威騰電子 (WDC) 2011 Q4 法說會逐字稿

Good afternoon, and thank you for standing by.

Welcome to Western Digital's fourth-quarter financial results for fiscal year 2011.

Presently, all participants are in a listen-only mode.

Later, we will conduct a question-and-answer session.

(Operator Instructions).

As a reminder, this call is being recorded.

Now I will turn the call over to Mr.

Bob Blair.

You may begin.

Thank you, I want to mention at the outset that we will be making forward-looking statements in our comments in response to your questions, concerning industry conditions in the September quarter, including the total available market for hard drives, customer demand, supply constraints, capacity mix, average selling price, and cost of components.

Expected benefits from, and the timing of completion of our planned acquisition of Hitachi GST, growth in the near-line enterprise market, our product offerings in the traditional enterprise market, our position in the branded products market, our expected capital expenditures and depreciation and amortization for fiscal 2012, our investments in new products and markets, and our financial results expectations for the September quarter, including revenue, gross margin, expenses, tax rate, share count and earnings per share.

These forward-looking statements are based on Management's current expectations and are subject to risks and uncertainties that could cause actual results to differ materially, including those listed in our 10-Q filed with the SEC on May 2, 2011.

We undertake no obligation to update our forward-looking statements to reflect new information or events, and you should not assume later in the quarter that the comments we make today are still valid.

In addition, references will be made during this call to historical non-GAAP financial measures, as well as forward-looking estimates of non-GAAP financial measures that give effect to our planned acquisition of Hitachi GST.

Investors are encouraged to consider the reconciliations of the differences between the historical non-GAAP measures to the comparable GAAP financial measures we provide during this call, and those that are included in the investor information summary posted in the Investor Relations section of our website.

The forward-looking estimates of non-GAAP financial measures that give effect to our planned acquisition of Hitachi GST exclude acquisition-related expenses that we expect to incur in connection with the transaction, and following the close of the transaction.

Because these acquisition-related items will not be known to us until on or after the closing of the transaction, we are unable to provide information about, or a reconciliation to the most directly comparable GAAP financial measures.

The impact of these excluded items may cause the estimated non-GAAP financial measures to differ materially from the comparable GAAP financial measures.

Also, as a reminder, until our acquisition of Hitachi GST closes, WD and Hitachi GST remain independent companies, so we will not be taking any questions about HGST's business or financial performance today.

I also want to note that copies of remarks from today's call will be available on the investor section of WD's website immediately following the conclusion of this call.

I now turn the call over to President and Chief Executive Officer, John Coyne.

Thanks, Bob.

Good afternoon, and thank you for joining us today.

With me are Tim Leyden, our Chief Operating Officer, and Wolfgang Nickl, our Chief Financial Officer.

In the June quarter, we saw stronger than anticipated demand, with the hard drive industry shipping over 165 million units.

This 4% quarter-on-quarter increase contrasts with historical seasonal patterns of 1% to 2% sequential contraction.

We believe that the stronger demand was driven by increased adoption of sea freight in the PC supply chain, which creates a long-term leveling of seasonal demand patterns, as well as supply continuity concerns in the aftermath of the Japan earthquake.

The industry grew fiscal year volumes 4% to 657 million units, while WD again grew faster than the market at 6%, shipping 207 million hard drives for the year, a 1% share gain, reaffirming customer preference for WD's value proposition.

This was a tough comparison year for the PC and HDD industries, coming off the recession snap back year of 2010, combined with the slow down in consumer spending and increased competition for share of consumer spend, from devices like smart phones and tablets.

We believe that 2012 could be a stronger period for the industry, and for WD for several reasons.

An acceleration of the commercial PC refresh as part of an overall macro reinvestment cycle, he potential for better consumer confidence, translating into stronger discretionary spending, the planned launch of redesigned feature-rich PCs, enabled by Windows 8, and our continued favorable standing with customers, as one of the preferred suppliers of the world's most cost-effective storage solutions for the massive amounts of content being generated on the client and in the cloud.

In this context, it's important to consider some history.

Throughout fiscal 2011, we operated close to the bottom of our business model range.

Others in the industry struggled even more, reporting results below their published models.

Historical cycles show that prolonged periods of below-model performance are typically followed by a return to business model parameters as suppliers and customers alike recognize the need for industry profitability to drive needed investment, in both technology and capacity.

WD has repeatedly outperformed as these cyclical corrections occur.

Furthermore, upon completion of our acquisition of HGST, we will have a stronger position in the traditional enterprise market, an improved d solid state drive lineup and further cost advantage.

Thus far in the regulatory review process, to complete this transaction we have received clearance from Brazil, Taiwan and Turkey, and we continue to work closely with the remaining agencies.

As previously announced, we currently expect the transaction will close in the fourth quarter of calendar year 2011, and our integration planning activities continue on schedule.

I will now turn the call over to COO, Tim Leyden, who will describe the operational highlights for the June quarter.

Tim?

Thank you.

As John indicated, demand in the June quarter was stronger than we originally anticipated, with industry unit volume exceeding 165 million hard drives, generating 4% quarter-on-quarter and 6% year-on-year growth, primarily driven by strength in OEM demand.

We believe there were two main factors behind this.

Management focus across the PC market, where lower financing and inventory carrying costs encouraged increased use of ocean freight, leading to pull-ins of build schedules versus historical seasonal patterns, and fear of supply disruption from the Japan aftermath led to pull-forwards by OEM customers to create inventory buffer, on the basis that it is better to be looking at it than looking for it.

We now see an industry TAM for calendar 2011 of roughly 670 million units, with the September quarter in the range of 170 million to 175 million.

Now, turning to WD's performance.

We shipped 53.8 million units in the June quarter, up 8% sequentially, and 8.2% from the year-ago period, as we worked successfully with our supply partners to overcome post-earthquake challenges, again, providing superior availability and value to our customer base.

Moderation in ASP declines delivered revenue growth of 7% quarter-on-quarter and 1% year-on-year for the June quarter.

Gross margins improved by 130 basis points to 19.5%.

However, we need to make further progress on profitability, as this margin level continues to be below our business model midpoint, and is some 300 basis points below the same period last year.

Price declines for the quarter were broadly as we had expected, and were less than the seasonal norm.

Average product capacity was up only moderately, but higher volumes, tight cost management, and improved utilization enabled us to come in above the upper-end of our implied gross margin guidance.

Revenues totaled $2.4 billion, net income was $158 million, and cash flow from operations improved sequentially from $313 million to $447 million.

Now, turning to market segment performance.

In the compute space, units increased to 117 million from 113 million in the March quarter, and were up from 111 million in the year-ago quarter.

WD shipped 39.2 million units into the compute space in the June quarter, compared to 36.3 million units in the March quarter, and 37.1 million units in the year-ago quarter, and we grew market share by approximately 1%, both sequentially and year-on-year.

The near-line enterprise market was up sequentially from 5.6 million to 6.4 million units and up from 5.1 million units year-on-year.

Cloud computing continues to spur growth in this market.

The traditional enterprise market, at 8.3 million units remained flat with the March quarter, and was up year-on-year from 7.1 million units, as demand in the commercial market remained robust.

WD shipped 2.5 million units into the combined enterprise markets in the June quarter, up from approximately 2.3 million in both the March and year-ago quarters.

In the traditional enterprise space, we are servicing a limited customer set with our first and second generation SaaS products, and we are on plan to bring our third-generation product to market within the calendar year.

The HDD manufacturers TAM in the branded product segment came in at 12 million units, down from 13 million units in the March quarter, and up from 9.8 million units in the year-ago quarter.

And the sequential TAM reduction followed typical seasonal patterns.

Year-on-year TAM unit growth in this segment was strong.

WD shipped 5.7 million units into this market in the June quarter, down from 6.4 million units in the March quarter and up from 5 million units in the year-ago quarter.

Competition is particularly intense in the branded segment, as competitors seek to improve their share positions, and we continue to compete strongly through differentiating product features and strong brand equity.

In the DVR market segment, the TAM was an estimated 14.4 million units, up sequentially from 12.9 million in the March quarter, and up from 13.2 million in the year-ago quarter.

WD shipped 6.5 million units into this market in the June quarter, up from 4.8 million in the March quarter and up from 5.3 million in the year-ago quarter.

WD's product capabilities and ability to respond quickly to customer needs helped us grow in this segment, where HDD's offer an efficient and cost-effective solution for storing and retrieving video content.

The remaining balance of the TAM is represented by gaming, automotive, and 1.8-inch drives.

Inventories in the HDD supply chain exiting the quarter were below historical run rate levels in each segment.

Now, turning to the September quarter.

The market visibility is cloudy, both from a demand and supply viewpoint, due to the supply uncertainty and the pull-forward of demand that I mentioned earlier.

In contrast to the HDD supply chain inventory status, we believe that inventory levels continue to build in the PC OEM supply chain, as the switch from air freight to sea freight continued, in an effort to save transportation costs.

OEMs continued to pull product on the basis of concerns about supply, and their historical extrapolation of demand expectations for back-to-school and the holiday season.

In our other served markets in the September quarter, we expect typical seasonal patterns, which are a branded products volume increase, a DVR volume reduction, and flattish volume in the enterprise segment.

Now, turning to our product lineup.

We are now shipping the WD Scorpio 1-terabyte, a two-disc, 2.5 inch drive, the first in a range of products that utilize our 500 gigabytes per platter technology.

In our branded product segment, we continue to lead the industry in volume shipments of USB 3.

In our consumer electronics segment, we released WD AV versions of our 2.5 terabyte and 3 terabyte SATA hard drives.

I will now turn the call over to Wolfgang Nickl for a review of our Q4 financial performance and our outlook for the first quarter of fiscal 2012.

Wolfgang?

Thank you, Tim.

A summary of financial information has been posted to the Investor Relations section of our website, which we will be updating with our Q1 guidance after this call.

For the June quarter, revenue was $2.4 billion, up 1% from the prior year and up 7% sequentially.

Hard drive shipments totaled 53.8 million units, up 8% from both the prior-year period and the March quarter.

Revenue from sales of WD TV media players, WD Livewire network kits and solid state drives totaled approximately $33 million, up 23% from the prior year and seasonally down 34% from the March quarter.

These results were above the upper end of the guidance we provided during our April investor call, due primarily to our ability to meet unexpected customer demand during a period of uncertain industry supply capabilities.

Hard drive average selling price was approximately $44 per unit, down $3 from the year-ago quarter and $1 from the March quarter.

Revenue from sales of our branded products, including WD TV and WD Livewire products, was $382 million, down 4% from the year-ago quarter, due to an aggressive pricing environment, as well as a continued shift from 3.5 to 2.5-inch products.

Revenue was down seasonally by 13% from the March quarter.

There was one customer, Dell, that comprised 10% or more of our total revenue.

Geographically, demand in Asia was particularly strong this quarter, as it grew to 60% of revenue from 54% in the March quarter, while Americas and Europe each declined.

Our decision to strongly support OEM customers in the aftermath of the Japan earthquake resulted in OEM sales representing 55% of revenue, up from 47% in the March quarter, while the distribution retail channels each contributed lower percentages of revenue.

Our gross margin for the quarter was 19.5%, down from 22.5% in the year-ago quarter and up from 18.2% in the March quarter.

The quarter-over-quarter increase in gross margin by 130 basis points is a function of firmer pricing in the client compute market, coupled with increased utilization of manufacturing assets due to higher volume.

Like-for-like, price decline was approximately 2% for the June quarter.

R&D and SG&A spending totaled $297 million in the June quarter, as compared to $242 million, and $252 million in the year-ago and March quarters respectively.

The June quarter included $32 million for acquisition-related expenses and unrelated litigation accruals, whereas the prior year quarter included $27 million for litigation accruals, and the March quarter included $10 million of acquisition-related expenses.

Excluding these items, R&D and SG&A would have totaled $265 million or 11% of revenue in the June quarter, was $215 million or 9% of revenue in the year-ago quarter, and $242 million or 10.7% of revenue in the March quarter.

The quarter-over-quarter increase is primarily a function of increased investments in new product and technology development and higher incentive compensation expenses.

Net interest and other non-operating expense was $2 million, including $2 million of acquisition-related debt commitment fees.

Excluding these fees, net interest and other non-operating expense would have been zero.

Tax expense for the June quarter was $12 million, or 7.1% of pre-tax income.

Our net income for the June quarter totaled $158 million, or $0.67 per share, as compared to $265 million or $1.13 per share for the year-ago quarter, and $146 million or $0.62 per share in the March quarter.

The June quarter included a combined $35 million for acquisition-related expenses and litigation accruals, whereas the prior-year quarter included $27 million of litigation accruals, and the March quarter included $10 million of acquisition-related expenses.

Excluding these items, non-GAAP net income for the June quarter totaled $193 million or $0.81 per share, as compared to $292 million or $1.24 per share in the year-ago quarter, and $156 million or $0.66 per share in the March quarter.

Turning to the balance sheet.

Our cash conversion cycle for the June quarter was zero days.

This consisted of 46 days of receivables, 27 days of inventory, or 13 turns, and 73 days of payables.

We generated $447 million in cash from operations during the June quarter, and our free cash flow totaled $294 million, reflecting strong sales linearity and tight asset management.

Capital expenditures for the June quarter totaled $153 million.

Depreciation and amortization expense for the fourth quarter totaled $150 million.

Capital expenditures for fiscal 2011 totaled $778 million.

Depreciation and amortization expense for fiscal 2011 totaled $602 million.

For fiscal 2012, we expect capital expenditures will be at the upper end of our business model range of between 7% and 8% of revenue, as we complete the 6 to 8-inch conversion of our wafer fab facility.

We expect depreciation and amortization to be approximately $650 million for fiscal 2012.

We made a $31 million debt repayment during the June quarter, and thereby reduced our debt balance to $294 million.

We exited fiscal Q4 with cash and cash equivalents of $3.5 billion, an increase of $260 million from the March quarter.

Let me now turn to our expectations for the September quarter.

As Tim mentioned, we forecast a total available market of between 170 million and 175 million units, which is below historical seasonality as OEMs have built some extra inventory in Q4 fiscal year 2011, to ensure security of supply and optimize transportation costs.

The actual TAM will depend on the level of back-to-school sales, and the expectation for PC demand for the holiday season, and the consequent decisions of PC OEMs on optimizing their ocean-to-air freight mix and build plans.

Market segments mix will reflect typical seasonal patterns which will mean an increase in branded product shipments, a decrease in DVR product shipments, and flat enterprise volume.

Price declines are expected to be moderate, while cost pressures will continue, driven by rare earth materials, logistic costs and foreign currency exposures.

We will continue to work internally and with our supply partners to find ways to offset these cost challenges.

We continue investing in innovation to support growth in new products and markets.

Our guidance does not include acquisition-related expenses.

Based on these assumptions, our guidance for fiscal Q1 is as follows.

We expect revenue to be in the range from $2.425 billion, to $2.525 billion.

R&D and SG&A spending of approximately $250 million, excluding acquisition-related expenses.

We expect our tax rate to be in the middle of our business model range of 6% to 9%.

We anticipate our share count to be approximately 238 million.

Accordingly, we estimate non-GAAP earnings per share of between $0.90 and $1 for the September quarter, which excludes acquisition-related expenses.

Operator, we are now ready to open the call for questions.

Ladies and gentlemen, we will now begin the question and answer portion of today's call.

(Operator Instructions).

And our first question comes from Ananda Baruah with Brean Murray.

Your line is open.

Thanks, guys, for taking the question.

I guess the first thing I want to ask is, I guess just on the rare earth issue.

Obviously, you guys did a better job of offsetting somehow, or absorbing the costs than Seagate did last night.

Can you talk about some of the dynamics I guess that have allowed you to do that seemingly in the June quarter, and the September quarter guidance, and I know you're not giving December quarter guidance, if you could give us any sense of the degree to which sort of those levers might be able to sort of continue through the balance of the second half of the year?

Yes, Ananda, this is John.

On an overall basis, the rare earth materials that affect both the magnetic components in our drives and processing of substrates for our media are, have two issues.

One is overall availability and consequent to that, the price for that availability.

The market, about 30% of the reserves exist in China, about 95% of the production is in China.

15 years ago, that was roughly one-third China, one-third US, one-third rest of world.

The year-on-year reductions in allocation quotas for export from China have been significant over the last three years, and the trajectory looks to continue.

As the price has risen, there's more interest in the rest of the world in terms of reopening mines and processing plants to bring further supplies to the market.

We continue to work very closely with our suppliers, multi-tier in our supply chain, to secure supply and to manage cost.

We continue to focus on the controllables that we manage, the design of the product and, therefore, the usage of these materials, the processing in the supply chain to manufacture the components we require, and so we're working there on process efficiency and reutilization of scrap materials and so on, and through those various means, we've worked with our supply chain to moderate some of the influence of the raw material increases.

We have not fully countervailed those pressures, and so we've gone to our customers and we've sought their help in reflecting, in our pricing, the cost increase which we could not offset in other areas.

And we'll continue to do that as we march into the future here.

We'll continue to try to manage down usage, to improve efficiency and utilization throughout the chain, and find other means within our overall control to continually address cost improvement, which is quarterly order of business, daily order of business here, and should all that not successfully drive down the cost of a hard drive, we'll work with our customers to ensure that we continue to provide very fundamental, effective technology to the marketplace that enables the revenue streams of all of our companies.

Okay.

That's helpful.

If I could just ask one clarification, if I could, John.

Would you care to give us any sense of how much of a headwind, gross margin headwind the rare earth might have been this quarter?

And is it too early to get any sort of sense of, I guess for sort of for the December quarter -- it sounds like you feel like you have pretty sound principles around working with the suppliers and with your customers, in offsetting some of the costs.

Is there any chance that we could get surprised, I guess, by any meaningful degree as you move through the fall, and the degree with which you're able to work with the suppliers in those processes?

Thanks.

The issue here, there's always a certain time lag in this process and the vulnerability is to a very rapid increase in the pricing of materials and recognize in these kinds of situations, there are two issues.

One is the price rise that relates to the demand versus the supply equation and we think we were helped last quarter by the disarray in the Japanese automotive industry, which reduced demand for magnets in automotive, temporarily.

But that will come back as the supply chain to the automotive industry in Japan recovers on the semiconductor side, primarily, that will enable recovery in the automotive build numbers, which will place an increased demand on the available magnetic materials.

So that's one driver, potential driver of cost.

The other is typically, when any traded commodity goes short, we get financial interests that jump into that pool and attempt to make the commodity even scarcer and make a profit by driving up that price and while the fact that this is a Chinese government-controlled quota system, may help in that regard.

There's always vulnerability to that effect as well, and we're working to try to manage all of that and I think our customers fully understand that supply chain and those issues, and fully understand the vital contribution of our technology to their businesses and we'll work it out.

Fantastic.

Thanks a lot.

Next question comes from Aaron Rakers with Stifel Nicolaus.

Your line is open.

Yes, thanks and congratulations on the quarter, guys.

A couple as well.

First question, there's a debate out there with regard to what the TAM looks like for the September quarter.

I know you guys have laid out 170 to 175.

You clearly pointed to a lack of good visibility through the full quarter.

Can you tell us what your assumption or what underlying assumption you're making with regard to trends into the month of September, relative to historical trends to get at that guidance where you're at, that you've laid out?

Yes.

This is Tim.

What we believe is that the inventory that's being carried on the ocean, people have made a call on that on the basis of historical extrapolation of demand, and they are continuing to put product on the ocean.

They will wait until back-to-school season in order to see whether back-to-school meets their expectations and on the basis of that, if it meets the expectations, they'll continue to put product on the ocean for the holiday season, we believe.

If the back-to-school season is less than their expectations, they will more than likely switch to -- they'll watch for demand and then they'll switch probably to air freight in order to be able to satisfy the needs of the market.

And that will happen in either direction.

So based upon that, we believe that the inventory that was there at the beginning of the June quarter is still in there.

We think that there was a slight build, if anything, during the course of the June quarter and so consequently, we think that there is that extra inventory out there, which is more a change in the way people are managing, the way customers are managing their inventory than anything else.

They're basically taking advantage of low financing rates, and of course they're trying to avoid the air transportation costs.

So consequently, we think that with that in mind, there normally would have been, we would anticipate on a seasonal basis with historical trends, probably be up somewhere in the region of 10% to 12%.

And under this scenario, we believe that some of that inventory buffer that's in there would allow the growth that we are looking at, which is somewhere in the region of about 5% or so.

That's helpful.

And then coming off the heels of your competitor last night, I'd be curious of where you guys stand.

I know you've made some announcements this week with regard to -- when you guys make announcements, 500-gig per platter, 2.5, and also 1-terabyte, 3.5-inch, can you update us exactly where you're at and whether or not you've seen a similar challenge as far as time to maturity or time to cost effectiveness if you will on those platform ramps?

I think this is -- this is John again.

The WD approach to the deployment of new technology is to focus primarily on deploying that technology where it serves a specific need in the marketplace, such as a new capacity point that has been previously inaccessible or as in the case of our announcement last night, the one terabyte in the 9-millimeter form factor which is restricted to two discs, and therefore deploying the advanced technology in that product enables us to offer a 1 terabyte capacity into the notebook environment, which is restricted to the 9.25-millimeter form factor.

We then -- we tend to manage our large scale deployment of the technology, which is purely to address cost on existing capacity points.

We manage that very much on the metrics, and we pace the introduction of that technology and the ramp of that technology to return the maximum financial advantage to the Company and I think you've seen how we managed that over the last five, in fact, 10 years.

It's a very effective, proven formula and we continue to prosecute that formula.

Final question from me and I'll cede the floor.

On the pending acquisitions, I know you've talked about some regulatory approvals you've gotten.

How do we think about timing of other key regulatory approvals?

Is there a specific time frame, October, November, that we should be looking for as kind of driving into that close of Q4?

I think based on the published time frames for each of the agencies, the US process is moving along a track that's going to be in the September time frame and the European process is moving along a track that looks like the October time frame, and we expect all regulatory agencies reviews to be complete within the calendar year.

Great.

Thank you.

Rich Kugele with Needham & Company, your line is open.

Thank you, good afternoon, gentlemen.

Just a couple questions.

We've seen increasing shipments by ocean freight from the OEMs for a number of quarters now.

And so it seems to be here to stay.

Can you estimate in any way what the industry's total volume that might be shipped by ocean freight is today?

Is it a substantial amount, such that it creates enough confusion about what inventory's actually out there?

And then secondly, if ocean freight does continue, what is the new normal for seasonality, as it seems to level out the quarters.

And can you keep your CapEx different than it has been in the past because of that?

Thank you.

Good questions, Rich.

We're working on trying to understand the split, the air/ocean split.

I think it's above 20% today, maybe in the 30% range, and rising.

In perspective, the PC industry ships over 1 million units a day, so -- and you consider a four to six week difference in the supply chain, air versus ocean, from Asia to Europe and the US.

So if you go on the four week delta, and take 10% movement between air and ocean, you're talking 4 million or 5 million drives.

So we're looking -- I think we mentioned at the end of March, we thought there were about 8 million drives out there, mismatch between PCs sold through and drives sold in.

I think we added a couple million units during the course of last quarter so you're probably looking there at a couple of weeks worth at the 20% level.

I do think it's a -- provided interest rates don't go crazy, and in the context of the current maturity of drive technologies, relative to drive prices quarter to quarter and the system configurations, and relative to the price points being hit in the market and the potential for significant price degradation quarter to quarter, I mean, they are the things that influence the decision on air/ocean.

And so I suspect it is here to stay at least for a while, and the advantages, it tends to level the seasonality, which allows us to ship the full year on a lower capital investment.

So that's positive for everybody in the chain, from a cost and efficiency utilization perspective.

The negative is that it reduces visibility and typically makes reaction to downside a more severe shell shock thing.

As Tim described, our thinking on the upcoming quarter, we see July and August pretty much locked in because people are building pre-back-to-school on the assumption that it will be normal and that, therefore the holiday will be normal.

Once we see in August what the back-to-school is shaping up like, then that will either continue to plan or they'll put the brakes on build, allow the ocean to flush through, and then use air to catch up on any minor miscalculations.

So we're a little cautious about September, depending on the outcome of the back-to-school.

Okay.

Great answer.

Just one last question on consumer electronics and branded.

Obviously, everyone's been concerned about the low-end PC market, the consumer segments, the notebook side.

But your branded and consumer business actually hasn't been that bad, hasn't fallen as much as perhaps the PC side.

What would you attribute that to?

Do you think that the consumer market is buying these backup drives for example for existing PCs, and there's just a recognition that they should be backing up, or are you able to gain share?

There isn't a whole lot of visibility into that market so any color you could provide would be helpful.

Our research into that market tells us that we still haven't effectively publicized or proselytized the backup story.

There's still way too many people out there totally exposed in terms of backup.

What we have seen is the deployment of what I call the personal cloud, where the continuing appetite for consumption of rich content, whether that be on PCs, on tablets, is leading to a significant level of sales for personal storage to expand the storage available in the home.

In parallel to that, we're seeing expansion of storage in the cloud which is driving the growth in the nontraditional enterprise space.

And so the growth of outside the PC storage is reflecting the huge growth in petabyte demand and the creation of content which is driving that 40% year-over-year growth in petabyte soft storage demand and one place it shows up is in the external storage.

Now, if we can do an effective marketing job of convincing people that not only do they need that incremental storage, but they need to back it all up, then we have an even brighter future out there to go turn that opportunity into financial performance.

Okay.

Thank you.

Mark Miller with Noble Financial, your line is open.

Congratulations on your quarter.

I'm just looking at, trying to compare -- looked like you had a similar ASP decline, percentage-wise to your competitor, but it looks like your cost-per-drive unit was significantly better.

Was there any product mix or any difference in sourcing of components externally, or could this difference be explained by your better management of the rare earth material issue?

No, we had moderate price declines as we mentioned.

I think you need to take into consideration the increase in volume as well.

We had good utilization of our assets and we had decent cost declines and as Tim mentioned, our channel and business segment mix was pretty much as expected.

Better operational performance.

I've heard recently from some people in the industry that the transition to energy-assisted magnetic recording is kind of moving up and I'm hearing things about maybe second half of next year.

Can you give me kind of a feeling for that?

Is that getting pulled in somewhat or is that still roughly two years out?

I think that's a difficult technology.

The industry is demonstrating the technology and has been for several years, but typically in this kind of technology area, when you see the announcements of the new technology performing at the current level of the mature technology, you can add three years to volume availability of that new technology.

And we have not yet reached the point of equivalents to the current technology in the lab demos that are demonstrating the new technology.

So it's at least three years out from mass volume deployment.

Just my prior question, I understand -- so there wasn't really any major change in the outsourcing of meteor hits from previous quarters.

No.

Thank you.

Nehal Chokshi with Technology Insight, your line is open.

Yes.

Your near-line shipments were up about 8% year-on-year whereas the industry near-line shipments were up 14% Q-over-Q and 28% year-over-year.

Looks like market share is declining, was hoping you could provide some color as far as what's going on there and hopefully remedies that you have in the pipeline here.

Actually, quarter-to-quarter we did grow market share in the near line enterprise.

We continued to execute in that marketplace.

We have -- we are shipping our near line SaaS and we are on track with our product introductions.

We are working on a few things in order to get a higher profitability on it but overall we're pretty pleased with where we are in that particular space.

Okay.

Sticking to the segments, the DVR shipments, up very significantly.

That does not seem to be market-driven.

It seems to be market-share driven.

Can you talk a little bit as far as what's going on there as well.

With the product capabilities that we have and the -- some of the disruption that was in the marketplace during the course of the quarter, we were able to react to customer upside in that marketplace and were able to do so effectively.

So consequently, it contributed to increased volume for us.

Does that also have anything to do with the proposed M&A activity going on, or that's purely just upside customer demand for your specific products?

Well, we wouldn't be able to separate out that from normal activities, so consequently, we believe it was due to our ability to be able to execute quicker than the competition.

Okay.

My final question was that Seagate indicated their CapEx will be at the low end of their model, so without the wafer fab conversion, where would you guys be at with respect to your CapEx in terms of the percent of revenue?

In general, we tail capital towards flexibility to respond to demand and to technology and be very reactive in real-time in reacting to capacity increases.

We put the upper end out because we complete the wafer fab conversion.

Without it, we would probably have been more in the middle of the range.

But it's also important to point out that we're focusing strongly on linearity of capital spending, and what we actually will end up spending will largely depend on our view at the beginning of next calendar year, how the second half of next calendar year will look like.

Okay.

Thank you very much.

Next question comes from Mark Moskowitz with JPMorgan.

Your line is open.

Thank you.

Good afternoon.

Two questions.

If I take the midpoint of your guidance in terms of the operating metrics, I get to around 20% gross margin.

Wolfgang or John, can you kind of talk about what could be the swing factors that could maybe apply further upward pressure to gross margin as you navigate the September quarter?

Is it about getting greater visibility on back-to-school in the month of September, or is it something else?

I think you're absolutely right, the midpoint is 20.5%, 18% to 23%.

You usually expect in the second half of the calendar year to be in the upper end of that range.

As we said, price declines are moderate so it will depend to a large degree how well we can work internally and with our supply partners to mitigate some of the cost challenges and then Tim pointed out that back-to-school is important, and the outlook of how the PC OEMs will look at the holiday season will take certain build and shipment mode decisions which could have an impact on volume.

Okay.

The second question is around the notebook market.

John or Tim, can you talk about trying to reconcile your sequential growth in the June quarter, versus your competitor, Seagate.

Just seems like their 25.5% sequential growth is rather humongous.

Does that present any challenges to the market going forward, or was there some sort of one-time event there that happened and it's kind of in their rear view mirror.

I think our performance in 2.5-inch for last quarter was supply-constrained.

We did call out in our April call that as a consequence of the earthquake, we were scrambling to underpin, and by the end of April, had underpinned our planned 2.5-inch volumes and support of customers for the June quarter.

We did execute to that plan and we did support all of the pre-planned volumes there, but we had no upside in 2.5.

In fact, we were somewhat constrained.

We shipped more to support our OEM customers and we constrained ourselves in allocation to our branded business, which is part of the reduction in our branded business quarter-over-quarter.

But that's not a constraint as we look forward.

Okay.

Thank you.

Katy Huberty with Morgan Stanley, your line is open.

Hey, thanks.

Nice job managing through all the variables this quarter, guys.

Just a quick follow-up on gross margins, first.

Do you have a sense for where your gross margin would have been in September, if not for some of the higher component costs and rare earth issues?

Is it 50 basis points or is it more than that?

I mean, it's hard to say that.

I don't think -- I think the overall -- if you take the baseline of the beginning of the year, and look at the current cost of the rare earth materials and how much of them we use in shipping the average drive, I think that 200 basis point number that was used yesterday is pretty close.

And then it's a matter of how much you can offset of that in usage, efficiency, utilization, and how much then we're forced to share with our customer base, and how timely we can make all of that understanding and action, and you can see the extent at which we've accomplished that in last quarter and the upcoming quarter guidance.

I think it's all implied in there.

Okay.

And you mentioned that the integration planning is on schedule.

Does that mean that even with the deal closing a quarter later than you originally expected, that you can hit those initial integration targets from a timing schedule, or does everything get pushed by three months or so?

Everything's on a day zero start schedule.

So depending what the closing date is, there's then a process which will -- initial process will be about six months to get the thing, to get us integrated, and most of the integration actions taken and then it will take realistically another year after that to really get the full benefits of the new WD in terms of operational performance and then over the next five years, you'll see the impact of our ability to increase effective investment in the fundamental technologies and product breadth that will allow us to further grow the business.

Okay.

Thanks.

Good quarter, again.

Thank you.

One more question, operator?

Keith Bachman with Bank of Montreal, your line is open.

Hi, John, could you talk a little bit about your views?

You mentioned the TAM this quarter.

What can the industry ship to?

In other words, where would there be constraints that would come up and do you sense that any of your competitors still have supply constraints?

There's -- I mean, we think the 170, 175 can be supported.

We think there may be some continuing constraints, primarily in the semiconductor side of the supply line.

And it's a very deep multi-layer supply chain and there's probably still some things from level five or level six working their way through the system that are not fully understood yet.

So proceeding with caution, and taking what we believe are all the appropriate actions to ensure that we have closed credibility around the supplier commits relative to our forecasts and our build plans.

I've got to say, I was impressed by the overall industry capability demonstrated in last quarter, because immediately post-earthquake, I was a lot more pessimistic about the industry's and our ability to hit our numbers last quarter and we managed to do better than we anticipated and looks like many of our competitors also did the same.

Okay.

So it's a credit to the resilience of the supply chain and the inventiveness and dedication of all of the people involved.

It looks like in your Q4, calendar Q4s, your embedding the market TAM to be relatively flat.

Is there somehow conservatism in there or is that more of the ship issues that you're thinking about for TAM that looks to be relatively flat in Q4?

Yes, that's the impact we think of the ocean versus air.

When you're using historical demand patterns to shape your build and logistics and you extend the logistics piece by several weeks, then the normal tail-off that would happen in December potentially now happens in November, and we run at a somewhat lower rate in the December quarter because the holiday stuff's all been shipped already.

Got it.

Okay.

My last one then is, again, John for you, is where did the clock start ticking you think on the rare earth and what I mean by that is, prices started moving up a few months ago, and on one side, you had the Chinese government but on the other you have presumably capitalism at work.

When do you think you could potentially see non-Chinese sources for the acquired rare earth metals?

Is it a year from now?

Is it six months from now?

Just any kind of metrics on when you might get some help on these issues from the supply side.

Well, bringing the mine back into production is a protracted process.

We do see some work going on in Australia that potentially could begin to impact the market next year and -- but I -- we're going to work on the other side of that one.

Yes.

To try to reduce usage per drive as a way to address some of that.

And the thing that's driving some of the quota behavior and so on in China is that there's an amped up increased focus on environmental impact of these mining and refining activities, where the weaker, less capable players are being forced out of the market because they're unable to meet environmental requirements and it's the more capable companies that are redoing their process to make sure they're in compliance with the environmental standards, and so I think it will get worked out, but it may take a while.

Okay.

All right.

Thanks very much.

Good luck, gentlemen.

Thank you very much.

So in closing, I'd just like to thank all of you for joining us today.

We do appreciate your questions and your interest in the Company and in the industry and we look forward to seeing you again next quarter.

Thank you.

Thank you.

This does conclude the conference.

You may disconnect at this time.