goldman Sachs. Please go ahead.

Good afternoon. Thank you for taking the questions. First, again on gross margins in the NAND business: there was nice expansion in the March quarter. Ninety days ago you talked about gross margins potentially being in the 35% to 40% range in the back half of the year. I appreciate you aren't guiding for the full year, but is that still an appropriate range or have things evolved given COVID-19?

We're going to stick to one quarter at a time, but things are moving in the right direction. We feel good about current demand. Bob mentioned we are looking at different scenarios for the second half of the year and will make investment decisions as we get more information. Visibility is difficult right now; we'll see how it goes week-by-week.

Understood. And as a quick follow-up to Mehdi's question, Dave, I appreciate you've only been around for a bit. Could you share one or two things you'd like to change or improve at the company? From an operational standpoint, what would you prioritize? And which financial metrics do you tend to focus on—revenue, margins, EPS, cash flow?

It's a difficult quarter to draw long-term conclusions. The operations team has done an incredible job maintaining global operations across many locations. They've shared best practices and kept sites open at safe levels. That is a tremendous strength of the company. As for financial metrics, gross margin is a top focus—making sure we invest resources where we get the highest return—and cash generation is another major focus. Those are two priorities at the top of a longer list.

Very helpful. Thank you.

Thank you. Our next question comes from Jim Suva with Citigroup. Please go ahead.

Hi, good afternoon. This is Mike Cadiz for Jim Suva at Citi. Would you mind giving a little more color on current factory utilization levels? And secondly, an overview on the health of your component supply chain at this time? Thank you.

It's been improving week over week. As it stands right now, we're in good shape. This is a very dynamic situation—things change daily. The team has done a great job keeping things open and functioning at levels that can support the forecast we put forward. Over the past two to three weeks, things have gotten significantly stronger which gives us confidence. We're implementing best practices across all facilities and have had good success keeping people safe. Our supply chain has been supported; we've worked with suppliers to get necessary government authorizations to operate. We've done some diversification to fill gaps and made non-regret moves. Right now, the supply chain situation is similar to our facilities: it's been getting better week-over-week and we're in a relatively strong position.

All vendors are producing at this point, although that could change. We're monitoring it closely.

Thank you. Our next question comes from Mitch Steves with RBC Capital Markets. Please go ahead.

Thanks. I had a couple of questions. First, regarding the dividend suspension, what type of leverage metric are you trying to get to? Is there any way to think about when it will be reinstated in terms of a financial metric? Second, given supply chain disruptions and broader economic disruptions, what's your view on smartphone units over the next 12 to 24 months?

We've studied capital structure and concluded that, because this is a cyclical business, we want a gross leverage that works through the cycle. We're expecting, as we bring debt down, to manage anywhere from one to 3.5 times EBITDA depending on where we are in the cycle. The goal is to get gross debt down to about $6 billion and net debt to $3 billion.

On smartphones, we don't forecast smartphone units. We're taking it quarter-by-quarter. We feel good about our guide for the next quarter and will have more to say about the second half next quarter.

Also, we're under-indexed to the mobile phone market, so we're not as exposed to it as some competitors.

Understood. Thanks.

Thanks, Mitch.

Thank you. Our next question comes from Steven Fox with Fox Advisors. Please go ahead.

Thanks. Good afternoon. I had a question on the retail channel. There's a disruption in that channel right now. Can you talk about how it impacted guidance for the current quarter? And secondly, in the longer term, given strong retail brands like Western Digital and SanDisk, is the focus to maintain those brands in retail, redeploy bits and heads into more profitable areas, and how do you think about that?

For the fourth quarter, we expect some headwinds in retail. It's typically a seasonally weak quarter and store closures make it tougher. We saw deterioration toward the end of the quarter when stores were closed and also a mix shift to lower-margin products. We have baked retail channel dynamics into our guidance. Longer term, those brands are a strength and provide differentiation; they can drive margin in those channels and are an asset. We'll have more to say on long-term strategy, but I'm positive about our retail capabilities.

Great. Thank you very much. Good luck going forward.

Thank you, Steve.

Thank you. Our next question will come from Srini Pajjuri with SMBC Nikko Securities. Please go ahead.

Thank you. Good afternoon. Dave, I'm trying to understand whether current demand is sustainable into the second half. You tend to have good visibility on the hyperscale cloud side given your design cycles. What are your customers saying about the second half? What sort of design activity on the drive side are you seeing?

We guide one quarter at a time, but we continue to see strong demand from the big cloud vendors. There's the question of inventory build and digestion, but everything we see is strong demand for their products. The architecture of cloud and remote work has been set and the pandemic has accelerated adoption; the question is how much persists after things subside. Our conversations with customers are strong and our relationships are deep. Nothing we're seeing suggests demand isn't real. How far it extends into the second half is something we'll watch as visibility improves.

Helpful. Thank you. Bob, as you try to improve free cash flow going forward, a couple of line items: OpEx and taxes. You're paying a relatively high tax rate on a non-GAAP basis compared to peers. Why is that and when do you expect it to come down?

OpEx should be around the levels we guided this quarter for the next few quarters. On the tax rate, we have a structure that is fantastic when profitability is higher. Right now, with lower profitability, we have certain minimum taxes we must pay around the world, which makes our tax rate relatively high. It will come down as overall profitability increases.

All right. Thank you.

Thank you. Our next question comes from Harlan Sur with JPMorgan. Please go ahead.

Good afternoon. It looks like you saw continued strong growth in the ramp of your new enterprise SSD platforms. You're targeting 20% market share. Based on your shipments in the March quarter and assumptions on industry shipments, did you achieve double-digit percentage market share in the March quarter?

I'd say the share was fairly flat. That market is growing quite a bit. We're a bit constrained on controllers right now, but the demand is definitely there.

Okay. Great. On the COVID-19 operational issues, any geographies creating more pressure points from operations or logistics?

I don't want to call out any one area over another because it changes based on local situations. There are a couple of categories: logistics have gotten more expensive and difficult because passenger flights have decreased, raising costs and complexity to move goods. In some places we couldn't run at full capacity, causing absorption costs, though that has been improving. There are also costs for increased cleaning and safety measures. May should be better than April, and June better than May. The trend has been improving week over week.

Thank you.

Thank you. Our next question will come from Tristan Gerra with Baird. Please go ahead.

Hi, good afternoon. There have been reports about HDD pricing going up to match higher logistical costs. What's your sense of HDD pricing going forward? Could supply disruptions create an environment where pricing is favorable for the next few quarters?

We've been somewhat successful in moving pricing to cover some increased costs. Our focus is to price to cover increased costs we have in the business. We have a good idea of what those will be next quarter and will respond accordingly.

I agree.

Thanks. One quick follow-up: you talked about supply chain disruptions improving recently. Is there a way to quantify the percentage of output this quarter impacted by those disruptions? Is there still a material impact on supply this quarter?

I don't want to put a specific number on it because it's a very dynamic environment. We have confidence in the supply to support the guide for the next quarter. The trend has improved and it gave us the confidence to put the guide in place, but things can change daily.

Great. Thank you.

Thank you. The last question comes from Weston Twigg with KeyBanc Capital. Please go ahead.

Hi. Thank you for taking my question. First, did you review the recent commerce rule change regarding company military exposure in China, Russia and Venezuela? Specifically in China, you had previously said you have 20% to 25% exposure. How much of that might fall under the new definition under this rule?

We've taken a quick look at it and we don't believe it will have a material impact on our business. We'll continue to monitor it closely.

That makes sense. Thanks. My other question is on notebooks. It's been a big driver of near-term revenue. Can you speak to density trends in notebooks in the back half of the year — might density increase if units decline?

We're sticking to guiding one quarter at a time and I don't have anything particularly insightful on notebook density trends at this point. Bob, any thoughts?

No, I don't. It has come up over the last year, but I think as we go forward, we don't really know.

All right. Sounds good. Thank you.

Thank you, Weston. All right. Thank all of you for joining us here today. We look forward to seeing you virtually at the upcoming JPMorgan and Bank of America conferences. Enjoy the rest of your day. Thank you.

Yes. Thanks, everyone.

This concludes today's conference call. Thank you for joining. You may now disconnect.