威騰電子 (WDC) 2012 Q2 法說會逐字稿

Good afternoon, and thank you for standing by.

Welcome to Western Digital's second-quarter financial results for fiscal year 2012.

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 meeting over to Mr.

Bob Blair.

You may begin

Thank you.

I want to mention that we will be making forward-looking statements in our comments and in response to your questions concerning the impact of the Thailand flooding, including its impact on industry demand in the next several quarters, and the industry's ability to meet that demand, charges and expenses in the March quarter related to the Thailand flooding, flood mitigation measures in Thailand, our insurance coverage, demand for storage in the long-term, the return to pre-flood capacity levels by WD, the industry and our supply chain, our internal slider production in Thailand and Malaysia, industry inventory, diversification of our supply chain and its impact on cost and pricing, our investments in development, the expected completion and the timing of our planned acquisition of Hitachi Global Storage Technologies, the timing and outcome of our motion to vacate, the award entered against us in our arbitration with Seagate, our capital expenditure plans and our financial results expectations for the March quarter including unit shipments, 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-K filed with the SEC on October 28, 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 non-GAAP financial measures.

Reconciliations of the differences between the historical non-GAAP measures we provide during this call to the comparable GAAP financial measures are included in the investor information summary posted in the Investor Relations section of our website.

The forward-looking guidance we provide during this call excludes charges and expenses related to the Thailand flooding and our planned acquisition of HGST.

Because these charges and expenses are not known to us at this time we are unable to provide guidance for 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.

I would also like to mention that due to daily changes in the industry supply picture and continuing evaluation of our Thailand flood losses and litigation exposures, our financial results for the December quarter are preliminary until we file our Form 10-Q for the quarter with the Securities and Exchange Commission.

In addition, we expect additional flood recovery expenses -- related expenses -- to be incurred in the March quarter and it is possible that our fixed asset impairment estimates for the December quarter may have to be adjusted as the recovered assets are put into production.

Also as a reminder, until our acquisition of HGST closes, WD and HGST remain independent companies.

So we will not be taking any questions about HGST business or financial performance.

We also ask that analysts limit their comments to a single question and one follow-up question 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 will now turn the call over to President and CEO, John Coyne.

Thank you, Bob.

Good afternoon, and thank you for joining us on today's call.

With me are COO Tim Leyden; and CFO Wolfgang Nickl.

After my introductory remarks, Tim will provide an update on our operations and Wolfgang will review our Q2 financial performance and current outlook.

I'm pleased to report that we've made substantial progress in our mission to restore our manufacturing capacity in the aftermath of the historic flooding in Thailand.

This is reflected in our Q2 financial performance announced earlier today, the continued ramp of our Thai HDD production capacity, and in the fact that we have now recommenced slider manufacturing which had been suspended since October 10.

While much work remains to be done over the next several quarters to reach our pre-flood manufacturing capabilities, the progress thus far is ahead of our original expectations and is a tribute to the dedicated and effective actions of our employees, contractors and Thai government agencies, the efforts of our supply partners, and the support of our customers.

I want to thank all of those involved in this huge and extraordinary effort.

We believe industry shipments in the December quarter were about 119 million units, which included approximately 11 million units of pre-flood inventory.

Today, one quarter after the floods hit, and despite the industry's heroic recovery efforts, supply remains significantly constrained.

We believe this condition will persist throughout calendar 2012 with gradual improvement during the year, with industry production in the June quarter approaching pre-flood quarterly build levels.

However, with the expected uptick in demand in the back half of the year, rollover demand from the current shortages and inventories throughout the supply chain at record lows, from component supply through HDD and system manufacturing and distribution and retail channels, we believe the pipeline will not be refilled to normal levels until the first half of calendar 2013.

We believe demand for storage for the long-term continues to grow unabated.

With the HDD industry's remarkable flood recovery effort and the gradual replenishment of the inventory pipeline, we believe rotating magnetic storage will weather its recent challenges and remain the preferred and most cost effective solution to meet the demand for storage in high-volume mass-market applications with no significant loss of share to competing technologies as we remain focused on innovating and creating compelling value for customers.

From a WD standpoint, we expect our own recovery to mirror the trajectory of the industry that I just outlined, with a return to pre-flood capacity levels in the quarter ending September and with our customers' inventory pipeline replenished in the first half of calendar 2013.

This pace of recovery is important as we focus on satisfying our customers' needs and as we respond to their strong encouragement to resume our leading role in the industry.

To that end, our priorities are clear for calendar 2012.

First, we will continue to focus on restoring our manufacturing and supply chain capacity to pre-flood levels.

Second, in concert with our supply partners we are establishing the most robust and resilient supply chain of critical HDD components as we ramp our manufacturing capability back up.

Third, during the flood recovery period we have maintained our focus and investment in development to ensure that we will be in a position to offer new products with advanced technology to sustain our leadership as we ramp our post-flood production.

We plan to achieve these goals in the same time-tested focus on high-quality low-cost and crisp execution that has established WD as a trusted leader in the storage industry over the last dozen years.

We believe that executing to this strategy and achieving the aforementioned priorities will prove to be a compelling value proposition for our customers as we compete for their future business.

Before turning the call over to Tim Leyden for a review of our operations and recovery effort, I want to comment on two additional matters, our plan to complete the acquisition of HGST and the pending litigation with Seagate.

Our plan to complete the acquisition of HGST by March of this year is on track and we continue to work on obtaining the remaining approvals of the transaction from the respective government agencies.

We remain very excited about the synergies of the acquisition and the advantages it will create for our customers.

On November 18, 2011, an arbitration award of $525 million was rendered against WD.

Earlier today, the arbitrator awarded pre-judgment interest in the amount of $105 million.

WD will promptly file a petition to vacate the award on the grounds that the arbitrator exceeded his authority and failed to consider relevant evidence.

We anticipate that the court will hear arguments on our petition in March or April of 2012 and issue a decision sometime thereafter.

While we can provide no assurance that we will be successful, we believe that if the court reviewing our petition correctly considers the law, the arbitration award should be vacated.

Tim?

Thanks, John.

In the aftermath of the Thailand flooding our primary focus was to bring stability and predictability back to our operations by getting our disabled manufacturing locations and those of our affected suppliers back in operation as quickly as possible.

With this overall objective in mind, we moved quickly to limit the disruption to our customers.

We optimized our HDD availability through increased through-put from our Malaysian factory, increased the availability of external HGAs with assistance from SAE/TDK, reengaged our previously idled Thailand employees to recover many of the inundated fixed assets, and once the flooding had receded we restarted production in our dried out factories on a limited basis.

In addition to these operational initiatives, we took further action to remain profitable and minimize the impact on our working capital.

Our team responded magnificently to these challenges and I am pleased to report that we have made substantial progress on the journey back to achieving full pre-flood capacity by the third calendar quarter of 2012.

Our focus now is on accelerating our recovery and increasing availability to our customers.

At this point in time, we are not constrained relative to HDD assembly or test.

We are still constrained by component availability, specifically sliders.

We are very pleased with the support we have been getting from SAE/TDK in providing both completed HGAs and processing WD's raw wafers.

Additionally, we're grateful for the expeditious recovery efforts of our mechanical and other suppliers who themselves were affected by the Thailand floods.

As of yesterday, we have completed our first batch of post-flood sliders in our Bang Pa-In facility and we are working through qualification and expect to have a meaningful quantity of internally produced sliders shipping in our HDD products by the end of the current quarter.

We are enhancing our infrastructure by extending slider production capacity and capability into Malaysia in order to mitigate risk.

We expect to have Malaysian sliders shipping in our HDDs in the June quarter.

The Bang Pa-In and Navanakorn Industrial Park landlords and the Thailand government are planning to reinforce and install flood barriers for these industrial zones and we intend to augment those with Company-specific initiatives.

We are working with our suppliers to diversify their manufacturing locations in order to reduce geographical concentration.

Supplier recovery is progressing well and we expect that suppliers will be substantially back to pre-flood run rate levels by the June quarter.

We are maintaining the pace of product and technology development and though we have encountered challenges due to the flooding, we are focused on minimizing the impact.

We are currently shipping 1 terabyte per platter 3.5-inch and 500 gigabyte per platter 2.5-inch drives in volume.

In accordance with our normal practice, the rate of deployment of those newer technologies is dependent on cost cross-over points at each capacity point.

Additionally, I am pleased to report that we have our 900 gigabyte 2.5-inch SAS product in qualification at multiple OEMs.

As we emerge from the aftermath of the flooding, we are mindful of coming back with a more robust supply chain model that seeks to disperse in-house and supplier risks across geographies and factory locations.

This dispersal of volumes across a wider geographical area will contribute to some structural and logistical cost increases, which should be recovered from customers in order to maintain the continuing investment required in what is a high-technology and capital-intensive business.

An unanticipated benefit of our recovery activities is that we are taking advantage of the down time to improve process efficiencies and cycle times.

The supply of HDDs is constrained at an overall industry level due to the supply chain disruption.

From WD's standpoint, we are allocating product to customers, segments and channels while attempting to maximize HDD availability through optimizing component utilization.

We are taking current inventory positions where known into account as we respond to immediate customer needs, while at the same time paying attention to the fundamentals of running a viable profitable business, conserving cash, and continuing to stay competitive technologically.

As a result of balancing all these factors, you will note that broadly speaking the percentages of volume [applied] to market segments and channels is different to what might be perceived as our more normal supply profile.

In general, channels with shorter inventory pipelines are getting higher and more immediate product allocations, while channels with longer inventory pipelines are expected to deplete available inventory before receiving further product allocations.

This methodology was and is being applied with the intent to maximize the availability of HDD products to the end customer within the shortest time horizon.

As a result, we shipped 9.8 million netbook drives -- notebook drives, apologies -- 11.4 million desktops, 2.4 million CE, 3.2 million branded, and 1.7 million enterprise units into the marketplace during the December quarter.

I will now comment on expected industry supply-demand conditions for the current quarter and the balance of calendar 2012.

We expect demand to again significantly exceed supply during the March quarter and to add to the net supply deficit that occurred during the December quarter.

We estimate that supply in the March quarter will be back-end loaded as component availability improves, and that there will be further depletion of inventory in each of the segments and channels leading to better clarity around supply-demand positions as the quarter unfolds.

WD's HDD production will continue to be constrained by component availability.

In contrast to the December quarter where inventory buffers in all sectors of the supply chain somewhat mitigated the HDD shortage, as evidenced by the PC OEM units being only modestly down from expected volumes, most of that excess inventory has now been extracted and inventory levels are extremely low.

These depleted inventory levels coupled with any rolled over demand as a result of the December and March quarter supply deficits mentioned above, the additional prospect of increasing seasonal demand in the back half of the year, and the value proposition from the emerging Ultrabook and Windows 8 introductions will mean that HDD supply will struggle to match demand through calendar year 2012.

Consequently, we do not expect meaningful inventory replenishment until the first half of 2013.

In WD's case, we are targeting through-put to approach 60%, 80%, and 100% of pre-flood production volumes in the March, June, and September quarters, respectively.

I will now turn the call over to Wolfgang for commentary on fiscal Q2 and our forecast for fiscal Q3 2012

Thank you, Tim.

As a reminder, a summary of historical financial information has been posted to the Investor Relations section of our website.

In my remarks, I will first summarize our financial performance for last quarter and then I will provide a range of expected financial results for the March quarter.

For the December quarter, revenue was $2 billion, down 19% from the prior year and 26% from the September quarter.

We shipped a total of 28.5 million hard drives as compared to 52.2 million and 57.8 million for the year-ago and the September quarters, respectively.

In excess of 3 million units that we shipped to customers during the December quarter were manufactured in the prior quarter.

Hard drive average selling price was approximately $69 per unit, up $22 from the year-ago quarter and up $23 from the September quarter.

There were two customers which each comprised 10% or more of our total revenue, Acer and Dell.

OEM sales represented 59% of revenue, up from 45% in the prior year and 53% in the September quarter.

Distribution channel sales represented 25% of revenue, down from 33% in the prior year and 29% in the September quarter.

Retail sales as a percent of revenue were 16%, down from prior year's 22% and September's 18%.

Revenue from sales of our branded products was $328 million, down 40% from the year-ago quarter and 33% from the September quarter.

As Tim mentioned earlier, we deliberately allocated production output by balancing immediate customer needs with prevailing inventory positions.

Our gross margin for the quarter was 32.5%, up from 19.2% in the year-ago quarter and 20.1% in the September quarter.

The increase in gross margin is a result of higher ASPs, partially offset by higher costs per unit.

On average per unit costs were approximately $10 higher than in the September quarter due to low production volume, increased use of air freight, a higher mix of externally procured heads, and higher costs for other components as a result of the flood's impact on ourselves and our supply chain partners.

R&D and SG&A spending totaled $287 million in the December quarter as compared to $235 million and $282 million in the year-ago and September quarters, respectively.

SG&A included $11 million of acquisition-related expenses in the December quarter and a total of $18 million in acquisition and unrelated litigation accruals in the September quarter.

Excluding these items, R&D and SG&A would have totaled $276 million, $235 million, and $264 million in the December, year-ago, and September quarters, respectively.

The increase in total R&D and SG&A is due to higher spending on development and marketing of new products, particularly in the branded and enterprise areas and higher incentive accruals.

Expenses for the December quarter also included $199 million for charges and expenses related to the Thailand floods.

These costs consist of $109 million of fixed asset impairments and $90 million for damaged inventory, recovery and remediation services, and wage continuation.

This does not include any offset for potential insurance recoveries.

The Company, as we have previously stated, carries property and business interruption insurance.

Discussions with our insurance carriers are moving forward, but the claim process is still in its early stages.

Net interest and other non-operating expense was $2 million, including $3 million of commitment fees on the credit facility related to the pending acquisition of Hitachi's drive business.

Tax expense for the December quarter was $15 million or 9.4% of pre-tax income.

Our net income for the December quarter totaled $145 million, or $0.61 per share, as compared to $225 million, or $0.96 per share, for the year-ago quarter and $239 million, or $1.01 per share, in the September quarter.

The December quarter included $199 million for charges and expenses related to the Thailand flood and $14 million for acquisition-related operating expenses and bank commitment fees, whereas the September quarter included a combined $21 million for acquisition-related expenses, bank commitment fees, and unrelated litigation accruals.

Excluding these items, non-GAAP net income for the December quarter totaled $358 million, or $1.51 per share, as compared to $225 million, or $0.96 per share, in the year-ago quarter and $260 million, or $1.10 per share, in the September quarter.

As John indicated in his remarks regarding the arbitration award, we intend to promptly file a petition to vacate.

We believe that if the court correctly considers the law, the award should be vacated.

As a result, we have not made an accrual for the award in the December quarter.

Turning to the balance sheet, our cash conversion cycle for the December quarter was a positive five days.

This consisted of 34 days of receivables, 31 days of inventory or 12 turns, and 60 days of payables.

Once we realized the extent to which our production was impacted, as well as the impact to our key suppliers, we shortened payment terms with our customers and directed more cash to our strategic component and equipment supply partners in order to stabilize the supply chain and support a quick recovery.

I would note that we did not accept prepayments from our customers and prepayments to suppliers were not material.

We generated $378 million in cash from operations during the December quarter and our free cash flow totaled $258 million.

Capital spending for the December quarter totaled $120 million.

December quarter disbursements were for assets that were ordered prior to the floods.

Depreciation and amortization expense for the December quarter totaled $140 million.

Recovery capital received during the December quarter was not significant, as the lead time for such items is several months.

March-quarter capital spending will include a significant amount of replacement capital.

The total amount of capital spending we will incur during calendar 2012 to restore our capacity to pre-flood levels and increase the robustness of our supply chain is approximately $650 million.

We expect capital spending for fiscal 2012 to be between $750 million and $800 million, inclusive of recovery capital.

This was accomplished by reallocating much of our original capacity capital to recovery capital.

Capital spending for technology-related assets continues as originally planned.

We made a $31 million debt repayment during the December quarter and thereby reduced our debt balance to $231 million.

We exited fiscal Q2 with cash and cash equivalents of $3.9 billion, an increase of $249 million from the September quarter.

Approximately $3.2 billion of our ending cash balance was offshore.

Let me now provide some context for our guidance for the March quarter.

Despite the heroic efforts of our employees and suppliers resulting in the recommencement of operations in both drive and slider factories, our March-quarter output will be significantly constrained and we expect to ship between 31 million and 33 million drives.

Total demand for the quarter is expected to significantly exceed industry supply capability.

We expect that our pricing will continue to be significantly above pre-flood levels due to the supply constraint environment, under absorption of our manufacturing assets, and higher component costs.

Average costs will not improve significantly quarter-over-quarter.

While we have greater output, and therefore, less impact from fixed cost absorption, we do not have the benefit of mixing in pre-flood lower cost inventory.

With respect to operating expenses, we will continue to invest in [close] areas such as our enterprise, SSD and branded products businesses.

Our March guidance does not include acquisition-related expenses or charges and expenses related to the flood.

In relation to expenses related to our flood recovery efforts, we expect to incur about $50 million, consisting primarily of ongoing reclaim and recovery work and wage continuation for idled workers.

With these factors in mind, our March-quarter guidance is as follows.

We expect revenue to be in the range of $2 billion to $2.15 billion.

R&D and SG&A spending will be approximately $275 million excluding acquisition and flood-related expenses.

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

We anticipate our share count to be approximately 239 million.

Accordingly, we estimate non-GAAP earnings per share of between $1.15 and $1.45 for the March quarter, which excludes acquisition and flood-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 Scott Craig with Bank of America.

Your line is open

Thanks.

Good afternoon.

Hey, John, maybe just a little bit of clarification on the expectations for getting back to 100% of your potential capacity to pre-flood levels.

Around when in the June quarter do you think that happens, and what are your assumptions around sort of some of the supply chain and the ability of the supply chain to ramp up to where you need it to for that quarter?

Thanks

Okay, Scott, actually we indicated that we would be back to pre-flood capacity in the September quarter, and the -- we believe that the suppliers and supply chain will be back to pre-flood capacity during the June quarter

Okay.

So then the 100% that you're talking about for the September quarter, you expect to hit 100% sometime in the September quarter or wouldn't you have to hit that in the June quarter to be able to hit 100% in the September quarter?

Yes.

I mean, it's splitting hairs really, but we will be -- we expect to be at 100% of capacity in the September quarter, so yes, exiting the June quarter we will have to be getting to that run rate.

Okay.

And just one other follow-up, on the ASP side of things for the quarter, Wolfgang, you guys just reported, can you maybe talk about like-for-like pricing versus the mix and sort of what the influences of both of those were?

Thank you

Yes, a couple of things to consider.

First of all, the pre-flood ASPs for the units that we shipped was, obviously, lower than what we shipped from week four to week 13.

There was a moderate mix down, probably 8% to 10% in the ASP, and if you take that into consideration the ASP included in our guidance is down from the Q2 level.

If you use the numbers we provided, it's somewhere in the 64 to 65 area and that's the result of us aligning pricing between channels

Thank you

Our next question comes from Aaron Rakers with Stifel Nicolaus.

Your line is open

Yes, thanks, guys.

I want to go back to the recovery discussion.

You guys earlier in the call had made a comment about 60% return to pre-flood levels of production.

Just math would assume that that's closer to about 40 million drives versus your guidance of 31 million to 33 million, which would be about 50% recovery.

I'm just trying to understand what the difference is between those?

Actually 60% of pre-flood recovery comes out at around 35 million units

Okay.

So you guys shipped about 58 million units pre-flood.

Yes.

You were running above your capacity level, normalized production capacity at that point?

That's the pre-flood capacity we were referring to is 58 million units and 60% of 58 million units is 34.8 million

Okay.

Fair enough.

And then just an update.

I know you're not talking post-acquisition dynamics, but can you remind us what kind of balance sheet, what kind of cash position you expect to have post the Hitachi deal as it stands today?

Yes, I can do that.

Like we said, we have an ending cash balance of about $3.9 billion.

We've arranged a term loan of $2.5 billion and an additional revolver available to us of $500 million.

We will take out the current debt we have on the balance sheet, the $231 billion -- million dollars, excuse me, and then the cash that will transfer to Hitachi is just short of $3.5 billion.

So with that in mind, we'll have a very solid cash balance after we consume the acquisition

So to be clear, you'll be net positive or net cash position post-deal?

That's a good assumption.

Okay.

Thank you

Your next question comes from Katy Huberty with Morgan Stanley.

Your line is open

Thanks.

Good afternoon.

You talked about a gradual improvement in supply-demand over the next three quarters.

Does the drop in pricing trend on a linear basis with that supply improvement or are there other dynamics as it relates to either volatility in channel pricing or long-term supply agreements that suggest that pricing will look different than the supply improvements?

I think the fundamental difference in a post-flood recovered era versus pre-flood is that we will have created a more robust and more geographically dispersed supply chain which will have some intrinsic cost increases relative to pre-flood footprint.

Additionally, in getting back the capacity wiped out by the floods, there's been significant incremental spending by ourselves and by our supply chain, and by the industry supply chain in general.

And so we expect that that incremental investment will be reflected in a -- in the costs that are carried forward into the future.

So we think that while there will be a gradual reduction of the pricing that's being driven by the imbalance between supply and demand, in a stabilized situation where inventories have been rebuilt throughout the chain to normal levels, which we anticipate will be in the first half of 2013 calendar year, that when prices stabilize in that environment we expect they will be at a higher level than pre-flood due to the incremental costs that I just outlined

And is it a moderate difference, a 5% to 10% difference versus pre-flood or could be it more than that?

I think it's a moderate difference.

Okay.

And then just quickly to change the topic way from Thailand, just curious what your view is on Ultrabooks?

Do you agree with Intel's view that 40% of consumer notebooks in a year or so could be Ultrabooks and what type of storage medium would you expect that form factor to have?

I expect Ultrabooks to have both hard drives, traditional hard drives, and hybrid hard drives and SSDs.

So I think it will be, depending on the specific version of Ultrabook you will see all three solutions, and even, in certain models, choices between those solutions in the same model.

And we think that the SSD penetration profile will be in very low-single-digits in a mature Ultrabook environment.

And then we see an emerging position for hybrids, a little early to develop a view on exactly what percentage of penetration, but we see hybrids as a very compelling alternative on the performance side to solid state on a bang for the buck, and we anticipate that in large capacity environments traditional hard drives will continue to be the compelling solution.

Thank you.

Our next question comes from Nehal Chokshi of Technology Insights Research.

Your line is open.

Yes.

Thanks.

Could you talk about the logic behind implied, the ASP guidance being down only 6% Q-over-Q, in terms of what you expect the channel to OEM mix to be?

It looks like the channel pricing is already exhibiting some pricing elasticity as supply comes back online here.

Yes.

I mean, I just can repeat what we said earlier.

We had a $69 ASP in the December quarter which included pre-flood pricing that was significantly lower than that.

So you can expect that our post-flood pricing was in the $70s and we're guiding to a revenue guidance that includes somewhere in the $64 to $65 range, and that includes some adjustments between the channels.

Okay.

And then also can you give any guidance on what you expect the disk-to-drive ratio trajectory to be as you get to this full gigabyte recovery into 1H '13?

When does that disk-to-drive ratio bottom?

Is it in the March quarter or will be it in the June quarter?

We actually had experienced a reduction during the course of the December quarter.

We expect that it will be a further slight reduction in the March quarter and then it will start to improve in the June quarter.

Thank you.

Our next question comes from Sherri Scribner with Deutsche Bank.

Your line is open

Hi.

Thank you.

Considering the shortages this year of HDDs and the need to refill inventory in the channel, in terms of your capacity planning, are you planning on increasing your manufacturing capacity beyond what it was in 2011?

As we've indicated, our targets that we have stated of 60%, 80% and 100% in the March, June and September quarters, that is a through-put number and that is the -- that's the indication of the capacity that we're planning in that period of time.

Okay.

I guess to me that suggests that you're not planning on increasing capacity about what it was at pre-flood levels?

I think we want to take a look at as the market builds back and gets close to a balance between supply and demand, we'll be able to get a closer look at true demand, true end market demand, unconstrained by supply, and then as we have done for years we'll make appropriate decisions on capacity expansion based on the market demand as we perceive it at that time.

Recognize that we can typically, off a stable base, we can add capacity at a pretty rapid lick, should we judge that the market requires it

Okay.

That's helpful.

And then, in terms of the pricing to the OEMs, I know some of your competitors have talked about long-term agreements that they've put in place with the OEMs.

Have you talked to the OEMs and put in place any long-term pricing agreements?

We've been extremely encouraged by the level of support from our OEMs and, indeed, from our broader customer base, but in particular our major OEMs have been extremely supportive of WD through these challenges, continue to press us to return to pre-flood capacities as soon as possible.

The award of business, the award of share is something that you execute every day in order to earn from your customers.

We have consistently done that over the last 12 years.

We will work to store our capacity and continue to work at delighting our customers and presenting them with an exceptional value they can get nowhere else in the industry.

And I can't say enough to thank our customers for their support and encouragement as we build back our capability.

Okay, great.

Thank you.

Our next question comes from Rich Kugele with Needham & Company.

Your line is open

Thank you.

Good afternoon.

Just two questions for me.

Can you talk about the average capacity drive shipped in the quarter versus the September quarter and what you think you might be able to do in March?

Yes.

I think I mentioned earlier, Rich, we mixed down about 8% to 10% from September to December and what Tim just indicated there might be a slight mix down in the March quarter before we see the capacity of the drive going up again.

Okay.

And then in terms of the cash award, or the judgment award that you're fighting against Seagate, should it go awry and you have to actually pay that, would that have to come out of US cash or would you be able to use your offshore cash since Seagate is an Irish company?

Well, another little piece of information, I mentioned as I referred to our petition to vacate that arbitration award, I said we would file it promptly.

I can confirm that we have filed the petition since the start of this call and we believe that the -- when that goes to court, as the court reviews that and considers the law, that the arbitration award will be vacated on that basis.

We have made no accrual for that award in the current accounts.

Okay.

So the issue of paying it, in our belief, does not arise.

Okay.

Thank you very much.

We can't assure you of success, but that's our position today.

Okay.

Thanks, John.

Our next question comes from Mark Miller with Noble Financial.

Your line is open.

Just like to get your feeling about the general -- we've talked about pricing, but do you see distribution pricing falling, since that went up significantly more than what I understand was the OEM price increases?

Do you see that falling more quickly than the OEM pricing or will they fall relatively in a linear fashion?

As we've indicated and the number -- the pricing number that we had in December was -- came out at $68, $69, and we have forecast that it would come down slightly during the course of the current quarter and that's more of an alignment by channel.

So we have taken that into account and as John indicated earlier on, it's more a question of aligning supply with demand and also satisfying the needs of our customers.

So consequently, there will be a cost increase, as John also indicated, and that cost will be reflected in the pricing once things settle down.

But at the moment, there is a pretty significant deficit between supply and demand and we're taking that into account as best we can -- make the assumptions at this point in time and that's what we're reflecting.

I believed you indicated that during the quarter there were more heads and that was one of the reasons the costs went up externally.

Was that driven by the shipment of these higher capacity products -- areal density products?

No.

One of the things that we've indicated for many years in maintaining our strategy of sourcing heads internally, and a significant proportion externally, was the management of risk.

And as we saw in the floods where we were dependent for slider fab of internal to a very significant extent in that one facility at Bang Pa-In, our long standing relationship and strategic decision to have a significant external source now stands us in very good stead as we ramp that external source to support us while we bridge to bring back up capacity in our own facilities so that we can ramp demand back up to full production.

So basically, we've indicated that we allocated those available heads, both internal and external, to a mix of product which was about 8% to 10% mix down in the December quarter versus the September quarter

Thank you

Our next question comes from Mark Moskowitz of JPMC.

Your line is open.

Yes, thank you.

A question, if I could, sorry, if it's been asked already.

In terms of the March outlook, I heard your estimates in terms of the WD units, but did you talk about what the industry shipments could be, now that the pre-flood inventory buffer is no longer present?

We don't really know yet.

Seagate gave some indication of their expectations for March capacity.

We've just given an indication.

We don't yet understand what Hitachi and Toshiba may be capable of, given their progress with supply chain rebuild, et cetera.

So what we do know is that there's going to be a significant shortage between the supply capability of the industry and its supply base and the demand pattern in the quarter, which comes on top of, now, a defined shortfall last quarter, if we accept that the true demand was in the 175 to 180 range, and we know the industry shipped 119.

So there's a 50-million-unit shortfall there and another 11 million that was squeezed out of the overall supply chain by our estimation.

We think there will be some of the small amount of remaining inventory will be squeezed out of the March supply line, as well as whatever the industry manages to ship in.

But in any event, there's going to be a significant shortage gap between those two numbers.

You think that gap kind of stays the same or does it get actually worse now this quarter?

I don't think it gets worse.

Okay.

And then my other question, John, or Tim, or Wolfgang, whoever wants to take it.

As you guys contemplate this return back to 100% of pre-flood level sometime during the summertime, can you give us a sense in terms of how much of your internal sourcing composition will change, in terms of what was external versus internally sourced prior to the flood versus how it will look after you're back to 100% post flood?

I think we, you know, we've consistently targeted that percentage to be about 20%, with a range around that that depending on circumstances goes plus, minus 5% to 10%, right?

And that model is going to continue into the long-term future.

Okay.

Thanks.

A nice job on the recovery.

Thank you.

Our next question comes from Ben Reitzes of Barclays Capital.

Your line is open.

Hi, thanks.

Gentlemen, you mentioned that you're still confident that the merger with HGST will close by March.

Would you mind just discussing a little more about why you have that confidence still?

There's just been questions around China MOFCOM support, as well as how the sale is going from the EU condition.

So any details around that would be helpful.

Thanks a lot.

Well, we have several full approvals.

We have several conditional approvals, conditional approvals from EU, Japan and Korea, and we continue to work with the FTC in the US and with China to gain approval there.

We believe that we will be in a position to meet the conditions of the approvals granted by the authorities that have granted conditional approval so far, and we believe that we will achieve approval from the two, China and the US, before March.

Okay.

Thanks.

And my follow-up is with regard to slider production, I'm sorry if you said this, but have you -- are you ramping efforts outside of Thailand as a contingency and there is any timeline on that, or do you think you're going to stay in Thailand with slider production predominantly?

I'm sorry if you answered that and said it.

In my prepared remarks I addressed that.

I indicated that we're extending capacity and capability into Malaysia in order to spread that risk.

Do you know when that's ready or you didn't say?

I didn't get in -- heads produced from the new Malaysia slider fab will be in drives in the June quarter.

Thanks a lot, appreciate it.

Next question comes from Jayson Noland with Robert Baird.

Your line is open.

Okay.

Thank you.

I wanted to follow up on long-term agreements.

Do you have a sense how the LTAs that Seagate has signed will impact your business, if at all, this year, calendar '12?

We don't have insight into the terms of any Seagate LTAs.

We believe that customer share is earned day by day with execution and value.

We're focused on that, working with our customers to rapidly recover our position as soon as we can.

The current conversations with our customers indicate that they are very desirous of that situation and our problem is not agreements.

Our problem is internal execution to be able to satisfy our customer needs and we're focused on improving our execution and building our capacity to supply our customers.

Would you want LTAs to be status quo for the industry post the Thailand issue?

Well, we've had LTAs with multiple customers for many, many years.

They generally provide an outline on their -- of the terms and conditions under which we will work with our customers and indeed we have LTAs with certain suppliers, and they provide a framework within which we execute.

And the extent to which we execute effectively typically influences the overall level and profitability of the business we do

Okay.

Last question for me, you talked about capacity coming on -- back online as the year unfolds.

Could you talk about certain drive types?

It's our understanding that there's more constraints in the near-line enterprise market specifically.

Yes, the near-line market was down quite a bit in the last quarter, significantly constrained, we would say, supply-wise, because there was some bleeding of inventory as well.

It went down from 6.8 million to 5.3 million, I believe.

So that continues to be short.

There is a lot of demand, cloud-related demand, in that market, and we continue to service as much of it as we can and will continue to do so.

Thank you.

Congratulations on the progress.

Thanks.

Our next question comes from Steven Fox with Cross Research.

Your line is open.

Thanks.

Good afternoon.

Just following up on that, could you maybe provide a little bit more color around how close you'll be to matching the mix demand when you get out to 100% capacity?

You talked in total units, but I was curious when you actually think your mix will be back to levels pre-flood?

Yes.

As we get back to full production capacity, we expect to be able to match the mix exiting the June quarter.

And then just lastly on the gross margins, given some of the direction you've given around pricing and mix as well, where would you anticipate gross margins trending over the next few quarters relative to your long-term targets and what would we be looking for, say a year from now?

The next quarter, if you do, take the numbers that we provided you can impute that and you'll see that somewhere in the 29% to 30% range.

It's a little bit early to talk beyond that timeframe, as we recover, and we're not changing our long-term business model right now.

We're going to wait until we close the acquisition and then we're back to pre-flood capacity and then we'll give you an update on that one.

Fair enough.

Thank you very much

One more question, operator

Our next question is from Cindy Shaw with Discern.

Your line is open.

Hi, a couple questions.

One, there's been some talk from one of your suppliers about the capacity that is being restored going straight to the next, basically areal density, and I was wondering is that, as you restore capacity, the plan and what are the risks you see around that?

Well, I think, Cindy, Tim already indicated that the way we have traditionally managed our business and the way we'll continue to manage the business is that we manage transitions on areal density based on the needs of each specific market capacity point and the cost profile, cost crossover profiles between old and new ways of satisfying that capacity point.

It's an area that WD has historically excelled at, relative to results in the rest of the market and we will continue to manage our business that way.

Okay.

And then there have been some comments about margins within the industry context really saying they think that the margins, gross margins will resettle at a much higher level than we've seen over the past few years.

It sounds from your last -- the answer to the last question, that you're not willing to drive a stake in the ground, but if you are, I would be curious as to your thoughts on that?

Yes, just like in the previous answer, we're not going to provide any forecast beyond the March quarter.

Okay.

Thank you, and congratulations on a great job.

Thank you.

Well, thank you all for joining us today and for your continued interest in WD.

I want to, again, acknowledge the heroic effort by our employees and our supply partners in helping us achieve the progress we have thus far, and to assure our customers and shareholders that we're working hard to return the Company to its leadership position.

Thank you very much.

That does conclude today's conference.

Thank you for participating.

You may disconnect your lines at this time.