Western Digital Corporation

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. At that time, if you would like to ask a question, you may press star 1 on your phone. 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 Geckler, 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 percent, 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 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 HGD 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 HGD and Flash businesses. Our HGD 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 near-line 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 OptiNAN with our SMR leadership uniquely positions Western Digital in the marketplace. Putting it all together, we have positioned our innovations in OptiNAN 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 our 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 10th. 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 BIX5 technology and 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 Bix technology leadership and our ability to develop innovative solutions, enabling our customers to unlock the potential of their PCs. Qualifications of Bix 5-based products for client and consumer end markets were largely completed. And we are making great progress in qualifying our next generation BIX 5 enterprise SSD products. We expect these products to drive revenue growth and mix improvements into the future. Lastly, BIX 5 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 mixed 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 VRAR 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 Wisam, 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 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. We saw and we'll 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. Wissam?

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-gap 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 18TB capacity point and ramp of 20TB drives drove a nearly 40% year-over-year increase in near-line revenue. This growth was partially offset by lower enterprise SSD and smart video hard drive revenues. The client and 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 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 $101.00. 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 fat 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 1.4 times compared to 2.6 times 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 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 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 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 gap-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 will 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 near-line 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 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 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, Wisam. 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 am excited that we are witnessing the positive impacts of those changes. Before I wrap up, I want to remind everyone we have Investor Day coming up on May 10th, and I look forward to seeing you all there. Let's start the Q&A.

Thank you. As a reminder, to ask a question, you will need to press star 1 on your telephone. Due to time restraints, we ask that you please limit yourself to one question. To withdraw your question, please press the pound key. Please stand by while we compile the Q&A roster. Our first question will come from CJ Muse with Evercore. Please go ahead.

Good afternoon. Thank you for taking the question. I guess the question relates to your June quarter outlook, and we'd love to hear, you know, 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, CJ. Thanks for the question. Yeah, 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 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, I think 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, yeah, 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, you know, we factored in all the risks into the guide, and we're comfortable with where the number's at. Busam, anything to add?

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

Thank you guys. Appreciate it.

Sure.

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

Yeah. Thanks for taking the question. I'll stick to one as well. I 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, you know, maybe give us some color on how you're thinking about the flash gross margin relative to the hard disk drive gross margin and And I guess within hard disk drives, how much COVID-related expenses are you still embedding? You know, just any of the variables you can help us appreciate on both those two segments.

So I'll take a – I'll start on it, and we can add. So on the drive business, you know, last quarter we talked about – you know, the 200 to 300 basis point impact that we were expecting. I think we took a little more of that in this quarter than we had expected. Some of that was some costs we didn't expect, like I just talked about in Shenzhen. I think I said Penang earlier, but Shenzhen. And so... In that business, looking forward, I think we see it as pretty much – we've pretty much hit the bottom. We basically see it flat going forward. In the flash business, we expect some acceleration of gross margin, given the supply-demand balance situation. So, Wissam, anything to add to that?

Yeah, David, just maybe to follow on 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 experienced in the fiscal third quarter.

Thank you. Thanks, Aaron.

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

Great. Thank you. Just following up on the contamination issue, is the seven 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?

Hey, Joe. Yeah, 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, you know, I don't think it will be super material to the number. So seven 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?

Yeah, I'm not going to speak for them, but we have joint manufacturing facilities for sure. Great, thank you. Thanks, Joe.

Thank you. Our next question will come from Patrick Ho with Stiefel. Please go ahead.

Hey, Patrick, are you there? Hey, Cherie, 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. Please go ahead.

Good afternoon, guys. Thanks for taking my question. You're seeing a really strong trend in the HED pricing side. Is that entirely related to the mix more towards Nearline, or are you seeing any underlying trends in other parts of the business as well? Anything helpful there will be really good. Thank you.

I'll put a much larger frame on it, Tom. I think what's happening, and we see it show up in a number of ways, and there's a lot of COVID implications and cost in it too, but I think we're just seeing the industry change from a world where there was always capacity enterprise drives available, you know, hard drives were available. It was about, you know, putting as many as you could in places where you could fill up factories and get good absorption and not have to pay incremental costs for that. You know, that's kind of the decline of the client era and the rise of the cloud era. We're pretty much through that. We're in the last legs of it. And I just think you're seeing a lot of industry dynamics change. You know, you're seeing long-term agreements come in much more, you know, something that last year was kind of a new concept that we were Working through, now it's becoming much more mainstream with our big customers just to give us visibility to making investments in this business. Essentially, we don't have a lot of capacity anymore to shift from client to enterprise in the cloud, and we're having to invest in that, and that's causing the whole industry to shift the way it thinks about this technology in my point of view. I think it starts with we're still driving... a strong TCO model for our customers. That's where it all starts. Every generation of technology, we're able to bring down the TCO for our customers. In the past, I think as we did that, the reward for our side of it was more volume to soak up that capacity. Well, that's not the case anymore. Now we have to invest in new volume, so the industry has to change. So we're bringing a lot of TCO value And I think you're seeing the industry move to providing more visibility, thinking about value-based pricing more, and how do we move that value equation in a way that we can continue to drive the TCO down and drive a better pricing environment. So that's the big picture. And then, of course, there's a lot of costs in the system right now and inflation input problems. Input costs are going up, and we're working through pricing if we can mitigate parts of that. That's happening as well.

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 we saw maybe any sort of color on the cost versus pricing impact in the out-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. Thank you.

Yeah, of course. Yes, Tom. So we do expect that, you know, our long-term, to continue to reach our long-term target of cost reduction, which is a 15% year-on-year. We did see a bit of a headwind in the current quarter, but it's really impacted by a few factors. that we expect will dissipate in the next couple of quarters. So we saw, for instance, we continue to ramp our BIX5 technology, as well as just like everybody, we're seeing some inflationary pressure, as well as the startup of our Yo-Kai-Chi FAB7. We still expect for this fiscal year 22 to be at least 15% year-on-year in terms of cost reduction. And as I started with, we do expect to continue to meet that target going forward.

Very helpful. Thank you.

You're welcome.

Thank you. Our next question will go to Timothy Arcuri with UBS. Please go ahead.

Hi, thanks a lot. This is Jason on for 10. So could you please provide a caller on the trajectory of your HDB gross margins through the second half of this year? I'm asking because we're expecting some benefit that we'll get on the likely stronger pricing environment in the second half versus the first half. Thank you.

Yeah, we do expect, as we talked about last quarter, we're pretty much in the same place, which is we expected the decline we saw this quarter. We actually expected gross margin to be a little lower next quarter. Now we think that will be flat. And then we expect that to improve in the second half for a number of reasons, mix, input costs that are changing a bit, and also some pricing benefit. So, yeah, we expect... We expect next quarter to be the low, and then we expect to improve from there. Thank you.

Thank you. Our next question will come from Patrick Ho with CIFL. Please go ahead.

Thank you very much. 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?

Yeah, so let me unpack that a little bit again. Thanks, Patrick. So... You know, it's largely the same customers that will move from 18 to 20. I mean, I think, as I said earlier, the TCO equation improves as you keep driving forward. So it's a very important part of what we do. I mean, this is, you know, I talk about innovation a lot around here and the innovation we've driven around EPMR and now Optinan and SMR. You know, those are all things that we layer into our products and allow our customers every time they move a generation forward, they get better TCO equations. So there's reasons to keep moving forward. So that's kind of the way that works a little bit. By the way, we'll come back and talk about SMR a little bit more. We're continuing to see more momentum towards SMR. That is the future of the cloud HDD business is SMR. All the big players are now moving down that path. which is a technology we've been investing in for quite some time. On your other question on, look, the LTAs don't drive the spending, and the LTAs help smooth out the spending. I think the whole idea with the LTA is to give, you know, we have a strong relationship with our big customers, and to give better visibility, you know, two, three quarters out. I've talked about this a lot in the past. The business If I think back a year ago or two years ago when I came in the business, the business was just transacted quarter to quarter and even within the quarter. And clearly, given the investments we need to make to continue to drive investments in heads and media to fuel the exabyte growth, we're going to need more visibility than that. And so the LTAs have been adopted, and we strike those with our big customers on multi-quarter timeframes. And then we stick to them. And that's been very good as far as smoothing out any ups and downs and builds on their side. And so as far as the second half environment, our big cloud customers continue to tell us and signal a strong demand environment in the second half of the year. So, you know, we'll be excited about driving to that with starting with 18 and then transitioning to 20 as we move through the year.

Thank you.

Thank you. Our next question will come from Krish Sankar with Cowan. Please go ahead.

Hey, hello, guys. It's Eddie for Krish. Thanks for taking my question. For HDDs, when do you expect a crossover between 20 terabytes and 18 terabytes? And can you please tell us if you did see a slowdown in the VIA market for HDDs over the last quarter? Thank you.

Yeah, I would imagine the 20 crossover will be in the second half of the year. I mean, we're deep into the 18s right now. I mean, 18 is probably... 80% of the portfolio of what's shipping. So it's the sweet spot of the market. As we move through the year, we'll start to ramp 20. So towards the end of the year, early next year, we can circle back on a specific date, but that's the way we're thinking about it. The surveillance market, smart video market, that's been soft. So, you know, we continue to see that with the lockdowns in China. You know, we expect that once that ends, there'll be some snapback and some recovery of pushed out demand there. But right now, given the COVID situation, you know, I think that that market's not going to change until the COVID situation changes.

And if I can squeeze one in, is surveillance margin accretive?

Is it margin? I don't think we break out at that level. I don't know. Wissam, do you have a comment on that, or Peter?

Yeah, actually, David, we don't break out down to that level of detail.

Great. Great. Thank you.

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

Thanks for taking my questions. A couple of short ones on the flash side. How are you thinking about your full-year bid shipment growth for calendar 22? I know you don't want stuff for quarter by quarter, but for the full year. And then the follow-up question is gross margin for Flash, and you talk about maybe up a little bit for next quarter. Are you actually expecting much price increase? How much is mixed a factor? And maybe talk about, Wazam, you talk about the Yukaishi startup cost. Can you kind of quantify what that number is? Thanks.

I'm going to let WeSum handle the gross margin question. The bid growth, look, our bid growth will be down this year. We're not going to put a number out there right now, but given the FAB excursion, we'll be down this year, and then we'll make it up over the next year or so, year plus. It'll take a while to fully come back to our fair share of bids. Our strategy has been very consistent for a long time. We invest to maintain share, and you see us doing that. including recent FAB announcements with Keoksha. Lisa, do you want to talk about gross margin a little bit in Flash?

Of course, David. So, Sidney, thanks for the question. When we think of the flash business, I think to address maybe the part of the question around the Yukaichi startup cost, they're not very significant, and actually they're much lower than the K1 fab startup. We're talking about really a brownfield expansion here versus a greenfield expansion. To the part of your question with respect to our flash gross margin that's sort of embedded in the guidance, of course, you know, mix always plays a part in any gross margin, whether it's actual or projected. But as I said earlier, we're still expecting to meet that 15% plus threshold. year-on-year cost reduction for flash in the fiscal year 2022. I hope this helps.

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

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

So maybe I'll – thanks, Mehdi, for the question. Then maybe I'll just talk about the effects in general. So our approach is we do – we use a layered hedging approach, which means, you know, it's – there's much more coverage in hedge on the shorter term versus the longer term. And so that smooths out the impact of effects over time. And the way also to think of it is any incurred cost within the quarter typically will not really impact the P&L until approximately 90 to 120 days later, given the manufacturing cycle times and lead time for delivery of product. Whatever we're seeing, at least in the past short term, in terms of currency fluctuations, will not be that impactful to the numbers. What we're sort of expecting... Actually, what we saw in this quarter and what we're anticipating for the fiscal fourth quarter is less than 1% impact on all of our cost of goods sold. That basically talks about all of the cost of goods sold, maybe not only the flash portion.

Okay. Can I now ask a question? FX was more like a clarification. Go for it, buddy. Okay. Just back to David. Given your LTAs and you sound confident that the cloud demand is going to sustain to the second half, how should they think about near-line exabyte growth prospect in calendar year 22 versus 21?

Exabyte growth in 22 versus 21. I can get you, let me, I'm going to look this up real quick. If I have it by, you know, look, I mean, Meddy, if I look at it over, looking at it over, you know, we keep coming back to 35% growth in the, you know, in exabytes in the cloud. You know, that's been a pretty consistent number. I'd have to go back and put it in. I tend to look at it more in fiscal years and calendar years, but I can follow up with you on a calendar year number.

Okay, thank you, and I look forward to meeting you at the end of the day.

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

Thank you. Our next question will come from Nick Todorov with Longbow Research. Please go ahead.

Yeah, thanks for the question and good afternoon. 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, margins, and HDD? Maybe can you touch on what kind of workloads are the cloud guys looking to deploy SMR initially?

Well, I'll defer the workloads until our investor day. We'll go into a little more detail there. But, look, I think big picture we see, you know, this last quarter I think, well, I know I said we had two big cloud titans that were working on SMR and we expected significant shipments towards the end of the year. Within the quarter we had another one and another one come to us about adopting SMR. So I think that... I think that it's very clear to me that the capacity gains that can be achieved with SMR, we've been investing in this technology for a long time, and this idea that you can get an extra 10% or more, and again, we'll talk about that in a couple weeks as well, is very attractive, especially given the size of the drives now and how big they are. You're talking big numbers, you know, multiple terabytes that are being added through the changes. Now, the thing that gives me a lot of conviction on this is because it requires, on the host side, you have to do some software work. And, you know, nobody wants to do software work if they can avoid it. or if the return is not good enough. And the fact that the big players are coming in, they're saying, look, we're going to invest in this, and we're going to pull SMR into our data centers, tells me that this is the next leg of growth in this industry. So, you know, again, we'll get to our investor day to talk about what it means on the portfolio, but I get back to just another way that allows us, using innovation to drive a better TCO, equation for our customers. And when we can drive better TCO, then we can leverage that into a conversation about value-based pricing. And that's exactly what we're doing, and it's exactly where the industry is going. Like I said, LTAs are a part of that, about getting more predictability. But the fact that we can continue to drive down the cost of storage, continue to drive a better TCO with every generation of product, do that through innovation and that gives us opportunity to create margin and create value.

Thank you. Our next question will come from Nam Tim with Art Research. Please go ahead.

Thank you for taking my question. How should we think about some of your hyperscalers 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. Thank you.

Various of our customers have DIY projects. I think that's fine. First of all, I don't know if anybody does 100% that because everybody wants diversity in their supply chain. But even DIY provides us opportunity to provide diversity. raw NAND, so not just the full enterprise SSD. But like I said, even anybody that's doing DIY is also going to be buying enterprise SSDs as well for part of their footprint, and the numbers here are getting so large that whichever way you play or both, it gives us the opportunity to play in both of those franchises, quite frankly, with our big customers providing enterprise SSDs and then providing NAND into their projects. So I think it's a reflection of how important enterprise SSDs are to the future of a very modern cloud data center. It's extraordinarily important technology, and we're very happy to be involved with the biggest customers and qualified as the biggest customers with our technology.

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

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, you know, kind of behind us, of course, working through that. With that being said, you know, 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 if you put in something to make sure such a thing doesn't happen again?

Yeah, I'll give some input when we some can maybe provide more details if we have them. But look, the issue is fully behind us. The team has done a fantastic job of root causing it down to the very, very bones of what the issues are and then putting in place obviously putting in place screens and other things to make sure it doesn't happen again, or if it does happen again, to make sure we catch it proactively. As far as the, you know, the costs are split by us and our JV partner, and as far as the ability to recoup any of those, I mean, I think we'll look at that. You know, once we get fully past anything, we'll look and see if there's anything that'll happen there. Anything to add to that, Wissam?

I think, no, David, I think you've covered it well.

Thank you. Our next question will come from Stephen Fox with Fox. Please go ahead.

Hi. Good afternoon. Thanks for taking my question. 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 at 4% of 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. Thank you.

I think, like I said, we're working on – I want to repeat the same thing again. Pricing starts with value. We have to deliver value, and we're constantly innovating to deliver more value. But we're clearly working on pricing to see, you know, to defray some of the input costs and all the logistics costs COVID has impacted so that that's going on across the portfolio. And then, you know, we're having conversations with our customers about the value we're providing with these next generation of drives about, you know, what that value is and how do we move to a value-based pricing model today. I don't know if there's a whole lot more to say about it than that. Wissam, anything from your perspective?

No, not on this, David. Thank you.

Thank you. Our next question will come from Christian Schwab with Craig Hallam. Please go ahead.

Great. I just have a quick question on disk drive gross margins. You know, given the positive impacts of mix and decrease input costs If we have a China COVID shutdown end, is there any reason why the distrived business can't be operating at 30% plus growth and exiting the calendar year?

I'm sorry. You broke up when you said the number.

Is there any reason that you wouldn't be exiting the calendar year with growth margins at 30% plus again?

Yeah, I mean, so I think we broke those numbers out. I think he's got the details. He had it in his remarks. But, I mean, if you just took all the COVID costs off the business right now, I think we'd be above 30, right, Wissam?

Yes, so that's very true, David. I mean, we did have in the quarter around 240 basis points. related to the COVID costs. You know, we've talked about we've been slightly impacted, of course, by COVID lockdowns. You know, we continue to see some inflationary cost pressures short term with supply chain disruptions. I mean, to your question, I wouldn't necessarily want to talk about where the margins are going to be in Q4, but would it say that we do expect the margins to be better from here in the second half of the calendar year 22?

Yeah. I mean, we're not going to commit to your number, but just as a general point, I mean, look, there's just been a lot of – a lot of additional costs on the business. We've talked about it for many quarters now, logistics costs and now increased input costs that have really hit us this past quarter. And you would think as the world comes out of the pandemic, I think which is the major crux to your point, as this starts to unwind and logistics gets back to a steady state and some of the input costs get more reasonable, we stop paying expedite fees for certain components and things like that because there's just a more smooth-flowing supplier ecosystem, it will unburden a lot of costs on the business. And again, I think this is masking somewhat, although not completely, a major fundamental structural change that's going on in the business, which I've talked about a lot, which is You know, the HDD market is a growth market, and it's a growth market where we're going to need to invest capital to build additional heads of media capacity. And when that happens, I think the economic equation changes, and we get, you know, the key thing in that kind of world is can you still innovate and can you still bring new things to the product that makes it more valuable to your customers? And I think that is what we've really been focused on from EPMR to OptiNan to SMR. We're just really focused on innovation, bring a better value proposition. That'll be able to build a better product for our customers and we'll get into that value-based pricing thing. So if we get both of those going and we can get the cost out because of the pandemic, I think we'll, you know, we feel very good about the business.

Thank you. Our next question will come from Mark Miller with Benchmark Company. Please go ahead.

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

You know, there's a couple dynamics to this. I think over the past couple of quarters, we've had a higher mix towards mobile as we were ramping BIX 5. You know, we talked about it in the prepared remarks. We've gotten past our qualifications of BIX 5 in the consumer market. and in our client SSD market, so we see an acceleration of mix into those on BIX5. And then, you know, there's a lot of hard work going on to qualify our enterprise SSDs on BIX5, and as that happens throughout this year, then you'll see an acceleration of that market as well into BIX5. The reality is we have demand on enterprise SSD. we can't meet because it's on BICS 4 right now. So as we get that into BICS 5, you'll see the mix change, and you'll see the enterprise SSD mix accelerate through the second half of the year, which will provide a parallel to those. We'll talk about this a little bit more on Investor Day as well to put one more plug in to see all of you on the 10th.

Thank you. Our next question will come from Kevin Cassidy with Rosenblatt Securities. Please go ahead.

Yeah, thanks for taking my question. Yes, looking forward to May 10th and May 9th too, right?

Yeah, absolutely.

Yeah, I just wondered if you could give us a little more details on the Fab 7 ramp. You mentioned Brownfield as production. Can I just understand a little better what that means? Is it you start off with only 20,000 wafers a month? Any numbers like that you can give us?

So first of all, let me clarify the brownfield. I think the point Misan was making there was that K2 expenses will not be at the level of K1 because K1 was a greenfield and K2 is a brownfield. So the same situation with Y7, which ramping in Yokaiichi, obviously, and obviously a brownfield launch there as well. I don't know, Wissam may have some information about how the expenses roll out. As far as how the wafers scale, look, we'll start ramping that, I think, on our newer nodes, but we'll have more to say about that when we start getting the tools in there and all of that. Wissam, anything to add?

Yeah, just maybe to clarify, thanks, David. To clarify, my comment on brownfield versus greenfield was exactly the You know, just to really highlight that the costs aren't as high as we've seen in K-1. They weren't really, they're not very significant. But, of course, it's a bit of a headwind 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 Geckler for any closing remarks.

All right, thanks, everyone. We appreciate you joining us. As we've said a couple times here, we look forward to seeing you. Hopefully we'll see you on May 9th, as was pointed out, for some new product launches. We'll have some exciting new technology coming out then. And then on the 10th, May 10th, May 9th and 10th, on the 10th, we will have our Investor Day, which we've been looking forward to for quite some time. So we will see you there. Thanks, everyone.