Kate Scolnick - Vice President of Investor Relations Steve Luczo - Chairman of the Board, Chief Executive Officer Dave Mosley - President of Operations and Technology Dave Morton - Chief Financial Officer, Executive Vice President Phil Brace - President of Cloud Systems and Silicon Group

Sherri Scribner - Deutsche Bank Rich Kugele - Needham & Co. Mark Moskowitz - Barclays Aaron Rakers - Stifel Ananda Baruah - Brean Capital Jayson Noland - Baird

Good morning and welcome to the Seagate Technology fiscal second quarter 2016 financial results conference call. My name is Abigail and I will be your coordinator for today. At this time, all participants are in a listen-only mode. Following the prepared remarks, there will be a question-and-answer session. As a reminder, this conference is being recorded for replay purposes. At this time, I would like to turn the call over to Kate Scolnick, Vice President, Investor Relations. Please proceed, Kate.

Thank you. Good morning, everyone and welcome to today's call. Joining me today from Seagate's executive team are Steve Luczo, Chairman and CEO, Dave Morton, Executive Vice President and CFO, Dave Mosley, President, Operations and Technology and Phil Brace, President, Cloud Systems and Silicon Group. We have posted our press release and detailed supplemental information about our second fiscal quarter 2016 on our Investor Relations site at seagate.com. During today's call, we will review the highlights for the quarter, provide the company outlook for the third fiscal quarter 2016 and then open the call for questions. We will refer to non-GAAP measures on this call, which are reconciled to GAAP figures on our supplemental information available on the Investor section of our website. We are planning for the call today to go approximately half an hour and we will do our best to accommodate your questions in that timeframe. As a reminder this conference call contains forward-looking statements about the company's anticipated future operating and financial performance, customer demand and general market conditions. These forward-looking statements are based on management's current views and assumptions and should not be relied upon as of any subsequent date. Actual results may vary materially from today's statements. Information concerning risks, uncertainties and other factors that could cause results to differ from these forward-looking statements are contained in the company's SEC filings and supplemental information posted on the Investor section of the company's website at seagate.com. I would now like to turn the call over to Steve Luczo. Please go ahead, Steve.

Thanks, Kate. Good morning, everyone and thanks for joining us today. Our second fiscal quarter results reflect in line performance in revenues and margins and outperformance on the committed cost control measures. For the December quarter, Seagate achieved revenues of $3 billion and on a non-GAAP basis gross margin of 25.6%, net income of $246 million and diluted earnings per share of $0.82. Our HDD exabyte shipments for the December quarter were 60.6 exabytes, up 10% sequentially. Within this, enterprise exabyte shipments were up 21% sequentially, reflecting strong demand for our high-capacity enterprise products. Average capacity per enterprise drive was a new record of 2.2 terabytes, up 15% year-over-year. Non-GAAP operating expenses in the December quarter were $453 million. On a year-over-year basis, we have reduced a quarterly expense run rate by almost $100 million or 17% reflecting reductions around the core business, adjacencies, restructuring activities and lower variable compensation. Overall inventory levels were down 5% with improved linearity and capital expenditures were in line with our expectations. Cash flow from operations in the December quarter was $382 million and free cash flow was $245 million, equating to free cash flow of $0.81 per diluted share. Fiscal year to-date, we have generated $1.2 billion in cash flow from operations and forecast cash flow from operations to be approximately $500 million for the March quarter. Our capital returned to shareholders remains a top priority at Seagate and we continue to balance the effective investment in our storage technology portfolio with shareholder returns and within an investment grade framework. There has been no change to our capital allocation policy and our dividend payout of $188 million a quarter works comfortably within our cash flow generation forecast. We have redeemed 23 million shares fiscal year to-date and considering the macro economic empowerment and investor sentiment, we view the stock as being attractive at these levels. Our balance sheet remains healthy and we ended the quarter with $1.3 billion in cash and cash equivalents and 296 million shares outstanding. Our debt structure and level of interest expense is manageable, particularly in light of whatever technology companies have done and/or are planning to do in the public markets. Seagate is focused on maximizing our opportunities in areas of the storage market that will position us to grow our topline, optimize the value of our core technology, continue to generate strong cash flow and create value for shareholders. Our specific areas of near-term activity for Seagate's management team are around our product portfolio monetization, operational efficiencies and continued financial discipline. Throughout the decades of storage technology innovation at Seagate, we have maintained a high priority on investing in R&D and acquiring the right assets to provide the most reliable, cost-effective and workload optimized storage products for customers. Market demand for storages across multiple forms and locations, including on-premise for performance, in the cloud for availability and directly on purpose built and market devices. We have many new products designed for these different workloads, including HDDs, cloud systems and flash technology products. In the nearline market, we have begun the initial ramp of our 10 terabyte Helium product and we are shipping our eight terabyte conventional products in high volume. We continue to believe high capacity enterprise demand will grow in calendar 2016 and our portfolio improvements position us well for full participation in this market. Surveillance and video applications are growing rapidly and they are seeing strong demand for our products specifically designed for these workloads. Our retail, gaming and client offerings are continuing to move to higher capacity points and are benefiting from the recent launch of products with industry leading areal density. In October, we acquired Dot Hill Systems for our cloud systems business and later in the quarter, the divestiture sale of EVault was announced. We believe this strategy positions us to leverage a broader storage systems and all flash array portfolio across a more focused set of storage OEM customers and channel partners. In addition, our ClusterStor high-performance compute end-to-end system solutions continue to gain traction in a high performance compute market and we are excited about several vertical market opportunities we are targeting with our channel partners. We recently announced products at the Supercomputing 15 show. That included a workload optimization HPC drive, emphasizing our direction to create solutions using all elements of Seagate's portfolio. Seagate's flash technology product portfolio has grown significantly over the last two years and includes enterprise SAS SSDs, PCIe accelerator cards, SATA controllers, all flash arrays and hybrid HDDs. In December, we had strong quarter in our PCIe business and we announced sampling of or PCIe and VME product set. Our enterprise SAS SSD qualification activities continue to be on track and are in evaluations with multiple customers. Combined, we are planning for our cloud storage systems and silicon business to exit fiscal year 2016 at a revenue run rate of over $1 billion a year. This will position us for continued success and profitability in fiscal year 2017, as several areas of these markets are projected to grow double digits over the next few years. Through the expansion of our HDD portfolio and new business adjacencies, we are having success in broadening our global hyperscale customer base and strengthening our channel partners. To best serve our customers and improve operational efficiencies within our marketplace and functions, we announced in January the alignment of our global markets and customers organization under Dave Mosley. We thank Rocky Pimental for his leadership of our sales and marketing organization and we will continue to benefit from his strategic insights in his role as an Executive Vice President. Personally, I am looking forward to working with our executive team over the next several years as we continue to lead Seagate in serving growing global customer base, expanding our storage portfolio, striking our competitive position and optimizing our business for continued financial performance. Turning to our business outlook. In the last several quarters, we have discussed our concerns over global economic conditions, particularly in Europe and China, which have proven accurate and we believe will persist at least through June this calendar year. While we are cognizant of the ongoing challenges of the macroeconomic environment, the IT transformational shifts presents significant opportunities for us to continue to be a leader in core storage technology and deliver value to shareholders. As we align our storage product portfolio to capitalize upon these market dynamics, our revenue opportunities are shifting with hyperscale customers continuing to drive strong exabyte growth with capital expenditure compounded annual growth rates of 40%. At the same time, our exposure to the traditional PC client market is changing and now represents less than 35% of total revenue. In light of these macro conditions and technology shifts, we took purposeful and thoughtful action last year to reduce our operating expenses and evaluated areas where investments were not paying off, resulting in measurable operating expense reduction and cost control implementation across our business. Taking into account macroeconomic factors, we believe overall storage market demand will be seasonally down in the March quarter which has ranged between 5% and 10% over the last five years. We are planning for revenues to be approximately $2.7 billion, which reflects the high end of the seasonal demand trend and operating expenses to be sequentially flat. We are forecasting cash flow from operations for the March quarter to be sequentially higher at approximately $500 million. We anticipate our non-GAAP gross margins will be sequentially flat in the March quarter and ongoing activities that will improve our profitability, including raising prices in certain markets, aggressive product transitions and internal and external supply chain optimization such as reducing manufacturing capacity. Based on these factors and expected growth in the nearline storage market, we still expect that our gross margins will be in our target range of 27% to 32% for the June quarter. I would like to thank our customers, suppliers and employees for their continued support as well as our shareholders and are now ready for Q&A.

[Operator Instructions]. Our first question comes from the line of Sherri Scribner with Deutsche Bank. Your line is open.

Hi. Thanks. I just wanted to dig a little bit into the gross margin improvement. You guys did a good job on managing that this quarter. How much of that was driven by the ramp of your eight terabyte drives and a more positive mix in your business? And how much of that was related to cost reduction actions?

Hi, Sherri. We are taking aggressive cost reduction actions, but the ramp of the nearline products and re-equilibrating versus what we saw in Q1 was pretty substantial. Nearline went up about 11% in exabytes quarter-over-quarter. That's 18% year-over-year and a lot of that is being driven by sixes and eights moving hard and we will continue that into this quarter as well. So it's pretty profound there.

And then maybe could I ask a quick question on the capacity business and the hyperscale business. How do you see that ramping over with the year? I know that you have talked about strong build plans from the cloud providers, but I wanted to get a sense of what you are seeing now? Thanks.

We still believe that some of the cloud service providers are in hold back mode. There is lot of diversity in the Tier 2 buildout, but there are still people there with their capital budgets that are fairly conservative through this time. So we do see that in the back half of this year, some of them will come back into, not only scale out but also refresh of their existing data centers as well.

Thank you.

Sherri, just to further point out what Dave said, so the cost actions really in terms of how they impact COGS are really in the quarters to come more so than the improvement in the last quarter. That was more related, again, to mix and introducing some of these new products that are higher traction on the eight TB, but I think in terms of the margin improvement we see going forward we are pretty encouraged by what we see in terms of the cost actions related to capacity and supply chain optimization that will impact COGS going through rest of the calendar year.

Great. Thanks, Steve.

Yes.

Thank you. Our next question comes from line of Rich Kugele with Needham & Co. Your line is open.

Thank you. Good morning and congratulations actually in a tough environment. Maybe first, let's take a bigger picture view. With all the puts and takes competitively, some people are concerned about the overall drive business health. What do you see now competitively with the Seagate/WD transaction? And even the potential Toshiba's exit in the space? And then I have a follow-up.

Well, I guess a couple of answers, Rich. I think in terms of the macro view on the industry, I still think the investing world is not quite grasping. The transition is around where storage is being stored. It's locale of the storage, just not the amount of what's being stored that's basically shifting and those are architectural implications. And architectural implications are actually enhancing the application. So it's feeding off of one another, but from every source of data that we have, we still have 95% to 98% of your bits are ultimately being stored on a disk drive or more. As you know, cloud infrastructures usually replicate. So even though there is a reduced number of drives being in the client, the data being generated by the client is still ultimately stored on a disk drive. And as it turns out, it's exactly stored in a disk drive that is harder to make and takes more absorption in the factories in terms of number of heads and disk and the content in those heads and disk is quit a bit higher. So, from a manufacturer's perspective, it's a good thing because you are getting more absorption. That being said, there is a lot of growth in the silicon related pieces of the business, not at the expense of the HDD business per se and that's an area that we are serious about obviously. We are building what we think is a very good business, both at the systems level and the device level. And it stands what we do with HDDs as well as how we incorporate various levels of silicon, all way up to all-flash arrays and other devices. So we like the overall storage business and we particularly like the fact that we think that the HDD business itself is going to benefit from the continued trend of more people being more connected, generating richer content. So I think, to that point, when you look at the competitive aspects, the WD, SanDisk transaction is interesting on one level that it certainly is a huge endorsement of the HDD industry, because in order to pay back anywhere from $20 billion to $30 billion over seven to 10 years just for the debt, that has to come from the HDD business, because the flash business obviously has its own capital needs that are becoming more substantial because the technology shift they are facing. So I think that's a big endorsement of, if WD can generate $20 billion, $30 billion over 10 years just to pay back debt and then you have to do capital and things on top of it, that sounds like a pretty good industry. And it's an industry that we think we are ahead technically, but if you want to say we are equal, that's fine. But it's also one that we are entirely focused now and we are not be cutting R&D. And so when I look at the transaction, I do think it's tough to 40 times earnings for a company and finance it all with debt. I do think that the interest expense on that transaction is obviously 2X what it should have been or what was maybe expected to be six months ago. And it fell to us, like the operating expense reduction side of $1 billion were aggressive in light of the fact there is only $4 billion of OpEx to begin with and we have always viewed WD as a pretty lean organization. So to say that there is $1 billion coming out of that business, that may be true but then some of it has got to be coming out of R&D. And that's not what we are doing. And so we believe investing in your core technology when at the product level and then on top of it there is this technology shift that as it does relate to our silicon business, we want to make sure that we have access to the best silicon technology and as we stack up the various players, you have Samsung as the clear leader, both in terms of capital and technology. They have announced their third fab, $17 billion, thank you, in 3D. Hynix is doing great in 3D and we have good dialogue with them. Micron and Intel, leading with 3D XPoint. And 3D XPoint, of course Micron is a planar technology company as well. So we think our engagement with those companies which is quite active provides us access to the technology that we need to pursue our silicon strategy. And we do think that the recent shift in Toshiba's position on what they can do with planar does raise questions of how are they going to compete with companies that have two to 10 times the capital budgets. So we feel pretty good about the industry and we certainly feel about our relative position.

Excellent. Just one follow-up. In terms of, obviously with the dividend yield now north of 9%, people are concerned supposedly on your cash flow and your ability to continue to pay the dividend. Do you believe that your cost cutting actions that you have implemented and I guess will be finished by June, that you will be able to have that more than $1 billion in cash flow annually and be able to fully fund that dividend?

Yes. As I cited in the opening remarks, Rich, that our cash flow relative to our dividend payment is not concern for us at all.

Excellent. All right. Thank you very much.

Thanks.

Thank you. Our next question comes from the line of Mark Moskowitz with Barclays. Your line is open.

Yes. Thank you. Good Morning. Two questions, if I could. Steve, can you talk a little more about your exabyte trend line? It was down about 7% in the September quarter, roughly flat for December? Should we anticipate, just getting from your comments, around improvement and targeting higher cap, especially 10 terabyte, that we can see exabyte starting to actually grow in the first half of calendar 2016? And then kind of a follow-up part two of my question is that partly why you are saying you will raise pricing? Or is that comment more around like-for-like pricing and not pricing going up because of new schemes?

Yes. Let me answer your back question and then I may direct you to an offline discussion so we may have debate about growth rates. But the pricing is like-for-like in certain rate market rises .We are not talking mix. We are talking about prices that have to address the value of the products in a lot of the client space, it's just ridiculous. And I think I made this statement a year ago that the industry was not serving itself by subsidizing client products by trying sell more nearline products just say within the margin range, because this day would come that you don't have any room left. And I think now the industry is recognizing it. Whether or not you are making 10 points of margin on the client or five points, it is nowhere near 20 which is what some people cited and that's nowhere near what you need to basically fund the technology going forward. So there is going to have to be adjustments on the client side to reflect what we do. So the price, I think, goes across certain markets and it's like-for-like. We show 10% growth sequentially in exabyte shipments for us, up to 60.6 exabytes. So I am not sure where that information is coming from that you are referencing. So instead of wasting time here --

I am talking year-over-year --

So instead of talking about it on this call, because we see growth in exabytes and in the nearline space, I would rather take it offline, because it is going to chew up too much time debating data right now. But as I said in the script, we have 10% up sequentially on exabytes shipped and our enterprise exabytes were up 21%. So we are encouraged by the mix up in the enterprise and in the cloud service providers.

Okay. Yes. I was talking about year-over-year, which pretty much dovetails with your numbers, but it sounds like you definitely feel good about that growth trend line and we can see it continue to be a positive, both on a year-over-year and sequential basis.

Yes. We do believe that.

Okay. Thank you.

Yes. Thanks.

Thank you. Our next question comes from the line of Aaron Rakers with Stifel. Your line is open.

Yes. Thanks for taking the question. First real quickly I want to go back to Rich's question. I am curious on your thoughts on Toshiba as it relates to the hard disk drive business, given the recent news. And then also I was curious if you could just give us an update on the OpEx. I think in the past you talked about $460 million. Obviously you have done better than that. Is there further OpEx realignment? And then an update to that $460 million level exiting the fiscal year. Thank you.

I forgot to answer the Toshiba question. Thanks for re-asking it. Yes, I don't know. We can't predict what's going on at Toshiba. We can say that we have noticed a marked decline in their presence in certain markets and maybe part of what Nidec was seeing was reduced from them. We don't know and we actually don't really believe Nidec sees all its orders two weeks into the quarter anyhow. But look, it's obviously a difficult situation at Toshiba at the corporate level and clearly their number one priority is to save the fabs and it doesn't make sense to me that being in the drive business serves that purpose. But what they decide is up to them. So if you had asked me where was my gauging of would Toshiba be in the business in the next one to three years today versus where was it six months or a year ago, I am much more towards the end that they are not going to be in this business in the next one to three years, just because I don't how I see how they can be competitively, given where areal density is going and given where manufacturing is and given some of their bigger corporate issues, I just can't imagine that that's where they want to spend their R&D expense or frankly their cash flow.

And on the OpEx?

On the OpEx side, Aaron, we did outperform. So we are ahead of where we said we would be and that was for exiting the fiscal year. I think we are happy at this level for now. We don't see a real reason to turn it down from here. We still have some ideas about how we might do that and still protect the product portfolio, but I think we are going to run the rest of the fiscal year at this level. And then we will see how the market develops in the next couple of quarters and see what we have do in FY2017.

Okay. Thank you.

Yes. Again, just to emphasize, Aaron, that's what my point was that we think the next focus of our effort is around issues that impact gross margin.

Thank you. Our next question comes from the line of Ananda Baruah with Brean Capital. Your line is open.

Hi. Thanks guys. Congrats on a really solid trend in a tough environment as well. Just a quick one for me. Steve, I would love to get your thoughts, again just sort of circling back on application set for flash and for flash storage systems. One of your largest customers, a couple of days ago on their earnings call seemed to make a point of putting more energy around their view that flash, flash based systems are going to increasingly address general application set. Your earlier comments on this call of the 95% to 98%, which I know is probably more of a historically data driven remark, but the way you spoke about it, seems to suggest that you believe that they can stay in that 95% to 98% range. Any sort of nuance being that you have with regards to flash systems and their ability to address general application sets, would love to hear that. Thanks.

I don't think they are inconsistent. I think you have the opportunity for flash to address general application sets, but the data is still being stored disk drives. It's just a question of what it is moving in and out of. In the old days, it was moving in and out of a CPU. Now it's being staged in different levels of, call it memory or storage, that basically allow for greater and faster processing applied against it. But at the end of the day, that stuff rests on an HDD. So my point was, sure, that layer above is a layer that we want to participate on and through Phil's efforts, we feel we will be quite successful there. But it's not eliminating the fact that bit ends up on a disk drive. In fact, it's going into a disk drive that's a pretty sporty, as Dave would say. It's a nearline drive that has lots of heads and disks and a really complicated VLSI architecture. So those are all things that we get paid for. Now, Phil, you want to talk a little bit more about what you are seeing?

Yes. I think that, to echo Steve's comment, where we see a lot of the flash, I would say, is on the new tier, if you will, right. A performance tier that does accelerate things and generally speaking, it's in front of large arrays of storage, large banks of storage. And that's where we see a lot of the growth. And we are investing some of our energy. And it is around that performance area.

I was going to say, yes, I think in particular, as it relates to the super high performance, super high data rate, data processing applications like petro and some of the other energy applications, that's where our high-performance compute solution has been particularly strong because we really have the fastest system to feed those higher levels of, again, call it storage, call it memory. But somehow you have to have a back end that's serving that thing very well. And we have to be the leader in that space. And that leadership comes through partnerships as well as some great companies like Cray and Teradata and others.

Yes. That's great context. I really appreciate it. Thanks a lot.

Great. Thanks. All right. We should probably have one last question.

Thank you. We have a question from the line of Jayson Noland with Baird. Your line is open.

Okay. Great. I guess a follow-up to this discussion. With some pressure on performance enterprise drives, 15K specifically and a tailwind in capacity drives, could you talk about your exposure to both? And if there is difference in the gross margin profile? Any significant difference between the two?

This is Dave. No significant difference between the two. I would say that the 15k lines are still in demand. There are still a lot of people pulling, not to the levels that maybe they were historically, but not 50% of what they were historically yet and I think we anticipate a fairly long tail there because it still provides a fairly low cost good value hitting the price band that has got a compelling performance tier. And it's important to note that a lot of places that those drives go today, that cost performance trade-off is really compelling compared to any other solution. Maybe the choke point is somewhere else in the architecture. Now that said, it's a million or 1.5 million drives a quarter and at the scale of Seagate, that's pretty small. So if we redeflect those heads and disks into other boxes, that doesn't really have a material impact on Seagate.

Okay. Great. Thank you. Congrats on the quarter.

Yes. Thanks very much.

Okay. So just to wrap it up again, I guess we will again thank everyone and we look forward to speaking to you after the next quarter.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.

Thank you.