Thank you for standing by, and welcome to the Western Digital's First Quarter Fiscal Year 2022 Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker, Mr. Peter Andrew. Thank you. Please go ahead.

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 contains forward-looking statements, including product portfolio expectations, business plans and performance, 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-K 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 will now turn the call over to David for his introductory remarks.

Thank you, Peter. Good afternoon, everyone, and thanks for joining the call to discuss our first quarter of fiscal year 2022 results. We reported revenue of $5.1 billion, non-GAAP gross margin of 33.9%, and non-GAAP earnings per share of $2.49, all within the guidance ranges we provided in August. This marks the sixth quarter in a row of meeting or exceeding guidance, a point that we are particularly proud of as we continue to navigate uncertainty and volatility in the market. Strong demand across diverse end markets, particularly for our cloud products, combined with Western Digital's strong innovation, broad routes to market, and sharpened execution enabled us to deliver results within our guidance range despite significant COVID impacts and supply chain disruptions. While these disruptions are transitory, the long-term opportunities for Western Digital remain unchanged as the world's digital transformation continues to accelerate. During the quarter, we shipped a record level of exabytes while also improving non-GAAP gross margins across both flash and HDD and generating profitable growth. We saw strong demand for our latest generation hard drives and flash products in the cloud end market as well as strong consumer demand for new 5G-based mobile phones incorporating our latest BiCS5 flash solutions. The strong demand for these products was partially offset by pressure in the commercial channel within the client end market and certain portions of the consumer end market, particularly retail. This was attributable to component issues impacting our customers' ability to ship products, greater component sourcing constraints within our own operations, and uneven geographic demand due to COVID lockdowns. Our continued focus on innovation and a more agile business unit structure enabled us to quickly adapt to these dynamics. When combined with an industry-leading portfolio and a strong go-to-market operation, I'm confident in Western Digital's ability to continue to generate improved operational performance for all of our stakeholders. Before I get into the business trends, I want to highlight a few changes we made to our end market breakdown, which we believe will help you understand why Western Digital is well positioned to capitalize on the opportunity presented by the increasing value and importance of data. We now split our end markets into cloud, client, and consumer. The cloud represents an incredibly large and growing end market for Western Digital, and we are uniquely positioned to address customer storage needs as the only provider of both hard drive and flash products. During the first quarter, cloud represented a record 44% of total revenue, led by record capacity enterprise hard drive revenue and nearly 30% sequential growth in enterprise SSD revenue. We believe the accelerated digital transformation will continue to drive growth in this end market and continue to shift our business mix towards the cloud. As we ramp our new innovative products and continue leveraging the benefits of the organization structure we put into place last September, I am confident we will capture opportunities to achieve a more stable and profitable growth profile over the long term. The client end market represented 37% of revenue in the first quarter. Here, we are providing a broad array of high-performance flash and hard drive solutions to our OEM and channel customers across PC, mobile, gaming, automotive, VR headsets, at-home entertainment devices, and industrial spaces. Lastly, the consumer end market accounted for 19% of revenue in the first quarter. The highlight of this end market is the strength of our SanDisk brand of retail products and the WD_BLACK brand of storage products for gaming enthusiasts, which is strong and growing. The brand recognition and infinity, combined with our unmatched reach with nearly 400,000 points of presence across the world is a great setup for Western Digital as we enter a seasonally stronger part of the year. With that, I'll now provide a recap of our HDD and flash businesses as it relates to our first quarter results. In HDD, continued strong demand for our latest generation energy-assisted drives among our cloud and enterprise customers drove record revenue and exabyte shipments in our cloud end market. In addition, we experienced strong revenue growth in our smart video product line and were unable to meet demand. During the quarter, we announced OptiNAND, a revolutionary technology that utilizes flash in the HDD control plane to further increase aerial density. With this leading architecture, we achieved 20-terabyte capacity using our field-proven 9-disk mechanical platform and ePMR technology. Next month, we will commence volume shipments of our 20-terabyte CMR hard drives based on OptiNAND technology. In flash, revenue grew in the quarter due to continued strong demand within the cloud and client end markets for our latest generation of our enterprise SSD products and the ramp of new 5G phones incorporating our latest BiCS5 node. Within enterprise SSD, we experienced continued success in the cloud with another successful quarter of qualifications. We are now qualified at 3 cloud titans and have made excellent progress working our way through the qualification process in the enterprise and distribution channels. We expect these qualifications to start to drive accelerated revenue growth in 2022 as our customers begin to deploy these products into their networks. The ramp of next-generation 5G phones incorporating our latest generation of BiCS5 products accelerated in the quarter, with revenue growing over 20% sequentially. We expect this migration to 5G, combined with a continued increase in the amount of storage per phone, to drive another strong quarter of revenue growth in the fiscal second quarter. Gaming was strong in the quarter with a solid lineup of products for game consoles along with a growing brand recognition of WD_BLACK based products in the channel and retail. Heading into the second fiscal quarter, we are well positioned to take advantage of seasonal strength and grow in a wide variety of gaming channels. As I noted earlier, the client PC OEMs' distribution channel and retail were impacted by our customers' ability to ship products, greater component sourcing constraints within our own operations, and uneven geographic demand due to COVID lockdowns. Demand was solid, but these transitory issues impacted our ability to realize this demand in our results. In total, bit growth accelerated to 30% year-over-year in the first quarter as we ramp BiCS5 to 17% of flash revenue. This quarter, we expect year-over-year bit growth to further accelerate to the mid-30s range with BiCS5 bit crossover to happen later in the quarter. Our long-term goal is to grow bits in line with the market, taking advantage of our product and end market breadth to shift our bits to optimize profitability. As we look into calendar year 2022, we are optimistic as our customers continue to indicate strong end demand across cloud, client, and consumer end markets. We have industry-leading technology, the right product portfolio and investments, and the organizational agility to fundamentally drive improved profitability regardless of market condition. We have a great position in 2 large and growing markets in flash and HDD, and we have proven our ability to drive innovation throughout our portfolio and deliver industry-leading products to a broad and loyal customer base. We believe that the migration to the cloud and demand for storage solutions throughout the client and consumer markets will drive a huge opportunity for Western Digital and our customers. I'll now turn the call over to Bob to share details on our financial results.

Thanks, Dave, and good afternoon, everyone. As Dave mentioned, overall results for the fiscal first quarter were within the guidance ranges provided in August, marking the sixth quarter in a row that we've met or exceeded guidance. Total revenue for the quarter was $5.1 billion, up 3% sequentially and up 29% year-over-year. Non-GAAP earnings per share was $2.49. Please note that EPS included $56 million in total COVID-related costs, which was higher than we anticipated entering the quarter. I'll provide more details on these costs in a minute, but we are pleased to deliver such good results in the face of this unanticipated headwind and other supply chain issues. From a disclosure perspective, in addition to the change in our end market breakdown that Dave discussed, this quarter, we moved to segment reporting for our flash and hard drive businesses. For more details, please refer to our earnings deck. Looking at our end markets, cloud represented 44% of revenue at $2.2 billion, up 12% sequentially and up 72% from a year ago. This represented the second quarter in a row of record revenue. What is encouraging about this cloud revenue growth is the strength and breadth of our revenue streams across product areas. There was growth on a sequential basis in both the flash and hard drive business units as well as across every product category within the cloud, including capacity enterprise drives, enterprise SSDs, smart video, and platforms. As the cloud continues to grow as a percentage of our revenue, we see an opportunity to reduce volatility in revenue and profitability. Over the last 3 quarters, we have successfully ramped our 18-terabyte energy-assisted drive to our highest volume mainstream product within the cloud end market. Overall, cloud HDD exabyte shipments grew 9% sequentially and over 70% year-over-year and comprised over 80% of total HDD exabyte shipments. Client represented 37% of revenue at $1.9 billion, down 2% sequentially and up 6% year-over-year. A highlight within the client end market was growth within our flash business unit, specifically in mobile, gaming, automotive, IoT, and industrial applications. Our strength here was more than offset by pressure in desktop and notebook hard drives due to supply disruptions at our customers and within our own operations. Finally, consumer represented 19% of revenue at $973 million, down 6% sequentially, but up 10% year-over-year. Both our flash and hard drive business units declined on a sequential basis due to similar supply disruptions in addition to uneven geographic demand due to COVID lockdowns. Turning now to revenue by segment. We reported flash revenue of $2.5 billion, up 3% sequentially and up 20% year-over-year. On a blended basis, flash ASPs were down 3% sequentially, primarily due to mix and pricing within our transactional markets. On a like-for-like basis, flash ASPs were flat. Flash bit shipments increased 8% sequentially and 30% year-over-year. Hard drive revenue was $2.6 billion, up 2% sequentially and up 39% year-over-year. On a sequential basis, total hard drive exabyte shipments increased 4%, while the average price per hard drive increased 5% to $102. As we move to costs and expenses, please note that my comments will be related to non-GAAP results unless stated otherwise. Gross margin for the first quarter was 33.9%, up 1 percentage point sequentially. As noted earlier, this included $56 million in COVID-related costs or a 1.1 percentage point impact. These were the highest COVID-related costs in over a year. Our broad routes to market and ability to proactively shift bits to the most attractive end markets enabled us to expand our flash gross margin by 1.5 percentage points sequentially to 37%. Our hard drive gross margin was 30.9%, up 60 basis points sequentially. This included COVID-related impact of $51 million or approximately 2 percentage points. Operating expenses were $761 million, within our guidance range. Operating income was $952 million, representing a 15% increase from the prior quarter and tripling year-over-year, highlighting our profitable growth. With our improving profitability, our tax rate in the fiscal first quarter was 11%. Earnings per share was $2.49, toward the top of our guidance range. Operating cash flow for the first quarter was $521 million, and free cash flow was $224 million. Capital expenditures, which include the purchase of property, plant and equipment and activity related to our flash joint ventures on our cash flow statement, was a cash outflow of $297 million. We continue to expect gross CapEx for this fiscal year to be approximately $3 billion and cash CapEx to be around $2 billion. In the fiscal first quarter, we paid off $213 million in debt, including a discretionary debt repayment of $150 million. Our gross debt outstanding was $8.6 billion at the end of the fiscal quarter. In addition, as a result of our strong financial results and free cash flow generation, last week, we repaid the remaining balance of our term loan B in the amount of $943 million, bringing total gross debt outstanding to $7.7 billion. Our adjusted EBITDA at the end of the first quarter, as defined in our credit agreement, was $4.2 billion, resulting in a gross leverage ratio of 2.0x, down from 2.7 a year ago and was the lowest in 3 years. As a reminder, our credit agreement includes $1 billion in depreciation add-back associated with the flash ventures. This is not reflected in our cash flow statement. Please refer to the earnings presentation on the Investor Relations website for further details. Moving on to our outlook. Our fiscal second quarter non-GAAP guidance is as follows. We expect revenue to be in the range of $4.7 billion to $4.9 billion and we expect flash revenue to increase sequentially and hard drive revenue to decline sequentially. We expect gross margin to be between 32% and 34%. We expect operating expenses to be between $760 million and $780 million. Interest and other expense is expected to be approximately $70 million. Our tax rate is expected to be approximately 11% in the second quarter and for the fiscal year. We expect earnings per share to be between $1.95 and $2.25 in the second quarter, assuming approximately 316 million fully diluted shares outstanding.

Thanks, Bob. I want to conclude by thanking the Western Digital team for their hard work and commitment to our customers throughout a challenging quarter. Despite the transitory issues we have been able to successfully navigate, it is clearer than ever that Western Digital's innovative technology portfolio is foundational to the rapid digital transformation and transition to the cloud that the world is experiencing. With our deep roots in a broad range of end markets and a sharp focus on execution, I'm confident in Western Digital's ability to capture this massive opportunity, and I'm looking forward to the rest of the fiscal year. Let's now begin the Q&A.

Our first question comes from Aaron Rakers with Wells Fargo.

Hey, Aaron?

Yes. Sorry guys. Can you hear me?

No problem. We hear you.

Sorry about that. Yes, so I've got 2 quick questions, if I can. I guess, first of all, it seems like there's a lot of moving parts in the quarter and more importantly, into the guidance outlook for fiscal 2Q. Bob, I'm just wondering if you can help quantify to your best estimate of how much impact you're carrying in revenue expectations relative to some of these "transitory effects"?

Yes, it's difficult to quantify, right, because there's impact in terms of our own execution, which I think we worked our way through pretty well during the quarter. And then we have customers who have supply chain challenges as well where they're trying to get match sets and build out their environments. And then, of course, we have supplier challenges as well, where we're working like everybody else, pretty hard to get components in. So it's difficult to give you a definitive answer in terms of what the impact was in the quarter we just closed or even obviously, in the next quarter. But it's certainly somewhere in the couple of hundred million dollar range and potentially a little worse in the December quarter.

Aaron, this is Dave. First of all, thanks for the question. I guess the one thing I would say as well is, whereas maybe a quarter or 2 ago, we were seeing it in maybe certain parts of the business, some of the OEMs, PC OEMs. Now we're seeing it more broadly, even the big data center players are having their demand impacted. Our demand from them is being impacted by their ability to get other components. So it's really become a much more broad-based issue across the portfolio.

Yes. And then if I can follow up real quickly, one of the things that stands out to me is that I think you reported a blended ASP decline of about 3% sequential in the flash business. So I believe the mix of enterprise actually went up to the positive. So when I look at that ASP erosion relative to actually some of your peers in the NAND market, it seems to be a bit of a disconnect. Can you help me understand the pricing dynamics you're seeing in NAND right now?

Yes, I can begin, and then Dave can provide additional details. At the start of the quarter, we indicated that we expected a decline in the blended average selling price, which was based on the mix we anticipated. The mix turned out as we expected. I won’t go into all the specifics, but we did mention earlier in the quarter that we expected an increase in mobile volume during September, and that’s what occurred. In fact, we anticipate even more mobile volume as a proportion of the total in the December quarter. While the mix presents a challenge for us, the average selling prices are not decreasing significantly. We are also very pleased with the cost reductions we achieved in the last quarter and what we expect for this quarter.

Yes, I guess, Aaron, Bob is right on the money on that. I guess the only thing I would add is a little bit of softness in some of the transactional and consumer markets, but that we're already seeing that level out a little bit. And we're really seeing this bifurcation where the qualified bits in the market are strong and the unqualified are a little bit weaker. I guess that's not surprising given all the nodal transitions the industry is going through. But the primary issue, I would say that's the issue in mix, as Bob pointed out. And we expected that walking into the quarter.

Our next question will come from C.J. Muse with Evercore.

I guess if I look at your revenue guide and kind of the commentary on NAND bits, it sounds like the implied HDD revenue guide is roughly down 15% sequentially. So I guess, A, is the math right there? And B, I guess, what's causing the severity of decline? Can you kind of help us understand what's digestion versus some of the transitory supply chain issues that you spoke to?

Yes, I think your number might be a bit high. We don't provide guidance for each business individually, but you've highlighted some of the challenges. Part of it is due to mix, and we have a major customer facing their own supply chain issues, which is delaying some orders. Additionally, there are supply chain challenges, especially in the mid-cap segment, affecting our ability to meet demand. We've discussed this in the recent quarter regarding the strong smart video market, where there is unmet demand. We are also experiencing some inventory challenges in China, particularly with high-cap inventory, which is putting downward pressure on next quarter's numbers. However, we believe these are temporary issues. We're quite pleased with our portfolio, particularly since AT&T now represents the majority of it. We mentioned shipping 20-terabyte on a 9-disk platform and the successful adoption of OptiNAND. Overall, we feel confident about the innovation delivered this quarter and the future direction of our drive business, with the new technology being well received.

That's great. And I guess as my follow-up, Bob, could you speak to how we should be thinking about gross margins into the first half of '22? Obviously, there's certain unknowns in terms of revenues and NAND pricing. But would love to hear perhaps some of the other puts and takes that we should be thinking about as well as the timing of when you think some of the COVID-related costs may abate?

Yes, C.J., you're correct. It's challenging to predict exactly what will unfold in the upcoming quarters. However, we provide guidance on a quarterly basis. That said, we are quite optimistic about 2022. We believe that many of the challenges we faced in the previous quarter and are experiencing now are primarily due to supply chain issues. The demand dynamics are very encouraging. As I mentioned regarding our cost reduction strategies, we are confident in our ability to maintain solid margins. While I won't offer guidance for next year, we remain optimistic.

Our next question will come from Joe Moore with Morgan Stanley.

I wonder if you could update us on where you are with BiCS5 qualification? I assume saying you'll be mobile heavy this quarter means you're kind of still getting qualified across the SSD markets? And I had a follow-up.

Yes, I think that's right. I mean it’s early in the node. We are happy with the ramp this quarter. We ended at, I think, 17% BiCS5, and we expect to get crossover before we exit the year. But like any new node, you're in more of the mobile components market as the rest of the products get qualified, but that's all work underway. And our customers are definitely pulling us in that direction. They want BiCS5 on the SSD products and the engineers are hard at work at getting that work done. That will be an evolving story as we work through '22.

Great. Thank you. And then I think you referenced some of the segments in client SSD maybe being a little weaker. Can you separate out? Is there a Chi effect there where it was good for a while and then it was less good versus just overall client SSD being oversupplied because of other issues in the supply chain? Like how do you sort that out? And what do you see happening in the client SSD market?

I don't think we see it as a Chi effect. I mean, I was just talking to our sales team this morning, and I think the channel has now kind of normalized and back on seasonality after the Chi disruption. I think we just see this issue with people not able to get all the components they need to put together the full kit for what they want to ship, and that's causing some softness in the channel. So I think it's more related to that than it is anything Chi related, at least in my view.

Our next question will come from Karl Ackerman with Cowen.

Bob, earlier in a response to a question, you had indicated some of the impact or challenge in your enterprise, I believe, HDD business and SSD business was a result of a pushout by a customer. My question there is if we isolate that customer, how do you see the demand trajectory of cloud in mass capacity markets not just into the December quarter, but also into the second half of your fiscal year? Certainly, as you begin to ramp some of these 20-terabyte drives and other higher capacity drives in HDDs as well as some of these new design wins you have in enterprise SSD.

Do you want me to take that or you?

I can start. Yes. So I think as a general statement, we're seeing continued very strong demand from our data center customers, especially we've very big data center customers. They're giving us good signals about next year and what they plan to do. It's hard to pin that down to a certain quarter right now, but we continue to see very strong demand there. Like I said, we're starting to see the supply chain impact show up there as well. But I'm sure that will all get worked through as we go through the year. But we look into '22, and we have our customers telling us, it continues to be a strong demand environment.

Yes. I don't think I have anything to add. I mean we believe in the cloud demand. I think it's strong, and there just is a lot of supply chain dislocation right now.

Our next question will come from Wamsi Mohan with Bank of America.

This is John on behalf of Wamsi. I wonder about the media attention on Kioxia. In the past, Western Digital has shown interest in the asset. Do you believe consolidation is still a viable option? And do you still have interest in pursuing it?

I believe Kioxia is an excellent joint venture partner. We've discussed the benefits of this partnership extensively. One of the key highlights of the quarter is our ongoing production of the flash roadmap and BiCS5, which is positively impacting our cost structure. The Western Digital and Kioxia teams have consistently prioritized capital efficiency and cost reduction. The groundwork for the BiCS5 performance we're observing now was laid long ago, and the focus remains strong among our joint teams. Collaborating with a supplier as significant as Kioxia enhances our investment in our roadmap, and we also benefit from producing together and achieving various synergies. This partnership has been successful for over 20 years, and we're committed to it for at least another decade. We continually assess our investments in fabs, and we are pleased with this partnership, which we intend to maximize.

Our next question will come from Mehdi Hosseini with SIG.

Two questions. The first one is for the team. Obviously, there is a long lead time associated with the equipment procurement. So at this point, I would think that you have a pretty good feel for bit, NAND, bit supply growth in calendar year '22. Is there any color you can share with us? And I have a follow-up.

Yes. I mean we do have good visibility, and you saw our bit growth came back up again this quarter. We expect it to be a bit higher year-over-year next quarter. Our long-term goal continues to be to grow at the rate the market is growing, and we won't get that perfectly every quarter, but that's our objective. And we think that, again, with Kioxia, we've got the right plans in place for next year.

But what is the target for next year, calendar year?

Yes. I don't think we put a specific number out there yet. Some of the industry analysts suggest industry demand growth in the low 30% range.

Got it. Thank you. And given the fact that your enterprise and cloud customers are expressing a good solid demand in calendar year '22. Have you determined how to allocate, and perhaps I'm trying to better understand how you're thinking about the mix between cloud enterprise and client and consumer.

Yes, we are definitely having those discussions. Each quarter, we review the current performance and look ahead for several quarters. While we don't commit to specific numbers, we consider our share of their businesses and what that implies for our demand. So, these conversations are ongoing, and we're incorporating them into our planning for next year and how we will distribute resources across our portfolio. There’s also a consideration of product availability from different manufacturing locations, and we are currently working through all these details.

Our next question will come from Timothy Arcuri with UBS.

I would like to return to the HDD guidance and inquire about the normalized base of revenue. Your peer has indicated flat guidance, while you are showing a decline in the low teens. This seems to suggest a figure around $2.25 billion. It appears that part of this is a delay and some may be due to specific supply-side issues. Could you clarify this situation for us? Is a 2.6% figure indicative of a flat normalized level if we account for these factors? Or is it slightly down quarter-on-quarter, but not down in the low teens?

Yes. I mean, again, it's hard to quantify exactly what the supply chain impacts were, and we're actually not giving guidance by segment, but we definitely believe the hard drive business is a growth business and it will continue to grow over the next few quarters. We think 2022 will be a strong year. And yes, this is a bit of an aberration in the December quarter, but the business is really solid. The underlying demand is very good. And you're right. I mean we already commented that there are some supply chain issues that are impacting us right now.

Our next question will come from Toshiya Hari with Goldman Sachs.

Dave, I wanted to ask about enterprise SSDs. You talked about now being qualified three cloud titans, which is great. You also talked about some of these wins translating into revenue growth and potentially driving an acceleration in '22. Can you help us kind of shape the ramp into '22? Could it be more first half weighted, second half weighted? I know these projects can move around a little bit. But any help there would be really, really helpful. And then related to that, the impact on profitability as you ramp that business, initially, would it be a headwind and then eventually a tailwind? Or should it be fairly margin neutral from the get-go?

We are very pleased with the progress of the portfolio. A year ago, we were focused on our first project, and now we have successfully completed three. We are still engaging with the enterprise OEMs, which typically involve longer sales cycles, and we are making solid advancements there too. We have finalized the calls, and we will begin seeing some deployments next quarter, with a ramp-up expected throughout 2022. This is an evolving situation as we move through the year. The total addressable market looks very appealing, and we expect good margins, which is why we are investing in our products. As we increase our involvement and improve our supply, it will benefit the overall portfolio. This is certainly a true observation.

Your next question will come from Ananda Baruah with Loop Capital.

Yes, I guess my question would be for whatever it is that you guys consider to be the revenue impact to the December quarter guide, could you just sort of anecdotally map out for us how much is from the flash business relative to HDD? And then inside of HDD, how much would be from the impact of kind of the cloud type. It sounds like there's some component stuff on their side there? And then you had mentioned some channel dynamics and some WD dynamics as well on the PC business. That would be helpful.

Yes, I’m trying to think of a different way to answer this question. We aren’t providing guidance by segment, but we do expect revenue to decline slightly in the hard drive sector while anticipating a sequential increase in the flash sector. There are supply chain issues affecting some cloud customers and certain PC OEMs. Additionally, we noted that there appears to be considerable inventory in China at the moment. Therefore, we're facing some short-term challenges in the hard drive business. However, looking at the long term, the underlying growth in that area remains strong.

Your next question will come from Vijay Rakesh with Mizuho.

Just had a couple of quick questions. On the client SSD side, as you look at next year, just wondering how you're thinking, what the outlook was. I know server looks pretty strong for next year. But on the client SSD side and on mobile too, how are you looking at next year's demand?

Yes. We believe the total addressable market for PCs will be solid next year. We're clearly coming off a strong year due to COVID. The pre-COVID baseline was around 265 million to 270 million units, which surged to an expected 340 million this year. For next year, we anticipate demand to settle between 320 million and 335 million units. While we expect a slight decrease from this year, the baseline has significantly increased compared to pre-COVID, and we feel positive about that. We've been communicating with our customers about their plans for 2022, including their supply needs, and those discussions have been productive. In the smartphone market, we've continued to observe strong performance this past quarter. A broader point regarding the flash market is that the diversity of end markets has improved, particularly with the growth of enterprise SSDs, leading to a more balanced demand mix. We are seeing positive trends in PCs, smartphones, and data centers. The more transactional markets this past quarter experienced notable changes, with increased availability of bits in those areas. As we move into a seasonally strong retail quarter, we will gain better insights into how retail will perform, especially throughout the holiday season.

Our next question will come from Sidney Ho with Deutsche Bank.

Relates to hard drive business, earlier, you talked about inventory issues in China. Can you add a little color to that? How much excess inventory are there? Do you think that will get back to normalized levels exiting the year? And any other geography you're watching out right now?

That's the main geography we're watching, and it's mainly high capacity, and we think it will get worked through in the next quarter. But it's definitely in the channel and it's some of the big customers. So it's just something that's going to impact the amount of business that flows through that part of the market, which is a pretty big market for all of us, but we don't see it more than a quarter, maybe a little bit more of impact.

Our next question will come from Patrick Ho with Stifel.

Bob, on the prepared remarks, you talked about the different variables in terms of the supply chain shrink and the suppliers, your own manufacturing efficiencies as well as the customers. Can you for both September and December give kind of a qualitative commentary on which were the biggest impacts in both September and December?

Yes. I think what I said earlier is we're actually expecting December to be a little more challenging than what we saw in September. The September quarter was not easy. And starting with our own teams, I think we did a really good job given what was going on with COVID in Southeast Asia. We did mention our COVID costs were up to $56 million this quarter. And we've done a really excellent job in terms of working with local governments to try and get as many employees vaccinated as possible and to really do the best we can to assure supply in terms of our own factories. Now as we mentioned, like everyone else, we have challenges in terms of getting components as well, particularly, obviously, the controllers on both the hard drive and the flash side, and that has an impact on the business. I don't know quarter-to-quarter, which quarter is worse, but it's a challenge in both of them. And it's a challenge that's not going to go away soon in terms of semiconductor availability. I mean we're getting some lead times of 50 weeks right now. So it's definitely a very real issue in terms of getting components in. And then we've already talked a fair amount about the customer challenges. And I would say it feels to me and Dave can comment like there are more customers impacted by the supply chain in the December quarter than there were in the September quarter. It seems a little more broad-based.

Yes, there is no doubt about that. When we communicate with our sales teams and customers, we have recently heard an increase in instances where they are unable to meet their true demand or can't source the necessary components for building their own infrastructure due to supply chain issues. This started with some PC makers, as we noted a few quarters ago, and now we are seeing similar challenges in other areas, including major data center providers. This has a tangible impact on our business, and we are navigating through it. The end demand remains very strong, and everyone is striving to figure out how to fulfill that demand and obtain the right components to build the necessary equipment, whether for resale or for their infrastructure needs. Our ability to secure components and keep our factories operational has been challenged, especially during this quarter, which was likely one of the most difficult since COVID began. We experienced significant employee quarantines and still managed to maintain operations. Given the current situation on the ground and the supply chain discussions, it’s clear why this is such a critical issue. The positive aspect is that we are working diligently with governments to facilitate vaccine distribution and restore normalcy. As we near the end of the quarter, we see improvement compared to a few months ago, which gives us optimism heading into 2022 that the situation will be resolved and we can meet the existing demand.

Our next question will come from Harlan Sur with JPMorgan.

So on your client business, you guys talked about the PC market being weak in September due to supply disruptions at customers. We all know about the match set challenges on component shortages, that's been pretty well telegraphed. But you also mentioned the WD sort of specific supply chain disruptions on client HDD as well. Is the primary impact the shortage of HDD controllers and preamps or is the primary impact on the COVID-19 related sort of operations disruptions? And given your semiconductor suppliers' lead times, when do you expect to see your client HDD specific chip supply issues start to ease?

I'll give my perspective first, and then Bob can provide additional insights. It really depends on your viewpoint. Our COVID-related costs have increased significantly this quarter, likely around 50% to 60% compared to last quarter. We had been relatively stable over the previous three to four quarters, but now we've seen a substantial rise. A significant portion of these costs is related to managing our infrastructure and the work being done by our teams. Logistics also plays a considerable role in these expenses. The rising costs are primarily tied to our supply of controllers. As Bob mentioned, we are planning ahead with lead times and collaborating with our suppliers to ensure we secure everything necessary to meet our demand, which has been quite challenging, and also to receive it within the required timeframe. We're navigating this situation. Looking back over the past few quarters, we've acknowledged our inability to meet the demand we observed. However, this quarter presents a new challenge as we are witnessing a broader impact across our customer base, affecting areas where we hadn't previously encountered issues. This situation is increasing uncertainty and dampening demand since customers are unable to obtain all the components they require, which means they don't need everything from us. So we're starting to see some hints in some markets, starting to clear up a little bit, super early days. But again, if you look at what's going on in the ground in Asia, things are getting better, at least from our perspective, our narrow perspective, although we have 40,000, 50,000 people there. Things are getting better on the ground and that gives us optimism that the situation will improve from here as we go through '22.

Our next question will come from Tom O'Malley with Barclays.

I had another one on the HDD business. You guys have done a really good job of improving profitability over the last year plus. My question is, as related to supply issues, clearly, there's a revenue headwind here. Could you talk about the impact to gross margins? Do you expect that you see a greater impact there because of the supply issues? Or is this more of a revenue issue with gross margins kind of hanging in? Any help there would be nice.

Yes. Let me start and then turn it over to Bob. I mean I think there are some headwinds. I mean one of them would be a little bit of mix because at least for a 1 quarter impact because we've got such a big customer pushing out some demand. And then you've got pricing going up on components. So you've got inflation in the supply chain is a bit of a headwind as well. All that said, we appreciate your comments. The team has worked extremely hard. We've rolled out a lot of innovation in the drive business and driven the gross margins. 30.9% this quarter, we thought was a great result. And on top of that, we had couple of points of COVID headwind on top of it. So it all starts with making sure we deliver a great product to our customers. It starts with innovation. You guys have heard me say this many, many times, and I think the innovation engine is alive and well. Another big step forward this quarter with OptiNAND. And I think as the team continues to drive innovation and we drive great products to our customers, we'll have the opportunity to continue to have a better conversation with our customers around profitability. All that said, there are some headwinds, I would say, in the near term.

Yes, there are definitely headwinds. But like you said, the team has done a great job in terms of the product portfolio, and we think the gross margins will be down a little. We are going to have probably COVID costs in the same ballpark as we have this quarter. So that's a couple of points. But I think we've got a really good chance of having gross margins above 30%, again, on the hard drive business.

Your next question will come from Jim Suva with Citigroup.

I just have one question, and it sounds like the December outlook is truly an aberration. So the people will push back and say, well, why is it truly an aberration and not simply the new norm? So maybe if you can just walk us through around why December is so unique because whether it be supply chain or shipping costs, they look quite prolonged. So if you could just kind of lay out the reasons about why December is so unique for such aberration?

We are currently in a very unique time. The supply chain disruptions caused by COVID, particularly the Delta variant affecting Asia over the last quarter, have been significant and severe. The teams managing the situation on the ground did an excellent job under tough circumstances. This has created a very unique environment for us. Regarding demand, our customers are expressing very positive sentiments, although the ability to build varies among different customers and is constantly changing. The results for any given quarter reflect this complexity. As supply chain issues are resolved, we believe demand trends in the business remain strong, and we are well-positioned to benefit from technological advancements. Notably, 44% of our revenue this quarter came from the cloud, which is a record. We hope you appreciate our clearer breakdown of revenue among cloud, client, and consumer segments. We anticipate continued growth in the cloud, with 72% year-over-year growth in that sector, and we are actively shifting our portfolio to participate in this growth moving forward.

Our next question will come from Steven Fox with Fox Advisors.

I am trying to understand the notion that none of the demand delays are temporary, especially since this is typically the strongest quarter of the year. How can we be confident that spending that usually happens in December won't be pushed to March, even if there is availability, simply due to the usual timing of expenditures?

I believe this relates to large cloud providers working to develop their infrastructure. If they can't secure everything they need this quarter, they'll acquire the necessary components in the following quarter. We are observing a strong demand environment, and as our customers obtain the components they require, they will come back to us to adjust their demand accordingly. We maintain close relationships with them, so I don't view their demand as a short-term issue. Instead, it's a continuous demand trend. Everyone is focused on acquiring as many components as possible to complete their projects. As they achieve this, they update their demand signals with us. For instance, some PC manufacturers may significantly reduce their demand one quarter, only to increase it the next quarter when they resolve their supply chain challenges. We've encountered similar situations in various sectors and have the experience to manage them. Currently, we're observing this trend across a wider range of our business, including some very large customers. We've been navigating these challenges over the past few quarters and will continue to do so this quarter.

Yes. And the most seasonal business is the consumer business, and we are expecting to have a sequential increase in the consumer business. So I think that's probably where it might be perishable demand. But we think that will be pretty solid this quarter.

And today's final question will come from Srini Pajjuri with SMBC Nikko Securities.

Dave, I had a question about your pricing strategy going forward, especially given the cost inflation we are seeing in the supply chain. I guess some of the cost increases are temporary and some may be permanent. I'm just curious as to hear your thoughts in your conversations with your customers, what kind of feedback you're getting as you kind of look to pass through some of these costs to your customers? And also I want to hear about what you think your ability is in terms of passing through some of these incremental costs if these costs continue to, I guess, remain permanent?

You touched on the key point in your initial question. We have long-term relationships with our customers, and they don’t fluctuate rapidly. We communicate with our customers when costs rise, but it’s not a straightforward process of simply passing costs on. We need to see persistence in these cost changes before discussions occur. Additionally, we operate within a market context, so market pricing plays a significant role. The main concern regarding pricing revolves around innovation, and we must ensure we continually drive innovation throughout our offerings. Reflecting on the last quarter, two major highlights stand out: first, the team's impressive execution during challenging circumstances, especially regarding our facilities in Asia; and second, our innovation roadmap, particularly our aggressive transition to BiCS5. We recently launched OptiNAND and have a 20-terabyte drive set for volume shipments in the coming month. This drive features our energy assist technology with a 9-platter, 9-disk configuration, each platter holding 2.2 terabytes. This situation will lead to innovation-focused discussions with our customers on pricing. On the cost side, we’ll engage in conversations if they are long-term. However, we maintain long-lasting relationships that allow us to navigate periodic fluctuations effectively. Our primary emphasis remains on innovation; when we foster innovation, we tend to achieve better returns. Over the past three to four quarters, particularly with our 18-terabyte drive featuring energy assist technology, we've observed significant results, as evidenced by a 30.9% gross margin in HDD, a multiyear peak. We’re optimistic about this trajectory.

And speakers, that was our final question. I'll turn it over to you for any closing remarks.

All right, everyone. Thanks for joining us. We really appreciate it. It's always good to talk to everyone. Thank you for all your questions, and we look forward to talking to all of you throughout the quarter. Take care.

Thanks, everyone.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.