Good afternoon, and thank you for standing by. Welcome to Western Digital's Fiscal Third Quarter 2022 Conference Call. Presently, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. As a reminder, this call is being recorded. Now, I will turn the call over to Mr. Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations. You may begin.

Thank you, and good afternoon, everyone. Joining me today are David Goeckeler, Chief Executive Officer; and Wissam Jabre, 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, demand and market 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 introductory remarks.

Thank you, Peter. Good afternoon, everyone, and thanks for joining the call to discuss our fiscal 2022 third quarter results. We delivered excellent performance in the quarter, with revenue of $4.4 billion and non-GAAP gross margin of 31.7%, both of which are at the higher end of our updated guidance ranges we provided in early March. Additionally, we reported non-GAAP earnings per share of $1.65, which exceeded our revised guidance. I am proud of the team's execution as we navigated the dynamic geopolitical and macroeconomic environment as well as ongoing supply challenges. On top of that, we successfully managed through a fab contamination event that is now fully resolved. Overall, the Western Digital team did an amazing job of meeting our customers' growing and evolving storage needs. This has all been made possible by the operational and technological improvements we have made over the last couple of years that enable us to unlock the true earnings power of the Western Digital model. Looking ahead, we are optimistic about the business outlook for calendar year 2022. We believe the secular demand for storage in our new product ramps in HDD and Flash, combined with the seasonally stronger second half of the calendar year, will drive growth across our end markets. With 40% of the world's data stored on Western Digital products, our innovation powers the global technology ecosystem from consumer devices to the edge to the heart of the cloud. Our vision is to create breakthrough innovation inspired by the convergence of human potential and digital transformation that enables the world to actualize its aspirations. At Western Digital, we have established an admirable position in the large and growing storage markets. Our proven ability to develop a diversified portfolio of industry-leading products, coupled with our broad routes to market, puts Western Digital in a unique position to capitalize on the promising growth opportunities ahead of us. I'll now turn to an update on our HDD and Flash businesses. Our HDD revenue was as forecast and in line with typical March quarter seasonality led by growth in capacity enterprise drives. Robust demand in the cloud end market for 18- and 20-terabyte drives generated a nearly 40% increase in nearline revenue from the same period last year. Of note, our 20-terabyte drive exabyte shipments approached high single-digit percentage of total capacity enterprise shipments. During the quarter, qualification of OptiNAND-based hard drives progressed as planned across multiple cloud and OEM customers. Combining OptiNAND with our SMR leadership uniquely positions Western Digital in the marketplace. Putting it all together, we have positioned our innovations in OptiNAND and SMR to drive business results in our capacity enterprise business for the rest of this calendar year and into the future. Our largest cloud customers are aligned with this strategy and are accelerating adoption of SMR products within data centers later this year. We are laser-focused on bringing new cutting-edge features and functions to our products for cloud storage. We will provide more details around these exciting innovations at our Investor Day on May 10. Turning to Flash. Our overall business was impacted by our ability to ship product due to the fab excursion. In light of this event, coupled with the supply chain challenges facing all companies across the industry, I would like to thank our customers and the Western Digital teams for working together diligently to mitigate the impact of supply chain disruptions. From a product perspective, client SSD demand improved in the quarter as our PC OEM customers successfully worked through their own supply chain issues. Gaming is another growth market for us, where we continue to have success with exabyte shipment nearly doubling year-over-year. We have a leading position in the marketplace with our brands, including WD_BLACK, SanDisk and SanDisk Professional, recognized globally for cutting-edge innovation, performance, and quality. An example of this is our WD_BLACK SN770 SSD product, which leverages our cutting-edge BiCS5 technology, an in-house DRAM-less controller architecture. This SSD product is one of the fastest and best drives available in the market. We have received excellent reviews from tech journalists, which is a great testament to the company's strength in both our BiCS technology leadership and our ability to develop innovative solutions, enabling our customers to unlock the potential of their PCs. Qualifications of BiCS5-based products for client and consumer end markets were largely completed, and we are making great progress in qualifying our next-generation BiCS5 enterprise SSD products. We expect these products to drive revenue growth and mix improvements into the future. Lastly, BiCS5 represented nearly half of the Flash revenue, up from 41% in the previous quarter. Let me now offer a few observations on the demand environment. In cloud, we see continued strength in calendar year 2022. The increase in cloud capital investment for data center build-outs is expected to propel growth for our HDD and Flash products in this growing end market. In client, PC end demand growth has been solid for the last two years, and we are starting to see some normalization in the PC market. We expect PC unit demand to remain significantly above pre-pandemic levels, with the return-to-site trend driving a mix shift towards commercial and enterprise PCs with richer client SSD content versus consumer-oriented PCs. In mobile, we have a strong position in 5G phones and we see demand for the latest 5G flagship phones remaining solid, with NAND content doubling from prior generation smartphones. In other emerging applications, demand from gaming and VR/AR devices remains robust. Industry analysts expect VR headset sales to grow at a 47% CAGR over the next couple of years. In consumer, we are experiencing short-term demand weakness outside the U.S. tied to the geopolitical events in Europe, as well as COVID-related lockdowns in China. However, we are confident in the strength of the business as we are entering a seasonally stronger second half of the calendar year with a number of new innovative products. We feel good about the overall demand in calendar year 2022. We are continuing to navigate the macroeconomic and geopolitical factors I mentioned earlier. While these transitory issues are affecting both revenue and gross margin in the near term, we expect them to subside over time. We are confident that the growth and profitability opportunities in front of us have not changed. In closing, I want to acknowledge the hard work and unrelenting spirit of our employees that goes into creating our game-changing products. In particular, I want to thank our employees in China for their efforts to work through all the supply chain and logistics challenges during the lockdowns. Before turning the call over to Wissam, I wanted to make a quick announcement that Western Digital and the IRS have reached a tentative agreement to resolve a long-running tax matter, covering the fiscal years 2008 through 2015. With offsetting tax benefits, we expect the ultimate net amount will be in the range of $500 million to $600 million. While this settlement will result in a previously unforecasted cash payment in fiscal year 2023, it does highlight the work that I and the rest of the Western Digital team have undertaken in the last two years to instill strong financial discipline and provide greater financial flexibility upon which we are building a foundation for future growth for the company. Wissam will go into more detail in a minute. Let me now turn the call over to Wissam, who will discuss our fiscal third quarter results and provide a more detailed outlook for the fiscal fourth quarter.

Thanks, David, and good afternoon, everyone. As David mentioned, overall results for the fiscal third quarter were better than our revised expectations. Despite the incredibly dynamic macro environment that David discussed, our results reflected the resilience of our business and our ability to continually deliver solid financial performance. In addition, we completed a debt restructuring with our lenders in the March quarter, marking continued success in paying down debt and providing increased financial flexibility and stability. Total revenue for the quarter was $4.4 billion, down 9% sequentially and up 6% year-over-year. Non-GAAP earnings per share was $1.65, above the revised guidance range of $1.30 to $1.60 we provided in early March. We are pleased to have delivered such strong results in the face of the challenging environment. Turning to our end markets. Cloud represented 40% of total revenue at $1.8 billion, down 8% sequentially and up 25% from a year ago. Within cloud, Western Digital's leadership position at the 18-terabyte capacity point and ramp of 20-terabyte drives drove a nearly 40% year-over-year increase in nearline revenue. This growth was partially offset by lower enterprise SSD and smart video hard drive revenues. The client end market represented 40% of total revenue at $1.7 billion, down 7% sequentially and 2% year-over-year. The sequential decrease was primarily due to typical seasonality in both Flash for mobile and client hard drives. On a year-over-year basis, growth in Flash was offset by a decline in hard drive. Lastly, Consumer represented 20% of revenue at $0.9 billion, down 17% sequentially and 8% year-over-year. On a sequential basis, the decline was primarily due to lower retail Flash shipments. The year-over-year decrease was roughly evenly split between hard drive and Flash products. Turning now to revenue by segment. We reported Flash revenue of $2.2 billion, down 14% sequentially and up 3% year-over-year. On a blended basis, Flash ASPs were down 1% sequentially. On a like-for-like basis, Flash ASPs were down 2% sequentially. Flash bit shipments decreased 14% sequentially and increased 9% year-over-year. During the quarter, we recognized the majority of the bit supply impact caused by the fab contamination. Hard drive revenue was $2.1 billion, down 3% sequentially and up 9% year-over-year. Sequentially, total hard drive exabyte shipments increased 1%, while the average price per hard drive increased by 4% to $101. On a year-over-year basis, total hard drive exabyte shipments and average price per hard drive increased by 20% and 22%, respectively. As we move to costs and expenses, my comments will be related to non-GAAP results unless stated otherwise. In the March quarter, total fab contamination charges of $203 million were excluded from our non-GAAP results. Gross margin for the third quarter was 31.7%, down 190 basis points sequentially and up 400 basis points year-over-year, including approximately $59 million in COVID-related expenses. Our Flash gross margin was 35.6%, down 50 basis points sequentially and up 560 basis points year-over-year. Our hard drive gross margin was 27.7%, down 290 basis points sequentially and up 270 basis points year-over-year. Hard drive gross margin included COVID-related impact of approximately $51 million or 240 basis points. Operating expenses of $740 million were below our guidance range as we tightly managed our expenses. Operating income was $650 million, representing a 26% decrease from the prior quarter and a 58% increase year-over-year. Earnings per share was $1.65, up from $1.02 in the year-ago quarter. Operating cash flow for the third quarter was $398 million, and free cash flow was $148 million. Cash and capital expenditures, which include the purchase of property, plant, and equipment, and activity related to our Flash joint ventures on our cash flow statement, represented a cash outflow of $250 million. We remain disciplined in investing in manufacturing capacity and expect gross CapEx for the current fiscal year to be around $2.9 billion. We expect cash CapEx to be around $1.3 billion as we actively manage our overall spending. In the fiscal third quarter, we made a discretionary debt repayment of $150 million. Our gross debt outstanding was $7.25 billion at the end of the fiscal quarter. We ended the quarter with $2.51 billion of total cash and cash equivalents. Our trailing 12-month adjusted EBITDA at the end of the third quarter, as defined in our credit agreement, was $5 billion, resulting in a gross leverage ratio of 1.4x compared to 2.6x a year ago. 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 our earnings presentation on the Investor Relations website for further details. Before discussing our outlook, I wanted to provide some more details on the settlement with the IRS that David mentioned. As previously disclosed in our quarterly SEC filings, the company has been in a significant long-running situation with the IRS regarding taxes owed for fiscal years 2008 through 2015. As you can see in our GAAP statements, we took a tax charge in the fiscal third quarter, primarily based on our latest assessment of the situation. In the last few days, we reached a tentative agreement to settle the transfer pricing issues in dispute. The actual amount to Western Digital will have to pay and exact timing of the payments have not been determined yet. However, we currently expect to make a cash payment in the range of $600 million to $700 million sometime in the first half of fiscal 2023. Please note that this is the cash out number. We currently expect that the ultimate net amount will be in the range of $500 million to $600 million after accounting for certain offsetting tax benefits expected to be recouped over the next three years. Finally, in the fourth quarter, we will make a GAAP-only adjustment to the reserve associated with this settlement. You will find additional details in our 10-Q, which we plan to file next week. I'll now provide our view of both hard drive and flash businesses for the fiscal fourth quarter. As we indicated on our last earnings call, we continue to expect hard drive revenue to increase driven by growth in nearline hard drives. We also expect Flash revenue to increase sequentially in the fourth fiscal quarter as our flash supply improves. For our fiscal fourth quarter, our non-GAAP guidance is as follows: we expect revenue to be in the range of $4.5 billion to $4.7 billion with sequential revenue growth for both hard drive and flash businesses; we expect gross margin to be between 31% and 33%; we expect operating expenses to be between $770 million and $790 million; interest and other expenses are expected to be approximately $70 million; our tax rate is expected to be approximately 11% in the fourth quarter; we expect earnings per share to be between $1.60 and $1.90 in the fourth quarter, assuming approximately 317 million fully diluted shares outstanding. I'll now turn the call back over to David.

Thanks, Wissam. Looking ahead, we remain optimistic about our business outlook for the calendar year as customer demand across our end markets continues to be generally strong. Despite the supply chain challenges and macroeconomic factors we discussed earlier, it is evident that we have the right foundation for long-term growth, the right technology portfolio in place to meet evolving customer needs, and the broad routes to market necessary to scale our business. Over the last couple of years, we have planned and executed significant changes to improve our focus, sharpen execution and set strategic goals to place Western Digital in a position of greater strength. And I'm excited that we are witnessing the positive impacts of those changes. Before I wrap up, I want to remind everyone, we have an Investor Day coming up on May 10, and I look forward to seeing you all there. Let's start the Q&A.

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

I guess the question relates to your June quarter outlook. I would love to hear how you're thinking about any kind of ongoing implications to both the NAND contamination issue, what kind of impact that might have on your bit availability. And then secondly, in terms of the China lockdown, the impact on your HDD media side and whether that's pushing out any shipments beyond the June quarter.

Hey, C.J., thanks for the question. Yes, on the flash side, so first of all, as we said, the flash contamination issue is behind us in the fab. We expect bit growth next quarter. We won't be all the way back, but we expect to accelerate from where we were this quarter. As far as the situation in Penang and China, we did have that facility shut down for a couple of weeks. At the end of last quarter, we've mostly recovered that as far as being able to meet demand for this quarter. I would say that as a general statement, it's very difficult for everybody to meet what true demand is right now in the market. So between component shortages and the situation in China, it makes it really tough. But I think we were able to navigate through the situation quite well. Quite frankly, the team there did a fantastic job and has kind of recovered. There were some incremental costs as we saw in the HDD margin line that we didn't expect. But all in all, I think we navigated through the situation fairly well. For the coming quarter, yes, we're still dealing with the situations in China, but we think we'll be able to navigate through, although it is very, very dynamic. But we factored in all the risks into the guide, and we're comfortable with where the number's at. Wissam, anything to add?

Not much, David. I think you've covered it well.

Our next question will come from Aaron Rakers with Wells Fargo.

I'll stick to one as well. I'm just kind of thinking about the gross margin guidance into this next quarter. I think it was 31% to 33%. I was curious if you could help kind of unpack the variables. Maybe give us some color on how you're thinking about the flash gross margin relative to the hard disk drive gross margin. And I guess within hard disk drives, how much COVID-related expenses are you still embedding? Just any other variables you can help us appreciate on both those two segments.

I'll start on it, and Wissam can add. Regarding the drive business, last quarter we mentioned the 200 to 300 basis point impact we were anticipating. This quarter, we experienced a slightly greater hit than expected, due in part to some unforeseen costs in Shenzhen. Looking ahead, we believe we have reached the bottom and expect stability moving forward. In the flash business, we foresee an improvement in gross margin, considering the current supply-demand dynamics. Wissam, do you have anything to add?

Yes David, just maybe to follow on the comments or Aaron's question with respect to COVID, where we see the COVID costs going into next quarter are expected to be a little bit less than what we've experienced in the fiscal third quarter.

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

Just following up on the contamination issue. Is the 7 exabyte number that you guys talked about still the right kind of number to think about the lost production? And how does that split across the March and June quarters?

Joe, yes, that's still the right number. I mean the team will always work in kind of an evolving situation to see what they can do with the material that we had to take out. But I don't think it will be super material to the numbers. So 7 is a good place to work from. And we haven't split it up over the quarters, but the majority of it we took in the previous quarter.

Okay. And your joint venture partner, I don't want to speak for them, but like just in terms of assessing the industry situation, would have lost proportionally the same amount?

Yes. I'm not going to speak for them. But we have joint manufacturing facilities, for sure.

Our next question will come from Patrick Ho with Stifel.

Patrick, are you there? Why don't we skip over and try to get Patrick back in.

Okay. Our next question will go to Tom O'Malley with Barclays.

You're observing a strong trend in HDD pricing. Is this trend solely due to the shift towards nearline products, or are there underlying trends in other areas of the business as well? Any insights on this would be very helpful.

I'll provide a broader perspective on this, Tom. We are witnessing several changes in the industry, influenced by various COVID-related implications and costs. Essentially, we are transitioning from a time when there was an abundance of capacity for enterprise drives. Hard drives were readily available, and the focus was on maximizing their placement in factories to optimize absorption without incurring additional costs. This marks the end of the client era and the beginning of the cloud era. We are reaching the conclusion of that transition. There are significant industry dynamics at play, including the introduction of long-term agreements, which last year were still new but have now become mainstream among our major customers, offering us greater visibility for investments in this business. We no longer have much capacity to shift between client and enterprise or cloud, necessitating investments to adapt, which in turn is prompting a broader change in the industry’s approach to this technology. Our commitment remains to provide a strong total cost of ownership (TCO) model for our customers. Every new technology generation enables us to reduce TCO, but unlike before, where increased volume would absorb that capacity, we now need to invest in new volume, compelling the industry to evolve. We are delivering substantial TCO value, while also seeing a shift towards more visibility and value-based pricing, aimed at continuing to reduce TCO and improving the pricing framework. Additionally, the current environment is challenging due to rising input costs and inflation, and we are exploring pricing strategies to address those challenges.

Helpful. And if I could just sneak just another quick one in. On the flash side, obviously, you had a lot of disruptions during the quarter. It looks like the implied cost was relatively flat. When you're looking into the out quarter, you're obviously saying gross margins are up. You should see some pricing tailwinds given the industry. But Wissam, maybe any sort of color on the cost versus pricing impact in the quarter. I know you don't like to get specific, but obviously, given the situation, anything would be helpful here to kind of move on the moving pieces.

Yes, we do expect to continue making progress toward our long-term goal of achieving a 15% reduction in costs year-on-year. Although we encountered some challenges in the current quarter, they are influenced by several factors that we believe will stabilize in the coming quarters. For example, we are ramping up our BiCS5 technology and, like many others, facing some inflationary pressures as well as the start-up of our Yokkaichi Fab7. Nevertheless, we anticipate that for fiscal year '22, we will still achieve at least a 15% year-on-year cost reduction. We remain committed to meeting this target going forward.

Our next question will go to Timothy Arcuri with UBS.

This is Jason for Tim. Could you provide any insights on the trajectory of your HDD gross margins for the second half of this year? I'm asking because we expect to see some benefits from the stronger pricing environment at the end of the first half.

Yes. We expect that, as we mentioned last quarter, our situation remains similar. We anticipated the decline we experienced this quarter, and we initially thought gross margin would decrease slightly next quarter. However, we now believe it will remain stable. We expect improvement in the second half due to factors such as changes in product mix, fluctuating input costs, and some pricing advantages. Therefore, we expect next quarter to be the lowest point, with improvements to follow.

Our next question will come from Patrick Ho with Stifel.

I apologize before. Dave, maybe if you could give a little bit of color. You gave some very encouraging commentary regarding the data center and cloud spending into the second half of the year. One, are these because of the long-term agreements you're signing with customers? And maybe secondly, along with that question, how do you see the customer base in terms of this transition from 18 to 20? Is it a new set of customers? Or are your 18 customers quickly transitioning over to 20 terabytes?

Yes, let me elaborate on that and thank you, Patrick. It's primarily the same customers moving from 18 to 20 terabytes. As I mentioned earlier, the total cost of ownership improves as we progress. This is a key aspect of what we do. I frequently discuss innovation, and the advancements we've made with ePMR, OptiNAND, and SMR are integrated into our products. Each time customers transition to a new generation, they benefit from a better total cost of ownership. There are solid reasons to continue this progression. Additionally, we'll revisit the topic of SMR shortly. We're witnessing increasing momentum towards SMR, which represents the future of the cloud hard disk drive market. Major players are now adopting this technology, in which we've invested extensively. Regarding your other question, the long-term agreements do not drive spending but instead help stabilize it. The purpose of the LTA is to strengthen our relationships with key customers and provide better visibility two to three quarters ahead. In the past, transactions were largely quarter-to-quarter, or even more frequently. Given the investments required in heads and media to support exabyte growth, we need greater visibility now. The LTAs have been established with our major customers over multi-quarter periods, allowing us to adhere to them, which has effectively smoothed out fluctuations in their orders. Concerning the second half of the year, our major cloud customers continue to indicate strong demand, so we're optimistic about our transition from 18 to 20 terabytes as we progress through the year.

Our next question will come from Krish Sankar with Cowen.

It's for Krish. For HDDs, when do you expect the crossover between 20 terabytes and 18 terabytes? And can you please tell us if you did see slowdown in the VIA market for HDDs over the last quarter?

I expect the crossover to occur in the second half of the year. We're currently heavily focused on the 18 terabytes, which make up about 80% of our shipping portfolio, reflecting the market's sweet spot. As we progress through the year, we'll begin ramping up production of the 20 terabytes, so by the end of this year or early next year, we can provide a more specific date. The surveillance market and smart video market have been weak all year, largely due to the lockdowns in China. However, we anticipate some recovery and a return of deferred demand once those lockdowns are lifted. For now, the market won’t change until the COVID situation improves.

And if I can squeeze one in. Is surveillance margin accretive?

Is it margin? I don't think we will exceed that level. Wissam, do you have any thoughts on that, or Peter?

Yes. Actually, David, we don't break out down to that level of detail.

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

I have a couple of quick questions regarding flash. What are your expectations for full-year bit shipment growth for 2022? I understand you prefer not to discuss it quarter by quarter, but I’m interested in the annual perspective. Additionally, can you provide details on the gross margin for flash? You mentioned it might increase slightly next quarter. Are you anticipating a significant price rise, and how much does the product mix affect this? Also, Wissam, you mentioned the startup costs for Yokkaichi. Could you give us an idea of what that amount is?

I will let Wissam address the gross margin question. Our bit growth will decline this year, and we won't provide a specific number right now. However, due to the fab excursion, we will experience a decrease this year. We expect to recover over the next year or so; it will take time to return to our fair share of bits. Our strategy has remained consistent for a long time; we invest to maintain our share, as evident in our recent fab announcements with Kioxia. Wissam, would you like to discuss gross margin in flash a bit more?

Of course, David. Thank you for the question, Sidney. When we consider the flash business, I want to address your inquiry regarding the Yokkaichi start-up costs. They are not significant and actually much lower than those of the K1 fab start-up. We're looking at a brownfield expansion rather than a greenfield expansion. Regarding your question about our flash gross margin, that's included in our guidance. Mix always affects gross margin, whether actual or projected. However, as I mentioned earlier, we are still expecting to achieve a 15% or more year-on-year cost reduction for flash in fiscal year 2022. I hope this clarifies things.

Our next question will come from Mehdi Hosseini with SIG.

Yes. And just as a follow-up to the previous question, how should I think about the impact of FX exchange rate on the flash gross margin?

Thank you, Mehdi, for the question. I'll discuss the foreign exchange impact in general. Our strategy involves a layered hedging approach, which means we have more coverage for shorter-term hedges compared to longer-term ones. This strategy helps mitigate the effects of currency fluctuations over time. Typically, costs incurred within a quarter will not significantly affect the profit and loss statement until about 90 to 120 days later, due to manufacturing cycles and product delivery times. Therefore, the recent currency fluctuations we've observed are not expected to have a major impact on our financial numbers. For this quarter, and in our outlook for the fiscal fourth quarter, we anticipate that the impact on our cost of goods sold will be less than 1%. This figure encompasses all costs of goods sold, not only those related to the flash portion.

Okay. Can I not answer a question? Is FX more like a clarification?

So far, Mehdi.

Just back to David, given your LTAs and you sound confident that the cloud demand is going to sustain into the second half. How should we think about nearline exabyte growth prospect in calendar year '22 versus '21?

Exabyte growth in 2022 compared to 2021 is something I can look up quickly. If I analyze the data, we've consistently seen about 35% growth in exabytes in the cloud. This figure has remained stable. I usually consider fiscal years rather than calendar years, but I can provide you with the calendar year numbers later.

Okay. And I look forward to meeting you at the Analyst Day.

I look forward to it. It's going to be fun.

Our next question will come from Nik Todorov with Longbow Research.

David, you talked about SMR quite a bit on this call. Maybe can you unpack how should we think about the impact on SMR on mix, pricing, and margins, and HDD. Maybe can you touch on what kind of workloads are the cloud guys looking to deploy some more initially?

I'll hold off on discussing the workloads until our Investor Day, where we will provide more details. However, I want to emphasize that looking at the bigger picture, during the last quarter, we had significant engagements with two major cloud companies regarding SMR technology, and we anticipate substantial shipments toward the end of the year. Additionally, we received interest from another company looking to adopt SMR. It's evident to me that the capacity enhancements made possible by SMR are significant. We have invested in this technology for a long time, and the potential to achieve an extra 10% or more in capacity is attractive, especially given the large sizes of current drives, which are multi-terabyte. What reinforces my confidence is that implementing SMR requires some software modifications on the host side, and typically, companies are reluctant to undertake software work unless the benefits are clear. The interest from major players in investing in SMR for their data centers indicates that this technology represents the next growth phase in our industry. We'll discuss its implications for our portfolio at the Investor Day. Ultimately, innovation allows us to improve the total cost of ownership for our customers. When we enhance TCO, it opens up opportunities to engage in value-based pricing conversations, which is precisely what we are pursuing. Our ability to consistently reduce storage costs and improve TCO with each product generation through innovation positions us to create margins and deliver value.

Our next question will come from Nam Kim with Arete Research.

How should we think about some of your hyperscaler moving into their own enterprise SSD build? Do you expect such DIY enterprise SSD to impact your business negatively or just have a limited impact? Any color would be great.

I believe many of our customers are engaged in DIY projects, which is acceptable. However, it's unlikely that anyone operates with a completely fabricated solution, as there is a desire for diversity in supply chains. Even DIY projects create opportunities for us to provide NAND products, not solely the complete enterprise SSDs. Furthermore, those involved in DIY will also purchase enterprise SSDs to complement their setups. This highlights the significance of enterprise SSDs for the future of modern cloud data centers. This technology is crucial, and we are pleased to work with the largest customers and be recognized by them for our technology.

Our next question will come from Jim Suva with Citigroup.

Thank you. And I look forward to seeing you all next month. But before that, it's great to see that the contamination issue is kind of behind us, of course, working through that. With that being said, the cost of all that, is that solely borne by Western Digital? Or does your supplier kind of remunerate you for that, or make up for it in future pricing or some type of insurance? And most critically, what are you doing? Have you put in something to make sure such a thing doesn't happen again?

Yes, I can provide more details when available. The issue is fully resolved. The team has done an excellent job identifying the root causes and implementing measures to prevent a recurrence. Should it happen again, we have systems in place to catch it early. Regarding the costs, they are shared between us and our joint venture partner, and we will evaluate the possibility of recouping any expenses once we have fully moved past this situation. Is there anything you would like to add, Wissam?

I think you've covered it well.

Thank you. Our next question will come from Steven Fox with Fox.

I was wondering if you could just talk a little bit more about the hard disk drive pricing. So as you mentioned, your ASPs were up 4% in the quarter. But can you talk a little bit about the like-for-like pricing currently and for the rest of the year, how you're approaching it maybe differently by the different segments. And whether it's being impacted by the sort of extended lead times you've talked about in terms of where you're maybe putting more bits than maybe you were a year ago.

I want to emphasize that our pricing strategy begins with delivering value. We're continuously innovating to enhance that value. We're also actively working on pricing adjustments to help offset some of the increased input and logistics costs we've faced. This effort spans our entire portfolio. Additionally, we're engaging with our customers to discuss the value we offer with our next generation of drives and how we can transition to a value-based pricing model. I don't have much more to add on this subject. Wissam, do you have any insights to share?

No, not on this, David.

Our next question will come from Christian Schwab with Craig-Hallum.

I just have a quick question on disk drive gross margins. Given the positive impacts of mix and decreased input costs and value pricing, if we have a China COVID shutdown end, is there any reason why the disk drive business can't be operating at plus growth exiting calendar year?

Yes. I mean, so I think we broke those numbers out. Wissam, I think he's got the details, he had it in his remarks. But I mean, if you just took all the COVID cost of business right now, I think we'd be about 30%, right, Wissam?

Yes, that's very true, David. We had around 240 basis points related to COVID costs in the quarter. We've mentioned that our results were slightly impacted by COVID lockdowns. We continue to face short-term inflationary cost pressures due to supply chain disruptions. To answer your question, I wouldn't want to specify where the margins will be in Q4, but I can say that we expect the margins to improve in the second half of calendar year '22.

Yes. We're not committing to your number, but generally speaking, we've faced a lot of additional costs in the business. We've mentioned logistics costs and increased input costs that have significantly impacted us this past quarter. As the world recovers from the pandemic, which is the main point you're making, we anticipate logistics returning to a steady state and input costs stabilizing. This should alleviate many costs for the business, and although it may be obscuring a significant fundamental structural change underway, I've discussed this extensively. The HDD market is a growing segment, and we will need to invest capital to expand our heads and media capacity. When that occurs, I believe the economic situation will improve. The crucial aspect in this scenario is whether we can continue to innovate and offer products that provide greater value to our customers. We are focusing on innovation, from ePMR to OptiNAND to SMR, to create better value propositions and enhance our products for customers, leading to value-based pricing. If we can achieve both progress in innovation and cost reduction as we move past pandemic impacts, we feel very positive about the business.

Our next question will come from Mark Miller with Benchmark Company.

I'm just wondering in terms of mix, NAND mix, how is that progressing in terms of mobile versus the other segment you ship into? Are you seeing increasingly more shipments in the mobile? And where do you expect that's going?

There are a few factors to consider here. Over the past couple of quarters, we have seen a higher shift toward mobile as we ramped up BiCS5. We mentioned in our prepared remarks that we have completed our qualifications of BiCS5 in both the consumer and client SSD markets, which allows us to accelerate our mix into BiCS5. A significant amount of effort is also being directed toward qualifying our enterprise SSDs on BiCS5, and as that progresses throughout this year, we anticipate a similar acceleration in that market as well. Currently, we have more demand for enterprise SSDs than we can satisfy since they are still based on BiCS4. As we transition to BiCS5, we expect to see a change in the mix and an increase in enterprise SSDs in the latter half of the year, which will support our business growth. We will elaborate on this further during Investor Day, and I hope to see many of you there on the 10th.

Our next question will come from Kevin Cassidy with Rosenblatt Securities.

Yes, I'm looking forward to May 10 and May 9. I was wondering if you could provide more details on the Fab7 ramp. You mentioned brownfield as production. Can I get a better understanding of what that means? Do you start off with only 20,000 wafers a month, or are there any specific numbers you can share with us?

So first of all, let me clarify the brownfield. I think the point Wissam was making is that K2 expenses will not be at the same level as K1 because K1 was a greenfield and K2 is a brownfield. It's the same situation with Y7, which is ramping in Yokkaichi, obviously a brownfield launch as well. Wissam may have more details about how the expenses will unfold. Regarding how we will start ramping the wafer scale, I believe that will begin on our newer nodes, but we will provide more information when we start getting the tools in place. Wissam, do you have anything to add?

Yes. To clarify my comment on brownfield versus greenfield, I wanted to emphasize that the costs aren't as high as what we encountered in K1. They aren't very significant, but they do present a slight challenge to the gross margin.

Thank you. Speakers, I'm showing no further questions in the queue at this time. I would now like to turn the call back over to Mr. David Goeckeler for any closing remarks.

Thank you, everyone, for joining us. As we've mentioned a few times, we look forward to seeing you on May 9 for some new product launches. We'll have some exciting new technology to share then. Additionally, on May 10, we will hold our Investor Day, which we have been eagerly anticipating. We look forward to seeing you all there. Thank you.

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