威騰電子 (WDC) 2007 Q1 法說會逐字稿

Please stand by, we're about to begin.

Good afternoon, everyone, and welcome to Komag's first quarter 2007 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 Company's financial outlook for the second quarter of 2007, the Company's expectations for 2007 and beyond with respect to its revenue, net margins, capacity and capacity utilization, trends in average selling prices, and cash availability, the statements regarding the importance of PMR media in 2007, PMR shipment levels, product qualifications, and product transition plan.

The statements regarding the expected levels of the Company's raw materials inventory and related statements regarding precious metals inventory, the statements regarding overall market and industry demands, demand trends, and market growth opportunities, and the statements regarding the disk drive industry's second quarter downward seasonal pressures.

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 views 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 in this call, important factors that could cause actual results to differ materially are contained in the press release issued today, announcing Komag's first quarter 2007 financial results, and in the Company's recent SEC filings including the Annual Report on Form 10-K for the year ended December 31st, 2006 and 2006 quarterly reports on 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 first quarter 2007 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 go ahead, sir.

Hi, this is Tim Harris, CEO of Komag.

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

I'll begin by providing an overview of Komag's first quarter 2007 results and our outlook for Q2.

Kathy will then discuss our financial performance.

Ray will cover customer and market conditions, and Tom will address technology, and I'll make a few closing comments.

We will then open the call to questions, and I expect the call to last approximately one hour.

This was a solid quarter, especially considering the seasonal nature of our business.

Overall revenue increased 27% in the first quarter of 2007 compared to the prior year's first quarter.

We increased our perpendicular magnetic recording, or PMR, shipments to over 8.4 million [dips] in the first quarter.

We have now shipped over 10 million PMR dips, making Komag the largest independent supplier of PMR media, second only to Seagate in total PMR media produced.

Komag's position in PMR media will become even more important as more products and customers move to higher volume of PMR media over the course of 2007.

The industry's transition to PMR media is important as it allows the industry to continue to increase storage capacity to keep up with the ever increasing needs for digital magnetic storage.

Komag is proud of our leadership position in PMR media, and we believe that this continues to support our position as a strategic, independent supplier of media for the disk drive industry.

Qualifications of our glass products are going well.

We expect to be qualified on 65 millimeter glass by the end of Q2, and anticipate volume shipments in the second half of '07.

Our substrates business is also doing well.

We sell substrates to strategic customers.

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

Our ability to increase substrate sales as a result of additional capacity due to the excellent performance and productivity of our substrate factories.

We continue to work closely with our customers and constantly monitor media supply and demand.

As the market expands we believe that we can increase capacity by 10 to 15% per year for several years through process improvements alone.

Q2 is going to be a much more difficult quarter for us.

We anticipate that overall industry demand for disk drives will be seasonally down in Q2, with more than the normal seasonal pressure on the 3.5-inch desktop and high capacity drive.

Given Komag's strong presence in these markets we expect that our currently served totally addressable market, or TAM, will be down more than the overall market, and we anticipate that our revenue excluding the affects of any precious metal inventory sales in Q1 or Q2 will be down by approximately 8 to 10% from the first quarter of 2007.

In addition to the lower demand and, therefore, reduced capacity utilization in Q2 we are facing margin pressures from several fronts.

Kathy will discuss the margin pressure in more detail, but the bottom line is that we are not pleased with our current margins.

They should improve as we get better capacity utilization from our activities to grow our TAM, as well as an improving market.

However, we do not expect to see the same margin profile that we have seen in the recent past until we achieve close to full capacity utilization and we substantially complete the PMR transition to replace the legacy products.

None of these issues are new to us.

We've encountered all of these types of challenges in the past, and we have successfully navigated through them.

It sometimes takes a few quarters to work through these types of challenging issues, but we believe that we are taking the right steps to promote the long-term success of the Company.

We remain optimistic regarding the Company's long-term business outlook, and are continuing to plan and invest for the future.

Now, let me pass the call over to Kathy to discuss the first quarter 2007 financial results.

Kathy.

Thank you, Tim.

Revenue totaled $264.7 million in the first quarter of 2007.

That compares to $255.9 million in the prior quarter and $208.5 million in the first quarter of 2006.

This is a 3.4% increase over the prior quarter and a 26.9% increase over the year ago quarter.

We shipped 39.8 million finished disks in the first quarter compared to 42.1 million in the prior quarter and 31.9 million in the year ago quarter.

Other revenue provided $47.7 million of revenue in the first quarter of 2007, that compares to $27.4 million in the prior quarter and $25.8 million in the year ago quarter.

Other revenue in Q1 included $36.5 million from the sale of substrate product and $11.2 million from the sale of precious metals inventory.

Net income was $33 million in Q1 and diluted EPS was $0.99.

Fourth quarter 2006 net income and diluted EPS were $46.5 million and $1.39 per share, respectively.

Net income and diluted EPS in the year ago quarter were $36.2 million and $1.09 per share, respectively.

Net income in the fourth quarter of 2006 included a $6.1 million income tax benefit compared to a $2 million income tax expense in Q1 '07.

Our income tax rate in Q1 was 5.9%, and we expect a similar rate for the year.

Our tax provision is primarily noncash, as we [inaudible] in Malaysia through 2016.

Gross margin in Q1 was negatively impacted by product mix, the high cost of precious metals primarily used in the production of PMR media, and a 2% further appreciation of the Malaysian Ringgit.

Operating expenses in the quarter were approximately 9.4% of revenue, that compares to 8.8% in the prior quarter.

R&D expense was $16.5 million in Q1 compared to $15.4 million in Q4.

R&D spending included additional cost to support the continuing accelerated development and qualification activities for additional aluminum and glass PMR products.

SG&A expense was $8.4 million in Q1 compared to $7.2 million in Q4 and included increased legal and audit expense and additional stock compensation related to 2007 stock grants.

Total noncash stock compensation expense was $4.1 million in the first quarter compared to $3.5 million in the previous quarter.

Depreciation in Q1 was $25.6 million.

On our balance sheet and cash flow, we ended the first quarter of 2007 with $253.5 million of cash, compared to $171 million at the end of the prior quarter.

The cash balance included the net proceeds from the $250 million, 2-1/8% convertible subordinated note that we issued in March, net of approximately $125 million of the proceeds used to repurchase 3.8 million shares of common stock.

More on the convertible later.

Our ending accounts receivable balance was $130.6 million compared to $133.6 million in the fourth quarter of 2006.

Net inventory was $159.6 million at the end of the first quarter of 2007 compared to $104.2 million at the end of the prior quarter.

Finished goods inventory was $11.2 million at the end of the first quarter.

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

Raw materials inventory increased significantly as we continued to increase precious metals inventory.

We expect that the absolute level of raw materials inventory will stabilize during the course of 2007.

Much of the increase in raw materials inventory levels has been caused by the long lead-times from the purchase of the precious metals through the processing of the [spudder] targets for the PMR product.

In addition, we have requirements to continue to carry spudder target inventories to support the existing longitudinal magnetic reporting or LMR product.

Total capital expenditures were $21.9 million in Q1.

We expect 2007 capital spending to approximate $100 million.

This is at the bottom end of our previous range of $100 to $120 million.

Capital spending is primarily for equipment upgrades for PMR products, other yield and productivity projects, as well as IT spending for a new enterprise resource planning system, which we expect to go live in the second quarter.

Operating cash flow in the first quarter reflected a use of cash of $10.6 million due to the increase in the precious metals inventory.

During Q1 Komag issued $250 million in convertible subordinated notes.

These notes have a coupon of 2.8% and are due in 2014.

Concurrently with the issuing of the new notes Komag repurchased 3.8 million shares of common stock at an average share price of $32.76, spending approximately $125 million.

This share repurchase was part of a share repurchase authorization plan of up to $200 million.

Komag expects to repurchase additional shares from time to time under this $2 million authorization.

In the future we will report on additional share repurchases when we report our earnings.

Additionally, the Company called for the redemption of the $80.5 million 2% note.

On April 13th all of these notes were converted into 3 million common shares by the note holders.

These shares have been outstanding for EPS calculation purposes, and as such there is no EPS impact from the conversion of these notes.

Weighted shares outstanding for diluted EPS in Q1 '07 were approximately 33.8 million shares.

Weighted shares for diluted EPS in Q2 will include approximately 4.3 million shares underlying the new note, offset by the 3.8 million shares we repurchased for a net increase of 500,000 shares.

In determining diluted EPS under the [if] converted method of accounting the interest expense on the new notes will be added back to net income.

The adjusted net income is divided by the weighted shares to determine EPS.

The net impact of the issuance of the new notes and stock repurchase is slightly accretive to EPS based on the above calculations, including the investment interest on the net proceeds from the debt, net of stock repurchase.

As Tim mentioned, we are facing a number of margin issues at the moment.

Let me discuss them.

The margin pressure is coming from four major fronts: capacity utilization, the seasonal softness and pressure on the 3.5-inch market means our utilization will be down in Q2 from Q1.

While the PMR ramp is doing very well in both our internal yields and the yields that our customers' drive programs are doing well, PMR products are still relatively new and a large volume ramp means that we are currently seeing increased depreciation from the equipment upgrades to support PMR, increased costs while the manufacturing process improved, and increased raw materials costs.

Product mix our customers require has included a significant quantity of legacy 80 gig by product.

These products continue to have aggressive pricing which partially offsets the price up side of the PMR product.

In addition, as our manufacturing operations are located in Malaysia, we are facing increased cost from the Malaysian Ringgit currency appreciation against the U.S.

dollar.

We continue to pursue cost reductions and improvement activity to mitigate the currency impact, as well as other product cost increases.

With the lower capacity utilization and other factors mentioned, we expect net margins to be down in Q2 from Q1 levels.

We expect the net margin in Q2 to be in the range of 8 to 10%.

Now, let me turn it over to Ray.

Thank you, Kathy.

Sales mix by customer in Q1 was Western Digital at 37%, Seagate at 37%, and Hitachi at 21% of total disk product revenue.

Shipments of 160 gigabyte and above disk were 41% of Q1 ships.

This includes over 8.4 million PMR 95 millimeter disks.

Our overall blended average selling price in the first quarter was slightly up from the prior quarter.

As the mix of 160 gigabyte and PMR product increases we would expect to see the blended ASP increase over the course of 2007.

As we said previously, our customers' product plans determine our product mix and, thus, our branded ASPs.

About 14% of our first quarter disk revenue was derived from sales of substrates.

We expect that our substrate revenue will increase Q2 and continue at a level of approximately 15%.

We continue to work to increase our TAM with both our glass programs and the opportunity to expand Samsung relationships.

Our new customer and product qualifications are going well.

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

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

We anticipate being qualified on an additional Samsung program during the second half of 2007.

Our qualifications work on 65 millimeter glass products is going well.

While 95 millimeter aluminum media is far and away the largest market segment, 65 millimeter glass media is the second largest market segment and the fastest growing.

Komag is the largest independent supplier of 95 millimeter aluminum media, but we have not been a meaningful player in the 65 millimeter market.

We see significant opportunities in 65 millimeter PMR media.

We expect to be qualified on 65 millimeter flash programs by the end of Q2 and anticipate volume shipments in the second half of 2007.

Additionally, we expect that more volume programs will transition to PMR technology and replace much of the legacy products over the course of 2007.

We are ready to support our customer base with this transition.

Now, Tom will provide some comments on technology.

Thank you, Ray.

Komag is quite proud of our technology leadership that is being demonstrated in our PMR product.

The [inaudible] from the PMR products are doing quite well in both our factories and our customers [inaudible.] Our leadership in 95 millimeter PMR technology is translated [inaudible] products.

We continue to upgrade our tools for PMR readiness.

We feel comfortable that our tool set is able to accommodate the aggressive PMR transition this year.

We expect that well over half of what we produce by yearend will be PMR products.

Komag can support both LMR and PMR products on the same tools.

As we convert our factory to more PMR products our two key tasks are to improve manufacturing efficiencies.

Specifically, equipment utilization and, secondly, to reduce the material costs.

This work is underway, and we are making good progress on that.

We are also making progress in reducing the amount of precious metals per disk, particularly [rodinium] consumed in the PMR process.

We expect to make additional improvement over the balance of the year.

We are investing in R&D to develop more advanced PMR media capable of [inaudible].

This enables us to support our customers' advanced programs and maintain a leading position in the PMR technology.

Let me now turn this back over to Tim.

Thank you, Tom.

In summary, Komag continues to execute our plan.

We continue to plan and invest for the future.

This includes upgrading our tools for expanding PMR products and in qualification work for the glass 65 millimeter market.

They include investing in R&D to provide technology leadership and in maintaining manufacturing flexibility to be able to provide our customers a wide range of products, including PMR and LMR products, both glass and aluminum 65 millimeter products, and even more advanced disks for the future.

We have also made sure we have sufficient raw materials, including precious metals, to support an aggressive ramp of PMR products.

Lastly, we have restructured our balance sheet to allow us to continue to aggressively pursue future options to buy-back shares and maintain our financial flexibility.

We're very pleased with our technology leadership.

Komag is the leading independent media supplier of PMR disks.

Our business plan is unchanged.

We believe that as long as we provide technology leadership, support close relationships with our customers, and remain the low cost producer we will continue to be the key strategic independent supplier for the major drive companies.

We remain optimistic about the growing demand for disk drives and disks in both the traditional computer related markets and the rapidly expanding markets of consumer electronics 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 over to Sherry for the Q&A, I would like to remind our audience that we will end this call at 3:00 p.m.

Sherry, please open up the call for questions.

[OPERATOR INSTRUCTIONS.]

Our first question will come from Mark Miller from Brean Murray.

I just wanted to talk about your other opportunities.

I know a lot of people are counting on that, but it seems like we've been hearing for a long time especially about other programs at Samsung.

And just my opinion is that, you know, 35 or 95 millimeter qual should be very easy for you.

I'm just wondering are there a whole host of other programs, and why does it seem to me that you're taking a lot of your qual in there?

Yes, as I said, we expect to be qualified in on glass here in this quarter with ramp next quarter, not necessarily at Samsung, but we're, as you know, I think, Mark, we're qualifying in at a multiple different customers with multiple different products so the whole glass qualification effort is going very well.

We're qualifying in and we have samples in our -- in qualification at Samsung on a variety of different products.

Actually LMR, PMR and glass, and those are all moving along nicely.

To some extent the timing of the qualification depends on the customer's transition plans, as well as on our ability to meet those plans.

But, again, I'd have to say we're quite pleased with the way the Samsung qualifications are going.

I'll give you my last two questions.

Any comments about, you know, what are you seeing in your competitors?

I know you're withholding capacity expansion.

Are people, you know, starting to tone down the number of tools they're buying or ordering?

And the third question would be your substrate sales seem to go on up.

I'm just wondering why they, you know, I think you're typically 10 or 11%, you're up to 14%, is that because more people are building higher capacity drives with lower technology products?

Yes, let me parse that out a little bit.

So, yes, we believe that the capacity expansion is being broadly slowed down.

Now, our plans are to increase capacity only through process efficiencies and better optimization and bringing PMR utilization and factory performance up to the LMR level, which, you know, which obviously we're still very early in.

We do believe that in general everyone is slowing down their capital expansion for, you know, I think obvious reasons.

In terms of substrates, yes, we are growing our substrate business.

That is, that is a good business for us.

It's growing nicely.

It's, you know, in all cases with strategic customers, and we're pleased to be growing that business because basically the -- our customers are going to be buying substrates from someone and we'd rather they buy them from us than from anyone else.

In general, I'm not sure I understood the last segment to your question but our substrates are really just perfect for LMR kind of on high capacity LMR and even better for PMR.

So these things are going broadly into the high capacity to more demanding applications.

Did I get that question right?

Well, I guess to clarify, Tim, you know, you've been around 10 or 11% of sales I think traditionally on substrates, and we see a jump up here in a quarter where, you know, certainly people aren't shipping more volumes.

And it just struck me as odd, and I was just wondering what the reason was for it, you know, unless you're doing and maybe that's what you're trying to say, you're doing a better job of marketing to your customers.

But it just struck me as odd to see a big jump in substrate sales in a quarter that doesn't show much big volume increases.

Got you.

Okay.

Mark, this is Ray.

Let me just add, tag on to what Tim said.

He mentioned that they work very well with PMR.

We think it's the leading technology and people are really looking for the substrates quarter PMR, and the PMR is what's growing in the space right now, and I think that's a good part of why that's gone up is the PMR increase.

And maybe to add a little bit more to that even, Mark, the, the factories have done a terrific job of increasing their productivity and output through yields and efficiencies, so it's a lot of to actually build more substrates than we need.

Since we already were building PMR, we had that really leading edge technology, so you combine the leading edge technology, our customers have the need for PMR specifically for the high end stuff, combine that with our economies of scale, and it's just a really attractive opportunity.

It's, you know, we look at it as an incremental opportunity.

We're certainly not going to become a primary substrate producer, we're a media producer, but as the factory, you know, produces extra product it's a great opportunity for us and for our strategic customer.

All right.

Thank you.

In fact, we do expect that to go up again slightly next quarter.

[OPERATOR INSTRUCTIONS.]

We'll take our next question from Dan Renouard with Robert Baird.

Hi, thanks.

I wonder, Kathy, if you could maybe help us understand the relative impact of, of the margin pressures you're currently seeing and maybe if we could get just a little more perspective on the magnitude of the, of what you just currently expect, what we should see in terms of some of those pressures mitigating?

Could it happen as early as the second half or are you more looking to '08 before we start to see margins moving back in the right direction?

Well, I think the -- you know, as we've said there are several things that are pressuring margins right now.

One of them is, you know, product mix and some current pricing pressure at the time.

Additionally, with the ramp of the PMR products, you know, that's a very, very new process that we're coming up a very steep learning curve and a fast ramp.

So the precious metal costs are very high and, you know, equipment utilization obviously is not optimized yet.

The other thing that over this last several quarters that has added, you know, additional pressure or, you know, we've basically increased our cost is the fact that the Ringgit has been appreciating against the U.S.

dollar.

So our spending is, you know, maybe 50% of it is local currency in Malaysia, and the Ringgit has appreciated about 8% over, you know, over the last year.

So all of those factors, I mean are really combining at this point, you know, pressure the margins.

And I think as far as when do they improve, I think Tim has some comments.

Yes.

Just in general the currency, you know, the currency the weakness of the U.S.

dollar is true against all [inaudible] currencies, so the currency issue is not a really competitive disadvantage from a [culminating sense] since everyone is producing in that same region.

Komag continues to be the lowest cost producer.

In addition to that we are, of course, investing a tremendous amount in the futures, in future product and product qual, the products that Mark mentioned and both in PMR, LMR and in the glass.

So this is really a challenging quarter for us because we're investing so much and we won't see the big volumes on that until late this quarter, next quarter.

So the specific answer I think, though, to your question is that we do expect margins to get better in the second half of the year for the reasons that Kathy said above.

We should have better capacity utilization.

I think we'll have a higher capacity mix next quarter.

We'll have another quarter of really substantial PMR learning under our belts.

And I think overall we'd expect the industry demand to be stronger in the second half than the first half just through the normal seasonality.

So we do, we would expect margins to be better in the second half than in Q2.

But so I guess the question is as PMR ramps for you as a percent of your revenue, as it gets larger in the second half, that's not going to be a big drag?

You sort of view the most headwind in Q2 or in the current quarter, and that, that PMR should actually start to be neutral towards being a benefit the second half, is that a fair interpretation?

Yes.

In general, we're always better off with higher capacity, more advanced media PMR, and we'll continue that.

We're making really good progress in reducing the costs in PMR and increasing the factory utilizations.

And we definitely, you know, we don't expect that to be a drag in the second half.

Okay.

Thank you.

We'll move now to Sherri Scribner with Deutsche Bank.

Hi.

Thank you.

I just want to make sure that I understand the revenue guidance clearly.

I think you said that you expect revenue to be down 8 to 10% versus the revenue you did this quarter, minus the $11 million in precious metal sales; is that the correct way to think about it?

Yes, that's correct, Sherri.

Okay.

And then in terms of the rodinium sales I assume that you are not modeling any rodinium sales in the second quarter.

Do you expect to have any sales of precious metals in the second quarter?

We are not modeling any.

There may be, but we're not modeling any.

Okay.

And in terms of the impact to the precious metal, how much of that fell to the bottom line in the quarter?

It had about -- it was positive and so it was probably around, somewhere a point of gross margin.

One point of gross margin, okay.

And then I think I probably missed this, but in terms of the share buyback authorization you had authorized the $200 million and then you spent, what, $125?

$125.

$125, so is that included in the $200 million, so you have about $75 million left now?

That's correct, Sherri.

Okay.

Great.

Thank you.

Our next question will now come from Paul Mansky with Citi.

Hi.

This is [Chris Horner] for Paul.

A couple of questions.

One, how many OEMs do you expect to be qualified on the 2.5-inch I guess end of Q2?

Yes, Chris, we expect to have I'd say at least one in Q2, by the end of Q2.

At least one, okay.

And then --

As we said, we're in the process of qualification with a number of different cultures and a number of different products, but I'm quite confident in the first one.

Okay.

Okay.

And in terms of the inventory balance how should we think about that going forward?

And, also, what, you know, what triggered the precious metal sale this quarter versus not next quarter and kind of how should we think about that?

As far as the level of the inventories, we basically, you know, expect that any further increases should be minimal and as we go through the PMR ramp we would actually expect the level to improve in the second half.

Why was there the sale this quarter?

Basically, I mean as we secured the amount of metals that we needed to meet the PMR ramp, considering all of the long lead-times and the process to make PMR that we had in place at the beginning of the year, once we got into the year we were able to see that there were some, you know, improvements that were going to materialize earlier than planned.

And to the extent we had additional material we felt that we didn't want to carry additional material for a long period of time.

So does the -- I mean I notice that the price of rodinium is down about 25% from its February highs.

I mean does that translate to any sort of gross margin tailwind going forward or does that help you at all, or the fact that you bought rodinium at higher prices it doesn't help [inaudible]?

Well, the important thing is that the actual, the price of rodinium has, you know, it did climb up into the 800s during the first quarter and then has stabilized and started to come down, so it's around -- in the $600 range now.

So the important factor is that we want to use the least amount possible and, you know, and lower price is obviously better than a higher price.

Right.

Yes, and Chris -- this is Tim again -- we still want, we still are buying certain rodinium.

And so it's a good thing for us that the price has come down and stabilized.

That's definitely a good thing.

The key is that we've been making just really good progress in decreasing the amount of rodinium per disk, working very, very closely with our customers.

That benefit will be spread over several quarters and there's room for substantial long-term improvement, but overall the progress has been at least as fast as we expected and, again, great credit for the customers, and we're working obviously really closer together to take as much costs out of the combined product as we possibly can.

Great.

Thanks.

We'll take our next question from Christian Schwab with Craig-Hallum Capital Group.

Great.

Thank you.

What -- Tim, what was our media capacity in the quarter?

Did it go up from the $41 million last quarter?

No, it's flat at $41 million.

Last quarter we suggested we should exit the year at 565 to 575 as a blended ASP "at least." Would you still believe that, or given the difficulty of current situations you aren't that optimistic about that much of a mix up improvement actually in the year?

Yes, we don't forecast ASP that far in the future, Christian, but it is fair to say that we certainly expect the ASP to continue to progress up over the course of the year as the mix of PMR and higher capacity disks gets richer.

So we haven't, we haven't had any change of opinion that the direction is up.

We haven't quantified what we expect that to be, but it is interesting that I would say that while everything we've seen in the last month or so we expect the transition to PMR to go actually faster than we previously thought to the point we'll be substantially over 50% PMR by the end of the year with our current view.

So, you know, we regard that as a good thing.

Right.

And then on the -- are you seeing any increase in ASP pressure, hearing from other component suppliers that given this environment that they're being squeezed really hard on the pricing side by, by customers?

Are you seeing that?

Yes, it's fair to say that we're not immune from overall industry pricing pressure on -- it was an extremely challenging quarter, and I guess we saw that particularly on some of the low end legacy products, where media competitors that could not build PMR were doing some pretty aggressive pricing at the very low end media.

And then on your net margins, you said that we could maybe recover to, you know, historical net margins for awhile.

I just want to make sure I don't misunderstand that.

Are you saying that we shouldn't be able to return to 17 for awhile, but you would expect to return to 13 to 14, or could you help us there directionally, the magnitude of improvement you would expect with better utilization and better seasonality?

Yes, let me speak maybe directionally, and first of all, from an industry perspective, margins are always under the most pressure when demand is a little soft.

Q2 is typically the worst quarter, and we'd expect Q3 and on to be seasonally and generally stronger for the whole industry.

We'll return -- our margins will get back to more recent norms when we get the higher capacity utilization, get some progress through the PMR transition, as Kathy said, and then, you know, get the benefit of the higher capacity media.

So, and I think glass will help that, as well, but that tends to be all second half activity.

So if our mix improves and our capacity utilization improves and the Malaysian Ringgit stays where it is and rodinium remains expensive, what type of gross margin recovery could we expect?

So we've gone from 28% gross margins in March of last year, you know, Xing out rodinium in the March quarter of this year we've gone to 21, so we've gone down 28 to 21.

What type of recovery, you know, as the business gets optimal, should we expect?

Yes, we should probably, we should probably stick to directional.

It's definitely going to be up, and I don't think you're -- I mean there's no reason that your estimations in the mid 20s, I mean that, that seems to be the right range, but it certainly should be up.

Okay.

Two last questions here.

I thought that we were, I thought you said last quarter conference call that we were already qualified at Samsung on the 2.5-inch aluminum product?

Yes, sorry, maybe I wasn't clear on that.

So, yes, we're in production and have been for over a quarter now on 65 millimeter aluminum.

In addition, though, we're working hard with them on 65 glass, as well.

Oh, so that maybe I misinterpreted, so the question that came prior when he said how many OEMs do you think qualified at 2.5 that was -- you were commenting on glass there [inaudible]?

Yes, sorry.

So I mean we're -- in Samsung we're looking, we're working currently on 95 PMR and LMR programs, and we're working on 65 millimeter glass, and we're already qualified in on 65 millimeter aluminum.

In addition to that we expect to qualify in at a customer on 65 millimeter glass this quarter, and that's really, that's a big thing because obviously the transition from the kind of 3.5-inch to the mobile is going faster than we expected, so that whole 2.5-inch glass market, we knew it was very important, and it's very, very important to us, so we're very happy to be, you know, approaching qualification this early in the year.

Christian, this is Ray, let me add to that.

We're getting a pull from all of our customers.

All of our customers are very interested in the glass 65 millimeter, so we look forward to that growing and being a significant part of volume, in the second half.

Right.

I would imagine given the dynamic and everybody wanting price concessions I would imagine that your customer list is very actively wanting you to produce that product.

My last question, did we sell the rodinium to Seagate?

I'm sorry?

Did you sell the rodinium to Seagate?

We don't, we don't talk about where we sell it.

I mean did you sell it to somebody in the industry or did you sell it in the open market?

We sold it in the market.

Great.

Thank you.

We'll move to Steven Fox with Merrill Lynch.

Hi, good afternoon.

First, the easy question, can you repeat what you said for options expense for the quarter and what your expectations are for the rest of the year?

This is Kathy, Steve.

Basically, what I said was in total stock compensation was $4 million this quarter compared to $3.5 million in the prior quarter.

That's total stock compensation, that includes restricted stock and stock options and everything.

And the option expense was what?

The option expense included in there?

Yes.

That's about $500,000.

Okay.

And then in terms of the PMR drag is there any way to quantify or qualify how, how much that hurt gross margins in the last quarter and into this quarter?

Well, the substantial ramp was really in this quarter, so there was limited impact in the fourth quarter from the PMR transition.

So I mean we really started seeing, seeing that this quarter because of the very, very steep ramp from going to, you know, doing less than a million units basically up to 21, 21% of our entire product list.

And in the coming quarter is the drag -- was the worst drag in Q1 and then it's lessening at least in Q2 in terms of the PMR ramp?

Well, you've got, in Q2, I mean there's -- we've got the, you know, softer quarter so there's under utilization.

We will be as a percentage of shipments we expect it to go up again in the second quarter.

And at the same time we're also, you know, working on the process of process efficiency so there'll be less utilization in the factory, there will be some process improvement, so, you know.

We also in addition start expecting to see more substantial benefit on the reduction of rodinium per disk.

That's spread out over a couple of quarters, but that'll help, as well.

Okay.

And then last question on PMR, if you guys have shipped about 21% of your units for PMR, where does that put you relative to the industry?

Do you have any estimate on how many PMR shipments were industry wide?

Yes.

No, we're by far the leading independent supplier, second only to Seagate.

Right, but --

Seagate and Komag are really the large producers of PMR at this point.

So you have a rough number on an industry percentage?

No, I'm sorry.

But it's not by a small amount.

Okay.

All right.

Thank you.

And our next question comes from David Bailey with Goldman Sachs.

Yes, thank you.

This is [Min Talc] on behalf of David.

Just a couple of questions.

First, does your decision around the rodinium have any relationship to any changes in your expectations for the ramp or demand for PMR media?

No, it really had to do with the rate at which we found we could improve the amount of rodinium utilized per disk.

Okay.

And then --

Sorry.

And as I said it, as we look over the course of the year we'd expect actually the PMR conversion to go faster than anticipated rather than slower.

I would say that's directional, you know, it's not 55% versus 50, but it does look like it's going to go faster than we originally expected for the year period.

Okay.

And then, second, you talked about a lot of your qualifications coming in the second half of the year, when do you think we can begin to see some material ramp in revenue from some of the vendors that you talked about?

I think you'll be able to see material benefits in the programs we're qualifying in in the second half for sure.

Okay.

The [inaudible] could easily be in Q3.

And, lastly, could you tell us, I think you mentioned that you expect your utilization rate, that to decline in June quarter.

Could you give us any ballpark of what your expectation for your utilization rate to be in the June quarter?

Yes, so we said we expect revenue to be down and utilization would probably be down proportionately.

Okay.

Great.

Thank you.

A pleasure.

And our next question will come from Mark Moskowitz from J.P.

Morgan.

Yes, thank you.

A few questions, if I may?

Obviously, you're pretty excited it seems in terms of what Samsung could bring to the table longer term.

I just want to get a sense, it seems like it's taking a little longer than expected, but also --

Well, Mark, let me answer that first.

Actually not, I mean I don' think we'd ever forecast anything before kind of second half benefit.

I'd say if anything, the way I think of it at least, Samsung is timing out about on plan.

And glass I think we're going to see benefit actually earlier than we'd expected or forecast.

So I'm not displeased.

It is, it is long, and the good thing is that we're doing 65 millimeter aluminum so we're developing the relationships and working with the customers, and that's all beneficial.

Right.

I guess to finish my question, though, in terms of just the level of frequency in terms of how you've been talking about this potential opportunity in terms of the number of conference calls, prior to today -- my question is Samsung is, can be volatile from an executional standpoint and in terms of what markets they do well in.

They don't always have a great string of consecutive quarters in a particular segment.

And I'm just wondering are you, are you putting safeguards in place in terms of adjusting your model down the road to maybe be able to [inaudible] or weather storms with Samsung because obviously it seems like you're looking to them to be kind of the offset to the inevitable push away from [you at] Seagate.

Okay, so, yes.

So that's not actually the way we think of it at all.

The benefit of Samsung directly is we'll be qualified in all the 95 millimeter producers.

So we'll have basically complete coverage on the market, so if one guy benefits or loses it doesn't matter, we're equally successful in all.

I don't -- the Seagate comment I guess is not, not our view of the world either.

You know, Seagate has long said that it's going to be 10, 15, 20% of their media will be outsourced to Komag as their strategic supplier.

We've certainly seen them execute to that strategy and we know that it's been a beneficial, I mean it's been a good and successful strategy for them and they continue to, you know, reinforce -- that continues to be their strategy going forward.

So we, we don't expect Seagate to stop being anything but, you know, a very significant and a lead customer.

Yes, but that's fair, but when you say 10 to 20% I think that includes the current transition that they're in the midst of.

Wouldn't you agree that over time it probably compresses more toward the lower end of that range?

Oh, that could be.

I mean, I mean there needs to be additional capacity both from the independent suppliers and from the guys in the control capacity.

[Inaudible] three doesn't really come on till next year.

Right.

So, you know, at that point then maybe there'll be a reduction.

I don't really quite know yet.

I think the key for us is to continue to provide them with leading edge disks that work really well in their factories and to maximize their factory yield.

And I think the relationship, the technical relationship with Seagate and Komag has never been better.

Uh-huh.

And that's really where we make the most difference and become the most help is maximize factory yield.

Okay.

And then speaking of capacity, if we look at your customer concentration, obviously, I mean it always adds up and down each quarter in terms of how each customer does or fares for you.

But Western Digital, in particular, seems to bog down a little more relative to the group.

I'm just trying to get a sense, is that driven by market dynamics or is that from competitive dynamics?

And I think of what [inaudible] and Fuji Electric are doing presently, is that having an impact?

I mean all the customers' demand goes up and down by quarter.

I don't think we see any trend, at all.

Mark, this is Ray.

I think it plays back to what Tim has already stated is as we try to grow our TAM and get all four major suppliers, that it, you know, that's going to shift back and forth.

Uh-huh.

And that's why our strategy is what it is.

Okay.

And then -- go ahead.

No, go ahead, Mark.

I'm sorry, what?

No, go ahead.

Okay.

And then I guess getting back to Christians' question, you know, I think back at how your predecessor was really loud about how you guys were going to keep adding capacity back in '06, and you kind of slammed on the brakes back in October of '06.

And now we're starting to see again where the capacity plans in the essentially the assembly side of things maybe misread the market, and now you're seeing the media guys are definitely pulling back in their capacity expansion in the media industry.

Where are you in terms of really being able to protect your business model and the volatility they're in going forward in terms of not getting squeezed by your customers in terms of maybe are they indicating that they actually need more demand or more supply than they really need?

I mean some of the guys are feeling that, and it seems like you guys are trying to mitigate that or at least the media industry is trying to mitigate that, but I think it's an increasing concern as you talk about how all of your drive customers are really salivating over the 65 millimeter glass opportunity with Komag?

So we definitely believe that the media industry as a whole and particularly the independents are substantially and significantly slowing down their expansion plans.

We believe that the 2.5-inch market is growing faster than expected and that that is definitely the place that we need to be.

That our strategy is to increase our total available market so that we are not susceptible to dips or movement in demand either between customers or form factors or PMR and LMR.

And that the way we protect ourselves is really by having a leading edge technology, be qualifying in, you know, somewhere near the lead on all of these programs and to be providing a broad cross section of products.

At the end of the day the guy that produces the media that works the best in the drives is the guy that's going to win, and we're pretty intense at that thought.

Uh-huh.

I hope that answers your question?

No, that's helpful.

And then just, lastly, to Kathy, I may have missed it but did you give us the rationale as to why the sale of precious materials was classified as revenues not a gain on sale of assets?

That's the accounting treatment basically is the precious metals inventory is a sale of inventory, and any sales of inventory no matter what kind of inventory it is is to be reflected as sales in cost of sales, it's the most recent accounting theory.

Okay.

Thank you.

So, Sherry, I think we have time for one more quick call.

Okay.

One last question.

Perfect.

Our last question will come from Dan Renouard with Robert Baird with a follow-up.

And I wonder if you could just talk a little bit more on the cost side, what you're planning, if anything, in terms of other operating cost efficiencies?

You talked about taking your CapEx down a little bit this year, should we view that as a maintenance CapEx level going into next year, and then are there other initiatives you've either got underway and, or are contemplating from an efficiency, you know, cost savings standpoint at this point, or are you not there yet?

Yes, just to clarify on the CapEx, I mean we have reduced CapEx down to the low end of the range.

We're going to continue to go through that in detail to try and make further improvements there.

As I said, the majority is for the upgrades of, related to the PMR product transition.

As we move into '08 a lot of the equipment will be upgraded.

You know, we will have gone through a lot of that expense already in 2007, so if -- as we said, it looks like PMR is transitioning probably faster than originally expected, so we would expect to get probably more of that type of activity out of the way this year in 2007.

Overall, Dan, I would just add that we're definitely an execution, continuous improvement type of Company, and we have a very, very broad spectrum, and hard work and closely monitored set of actions to improve everything from the amount of hours per piece, to overtime to consumed, to spare parts, to rodinium per dip, to the cost of the substrate, so we definitely have a great number of initiatives that are in place.

And, you know, it's just been essential as currency changes or as material costs go up or down.

And we've continually been able to manage keeping the yield up and managing the costs down, and that's certainly a major focus as we go forward.

Okay.

Great.

Thanks.

Thank you.

That does conclude the question and answer session today.

At this time, Mr.

Harris, I would like to turn the conference back over to you for any additional or closing remarks.

Well, thank you, Sherry.

And thank you to our listeners.

This was a solid quarter, especially considering the seasonal nature of our business.

I'm especially pleased with our 27% increase in revenue, and our shipping of a total of over 10 million PMR disks to date.

As I said earlier, we do expect the second quarter to be challenging.

The dealing with bumps in the road is part of the nature of our business.

We've navigated them before, and we're confident that we will do so again.

We remain optimistic about our future for several reasons.

We believe that we are in a fundamental and long-term growth industry.

The need for storage is insatiable and it's growing fast, and Komag continues to have the best cost structure in the business.

We have a leadership position in PMR, the next technology, and we have a huge growth opportunity in 65 millimeter, as the fastest growing segment to the market.

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

Thank you.

Ladies and gentlemen, that does conclude today's conference call.

We do appreciate your participation, and you may disconnect at any time.