Good morning, and welcome to the Seagate Technology fiscal first quarter 2016 financial results conference call. My name is Kaylee, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. Following the prepared remarks, there will be a question and answer session. As a reminder, this conference call is being recorded for replay purposes. At this time, I would like to turn the call over to Kate Scolnick, Vice President, Investor Relations. Please proceed, Kate.
Thank you. Good morning, everyone, and 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; Rocky Pimentel, President, Global Markets and Customers; Phil Brace, President, Cloud Systems and Electronic Solutions; and Patrick O'Malley, Executive Vice President. We've posted our press release and detailed supplemental information about our first 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 second fiscal quarter 2016, then open the call for questions. We will refer to non-GAAP measures on this call, which are reconciled to GAAP figures in our supplemental information available on the Investors section of our website.
We are planning for the call today to go approximately half an hour, and we will do our best to accommodate your questions in that timeframe. 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, and thanks for joining us today. The first fiscal quarter of 2016, Seagate achieved revenues of $2.9 billion, on a non-GAAP basis, gross margins of 24.2%, net income of $165 million, diluted earnings per share of $0.54. Overall shipments for the September quarter were 55.6 exabytes, up 7% sequentially, with the average capacity per drive over 1.1 terabytes per drive. As we stated in our pre-announcement, there were intra-quarter demand developments that brought our revenue in at the lower end of our forecasted range and impacted the profitability contribution of our HDD portfolio to corporate margins by approximately 300 basis points.
While the September quarter nearline and enterprise demand was marginally lower than expected in terms of both units and exabytes, we believe Seagate's CSP and OEM customer base is more highly concentrated than the competitors and therefore has a higher degree of volatility. This dynamic led to a negative impact on Seagate in the September quarter, resulting in lower mix, higher inventory carry, and reduced absorption, impacting the corporate gross margin by approximately 190 basis points. The company needs to further leverage its technical leadership across its product offering to address the broader market opportunity and needs more active engagement with these customers on the sales and technical side. These issues are being addressed and progress will be achieved over the next two to three quarters. In addition, we saw upside in two-and-a-half inch notebook and gaming client applications, which have margins at the lower end of our product portfolio.
The lower margin contribution from the portfolio shift in volumes impacted the corporate margin by approximately 110 basis points. While we are disappointed in our overall corporate margin results for the September quarter, we believe we have a path to sequential margin improvement that I will cover in our December quarter outlook. Non-GAAP operating expenses were $501 million, down 9% year-over-year, reflecting expense control around the core business, adjacencies, restructuring activities, and lower variable compensation. Drive inventory levels increased by approximately $160 million sequentially, due primarily to the increase in finished goods from our enterprise products. Capital expenditures were in line with our expectations. In the September quarter, we had strong cash flow from operations of $824 million and free cash flow of $615 million.
We effectively executed on our long-term capital allocation goals for the shareholders and redeemed approximately 20 million shares in the September quarter, reducing our outstanding shares down to 299 million shares. Our balance sheet remains healthy, and we ended the quarter with $1.9 billion in cash and cash equivalents. There are a few developments from the last few weeks that are meaningful to Seagate that I'd like to provide some additional context. We closed our acquisition of Dot Hill on October 6th, and we have begun integrating the business into our Cloud Systems and Solution Business. We are pleased to have the Dot Hill team on board and believe the expansion of our cloud systems and solutions product portfolio will enable us to better serve our storage OEM customers and further leverage our core storage technology expertise.
On October 22nd, we were notified by China's Ministry of Commerce that the company can now integrate Samsung's hard disk drive business completely into Seagate. This now allows us to move forward in our plans to consolidate our product portfolio, leverage go-to-market synergies, broaden sales coverage, and optimize design centers. All of these activities will benefit our customers. At our board meeting last week, we approved a 17% increase in our dividend payment, raising our annual rate to $2.52 per share. This dividend raise reflects the confidence we have in the future cash flows of our business and fulfills our goal to increase our dividend by at least 10% for the fiscal year. Our capital return to shareholders remains a top priority at Seagate, and we continue to balance the effective investment in our technology portfolio with shareholder returns and within an investment-grade framework.
Turning to our business outlook, we believe the overall storage market demand will continue to be relatively flat in the December quarter. This includes some slight uptick in enterprise nearline exabyte demand and seasonal declines in the client and gaming markets. For the December quarter, we are planning for revenues to be between $2.9 billion and $3 billion. We are forecasting operating expense to continue to decline to approximately $485 million in the December quarter. We plan to exit fiscal year 2016 with operating expenses of $460 million per quarter, including Samsung integration synergies and the acquisition of Dot Hill. Under these assumptions, we will reduce our fiscal non-GAAP year-over-year spend by approximately 12%. Our non-GAAP gross margins should be sequentially improved with mix, new product offerings, and absorption costs benefit to approximately 25.5%-26%.
As enterprise exabyte demand continues to grow at 35%, along with our ability to monetize the demand with our product offerings, we believe we will be back in our targeted margin range of 27%-32% by the June quarter. Before we open up for the questions, I would like to highlight the promotion of Dave Morton to Executive Vice President and Chief Financial Officer at Seagate. With over 20 years at the company, Dave is already a very active contributor of our management team, and the board and I are confident in his abilities to continue to provide effective leadership and financial stewardship for Seagate. I also thank Pat O'Malley for his seven years of service in the CFO role and over 25 years of contributions at Seagate.
Under Pat's leadership, we have refined our effective and resilient financial model, executed a very good track record on total shareholder return and return on invested capital, and strengthened our balance sheet. I am very pleased Pat will be continuing his career at Seagate in an Executive Vice President role, reporting to me and working on a number of strategic initiatives. I would like to thank our customers, suppliers, employees for their continued support. We are now ready for Q&A.
Ladies and gentlemen, if you have a question at this time, please press star and then one on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Our first question comes from the line of Rich Kugele with Needham & Company. Your line is open.
Thank you. Good morning. Two questions. First, when it comes to the high cap in nearline, and the enterprise for that matter, can you just talk about where you are for the PMR and the shingle versions, and what your thoughts are on timing for the 10 terabyte helium? As a follow-up, I know that there's some software changes that some of the customers have to do to be able to hit those capacity points in their systems. If you have any thoughts on the adoption rate once you get to those points.
All right, this is Dave.
Hi, Dave.
First of all, I'll start with the shingle version. The volume for that's an archive market only. The volume's small, but the traction's been pretty good. That's eight terabyte. The other eight terabyte, I'll call it workhorse drive, is really a high-performance nearline drive, and we're quite happy with the way it's proceeded through quals and built up its quality and so on and so forth in the ramp. We're right on plan for that, per earlier discussions. Relative to 10 terabyte, realistically, we said we'd be introducing helium at 10 terabyte, I think, in the last call. We're still on plan for that. It'll happen in the first two calendar quarters. The ramp will be pretty slow because that's bleeding edge areal density, but we're pretty excited about that product next year.
Okay, you don't see the software issue as an adoption hurdle?
For shingle, if that's what you're referring to, there's a difference between drive-aware and host-aware. Our drives today are drive-aware, the industry is going through a transition, which I think is what you're referencing, which is host-aware. That's where the customer side has to go modify some of their software to be able to adopt it, there's industry consortiums that are helping shuttle that thing along. I think we're right on the cusp as an industry of going through that transition, we haven't shipped any of that product yet, just test units.
Okay. Then just lastly, Steve, if you have any thoughts, big picture on the SSD market, your positioning, and your relationship with Micron in the wake of WD SanDisk.
Well, look, we've said for a while that we view these markets as more complementary than competitive. We've struck relationships with the companies that we view are the ones that are either technical leaders and/or low-cost leaders and/or have the broadest technology and/or are furthest along in transition to next generation of technology. None of those are really reflected by the WD target. Our engagement will continue to be with companies that fit that profile. Micron is certainly the one that we've publicly discussed the activities that we're undertaking together, that relationship continues to be very positive. We're happy with the engagement that we've had. There's kind of multiple threads of leveraging the joint technology between Seagate and Micron at the product level, of course, a lot of that falls under Phil's domain.
Phil, if you want to provide any additional color that where we're at versus what we've said to date. So far, Rich, we're pretty happy with where we stand, and we have similar potential engagement with other leaders in the flash space. Excellent. Thank you very much.
Our next question comes from the line of Aaron Rakers with Stifel. Your line is open.
Thanks. A couple of questions, if I can, as well. First of all, just curious, when you look at the model now with the Dot Hill transaction closed, how do we think about that in terms of the current expectations for the current quarter? Can you just touch on it, by my model, it appears that you had a decline both sequentially and year-over-year in your non-hard disk drive business. I do have a real quick follow-up.
This is Phil Brace. So far, I guess the model going forward, we're pleased with the integration going to date. Today, I would say that in aggregate, the model is probably underneath the corporate gross margins. Our obviously target is to actually get it above that. From this point of view, previous financials of Dot Hill had it above it, you would see us kind of integrating that and moving in that direction long term. On a year-over-year perspective, I think we were up year-over-year, quarter-to-quarter, so I'm not sure of the models. We were up a pretty strong year-on-year on both the systems side and the flash side.
Okay. As a real quick follow-up, I'm just curious with the moving dynamics that shows up in your working capital this quarter, and obviously being a driver of the free cash flow generation, how do we think about your free cash flow? How does the company think about the free cash flow generation from the model as we look forward on an annualized basis?
Hi, Aaron, it's Dave. We continue to work down our needs for our working capital. As you can see, through our stronger sales linearity this past quarter, a lot of our DSOs had improved. We got some benefit from our DPOs as well, and we're going to continue to monetize what we can out of our turns and inventory. We continue to be very thoughtful with a discerning eye on how we view that aspect of our business.
To be clear, you think you sustain this kind of cash conversion cycle level going forward?
Yes.
Okay. Thank you.
Our next question comes from the line of Joe Wittine with Longbow Research. Your line is open.
Thanks. Also on the non-hard drive business, give us some reasonable expectation of a revenue run rate. Based on the numbers you provide, and granted they're rounded, you're at $165 million last quarter, give or take. What kind of opportunity should investors expect over the coming, let's say, over fiscal 2016, where can you get?
Sorry. Could you repeat the question? Sorry, I missed the question.
That's okay. Just looking for a reasonable expectation of a revenue run rate for the non-hard drive business going forward now that Dot Hill is in the mix. A stretch goal, reasonable goal, where can you get the quarterly run rate by, let's say, exiting 2016?
Yeah. I think exiting 2016, you'd see us kind of on the $200-$250 a quarter kind of run rate, tracking to $1 billion+ a year, kind of in that factor.
Okay, thanks. Then maybe on the hard drive, TAM, anything you could talk about for the first half of the year beyond the current quarter here? Do you expect where we sit today to see the large seasonal decline in March? Like some have talked about previously, could the decline be a little bit more muted this year? It's hard to say just given kind of the lack of traction that's developed even in the second half of the year. Again, our view is narrower than it should be. It's not often that the CSP base in particular doesn't engage for more than three or four quarters, and we're kind of on the outer end of that dimension right now. We'd expect at some point here that there'd be a capital cycle that would improve.
For us, I think it's as much as broadening the customer base. Some of that is product related, and some of it is just engagement related. That's opportunity in front of us, I think regardless of whether or not there's a market acceleration. The fact that the second half of the year didn't develop the way I think the industry expected it would, I think that does probably say at some point there's going to be a capital cycle up. Right now, we don't have any signals that say it's going to be in the first half of the year, but we don't have any say that it's going to not either. I think a lot of it just depends on what happens through December, then do people start letting contracts. As you know, it's a cyclical business that's highly concentrated.
Until there's more diversity in that customer set, it's going to have an ebb and flow that can be challenging like it was for this quarter for us.
Makes sense. Thanks, Steve.
Yep.
Our next question comes from the line of Sherri Scribner with Deutsche Bank. Your line is open.
Hi, thank you. I think, Steve, you said that you expect to get back to your gross margin targets within the year over the next couple of quarters. I think you said the June quarter next year. Can you walk us through the steps that help you get to that? How much does MOFCOM add? How much does the improvement in the mix related to the storage business add? How do the cost cuts help?
The biggest thing clearly is better traction on our higher capacity nearline and mission-critical drives. That's the bulk of what hurt us last quarter. Again, reading some of the analysts' and other industry observers' work, I don't think there's still a great understanding about the leverage that's in a manufacturing system, especially on these enterprise drives. We're absorbing as many heads and disks and test time as we are. So unit misses in the 500,000-unit range, while they don't sound big relative to a 45 or 50 million shipment, they are. Especially obviously at the margin when the cost has been completely absorbed. Of course, those are decent price points, but they're good margin products to begin with, but obviously, if they're already built and sitting in inventory, then they're really good margin products.
You could see from our inventory uptick of $160 million, that translating into revenue accounts for a couple of hundred basis points of gross margin. Clearing through that inventory in a responsible way is going to take a couple of quarters. As we do that, we're going to see a more regular trend back to the overall gross margin that we expect to deliver. The other thing about that is, it kind of may feel like a big surprise. The other reality is the industry moves a lot of drives in the last two weeks of the quarter. Really with a week to go in this quarter, we could have still delivered the gross margin that we should have. It was just basically not executing or not having customers take the drives that we thought they were going to take.
That being the case, we're hoping that we can get those drives moving and again, in a reasonable way sooner rather than later, so that we can get back to the margin model that that piece of the business delivers. I think in terms of the incremental margin improvement of Phil's business, we really have, I think, a nice path of saying where we're at today from a gross margin and an operating margin perspective to make sequential quarter improvements in the direction that Phil talked about. Ultimately, we do believe that at the gross margin level, it's accretive to the range and certainly to the midpoint of the range. I think that certainly will help. Another big hunk of it, as you pointed out, is operating expense control.
Like we said, we think that we can still take another $20 million out of that number, which is, as you know, two quarters ago was on its way to 580. To get down to 460, we feel pretty good about. I think it's a combination of all three. It's all stuff that's right in front of us. It's for us to execute against. The trickiest stuff is frankly finding those customers that are taking those higher capacity drives and for the customers that we do engage with, understanding how we can get a better mix because clearly right now we're not getting the mix that we should.
Okay, that's helpful. Just to follow up, how much does MOFCOM add in terms of margin benefit? As a clarification, what share count should we use next quarter? Is it the 299 or is it slightly above that because of the diluted shares? Thanks.
I'll let Morton figure that out. The MOFCOM thing, it's hard to answer the question. For us, of course, if you just looked at it from a synergy perspective on quote, "OpEx", as you know we were basically maintaining a separate go-to-market organization for that. It wasn't a huge go-to-market organization. The synergies isn't so much immediately OpEx related. There will be some. There may be some OpEx related in that we were moving a lot of units, over 10 million units, with a pretty lean organization, and we are actually kind of reverse engineering that to saying, how can we take advantage of, quote, "The Seagate operation" to maybe look more like that. Actually, the synergies may effectively come from reduction in Seagate OpEx as opposed to the apparent reduction in the small single-digit millions of dollars that we were spending on the Samsung side.
I think the other big piece is revenue synergies. Clearly now, that product line is the highest areal density product in the industry. It has been for a couple of years, and we can now broaden that to the broader Seagate sales force. I think there's going to be some nice revenue synergies from that. Then the other big synergy that's an OpEx synergy, but I can't tell you, and it's going to save this many dollars, is that design center, which is a very competent design center, is now free to design products that don't have to be subject to the hold separate. So that allows us basically to start putting products into that design center or having products come out of that design center that aren't going to be limited to the Samsung sales force.
So in that sense, there's nice operating leverage because the design center is an expensive thing to keep. So having a broader portfolio come out of that, we think is beneficial. Net-net, we think it basically drives better revenue opportunity, clearly better margin opportunity as we mix across the portfolio, and then better operating margin because the more efficient dynamic on the design center as well as the go-to-market side.
Thanks.
Sherri, this is Dave.
Yep.
Just a quick follow-up. Please use 304 million shares for your fully diluted EPS calculation.
Great. Thank you very much.
Thanks.
Our next question comes from the line of Amit Daryanani with RBC. Your line is open.
Yep. Thanks. Good morning, guys. Two questions from me as well. Dave, I just want to go back to Aaron's question on the cash conversion cycle. Very specifically, though, could you talk about the DPOs, those extended pretty materially this quarter. What did you guys do differently, I guess, to get to 77 days there, and how can you sustain that?
If you go and compare it to where we were running kind of under the averages, both between us and our competitor down south, it was just a higher activity in and around of how we manage our working capital. There was nothing being done outside of anything with our normal terms. It was just we got very critical. Plus, we also had a lot of strong linearity in and around the quarter, which suited as well versus the previous quarter. That's where we see those upticks.
Got it. I guess, as a follow-up, given the transition or the acquisition Western is going through with SanDisk, I'm curious, do you think it creates an opportunity for Seagate to perhaps increase their market share in select markets, ideally enterprise, given the fact that your largest competitor may be a little bit more distracted as you go forward?
Yeah. It's not the distraction that I think is the opportunity. It's kind of the overall transaction. When you kind of go through it's a $10 billion premium to the 90-day average. 35 times earnings for a company that hasn't had earnings growth in five years, actually has earnings decline in five years, isn't a technical or cost leader, and you're going to finance it with $18 billion of debt, which means you have to somehow have big OpEx cuts because there's not enough SG&A to pay for that. Wouldn't appear to be enough revenue synergies because it's not a competitive technology relative to the leaders. It's going to come down to engineering cuts. I think that's the opportunity. It's not so much the distraction. Maybe there's a distraction, maybe there isn't.
The reality is, in order to make that model work, there's going to have to be OpEx cuts to pay back that huge debt load, or you never build in another fab. This is just an industry where, whether or not it's the flash side or the HDD side, massive cuts in R&D doesn't seem smart. For us, it's good. I think the opportunity is make sure Look, Seagate feels great about where we're at technically. We don't obviously feel great about having the broadest portfolio that we need, and we need to address that. The good news is we have the technical leadership to do that. We'll keep pressing that case. That's I think what's going to translate into the market opportunity, whether or not it's the enterprise level or the client level, or nearline level.
I do think that that transaction gives us an opportunity just because the OpEx side of their business is going to be challenged to pay back all that debt.
Perfect. Thank you, guys.
Okay, we have time for one more question.
Our last question comes from the line of Steven Fox with Cross Research. Your line is open.
Thanks. Thanks for squeezing me in. Since no one's asked about the PC market specifically, I was just curious if we could get your thoughts on how it looks maybe even into the middle of next year. Just very quick, Dave, just on the OpEx exiting this fiscal year, does that put you guys at sort of a normalized or a comfortable level with OpEx? Or do you think there's more that you could do depending on based on what you see about growth in the markets going forward? Thanks.
I think on the PC market, it's kind of always hard to tell where you're getting traction or not, especially when the gaming stuff comes in and out as much as it does. It feels like the PC market has kind of found its space and that there's probably a little bit of traction for some marginal growth. I think with respect to Seagate, kind of gets back to the technical point. We are excited about the product portfolio that we're about to roll. We do think when you transition to kind of one and two terabyte products, that's compelling for those client-based systems that actually do need onboard storage. Of course, we can do that in the form factors that fit into the new thin and light notebooks.
I think Seagate's always been a little bit more bullish on client than maybe others, and I think within that segment, we feel that we're particularly well-aligned, and maybe, again, that's a reflection of the fact that we're very OEM concentrated, and we feel good about lining up with what the OEMs need in that space. I feel okay about the client space going forward. As you know, I'm more encouraged also that there's some client that goes beyond what we're calling a client today, and I still think those opportunities continue to open up, and they're going to need one and two and four terabytes of data. By the way, same could be said about the branded market.
We've got a nice four terabyte market product out there right now, and we're gaining traction with it, and we continue to believe that the direct attached storage business will be quite good on the client side, especially as people skinny down on what they have on board.
In regards to modeling question, exiting FY 2016 at the $460 million non-GAAP run rate for OpEx. I think that's fair to continue on that trajectory. Obviously, we continue to evaluate in how we monetize our OpEx investments around the specific workloads that we deliver to our customers.
Great. Thank you very much.
All right. Thanks, everyone. We're going to work hard to gain back some credibility here, we appreciate you being on the call today. Look forward to talking to you next quarter.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, you may all disconnect. Everyone, have a wonderful day.