Good morning, welcome to the Seagate Technology fiscal third quarter 2016 financial results conference call. My name is Christy, and I will be your coordinator for today. At this time, all participants are in a listen only mode. If time permits, there will be a question and answer session at the end of the call. As a reminder, this conference call is being recorded for replay purposes. At this time, I would like to turn the call over to Kathryn Scolnick, Senior Vice President, Investor Relations. Please proceed, Kate.
Thank you. Good morning, everyone, welcome to today's call. Joining me today from Seagate's executive team are Steve Luczo, Chairman and CEO, David Morton, Executive Vice President and CFO, Dave Mosley, President, Operations and Technology, and Phil Brace, President, Cloud Systems and Silicon Group. We've posted our press release and detailed supplemental information about our third fiscal quarter 2016 on our investor relations site at seagate.com. During today's call, we'll review the highlights for the quarter, provide the company outlook for the fourth fiscal quarter 2016, open the call for questions. We will refer to non-GAAP measures on this call, which are reconciled to GAAP figures on our supplemental information available on the investor section of our website.
We are planning for the call today to go approximately half an hour, we will do our best to accommodate your questions following our prepared remarks as time permits. As a reminder, this conference call contains forward-looking statements about the company's anticipated future operating and financial performance, customer demand, and general market conditions. These forward-looking statements are based on management's current views and assumptions and should not be relied upon as of any subsequent date. Actual results may vary materially from today's statements. Information concerning risks, uncertainties, and other factors that could cause results to differ from these forward-looking statements are contained in the company's SEC filings and supplemental information posted on the investors section of the company's website at seagate.com. I would now like to turn the call over to Steve Luczo. Please go ahead, Steve.
Thanks, Kate. Good morning, everyone, thanks for joining us today. In addition to my usual commentary, I've extended the prepared remarks for today's call, I've asked the management team to cover a few important aspects of our business as it relates to the March quarter and the positioning of the company moving forward. We will discuss some of the actions we're taking to align with near-term market realities and to improve the company's profitability and cash flow. First, I will cover the higher-level trends we are seeing from customers and provide information as the direction we will be taking with the company with respect to structure and focus. David Morton will walk through certain financial metrics.
Dave Mosley will cover the HDD business, particularly with respect to our evolving product portfolio, and I'll close the call with our guidance for the June quarter and our general expectations for the second half of calendar 2016. For the March quarter, Seagate achieved revenues of $2.6 billion and on a non-GAAP basis, gross margins of 23%, net income of $66 million, and diluted earnings per share of $0.22. Non-GAAP operating expenses in the March quarter were $439 million, reflecting cost controls and lower variable compensation. Overall, inventory levels were down 11% sequentially and ended at the lowest level of finished goods, excluding the floods, since June 2010. Capital expenditures of $95 million were in line with our expectations. We believe Seagate's March quarter results are reflective of a generally weak macroeconomic environment as well as accelerating usage shifts of technologies and architectures by end users.
Our HDD shipments for the March quarter were 39.2 million units and 55.6 exabytes, reflecting a seasonally lower TAM than expected overall. In the March quarter, we initiated targeted pricing increases across our product line. We were successful in some areas and unsuccessful in others. We continue to believe the industry needs a more stable pricing environment to deliver the higher level of requirements being placed on our products and to realize the value we are providing to the market. As a result, we will continue to pursue a pricing strategy that reduces and properly reflects the investment in technology the market requires. We experienced particular weakness in the client desktop markets as well as in the enterprise legacy market, with offsetting strength in the enterprise nearline cloud market.
Overall, average capacity per drive was 1.4 terabytes, up 30% year-over-year, and within this nearline cloud average capacity per drive was 3.9 terabytes, up 25% year-over-year. On a year-over-year basis, unit shipments were down 22%, while total exabytes shipped were up 2%. The decrease in the unit TAM in our markets presents challenges for Seagate that will require alignment to our operational footprint. It pressures the overall HDD supply chain, especially for suppliers that are supplying one part per drive. However, we are encouraged by the trend towards significantly higher average capacity per drive applications, which results in greater absorption in heads and disk and favor HDD over any other storage device now and in the foreseeable future in terms of cost as a function of required performance.
The continued advancement and adaptation of mobile and cloud-based computing architectures is reflected in the revenue shifts we are seeing in our portfolio. Our long-term business thesis continues to be that there will be a significant transition in HDD market from a historical Revenue split of 60% client and 40% enterprise revenue to 40% client and 60% enterprise revenue over the next several years. We also expect that the average capacity per drive will increase in all markets. Most important to our product positioning and related investments is not just the mix between client enterprise, but the mix shift within these markets. In the client space, we expect a continued decline in PC shipments that we anticipate to moderate in the next year. PC HDDs now represent about 56% of Seagate's client revenue and approximately 30% of the total company revenue.
While overall PC client HDD revenue is declining, the remaining share is dominated by high-capacity products, which will continue to increase with the new product offerings that we have started to introduce in the June quarter. We are starting to see our client business shift to consumer, surveillance, gaming, and DVR markets, which are all high-capacity user environments. We believe over the next several quarters, this growth will result in these combined markets being greater than the traditional PC compute market today. As an example, our consumer business revenues as a percentage of total client revenues have grown 6% in the last 12 months, whereas PC revenues as a percentage of client revenues have declined 6%. This is consistent with our belief that reducing the amount of storage on certain client devices propagates it to another location.
In the enterprise market, revenue mix continues to trend from the legacy mission-critical market to the nearline cloud market. In the March quarter, we experienced unexpected weakness for our legacy mission-critical HDDs, which were approximately 700,000 units below our forecast. While it's difficult to attribute the weakness in enterprise mission-critical between macroeconomic factors and architectural shifts, we expect further declines in the mission-critical market in June quarter, and then declines should moderate over the quarters thereafter. This mission-critical market weakness in the March quarter was offset by nearline cloud upside demand of more than 500,000 units, of which we could only deliver 350,000 additional units due to the long lead times required to fulfill demand.
Importantly, in the March quarter, the average capacity per drive for the mission-critical HDDs that came out of our forecast versus the average capacity of eight terabytes for the nearline HDD upside demand we saw reflected a shift in exabytes of almost six to one. Demand signals from our nearline customers has improved over the last few weeks, and we are planning for our fourth consecutive quarter of growth with high demand for our eight-terabyte portfolio and initial volume shipments of our 10-terabyte Helium HDD product. As a result of these trends, as well as input from our major cloud customers, we believe that the shifts from legacy to cloud for enterprise applications has accelerated in the last six months and is now complementing the demand for cloud storage generated by consumer applications.
As we manage the shifts in our product portfolio demand and changing nature of our customer base, we are aligning the operating model of our HDD business to optimize our manufacturing footprint, and we are reducing our CapEx to maintenance capital requirement levels. Through these actions, Seagate will be operating at or very near full capacity, and our operating philosophy will shift to chasing demand upside versus managing excess capacity. In the March quarter, we began the process of reducing our HDD manufacturing capacity from approximately 55-60 million drives per quarter to approximately 35-40 million drives per quarter. The actions required will be completed within the next six to nine months. At the same time, we are continuing to accelerate the utilization of our own drive factories, internal head, and media facilities.
For FY 2016, total capital expenditures are expected to be approximately $535 million, down approximately 28% over FY 2015. For FY 2017, assuming current outlook on demand, we are targeting an additional reduction in spending, reflecting a very low maintenance capital plan of approximately $400 million. In addition, we will continue operating expense management actions across the company that aligns with the market trends. We believe that given the shifts in our product revenues discussed above, as well as recognizing the full impact of the significant changes in our manufacturing footprint and operating expenses, the company will see revenue growth, product gross margin improvements, and improved profitability, assuming a relatively stable macro environment. David Morton and Dave Mosley will go into more detail on these activities, and I'll turn the call over to David Morton now.
Thanks, Steve. With the shifts taking place in Seagate's business, there are a few specific areas of our financial model that were impacted in Q3. I would like to provide some detail to these conditions to provide further context to Steve's earlier discussion around the actions we are taking to manufacturing and operating expense levels. For the March quarter, the addressable HDD and cloud storage systems markets were lower than forecast, impacting our revenue results for the quarter. Within this, there were specific HDD product areas where demand fell short of our expectations, including traditional mission-critical HDD enterprise products and desktop client products, primarily in China. In addition, we made strategic decisions to not aggressively participate in certain areas of the low-capacity notebook market. In our systems and silicon business, we experienced weaker than expected demand across most of the product lines.
The lower than forecasted HDD demand impacted our production levels and increased our factory absorption costs. We also aggressively managed our finished goods in the quarter and improved our inventory levels by approximately $118 million. This reduction in inventory negatively impacted our factory utilization. Combined, these factors were the primary reasons for our product gross margins declining approximately 290 basis points sequentially to approximately 23%, with 80 basis points impact from the HDD revenue shortfall, 70 basis points from the systems and silicon business revenue shortfall, and 140 basis points from factory underutilization. While we are disappointed we did not anticipate the weaker demand in the March quarter, the company is evaluating and implementing a variety of actions to reduce the company's cost structure, which will result in financial improvements over the next several months.
Towards our infrastructure cost alignment in fiscal Q3 alone, we implemented certain cost reduction activities and recognized approximately $90 million of one-time restructuring charges, write-off of certain fixed assets, certain terminated contracts, and discontinued inventory. We are currently sizing future non-reoccurring restructuring cash charges that we are estimating will be approximately $150 million over the next several quarters. We anticipate having more detailed actions identified within 60 days, and we will expect that the financial benefit of these actions will begin to have a positive impact in the September quarter, with the full benefit occurring in calendar 2017. As we formalize the specific actions and timing of cost savings, we will continue to provide updates to this framework.
While we are still formulating all of the actions we will take to address gross margins and operating profit, we believe the overall cost alignment activities we will implement will benefit our product gross margins and overall profitability of our business with the goal of achieving a minimum of $2.50 in non-GAAP earnings per share in calendar 2017. For the March quarter, non-GAAP operating expenses were approximately $439 million, slightly lower than forecasted. Looking ahead, our expenses in the June quarter will be relatively flat, with additional cost reductions being planned for FY 2017. Cash flow from operations in the March quarter was $205 million, and free cash flow was $110 million. Fiscal year to date, we have generated $1.4 billion in cash flow from operations. Our balance sheet remains healthy, and we ended the quarter with $1.2 billion in cash and cash equivalents, and 298 million shares outstanding.
Our debt structure and level of interest expense is manageable. As announced today, our board has approved our quarterly dividend payment of $0.63. There has been no change to our dividend policy, and our dividend payout of $188 million a quarter is supported by our cash flow generation forecast, albeit at a higher payout ratio than previously stated as our objective. I'll now turn over the call to Dave Mosley to cover our HDD business in more detail.
Thanks, Dave. Beginning with the nearline cloud product lines, our 8-terabyte business critical product continues its aggressive volume ramp, and we've been essentially sold out for the months of March and April. We've had over 200% volume growth of 8 terabyte in the March quarter, and we anticipate continued growth in the June quarter. In addition, our 10-terabyte product lines shipped a large volume of qualification units in the March quarter, and the volume growth is accelerating in the June quarter as well. We believe our 10-terabyte product to be leading in all performance and power metrics, and we're very happy with the feedback from our customers and our qualifications. In the client space, as Steve said, the PC market continued to decline in Q3, and we began end-of-life activities on some of the older 500-gigabyte and below products that have very low margins.
Most of the margin cost benefits of these product exits will be realized over the next few quarters. In the March quarter, we began the ramp of our 1 and 2 terabyte, 7-millimeter, 2.5-inch product line for our consumer notebook and DVR customers. This new product line allows us to address those target markets with lower costs and improve value propositions for our customers. Qualifications have gone well with customer interest high, and we anticipate shipping several million units in the June quarter. Initially, the product will be a consumer offering, moving to OEM offerings in September and December, and we believe we will have competitive technology leadership through the end of the calendar year. We are also accelerating the application of these same technologies into our 3.5-inch product lines for surveillance, NAS, and DVR at the end of the calendar year.
The mission-critical market, served by our 10,000 and 15,000 RPM products, has been declining over the last few quarters. We have seen traditional TAM of approximately 8 million to 8.5 million units per quarter decline to approximately 6.5 million to 7 million units in the March quarter. Within the mission-critical market, approximately 25% of the volumes are 15,000 RPM HDDs. This is the primary area where we are seeing a shift in low-end servers moving to lower capacity flash SSDs. We expect this trend to continue. In 10,000 RPM HDD, there has been some technology shifts happening as well. However, we believe the 10,000 RPM HDD market will have a much longer transition horizon.
Our goal over the coming months is to manage our forecasting conservatively with mission-critical TAM declines in the June quarter, potentially leveling to modest declines in the back half of the year. Over the long term, we believe the technology shifts in this market support our complementary investment thesis of flash for performance and driving HDD for capacity architectures. Shifting our HDD build volumes to higher capacity offerings will allow us to simplify our wafer requirements and optimize our product portfolio, which will not need further product refreshes for some time. Coupled with this, improved utilization of our own factories sized properly for the market demand will improve our cost considerably. We realize our non-depreciation-related fixed costs are high competitively and also too high for current demand. These cost items will be addressed sooner than those related to the manufacturing footprint.
There are also many costs related to the product transitions that, while temporarily driving a higher cost profile, will allow us to improve our cost footprint in FY 2017. With respect to the shift to higher capacity products, we do need to be mindful of longer lead times and supply chain management requirements for these products. By engaging directly with a broader customer base and establishing deeper channel partnerships, we believe we will improve our sales operations efficiency and forecast visibility. Thanks. Now I'll turn the call back over to Steve.
Thanks, Dave. Given the recent published earning results and related conservative guidance from a broad base of large corporations that serve the global technology and industrial markets, we are planning for seasonal declines in revenue in the June quarter for most of the markets we serve, with the exception of the nearline market. Based on these factors, as well as our decision not to participate in the low-capacity PC client market, we expect to achieve revenues of approximately $2.3 billion in the June quarter, with relatively flat gross margins and operating expenses. We continue to expect that demand in the second half of calendar year 2016 will be stronger than the first half, with positive seasonal trends and continued growth in nearline demand offset somewhat by macroeconomic pressures.
With this anticipated revenue growth, as well as the actions we are taking to align our manufacturing footprint and OpEx investments, gross margins and profitability will improve in the second half of the calendar year 2016. Should there be improvement in the overall macroeconomic conditions, we would expect to see improved HDD unit demand across all markets, with commensurate benefits to the company's performance. Thank you for joining us on the call today, and we can now open it up for questions and answers.
Thank you. Ladies and gentlemen, if you have a question at this time, please press the star then the one key on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press pound key. Our first question is from the line of Richard Kugele of Needham & Company. Your line is open.
Thank you. Good morning. Just a couple of questions. In terms of the restructuring, Steve, you talked about getting to something around $2.50. Should we assume something revenue-wise lower first before it can start to grow again as you realign those lines? To get to 35 million-40 million units of capacity, that assumes you're probably exiting quite a few categories.
I think the capacity issue also relates to the amount of outsourced drives we have, Rich. Again, I think in the second half of the year, we expect revenue growth off of the guide for June, and we would expect that to continue through the calendar 2017 year. The adjustments on manufacturing are both where we take our internal capacity, which was under-absorbed, and then taking production inside, which was basically, if you could think of it, as additional under-absorption, whether or not that was the non-operating fixed costs or the cost of the factories themselves. There's a double effect of what happens once we bring the drives inside as well as reduce our overall footprint.
We would expect that the calendar year 2017 revenues, other than maybe seasonal decline from December to March, should continue to grow, assuming a macro condition that's stable, in part because also the portfolio gets a lot stronger with the 1 TB on the 2.5 and the 2 TB on the desktop, which are products that are highly competitive, we believe at least 6 months ahead of the competition, and at capacity points that are much more relevant to us in the client space.
As a follow-up, just to understand the difference in moving from mission-critical to high capacity, can you just talk about the gross margin dollar impact and the technology investments required to go and do that? Is it similar R&D investments? Any thoughts on just as that shift takes place?
Let me just give a general answer, then Mosley can talk about the R&D side. In general, the gross profit dollars are about the same, which is why losing 700,000 units but picking up 350 hurt us. The gross margin percentages are about the same. As the shift continues, once you've reached the crossover point where we can either meet that upside demand or it just naturally exceeds whatever erosion continues in mission-critical, then you get growth there. Like I said, it's really hard to understand what's happening in mission-critical right now. Is it being driven by macro, or is it the incursion by flash at certain segments of that? I think the answer is it's a little of both.
Maybe the macro is even accelerating the incursion of flash, and it doesn't really matter, because once that happens, it's not like it's going to reverse itself. We're preparing for the continued decline of the 15K segment. As Dave indicated, the 10K segment, from our customer input, is probably going to remain intact for a number of quarters, if not a number of years. I think it's more about managing our investment in the portfolio going forward, which clearly means continuing to emphasize the near line. Obviously, again, just adjusting the manufacturing footprint so you're basically keeping pace or a little bit ahead of the decline, so you're always sold out versus having excess capacity. Dave, talk to it in more detail.
From an R&D perspective, Rich, it's fairly applicable. You can move the technologies, whether it's head media technologies, over from one market segment to the other. As Steve commented, I won't elaborate too much, the speed of the shift that we saw last quarter with really high demand for the cloud products and then the falling demand for the mission-critical products were more of a factory reaction time issue than anything.
Okay. Thank you.
Thank you. Our next question is from Sherri Scribner of Deutsche Bank. Your line is open.
Hi. Thank you. The cash flow number came in a little bit this quarter, obviously with gross margins coming down. I wanted to get your sense of how you're thinking about your uses of cash going forward. How will the cash costs related to some of these restructuring actions impact you? Are you still committed to the dividend? Is there a plan to buy back shares, considering shares have come back? Do you have any plans to buy back any of your debt, which is trading at a discount to par? Thank you.
Hi, Sherri. This is Dave. As we think about heading into the back half of the year, obviously, first and foremost, we're going to continue to invest in our business ourselves. As we stated, as we look at some of these one-time costs, restructuring, cash charge, specifically around $150 million, we think that's very manageable over our generation and what we're able to yield here, again, over the next six to nine months. As far as the dividend, we think that is well manageable, albeit at the higher end of those levels of a payout ratio, and obviously up to the board of directors. With that said, we feel that it's very defendable against what we're able to generate moving forward.
I think in the near term, Sherri, meaning the next 6 to 12 months, though, the considerations clearly go invest in the business because we do feel we have technology and product leads across the portfolio that we really want to execute to. As long as the macro environment stays, I won't say decent, because I don't know that I can call today decent, but as long as it stays like it is today with that product execution, we feel pretty good about the company's position competitively. In terms of what we would do with that cash flow, again, I think defending the dividend is the first thing that we would do. We'd certainly like to keep the dividend level where it is. Initially, obviously, these are payout ratios above the 30%-50% that we had indicated.
If the company's growing into that with improving revenues and margins, then certainly we put the company in a position where the board has at least hopefully an easier decision to make than if it were the other way around. I think in terms of buybacks, whether or not it's debt or equity, for the near term, that's probably not going to be the use of cash. It'll probably be if there's excess cash, we keep it on the balance sheet, just in case the macro situation turns on us as we had more confidence about a 2017 outlook and again, kind of the success of our products, and we would reevaluate that in terms of what's the best use of it beyond dividend or going on the balance sheet.
Thank you.
Thank you. Our next question is from the line of Aaron Rakers of Stifel. Your line is open.
Yeah. Thank you for taking the questions. Steve, I was just curious, in the past you've talked about kind of returning to that 27% plus gross margin. I know at the analyst day, you even talked about 27%-32%. On top of that, you talked about 13%-15% OpEx to revenue. Understanding there's a lot of things going on in terms of the realignment and stuff, I'm just curious of when do you think you're able to get back into that target model at this point?
Yeah, Aaron, thanks. We talked about was it worth guessing right now to provide you some guidance. I think I would prefer just for us to get through this next 60 days of really understanding the changes we're going to be making to the operational footprint and the related OpEx investments. The reality is depending on which decisions we make, there's different timing implications. Some of the things we can get after right away, as Mosley mentioned, but others are really a function of product transitions, customer qual issues, regulatory issues, et cetera. I think it's just probably not worth guessing at this point. I think as we get more clarity on the specific actions we're taking, we'll get back to you.
If the question is do we think, though, that we still get back into that range in a reasonable period of time, the answer is yes. We think we can work ourselves back into the range. We want to get a little more work done before we kind of give you an idea of when that's going to happen in terms of in this quarter. As you know, our world does not work in the crisp 90-day segments that the calendar provides. We'd rather just kind of do a little more work before we lay that out for you.
Steve, what gives you confidence that the mission-critical business declines in the June quarter but then seems to stabilize into the back half of the year and going forward? It seems like there's not that much visibility there given the moving parts, be it macro and then obviously the element of flash.
I think our feeling based on customer input is that, I was mostly talking to the application shift, Aaron. I mean, the macro stuff I'm not going to speculate on. If it gets worse, obviously all these markets will be under pressure. If it gets better, all of them probably get a little bit of reprieve. It feels to us like the trend of where mission-critical 15K is being taken out is the point of exposure, and the 10K piece isn't, at least for now, and maybe not for quite a while based on some of our customer impacts. Our only point is that as it transitions at some point, it stabilizes, and we feel like that probably happens in the second half of this calendar year.
Okay. Thank you.
Okay. All right. Great, everyone. Thanks for taking the time today, we look forward to talking next quarter. Thanks for all your support as well to our customers and our suppliers and most importantly, our employees. Thanks very much.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.