威騰電子 (WDC) 2006 Q4 法說會逐字稿

Good afternoon everyone.

And welcome to Komag's Fourth Quarter 2006 Financial Results conference call.

Today's conference is being recorded.

The company reminds the audience that they will be making forward-looking statements during this conference call, such as the statements regarding the outlook for the first quarter of 2007, including revenue, net margin, expected capacity and capacity utilization, trends in average selling prices and cash availability.

The statements regarding PMR shipment levels, product qualifications and product transactions, and key materials in 2007, the statements regarding overall market demand, demand trends, and market growth opportunities.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from the Company's forecast.

These forward-looking statements speak only as of today, and you should not rely on them as representing Komag's view in the future.

Komag undertakes no obligation to update forward-looking statements to reflect events or circumstances after the date they were made.

In addition to factors that may be discussed on this call, important factors that could cause actual results to differ materially are contained in the press release issued today announcing Komag's fourth quarter and full year 2006 financial results and in the Company's recent SEC filings, including the annual report and Form 10-K for the year ending January 1, 2006, and 2006 quarterly reports in Form 10-Q.

Copies of these documents may be obtained from the SEC's website, or by visiting the investor relations section of Komag's website.

The press release issued today describing Komag's fourth quarter and fiscal 2006 financial results is currently posted on the Company's website at www.komag.com.

At this time I would like to turn the call over to Mr. Tim Harris, Chief Executive Officer of Komag.

Please proceed sir.

Thank you, Dave.

Hi.

This is Tim Harris, CEO of Komag.

With me on the call today are Kathy Bayles, our CFO, Ray Martin, our EVP of Sales and Customer Service, Ed Casey, our COO, Tom Yamashita, our CTO, and other company officers.

I'll begin by providing an overview of Komag's fourth quarter and full year 2006 results.

Kathy will then discuss our financial performance, Ray will cover customer and market conditions, and Tom will address technology.

I'll then discuss operations and our outlook for the first quarter of 2007 before making a few closing comments.

We will then open the call to questions.

We expect the call to last approximately one hour.

First, let me say how pleased we are with Komag's record operational and financial performance.

In the fourth quarter, and for the full year of 2006, Komag continued to deliver outstanding results in all operational and financial categories.

We believe that Komag's record of performance, coupled with the ever-increasing demand for high-performance disks, creates conditions for a very successful future.

We continue to see a growing market for hard disk drives and traditional computing applications, as well as many new digital consumer applications.

We're proud to have achieved another quarter of record revenue and earnings enabled by a growing market and our continued focus on strong execution and results.

This is our tenth consecutive quarter of revenue growth.

In addition, we achieved record revenue and earnings for the full year of 2006.

Revenue increased 32.7% in the fourth quarter of 2006, compared to the prior year's fourth quarter.

Revenue increased 36.7% for the full year.

Fourth quarter and the full year 2006 net income and EPS were both all time records for Komag.

If you look at the results of the last two years, Komag has doubled revenue and tripled net income.

We increased total media capacity to a little over 41 million units in Q4 to support strong demand throughout the quarter.

This, together with the extra inventory we intentionally built at the end of Q3, allowed us to ship a record 42.1 million disks.

The increase in capacity from the original 40 million was achieved through excellent manufacturing execution with improved yields and productivity on the existing manufacturing tools.

It's important to remember that our capacity includes a mix of both perpendicular magnetic recording disks, known as PMR, and longitudinal magnetic recording disks, called LMR.

As the mix of PMR products increase, we're working to maintain our overall capacity at a constant level.

In that way, we can continue to supply our customers with the products they need without any impact on capacity.

We continue to work closely with our customers, and constantly monitor client demand.

We will not add capacity until we're sure that the demand is there [on of] the same basis.

As the market expands, we can increase capacity by 10% to 15% through process improvements alone.

We expect this additional capacity to be required in the second half of 2007.

Komag also sells substrates to strategic customers.

Demand for Komag substrates is especially strong for advanced LMR and PMR media applications.

With this extra demand, Komag expects to increase substrate sales during 2007 from about 10% of our total revenue of the past couple of years up to 15% going forward.

Our ability to increase substrate sales is the result of additional capacity due to the excellent performance and productivity of our substrate factory.

Now, let me pass the call over to Kathy, to discuss the fourth quarter and 2006 financial performance.

Kathy?

Thank you, Tim.

Komag has achieved another record quarter and full year of revenue and profitability.

Net sales for 2006 were $937.7 million, a 36.7% increase over 2005.

Net income was $157.5 million, a 36.2% increase over the prior year.

And EPS increased 33.8% to $4.75 per share for 2006.

Net sales totaled $255.9 million in the fourth quarter of 2006.

That compares to $239.6 million in the prior quarter, and $192.9 million in the fourth quarter of 2005.

This is a 6.8% increase from Q3, and a 32.7% increase from the year ago quarter.

We shipped 42.1 million finished disks in the fourth quarter, compared to 38.1 million in Q3, and 29.7 million in the fourth quarter of 2005.

Other disk revenue provided $27.4 million of revenue in the fourth quarter of 2006.

That compares to $23.2 million in the prior quarter, and $24.7 million in the year ago quarter.

Net income was $46.5 million for the quarter.

Diluted EPS were $1.39.

Third quarter net income and diluted EPS were $34.5 million, and $1.04 per share, respectively.

Net income and diluted EPS in the year ago quarter were $35.2 million and $1.07 per share, respectively.

Net income in the fourth quarter of 2006 included a $7 million non-cash income tax benefit resulting from the release of certain valuation allowances related to deferred tax assets.

As a result of this adjustment in the fourth quarter, our income tax rate for 2006 was a 0.2% benefit.

Net margins, including the tax adjustment, was 18.2% in the fourth quarter of 2006.

That compares with 14.4% in the prior quarter.

Gross margin in the fourth quarter of 2006, compared to the prior quarter, was negatively impacted by an unfavorable Malaysian currency rate change, which primarily occurred in December.

The impact on gross margin was around 1.5 points.

Operating expenses in the quarter were approximately 8.8% of revenue.

That compares to 11.5% in the prior quarter.

The primary reason for the reduction was completion of executive retirement stock compensation charges in Q3. another factor was a $2 million reduction in R&D spending due to successful completion of initial PMR media qualifications.

SG&A spending in the quarter was $2.7 million lower than in the third quarter.

This was primarily due to the lower non-cash stock compensation I mentioned earlier.

In addition, other FAS-123R non-cash stock compensation expense, or stock option amortization, was $500,000 in the fourth quarter, and $2 million for the year.

Depreciation for the fourth quarter was $24.6 million, up $2.5 million from Q3.

Depreciation in the year ago quarter was $12.6 million.

On our balance sheet in cash flow, we ended the fourth quarter of 2006 with $171.1 million of cash, compared to $164.6 million at the end of the prior quarter, and $205 million at the end of the fourth quarter of 2005.

Our ending accounts receivable balance was $133.6 million, compared to $147.1 million at the end of the third quarter of 2006.

This reflects the timing of sales during the fourth quarter.

Net inventory was $104.2 million at the end of the fourth quarter of 2006, compared to $88 million at the end of the prior quarter.

Finished goods inventory decreased by $3.3 million to $9.6 million at the end of the fourth quarter.

This includes inventory at all customer hub locations and approximates one week of inventory based on the shipment rate in the fourth quarter.

We increased the level of certain raw materials, primarily precious metals, in the fourth quarter.

We are maintaining a high level of some raw materials to be able to support long lead times and tight supply for these key materials.

With the PMR round, we expect precious metals inventory to increase further in Q1.

Capital expenditures decreased significantly in the fourth quarter to $31 million.

Total capital expenditures were $271 million for the year, down from the $300 million we had originally targeted.

We expect 2007 capital spending to range between $100 million and $120 million.

Operating cash flow in the fourth quarter was $48.2 million.

It was $251.4 million for the year.

Now, let me turn it over to Ray.

Thank you, Kathy.

We shipped a total of 42.1 million disks in the fourth quarter of 2006.

This represents a 10% increase in units [over] 38.1 million disks shipped in the prior quarter.

Sales mix by customer was Western Digital, 42%, Seagate, 37%, and Hitachi, 18%.

Shipments of 160 gigabytes and above discs were 36% of total shipments in the fourth quarter.

In addition, we shipped over 1 million PMR 95 mm aluminum discs during Q4, and we expect this level to increase significantly in Q1 through 2007.

As we said previously, our customers' product plans determine our product mix.

We ship the product that each of our customers needs.

We continue to provide flexibility in our manufacturing operations to support all of our customers, and we'll maintain a broad product portfolio to meet their requirements.

Our overall blended average selling price in the fourth quarter was down from the prior quarter.

As expected, the 80-gigabyte product mix increased in the fourth quarter.

This, combined with the end of life of our Enterprise programs led to the drop in blended ASP.

With the increase of PMR products and other advanced disks during 2007, we expect the blended ASP to begin trending up in Q1 and continue throughout 2007.

About 11% of our fourth quarter revenue was derived from sales of substrates and related products.

As Tim has mentioned, we believe the level of substrate sales should increase during 2007.

This is due to the high quality of our substrates and our excellent performance for PMR media.

Our new customer and product qualifications are going well.

We qualified last quarter with Samsung on a 65 mm aluminum product, and we are working with them on additional 65 and 95 mm programs.

Adding Samsung to our customer base allows Komag to cover close to 100% of the aluminum market for media.

Ninety-five millimeter media is far and away the largest market segment.

Sixty-five millimeter media is the second largest market segment, and the fastest growing.

Komag is the largest independent supplier of 95 mm aluminum media, and we see significant opportunities in 65 mm PMR media.

We are currently sampling, and expect to ship products in the second half of the year.

Now, Tom will provide some comments on technology.

Thank you, Ray.

Komag is the leading independent supplier of 95 mm aluminum PMR disks.

We have begun sampling of 65 mm glass PMR media, and we expect to qualify into several programs in 2007.

We also have a 65 mm aluminum version of the PMR media that we are sampling to our customer.

The customer feedback has been excellent.

PMR technology requires more materials to be deposited on the disk surface.

We're developing improved processes and more efficient tools to do this cost effectively without reducing our total output.

There are still many challenges to be faced as more and more of the new products use PMR technology.

Komag is very proud of our demonstrated leadership and performance in PMR technology.

In addition to increased materials being deposited on a disk, PMR uses increased amounts of key precious metals. [Ruthenium], for example, is needed to obtain the critical magnetic performance from the media.

Ruthenium is a scarce material that has increasing demand from several applications, including its use in PMR disks.

As a result, the price of this material has recently increased significantly.

This is an industry-wide problem.

Komag and others in the media business are looking at ways to reduce amounts of Ruthenium used in PMR disks.

First, we're implementing methods to be more efficient in the deposition of the Ruthenium layers on the disk.

Second, we're testing ways to reduce the thickness of the Ruthenium layers.

Further, we're developing other lower cost materials to significantly reduce Ruthenium usage.

Good progress is being made on all three fronts.

PMR disks have a fundamentally higher cost, because of thicker layers and use of materials like Ruthenium.

But they also have higher capacity [per platter], and a better level of performance at the drive level than LMR disks.

This is why we believe that both PMR and LMR technology will continue to coexist throughout 2007 and 2008.

Komag will supply both technologies to our customers.

Now let me turn it back over to Tim.

In summary, I am very pleased with our performance.

We achieved record revenue and earnings for both Q4 and the full year of 2006.

I'd like to sincerely thank all of our employees for the ongoing excellence of their continuing efforts, and their commitment to Komag and to our customers, which make these outstanding results possible.

We expect solid growth for disk drives and strong demand for advanced media during 2007.

Many outfit forecasters are looking for disk drive unit growth in the mid-teen levels for 2007.

Because of the demand from key strategic customers for Komag's advanced substrates, particularly PMR substrates, we expect to grow substrate sales during 2007 to around 15% of total revenue.

We anticipate that overall unit demand for finished media during Q1 will be normal, and seasonally down by approximately 4% to 6% compared to the fourth quarter of 2006.

Total revenue is expected to be down 2% to 3% compared to the fourth quarter.

But it will be up approximately 20% from last year.

This is due to an increased and blended average selling price for finished media, and an increase in substrate sales to approximately 14% of revenue in Q1.

With this level of expected revenue, the mix of products, and certain cost increases, we expect net margin in Q1 to be n the range of 12% to 14%.

The income tax rate in Q1 is expected to be approximately 5%.

The tax rate in 2006, without the benefit of the fourth quarter tax adjustment, was approximately 2.4%.

With an increasing level of PMR and other advanced products, we expect that blended ASP will trend up over the course of 2007.

We're very pleased with our technology leadership.

Komag is qualified and ramping new 95 mm PMR media.

In addition to our 95 mm PMR product development activities, we are also working on advanced 65 mm PMR designs for both aluminum and glass for shipment during 2007.

The 65 mm market is large and growing, and therefore a significant incremental opportunity for Komag.

With the transition to PMR, the timing is completely appropriate for Komag to produce both glass and aluminum 65 mm products as our customers have requested.

We believe that these opportunities can be significant to Komag during 2007, particularly during the second half of the year.

We anticipate that all of our customer base will begin to transition to PMR products during 2007.

Komag is ready to support our customers' needs.

We remain very optimistic about the growing demand for disk drives and disks, in both the traditional computer related markets, plus the rapidly expanding markets for consumer electronic devices.

We believe that we continue to be well positioned to benefit from this growing demand for disk drives in multiple markets and applications.

We're convinced that we have the right financial model for long-term profitability.

We're committed to maintaining our high quality, low cost manufacturing, technology leadership, and growing our business through excellent customer support.

As I turn the call back over to Dave for the Q-and-A, I would like to remind our audience that we will end this call at 3:00 p.m.

Dave, please open the call for questions.

Thank you very much, Mr. Harris. [OPERATOR INSTRUCTIONS] And we'll take our first question today from Mr. Mark Miller with Brean, Murray.

[Inaudible] your quarter.

I just wanted to talk-- I assume it's just factory loading, but it appears from your guidance, your net margins are continuing to trend down.

Is that primary factory loading for the projection for the March quarter?

Thank you, Mark.

I wouldn't say trend down.

We do expect Q1 margins to be down slightly due to a combination of factors, including, as you mentioned, the seasonally low utilization for finished media in Q1.

We also have the impact of the currency, and as mentioned, some increases in material costs.

That will all be offset slightly by increasing the ASP, which we would expect to continue throughout the year.

Second question, and I'll end here.

Hoya looks like they've had some problems.

There's a lot of talk about very aggressive pricing in the mobile space this year, including media.

And, of course, you're trying to get into that.

What's your strategy there?

Can you give us any insight in terms of what's going on over in that market, especially with the pricing?

Again, thank you, Mark.

Our customers have been pulling hard for us to enter into that market to provide that particular product, and in most cases, to support their entire product line.

It's very valuable for us to be not only in aluminum, but in glass for them, as well.

In terms of pricing, I guess all I would say is that overall, we've seen that the prices have been maintained actually better in glass than aluminum over the last time period.

And we think that we will have an extremely competitive product that will be able to be priced competitively and provide our customers with the product and support they need.

If I could just ask, do you have any ability to pass along the material cost increase for Ruthenium?

I know there's other materials, as you noted, and they've been around for a while.

And you can do things like improving your cathode usage.

But do you have any ability to pass on those costs, especially with the rapid rise we've seen?

Well, let's talk about Ruthenium, maybe, as a more general statement, a more general problem.

So the first thing to remember is that we have an adequate supply of Ruthenium.

We're not in a position that we're not going to be able to meet our customers' demand.

Secondly, I would say that-- I guess I'd acknowledge that, the Ruthenium cost has certainly gone up.

It's certainly more expensive now than it was a quarter ago, and we're working really hard to minimize their usage.

Now, Ruthenium, and all these kinds of costs really are industry-wide issues.

And we're, of course, working closely with our customers to get through those.

We always price competitively, and over time, pricing always reflects the costs of the product.

The key right now for us is really the work we're doing, and others are doing, to reduce our usage of Ruthenium.

And I break that down into maybe three main areas.

The first is process.

There are significant opportunities to minimize our usage of Ruthenium by use targets that have various process conditions.

Secondly, by the use of alternative materials and design optimization, and thirdly, supply chain optimization.

And all three of those have very significant opportunities to improve and to reduce the amount of Ruthenium that we use.

So we will start to see data [pits] from those efforts this quarter, and the roll out of those benefits will occur at various times for the various different methods of completion.

Thank you.

We'll go next to a question from Andrew Neff with Bear, Stearns.

Sure.

If I could, a couple questions.

One.

Even if you take into account the 1.5% hit from currency, one would have thought that your gross margin with the higher loading would have been better in the fourth quarter.

Can you address that?

And also, what percent of cost is Ruthenium as a total cost, roughly?

Hi Andy, this is Kathy.

Let me try and address the first question you asked relative to the margin.

In the fourth quarter, the net margin with the tax adjustment was 18.2%.

Without the tax adjustment, it was about [15.4%.] And without the currency adjustment, it would have been around 17% net margin.

And that's how we would look at the net margin in Q4.

As far as the second question, can you repeat the second question?

The second question was, when you look at Ruthenium, what is it as a percent of total cost of your-- generally.

Can you give a ball park of what the impact is?

Yes.

We typically don't break out the specifics on any particular cost.

No, for competitive reasons.

And yes, we definitely don't want to say what percent of our total cost is.

Various people have done various modeling, and it's important that that cost be the same for everyone in the industry.

We're all paying market prices.

And so it's something we'll have to accommodate, and as I said, to minimize.

And then, two things.

One, on Samsung.

It looks like you've been shipping to them, but they don't really show up as a percent as a customer.

When will we see that.

Second, the tax rate.

You've indicated it was going to be around 3%, now it's about 5%.

Can you give us a sense of what's going on with tax rate, generally?

I'll attempt to speak to the Samsung question, and then I'll let Kathy speak to the taxes.

So we're currently shipping 65 mm aluminum product to Samsung, and that's going well.

Although, frankly, the 65 aluminum has not grown as fast as we thought it might.

We are working, though, we are in qualification for both 65 mm aluminum and 95 mm PMR programs with Samsung, and I say that's going very well.

So we continue to expect to see material benefits in the second half of '07 with Samsung.

And the question on the tax rate.

Andy, this is Kathy.

The tax rate without the tax adjustments for 2006, we were projecting about 3%.

It was a little bit lower than 3%.

On a go-forward basis, as we said, we're looking at about 5% rate.

There's been a little bit of a change in tax rules that's increasing the tax rate.

I think the important thing about our tax rate is that it's still a very low rate, it's primarily non-cash, and we have tax holidays in Malaysia through 2016.

And lastly, just on currency.

Could you just talk about how you tend to hedge, and what's happening with the Malaysian currency, in particular?

Did you get any benefit from that on the expense side?

Hedging.

I mean, we do do hedging from time to time.

That can help smooth short-term fluctuations.

What happened in the fourth quarter, it was a very large change in December.

So those changes-- we do operate in Malaysia and if the currency rate changes in an area where we operate, that just changes your cost structure one way or the other.

Was there any benefit from that as well, or was it just a hit to...

No, it was basically just an increase in cost.

Thank you.

And we'll move next to a question from Kevin Hunt with Thomas Weisel Partners.

Thanks.

I had a couple of questions.

First, just following up on Andy's question on the margin.

You still would have thought you would have been 100 to 200 basis points higher than what you just said, Kathy.

So can you give us some of the other factors that might have been impacted.

You mentioned materials and placing.

Any way you can quantify what those in sum might have been?

And I had a couple follow ups.

The two items that I pointed out were the tax adjustment, which was favorable.

Without the tax adjustment, we were at about 15.4%.

That, including the over 1.5 points in gross margin for the currency.

Without those two impacts, the net margin would have been around 17%.

Other items, the ASP was decreased because we had a very high mix of 80-gig product during the quarter, and some additional items relative to material costs.

But everything else kind of [inaudible] out.

Okay.

So there wasn't any big substantial shortfall from the mix pricing or the materials is what you're saying?

Not any major differences.

I think the mix of the 80-gig was a little bit higher than we had originally expected.

Okay.

You gave the $500,000, you said, for stock option expense.

Can you give what that would have been total, with all the executive charges and so forth for both the quarter and the year?

The executive charges through six months, or through the nine month period which ended in Q3, that was $6 million.

And there was none in Q4?

And there was none in Q4.

We completed those charges in Q3.

Okay.

So there was only $500,000 total for Q4?

Q4 was the stock option amortization expense.

And then one last thing.

You mentioned the substrate smoothing up as a percent of the total sales mix.

Looking out through '07, are you still assuming normal seasonal patterns on your finished disks as well?

Or should we assume that those are going to be less than what the industry growth is going to be?

We expect some finished media to be completely seasonal with some slide down in the first half and a very strong second half.

So you're basically saying that you should be in line with industry unit growth on units, but having some incremental substrate sales.

Is that the way to take this?

Yes.

Okay.

Thank you very much.

Maybe just a comment on the substrates.

Komag is primarily a media supplier.

Nonetheless, the incremental opportunity with substrates is really a good thing on incremental revenue for us, and allows us to provide good strategic support for our customers.

Komag, of course, is the number one producer of aluminum substrates, but we have really good economies of scale.

So we're pleased with that opportunity as incremental business.

And our next question comes from Rich Kugele with Needham & Company.

Thank you.

A few questions.

First, on the net margins.

Historically, you've been able to keep them somewhat higher than where you were guiding here for Q1.

Do you expect it to return to your more normal range going forward from second quarter on, or do you anticipate some of these costs to linger?

Rich, this is Kathy.

I think, in the net margin guidance in Q1, we are expecting the change in the tax rate.

That will have a little impact.

Also the ongoing currency impact, that's about 2 points in margin.

That, with some additional materials costs and other items, those things are factored into our margin for Q1.

As we go through the year, we haven't changed the long-term model, and so we expect to have continuing disk performance, basically, throughout the year.

Rich, this is Tim again.

I would just say that we'll often see fluctuation in the margin, short-term fluctuations in the margin, but that the long-term is unchanged.

How quickly do you anticipate seeing improvements in your own usage and expense of Ruthenium?

We're starting to roll out improvements here, as we speak.

And so there's-- if you will, the rate per [inaudible] is starting to go down really just immediately.

And I should, maybe just to clarify, though.

There's going to be a whole series of rounds of improvements.

And the first one is good and significant.

We'll start seeing benefit of that this month, and then we'll continue to get them, have benefits roll out going forward in time.

So if you had to rank the things-- not to belabor the margins-- but if you had to rank the things that are hurting you the most, is first and foremost the currency, followed by your mix, and then the Ruthenium?

I don't want to put words in your mouth.

What do you think?

That's a good summary.

And then lastly-- and this is something that we wouldn't know outside of the company.

What do you think your capacity would be if you start shipping 65 mm?

How does that change the dynamic of what your capacity will be in the second half?

In the short-term, the capacity is approximately the same, whether it's 65 or 95.

If the volume got high enough, there's some things we can do, but for modeling purposes, it should be treated the same.

Okay.

Thank you very much.

Thanks, Rich.

And we'll take our next question from David Bailey with Goldman Sachs.

Yes, great.

Thank you very much.

Two questions, please.

The first one is, Hitachi seems to be dropping as a percentage of your mix, and on a unit basis for the past couple of quarters.

And I was wondering if you could give us a little more detail around the main factors that are driving that decline?

And where do you expect Hitachi to be as a percent of your units in the March quarter?

Thanks, David.

Good question.

What I'd start by saying is that there really isn't a trend either as a percentage or as a sheer number of units.

The mix of our customers, always will vary quarter to quarter, and Hitachi was a bit down in Q4, but there's no reason to believe it will continue at that particular level.

And then just a quick one on--

Just one other point on that.

That's really a good example of why we think it's so important to be qualified in, at all of the four major producers of the 95 mm aluminum prods.

And that's why Samsung's very important to us, because then, as one customer goes up and another customer goes down, it really minimizes our exposure to variation within the desktop arena.

And then just one quick one.

Given that you're going to be increasing your mix of substrates, can you give us a general idea of the difference in gross margins between the finished media and substrates?

Yes, good question.

The way to think about it, I think is that substrates may initially have a slightly lower margin percentage.

But it's additional incremental margin dollars.

And it's important-- the comment we made earlier that these sales are primarily enabled by increasing productivity within the factory says that we did not have to add a bunch of capital equipment to do this.

So the margins may be slightly low to begin with, but I think that they will be very similar to completed media soon.

Great.

Thank you.

Thanks, David.

And we'll take our next question from Christian Schwab with Craig-Hallum Capital.

Great, thank you.

On the ASP trending up, can you quantify that?

Historically, if they were going to modestly decrease, historically they kind of went down 2% to 3%.

Should we be thinking that they kind of trend up 2% to 3% a quarter, or is there a ladder step?

I don't think we'd want to break it out by quarter, but it is fair to say that it continues to increase.

It starts increasing in Q1 and increases throughout the year.

And I think that makes a lot of sense.

The mix, of course, gets richer, and the percent of PMR grows throughout the quarter.

So I think, as you'd expect, it goes up throughout the year.

So should we think that we exit in 2007 with similar prices to what you have been at the previous four or five quarters to December?

Will the mix surprise you?

Meaning somewhere between $5.65 and $5.75 roughly?

It'll really depend on mix, and it'll depend on how well the industry does in replacing Ruthenium and other things.

At least, the range in which you're speaking.

At least in that range?

That's what I'd say.

That's very helpful.

And then, when do we expect the currency issue to go away, on impact to gross margins?

From an operations viewpoint, I would say that we're very good-- we're really an execution branded company.

We're very, very good at taking on costs.

So over time, we'll be able to minimize the impact of that currency change.

So I don't think we can predict whether the dollar's going to strengthen or weaken versus the Ringgit.

But it's not just a Malaysian issue, it's all of Southeast Asia, at least.

But again, I think it plays, in some ways, to our strengths, and we've got a really good team there, we've got a really good cost structure and they're really focused on not only technology quality, but also rigorously working to take cost out.

So we'll whack away at that and eliminate that [team].

Are you pursuing a hedging strategy?

As I said before, Christian-- this is Kathy.

We do look at that on an ongoing basis, and we consider whether or not that's appropriate or not.

And then, remind us what your long-term goal is for net margins?

Well, for net margins, we basically said that we were looking at the range of, I think on a low-end, in the past, we were down in the 13%-14% range.

So somewhere in that range, up to the upper teens.

What kind of things would have to happen to return to 17% in the back half of the year?

Can you just walk me through the simple things?

Factory utilization's obviously a key.

A richer product mix, more PMR will help.

We're working on all the cost improvement activities.

Yes.

So those are certainly the three main factors.

Then just one last question, a follow up to the Hitachi question.

I guess, from your comments of why you're excited to be qualified at all aluminum customers, I guess that would kind of suggest that we should assume that Hitachi lost year-end Q4?

I was afraid that came out.

I really have no knowledge at all about how they did it-- how their desktop share was in Q4.

They're a good customer, and we work really closely with them, and we think they've got really good product, and they're a strategic customer for us.

So overall, we see that as increasing, not decreasing.

Is there any new significant programs that you're ramping on your largest customer that would explain the significant increase?

Well, we're actively qualifying in next generation after that, really in all of our customers.

So I don't think I'd say there's any unusual or abnormal focus on one customer versus the other.

They're all important and they're all working on the next generation products.

Do you believe you gained share this quarter?

Sorry?

Do you believe you gained share, versus those who can't produce platters internally?

Clearly we gained share over the last couple years.

And I guess I'd say clearly in the year we gained share.

I think it's too early how Q4 looks.

Great.

Thank you.

Thanks, Christian.

And we'll go next to a question from Steve Fox with Merrill Lynch.

Good afternoon.

I guess most of the expense questions have been answered.

I just want to clarify a couple things on the RD&E expense going into next year.

So is a $15 million a quarter run rate reasonable to expect now, or is there other projects planned for next year that'll bump that up?

Hi, Steve.

This is Kathy.

Hi.

Thanks for the question.

On operating expenses, in the fourth quarter the operating expenses were about 8.8% of sales.

We expect operating expenses to be more in the range of 9% to 10% of sales.

In the first quarter there will be additional development activities related to PMR programs, including glass.

And as we said, we expect total revenues to be down a little bit in the first quarter.

So on a go-forward basis, the 9% to 10% range is more reasonable.

Okay, great.

And then just secondly, on the improvement in the mix that you see later on in this calendar year, just a better feel for the timing.

It sounds like it's sort of a mid-year type of event.

Is that fair, and is it mainly driven by PMR, or is it mainly driven by the mix shift in terms of gigabytes per platter?

We expect the ASP to start increasing right away.

And certainly, we see that both in the more advanced LMR and the PMR, as well.

Okay.

I think I just wasn't clear on that.

Thank you very much.

Thank you.

We'll go next to Matt Kather with WR Hambrecht.

Hi there.

Can you hear me?

Yes.

Tim and Kathy, I'm interested in getting your viewpoint on the disk per drive ratio, and where you see that in 2007.

Certainly, other component players have speculated that due to a slower migration [of] the higher capacity points in desktop, et cetera, that we might see a decrease in that ratio for this year.

I would love your thoughts.

Sure.

I guess our belief would be that-- the headline would be that we believe, and expect it to be, roughly flat.

And so, it's worth delineating, or dividing up the market a little bit.

I mean, the majority of desktop is already single disk.

And I think that'll probably continue single disk.

In addition, though, the whole impact of the CE to consumer end of it is just very beneficial.

Particularly in 95 mm, where a lot of the applications are the PVR/DVR applications, with multiple high-capacity disks per drive.

And I think you've seen that with recent product announcements with 1 terabyte, 750 gigabyte.

Certainly, on the consumer, the CE end, people are taking all the additional capacity they can get, and we don't see any significant reduction in disks per drive.

You could imagine a reduction in heads or something similar, but you need a disk.

You need a minimum of one disk per desktop.

Which is a good thing.

If I could ask one follow up.

Just on the PMR ramp, you said that will happen very rapidly.

It looks like only just over 2% of your disks that you're shipping use PMR.

Can you give us any more color on how steep that ramp is, given what your customers are communicating with you?

Yes.

Great question.

We were hoping someone would ask.

First of all, I guess, in context, we're just extremely pleased with the way it's going.

And we shipped over a million disks, went from basically zero to a million.

We're doing substantially more than that in Q1, and we'll ramp it throughout the year.

Our view at this point would be that we would see about 50% PMR in the last quarter, 50% of the disk that we would ship would be PMR.

The vast majority of 65 mm will be PMR, and maybe half of the 95 mm.

The transition rate will really, to a large extent, be determined by the customer.

But everything we're seeing is that the disks are performing very well, both at the manufacturing disk level and the drive level.

So all are really positive stories, and we're happy to be ramping our production.

And the last thing, just on the point as we see PMR ramp, obviously higher costs involved with the manufacturing.

You still are thinking that margins will be roughly the same because you'll be able to get a premium and recover all those costs?

Yes.

We think, as we look at it, and from what we've seen in the past, in the long run pricing always relates to cost.

So we would expect to get our normal margins.

Great.

Thank you very much.

Thank you.

Our next question comes from Mark Moskowitz with JP Morgan.

Yes, hi.

Thanks for the opportunity.

A couple questions here.

First off, if we get back to your outlook in terms of expectations for normal seasonal downtick of 4% to 6%.

I know we're kind of out of the box here, and not completely yet as far as the other drive participants provide in their outlook.

But it seems to be a little lighter than what we've heard so far.

Can you maybe just comment on, are you losing share, or is there sort of mix shift in terms of external versus internal capacity [inaudible]?

Good question.

So Seagate announced flat, slightly down.

A lot of it is affected and determined by the particular market segment that we're playing in at the moment.

So we're, at this point, 95 mm-- a substantial part of the 95 mm product is desktop, which seems to be the disk drive market segment that's most susceptible to the slower first half and the stronger second half.

So that's one of the reasons that we're working so hard to qualify both into mobile, and also into the other desktop suppliers.

Okay.

And then, as far as your substrate opportunity, you seemed quite constructive about what that could bring for 2007.

Can you give us a sense, in terms of what type of commitments, if there are any commitments, from some of these potential customers, in order to prevent [these from] volatility that that target of 15% could project?

And then kind of a follow up to that.

Can you give us a sense in terms of how much of your overall capacity does your substrates business consume now, at around 10% or 11% of revenues.

What happens when you go to 15%, from a fixed cost absorption perspective, as well?

The substrate sales are all long-term commitments.

It's not spot market sales, I think was your first question.

Secondly, I guess, in terms of capacity, we don't break it out that way.

Again, I don't want to oversimplify it, but it sort of goes back to what I said before, that it's incremental capacity that we made available by improving the processes and capabilities of the factory.

So there is no impact at all on our immediate capacity by our selling additional substrate capacity.

And we'll certainly expect that to continue.

We are primarily a media company, and the substrate business is just nice incremental business.

It's good to spread costs and it's good to challenge our guys, it's good in every way.

But we're a media company, and the substrate business will not interfere with them.

How should we think about it then, if it's really not impacting your current state of capacity?

Shouldn't the incremental margin there be better from a fixed cost absorption perspective?

I don't really want to get into that level of detail [inaudible].

Okay, that's fine.

And then, lastly.

Kathy, could you just kind of walk us through the depreciation schedule, the movement into the December quarter?

I would have thought it would have been maybe a little bigger, just given how we've talked about this subject in the past, in terms of the lag effect, and in terms of when the CapEx actually hits the books and when the actual associated depreciation follows through.

We started to see a bigger incremental movement in depreciation going through the middle part of last year.

That kind of dovetailed to the prior CapEx deployments that were six to nine months before that.

Can you kind of help us out as far as why that trailing depreciation expansion's not there anymore?

Mark, I think what I said on the last conference call was that we had expected, with decreasing capital spending on a GAAP basis, which has occurred fairly dramatically in the third quarter and the fourth quarter this year, that the rate of increase of a quarter to quarter basis and depreciation would start to flow.

So the rate of increase did flow in the fourth quarter, and we would expect that to continue in '07.

And I would just add, operationally-- two things.

One is we dramatically spent less for the year than we forecasted right up to kind of the middle of Q3.

And we capped the capacity growth at a point where that last $30 million did not roll into Q4 at all.

So Q4 would have grown less than you would have anticipated I think.

Okay.

And maybe I can squeeze one more question in, Tim.

I really appreciate your constructive presentation here in the last two earnings calls.

I want to get a sense-- why don't you just talk about the significance, rationing back of your capacity.

Your predecessor used to be pretty loud about saying Komag would have to continue to add capacity through the end of 2007, maybe even beyond, I believe, in prior prepared remarks.

What led to that?

What was the underlying force to really pull away that inspiration to keep on adding capacity [to] each order?

Thanks, Mark.

I'm glad you asked the question.

First of all, the backdrop is that, as I've said many times here already, that we doubled the capacity and tripled the net income in the last two years.

So there's a growth far faster than market.

And in fact, we have the ability-- and in fact, we expect to grow in '07 with the market.

We just expect to do it less by adding large amounts of capital and more by optimizing the factories and the processes, and all of the investments we've made in the last couple years.

So we've really got what I regard to be the beneficial situation where we could simply squeeze a lot more out of what we have.

And I think that'll be beneficial on every front.

So it doesn't make any sense to add a lot of capacity in Q4 if you think that your particular markets are going to be seasonal.

And that was certainly our case.

In fact, we did add a million in Q4 because our customers urgently needed it.

But we sold that growth substantially.

And as we need incremental or additional capacity again in the second half of the year, we'll squeeze and create that capacity.

Okay.

Thank you.

Mr. Harris, we are approaching the end of our allotted time.

We have time for one final question.

We'll take that question from Shaw Wu with American Technology.

Thanks for the opportunity.

I'm going to go back to the expenses again, with Kathy.

Your expenses were a bit lower than I expected for this quarter.

You cut back on both R&D and SG&A.

I was just wondering what led to that.

And just another follow up.

Can we expect expense levels to kind of go back to where they've been in the past?

Thanks.

Again, I think on operating expenses, as we said, it was about 8.8% operating expense in Q4.

The two biggest factors on that was there was a $2 million reduction in R&D.

That was primarily because in the prior quarter, we were doing our initial R&D development work to ramp the initial R&D program.

We completed that successfully, and so we were able to reduce the R&D in Q4.

The other item in SG&A was due to non-cash stock compensation, which we completed those expenses related to the executive retirements in Q3.

So that was the main reason for the reduction in G&A.

On a go-forward basis, as I said, I think we do expect that operating expenses would be more in the 9% to 10% range.

And in Q1, we will have additional developments related to additional PMR programs, including our [inaudible] program.

On R&D spending, let me add maybe some more color from a 20,000 foot view.

We haven't reduced our R&D spending, in terms of head count, or activity.

And in fact, we have suddenly more people working R&D than we did before.

We always work at doing it more cost effectively, and if we can reduce costs, we certainly will.

But there's not been any reduction in the amount of development work.

There tends to be, and can be fairly substantial quarter-to-quarter variation on, specifically, where we are in the product qualification cycle.

As Kathy mentioned, in Q3 we completed qualification of a number of PMR programs.

So that was really our peak spending in Q3, and then that was spending we didn't have to do so much in Q4.

Also, it's fair to say-- I guess, as I look at it, the development load, the R&D load, if anything has increased.

And part of the way we're dealing with that is by doing as much of the incremental, or as much as the additional development load, we're actually doing in our facility in Malaysia, as compared to just doing it here in the U.S.

And that's a really good sign of the maturation of the Malaysian factories, but also the U.S. development center's ability to support it.

So we're very pleased with that change.

Thanks for your insight.

Thank you.

And that concludes our question-and-answer session.

Mr. Harris, I'll turn the conference back over to you for any closing remarks.

Well, thank you.

In conclusion, Komag is very proud of our 2006 record results.

We see 2007 as another year of strong growth for the disk drive industry.

We believe that we've demonstrated both our technology leadership and our manufacturing excellence, and that positions us well for another excellent year in 2007.

So thank you very much for joining us on this call today, and we look forward to speaking with you again next quarter.

Bye bye.

And this concludes our conference call.

Thank you everyone for joining us.