Western Digital Corp

NASDAQ:WDC

Earnings Call Transcript 2023-Q2

[Operator]

Good afternoon, and thank you for standing by. Welcome to the Western Digital Fiscal Second Quarter 2023 Conference Call. Presently, all participants are in a listen-only mode. [Operator Instructions]. And as a reminder, this call is being recorded.

Now I will turn the call over to Mr. Peter Andrew. You may begin.

[Peter Andrew, Investor Relations]

Thank you, and good afternoon, everyone. Joining me today are David Goeckeler, Chief Executive Officer; and Wissam Jabre, Chief Financial Officer. Before we begin, let me remind everyone that today's discussion contains forward-looking statements, including expectations for our product portfolio, cost reductions, business plans and performance, demand and market trends and financial results based on management's current assumptions and expectations, and as such, does include risks and uncertainties. We assume no obligation to update these statements.

Please refer to our most recent financial report on Form 10-K filed with the SEC for more information on the risks and uncertainties that could cause actual results to differ materially. We will also make references to non-GAAP financial measures today. Reconciliations between the non-GAAP and comparable GAAP financial measures are included in the press release and other materials that are being posted in the Investor Relations section of our website.

With that, I will now turn the call over to David for introductory remarks.

[David Goeckeler, CEO]

Thank you, Peter. Good afternoon, and thank you for joining the call to discuss our 2023 second quarter results. The Western Digital team worked diligently within a dynamic market and delivered revenue at the high end of the guidance range we provided in October. We reported second quarter revenue of $3.1 billion and non-GAAP operating loss of $119 million. Our non-GAAP loss per share was $0.42.

Our ongoing efforts to control expenses, optimize working capital and deploy capital judiciously helped us manage cash flow amidst a challenging flash pricing environment and larger-than-expected ACD underutilization that pressured gross margins.

Before we discuss the details of our second quarter results, I wanted to cover two other announcements that we are making today. First, we disclosed that Western Digital has entered into agreements with Apollo Global Management and Elliott Investment Management for convertible preferred equity investments totaling $900 million.

In connection with the agreement, Reed Raymond, a partner at Apollo, will join our Board starting immediately. On behalf of the Board, I am pleased to welcome Reed, a leading technology investor who will provide us with additional financial and strategic expertise, which will be critical as we continue to execute on our business strategy and complete our strategic review. Second, on January 25, we secured access to $875 million of financing through a delayed draw term loan.

When combined with the actions we undertook to structurally lower our cost structure, these financings provide valuable financial optionality and flexibility to Western Digital as we continue our strategic review. Regardless of the outcome of the strategic review, our goal is to ensure the business is in a solid financial position to invest in innovation and create long-term shareholder value.

Given the ongoing nature and confidentiality of the process, we will not be answering any questions about the strategic review process or making comments on market rumors. We will provide updates as we have them. Over the past three years, we have worked continuously to reinvigorate innovation and bolster business agility for both our flash and HDD organizations, which enabled the Western Digital team to stay ahead of the market. Over the same period, we paid down $2.7 billion in debt and arranged for settlement of a long-standing tax dispute.

Since the beginning of fiscal year 2023, we have taken additional actions to reset the business in response to the post-pandemic environment. These actions include: first, we have further reduced our capital expenditures across Flash and HDD to moderate our supply. As a result, our projected cash capital expenditure for fiscal 2023 has declined nearly 40% from six months ago. Second, we have decreased supply bid growth across both Flash and HDD. In Flash, we reduced wafer starts by 30% in January.

In HDD, during the fiscal first quarter, we consolidated production lines across our manufacturing facilities and idled certain media production lines in Asia, reducing client hard drive capacity by approximately 40%. During the fiscal second quarter, we continued to optimize our capacity enterprise manufacturing footprint to align our supply with the new demand environment.

Third, we have reduced our quarterly non-GAAP operating expense by over $100 million since the close of fiscal year 2022, driven by lower headcount, discretionary spending and variable compensation. We are targeting to reduce quarterly non-GAAP operating expense level to below $600 million by the time we exit the fiscal year. And lastly, in December, we successfully executed an amendment to the existing financial covenants under our credit agreement.

Turning to end market demand during the fiscal second quarter. Demand for consumer-oriented products stabilized as we discussed in October. In Consumer, we experienced a seasonal uptick across both Flash and HDD. In client, channel demand for both SSD and HDD have improved. However, commercial PCs are now being impacted by tightening budgets and spending across corporations, which is negatively affecting client SSD shipments.

In cloud, we experienced a decline in nearline shipments as our customers were undergoing inventory digestion and ongoing subdued China demand. I'll now turn to business updates, starting with HDD. During the fiscal second quarter, our HDD revenue declined significantly as cloud inventory digestion intensified, while demand for retail and client HDD improved.

We continue to successfully execute on our product road map as we completed qualifications and commenced shipments of our latest generation 22-terabyte CMR hard drives at multiple cloud and major OEM customers last quarter.

We are aggressively ramping this 22 terabyte CMR product this quarter and expect this drive along with its SMR variants to be our growth engine going forward. Qualifications of our 26 terabyte UltraSMR drives are also progressing well. Our major customers remain committed to adopting SMR drives as the 20% capacity gain that UltraSMR drives over CMR offers multi-generation TCO benefits to the most complex data centers worldwide.

We expect sequential growth in revenue and margin into our fiscal third quarter and continued recovery as we move through calendar year 2023. Turning to Flash. Thanks to our broad portfolio, diverse routes to market and leading retail franchise combined with strong seasonal demand, bit shipments increased 20% sequentially, exceeding our forecast.

While we continue to experience pricing pressure in the market, our premium brands, including SanDisk, SanDisk Professional and WD_BLACK continued to deliver strong share and profitability to support the business.

Our premium WD_BLACK client SSD, which is optimized for gaming continues to be well received in the marketplace. It achieved a record exabyte shipments, unit shipments and average capacity per drive resulting in exabyte shipment increase of 73% sequentially and 41% year-over-year for this product.

On the technology front, BiCS5 represented 70% of our flash revenue in the December quarter, while BiCS6 will reach cost crossover in the fiscal third quarter. Our next-generation 3D NAND node BiCS8 has entered productization phase. BiCS8 incorporates several groundbreaking 3D NAND architectural innovations to deliver a major leap in performance and cost-effective solutions to a broad range of exciting products, demonstrating the benefits of Western Digital's strong partnership with Kioxia and our innovation leadership in 3D NAND architecture.

As we look into the fiscal third quarter, in hard drives, overall demand in cloud has stabilized, and we expect modest improvement in near line to offset a seasonal decline in client and consumer hard drives. We expect stronger improvements in the second half of this calendar year, led by the aggressive ramp of our 22 and 26 terabyte hard drives. In flash, we expect enterprise SSD product demand for the fiscal third quarter to be sharply reduced as certain large cloud customers have entered a digestion period.

In addition, a reduction in commercial PC demand is expected to impact client SSD shipments in the near term. Driven by the lower customer demand forecast in enterprise and client SSDs, we anticipate bit shipments to decline in the fiscal third quarter and return to growth in the fiscal fourth quarter. As I mentioned earlier, Western Digital lowered wafer starts in January, and we remain flexible in adjusting the magnitude and duration to restore our flash supply and demand balance.

As noted, for calendar year 2023, we expect reduced capital investment and lower utilization in response to the new demand environment. Our initial estimate is for flash demand bit growth to be in the low 20% range with production bit growth to be well below that of demand.

With that, let me turn the call over to Wissam, who will discuss our second quarter results in greater detail and provide an outlook for the third quarter.

[Wissam Jabre, CFO]

Thank you, David, and good afternoon, everyone. Total revenue for the quarter was $3.1 billion, down 17% sequentially and 36% year-over-year. Non-GAAP loss per share was $0.42. Looking at our end markets, cloud represented 39% of revenue at $1.2 billion, down 33% sequentially and 36% year-over-year.

Sequentially, the declines in capacity enterprise drives sold to our cloud customers and smart videos were partly offset by an increase in Flash shipments. Nearline bit shipments were 61 exabytes, down sequentially, driven by inventory digestion. The year-over-year decline was also primarily due to inventory digestion in hard drives. Client represented 35% of total revenue at $1.1 billion, down 11% sequentially and 41% year-over-year.

Sequentially, the decline was driven by pricing pressure across our Flash products, which was partly offset by an increase in hard drive shipments. The year-over-year decline was also due to pricing pressure in Flash as well as lower client SSD shipments for PC applications. Finally, consumer represented 26% of revenue at $0.8 billion, up 17% sequentially and down 25% year-over-year.

Sequentially, the increase was driven by a seasonal uptick in both retail hard drives and Flash shipments. The year-over-year decline was driven by lower retail hard drive shipments and pricing pressure in Flash.

Turning now to revenue by segment. We reported HDD revenue of $1.5 billion down 28% sequentially and 34% year-over-year. Sequentially, total HDD exabyte shipments decreased 35% and average price per hard drive decreased 21% to $99. On a year-over-year basis, total HDD exabyte shipments decreased 33%, and average price per unit increased 2%. Flash revenue was $1.7 billion, down 4% sequentially and 37% year-over-year. Sequentially, Flash ASPs were down 20% on a blended basis and 13% on a like-for-like basis.

Flash bit shipments increased 20% sequentially and remained approximately flat year-over-year. As we move to costs and expenses, please note that my comments will be related to non-GAAP results unless stated otherwise. Gross margin for the fiscal second quarter was 17.4%, down 9.3 percentage points sequentially and 16.2 percentage points year-over-year. Our HDD gross margin was 20.7%, down 7.8 percentage points sequentially and 9.9 percentage points year-over-year.

On both a sequential and year-over-year basis, the decline was due to underutilization related charges of approximately $100 million. Our Flash gross margin was 14.5%, down 10 percentage points sequentially and 21.6 percentage points year-over-year. We are continuing to reduce our costs with operating expenses at $659 million for the quarter, down $30 million sequentially. Operating loss was $119 million. Taxes were a benefit of $48 million. Taxes are influenced by several factors, including the projected quarterly profitability for the rest of the year and our corporate tax structure.

Earnings per share was a loss of $0.42. operating cash flow for the second quarter was $35 million, and free cash flow was an outflow of $240 million. Cash capital expenditure which includes the purchase of property, plant and equipment and activity related to our Flash joint ventures on our cash flow statement was $275 million.

Our gross debt outstanding remained at $7.1 billion at the end of the fiscal second quarter. Our trailing 12 months adjusted EBITDA at the end of the second quarter, as defined in our credit agreement, was $3.3 billion, resulting in a gross leverage ratio of 2.1 times compared to 1.5 times a year ago.

As a reminder, our credit agreement includes $0.8 billion in depreciation add-back associated with the Flash Ventures. This is not reflected in our cash flow statement. Please refer to the earnings presentation on the Investor Relations website for further details. As David mentioned, during the fiscal second quarter, we executed an amendment to the credit agreement that temporarily increased the covenant leverage ratio for the next seven quarters. Our liquidity position continues to be strong.

At the end of the quarter, we had $1.9 billion of cash and cash equivalents and a revolver capacity of $2.25 billion for total liquidity of $4.1 billion. Today, we announced multiple agreements to further enhance our liquidity position by $1.8 billion as follows.

On January 25, we closed the delayed draw term loan agreement with our lenders in the amount of $875 million. In addition, as David mentioned, Western Digital entered into an agreement with Apollo Global Management and Elliott Investment Management for a convertible preferred investment of $900 million.

Together, these actions significantly increase our ability to access liquidity and provide additional financial flexibility and optionality as we manage through this challenging downturn and execute on our strategic review. Before I go over guidance for the fiscal third quarter, I'll discuss the business outlook and the financial impact associated with the actions we are taking to rightsize our cost structure.

In HDD, we expect revenue to increase modestly in the fiscal third quarter as growth in nearline shipments outpaces decline in consumer. In Flash, we expect both shipments and ASP to decrease sequentially. We expect bit growth to resume in the fiscal fourth quarter. For the fiscal year 2023, we are reducing our gross capital expenditures to approximately $2.3 billion compared to our prior forecast of $3.2 billion entering this fiscal year.

We are also aiming to reduce our cash capital expenditure to $900 million which is about 40% below our forecast six months ago. The primary drivers of our lower capital expenditures are the delay of the BiCS6 transition in flash and reduced investment levels in both client and capacity enterprise hard drive manufacturing.

We have reduced our quarterly operating expenses by over $100 million compared to six months ago. We are targeting to exit this fiscal year with quarterly operating expenses below $600 million. These actions will allow us to weather this cycle while also enabling us to continue advancing our innovative product road map going forward.

I'll now turn to guidance. For the fiscal third quarter, our non-GAAP guidance is as follows: We expect revenue to be in the range of $2.6 billion to $2.8 billion. We expect gross margin to be between 9% and 11%, which includes underutilization charges in Flash and HDD totaling $250 million, with Flash driven by a 30% reduction in wafer starts.

We expect operating expenses to be between $600 million and $620 million. Interest and other expenses are expected to be approximately $90 million. We expect tax expenses to be between $60 million and $70 million for the fiscal third quarter and approximately $240 million to $260 million for the fiscal year. We expect loss per share of $1.70 to $1.40 in the third quarter, assuming approximately 319 million shares outstanding.

I will now turn the call back over to David.

[David Goeckeler, CEO]

Thanks, Wissam. Before we open up for questions, I wanted to reiterate our view of the long-term opportunities for both Flash and HDD storage. Importantly, our efforts have enabled us to regain architectural leadership in both Flash and HDD, and we are preparing these technologies to address the meaningful long-term growth for data storage from client to edge to cloud. With our diverse portfolio, broad go-to-market engine, an enviable retail franchise and a lower cost structure, we remain confident in our ability to deliver long-term shareholder value.

Okay. Peter, let's open up for Q&A.

[Operator]

[Operator Instructions] And our first question today will come from C.J. Muse with Evercore.

[C.J. Muse, Evercore]

Yes, good afternoon. Thank you for taking my question. Obviously, we're kind of in a perfect storm here. But curious, as you think about maintaining your technological competitiveness in the NAND side, while at the same time, significantly slowing down CapEx for both you as well as what we've heard from Kioxia for BiCS6. I guess, how do you balance those two things? How do you set the stage into a recovery and maintaining that leadership? And how much longer can you squeeze the requisite kind of 15% cost down out of BiCS5.

[David Goeckeler, CEO]

C.J., thanks for the question. Good to hear from you. So yes, that's a balancing act. There's no doubt. I mean one of the things we talked about in the script and we feel really good about is BiCS8, I think BiCS8 has reached productization. We'll have more to say about BiCS8. Siva will do -- I think we'll do a webinar during the quarter on all the technological innovation there. There's been an enormous amount of R&D going into that.

So, we feel very good about where we are from a technology road map. I'm actually in my hand right here I'm holding a BiCS8 USB, one of the first ones. And so, we're putting enough capital in the system to move BiCS6 along. I mean, BiCS6 will be a shorter node for us. It won't go into all products. We'll be making choices about what we take it into or where we need BiCS6, BiCS5 will serve us well for the rest of the portfolio, and then we'll move right into BiCS8, which quite frankly, is ahead of schedule as far as production, and we feel very good about it.

So, we'll balance all of that and have enough capital to accelerate, have enough BiCS6 there that we need it and then accelerate BiCS8 when we see the growth come back. As far as the cost downs, look, I mean, in the second half of the year, cost downs are going to be very difficult because we are far along in BiCS5 and BiCS6 is not ramping that much. We'll return to those as we start to ramp BiCS8.

But we'll still have some, but not to the level, especially with the underutilization of fabs. So, all of those mixed in, we're going to -- we will have gotten most of our cost downs in the first half of the year, and then we'll see them come back as we ramp up BiCS6 and especially BiCS8.

[C.J. Muse, Evercore]

Very helpful. If I could follow up, Wissam, can you confirm that for the March quarter is just $150 million incremental underutilization charges? And then how are you thinking about that rolling off through calendar '23. Thank you so much.

[Wissam Jabre, CFO]

Yes. C.J., so the -- for the March quarter, we're projecting $250 million in total. That's between both Flash and HDD. We expect the probably, I would say, 3/4 of those to be in the Flash -- on the flash side and 1/4 in the HDD business. As we roll into the fourth quarter, I expect HDD to become minimal. But Flash will depend on how long we continue with the underutilization.

The way to think of it is typically we -- as we under or as sort of we reduce the wafer starts, given the cycle time, we expect approximately 60% to 70% of the impact to come in the first, let's say, 90 days and then the remaining impact would be in the following quarter. So, the way to think of it is the March quarter would have around 60% to 70% of the impact from the underutilization for -- that we've taken -- the actions we've taken so far.

Now that said, it could be that, depending on how the demand picture evolves, we haven't yet decided how long the underutilization is going to be, and we'll manage this in a very dynamic way as we continue to look at market inputs and so on. My comments were around assuming, let's say, a one-quarter event.

[Operator]

And our next question will come from Aaron Rakers with Wells Fargo. Please go ahead.

[Aaron Rakers, Wells Fargo Securities]

Thanks for taking my question. I'll try to slip in two as well here real quick. First of all, on the 30% reduction of the wafer starts starting in early January. I'm just curious in the context of what you had outlined, you still -- it sounds like I think that NAND Flash bit demand growth is somewhere in the 20% plus range. With that 30% reduction, how has your bit production changed as you look at calendar '23, how much -- what's your assumption as far as your own bit supply growth as we move forward?

[David Goeckeler, CEO]

So first of all, let me talk about the kind of how we're thinking about it. It is a very dynamic situation. I think when we were looking at our CQ1, we've seen some demand drops. We've come off a very strong quarter of bit growth. We just delivered 20% sequential bit growth. That's why we didn't cut wafers earlier.

When we look at our fiscal Q3, we're seeing some drop in both client and enterprise. The enterprise SSD side of it is more a digestion issue. So, to make sure we manage our inventory and we don't get things to build up. And so that's why we're -- we've decided to cut wafer starts in the first quarter.

Again, as Wissam said, that's a -- it's literally a decision we can make every week about how do we load wafers into the fab. Right now, that's a one quarter decision to make sure we keep our supply and demand balanced as best we can. I see Wissam looking up -- do you have a number on the overall bit growth for the year.

[Wissam Jabre, CFO]

Yes. I think the -- from a supply perspective, I would say, it will be in the lower -- I would say, it's probably given the CapEx situation, we're looking at this to be in the single-digit growth from a supply perspective.

[Aaron Rakers, Wells Fargo Securities]

That's helpful. And then as a quick follow-up, on the hard disk drive side, I mean, looking at 61 exabyte capacity shift, that's down 40%, 45% sequential. What gives you the confidence that, that's just a transitory digestion thing? And maybe there isn't anything going on competitively? Just any kind of visibility you want to share in that business?

[David Goeckeler, CEO]

Yes. I think we signaled this a little bit last quarter. We knew there was going to be some variability in demand across the industry and across customers. Quite frankly, when you're at these revenue levels, which are the lowest we've seen in the long time, orders from big customers make a very big difference.

So, if you go back for the last couple of quarters, the way different big cloud customers, the way either LTAs were restructured, the way big orders came in one way or another, you're seeing some pretty large share shifts quarter-over-quarter.

But when you look at it on a sex month basis, you look at it on a 12-month basis, you see pretty consistent share. I think we've gained a little bit. But again, we're managing for profitability. We think share is going to be over a multi-quarter period, pretty stable, and that's actually the way it's working out, you're just seeing some pretty big swings here quarter-over-quarter. So, we feel really good about the competitive situation. The 22 terabyte drive shipped significant volume this quarter. We expect to ramp that throughout the year. We've got big customers very committed to SMR.

Our UltraSMR technology gives us a unique position of an additional 20% gain over CMR. And that is in qualification across a number of very large customers. So, we feel like as we ramp throughout calendar year '23, we ramp into a stronger and stronger portfolio as we move through the year.

[Aaron Rakers, Wells Fargo Securities]

Thank you, David.

[Operator]

Our next question will come from Joe Moore with Morgan Stanley. Please go ahead.

[Joe Moore, Morgan Stanley]

Thank you. I just wanted to make sure I understood the mechanics of the underutilization charge. Is that sort of the cost of just higher cost per bit because you're running underutilized? Or are you -- I mean it sounds like you're pulling some of that forward in time, but maybe not all of it. Can you just talk about what exactly that charge will represent and how that's going to play out this quarter and next?

[Wissam Jabre, CFO]

Yes. Sure, Joe. I should have clarified when I talked about the underutilization that we don't necessarily have a similar approach to the accounting for underutilization as some of our peers. For us, the underutilization charges are taken as a period expense. And so, any portion of the factory that's not being utilized is basically expensed within the quarter. And so, it does not flow through the inventory and back to the P&L, if that helps.

[Joe Moore, Morgan Stanley]

Okay. It does. I guess, how are you guys thinking about the signals of like when that goes back to full utilization? I mean do you wait for pricing to stabilize? Or is there something you can see beforehand that will tell you and it's time to kind of keep to move the fab back to full.

[David Goeckeler, CEO]

Yes. Well, we're always talking to our customers, right? So, we have a very good sense of where they're at and what the demand signals are going to be. I mean as we talked about, we expect volumes to increase going into our fiscal fourth quarter. So, as we get closer to that and we understand what that looks like we'll make an incremental decision on when and how to ramp back up the fab.

[Joe Moore, Morgan Stanley]

Great. Thank you very much.

[Operator]

And our next question will come from Tim Arcuri with UBS. Please go ahead.

[Unidentified Analyst]

This is Jason on for Tim from UBS. I have a couple of questions. So, my first question is on your -- on the NAND segment. Sorry if I misunderstood, but I believe you said single-digit bit growth for NAND in calendar year '23. So, I was just curious which end markets are driving this demand weakness this year. Also, I was just curious whether we should expect any potential risk for NAND inventory write-downs in March quarter or June quarter. Thank you.

[Wissam Jabre, CFO]

Yes. So, Jason, my comment was around the supply side. I would say, single digit, let's call it, high single-digit percentage growth. I didn't necessarily make any comments on the demand side. On the demand side, it'll probably be in the low 20% range in calendar '23 versus calendar '22.

As for the second part of your question, which is related to inventory. Look, we go through the process at the end of every quarter as part of our quarter close. We look at the various demand signals versus the inventory on hand and the costs, et cetera. And we're comfortable with where we ended at the end of calendar Q4.

[Unidentified Analyst]

Got it. Thank you. And my second question is, apart from your comment on the utilization charges, do you guys also see any potential additional risk or purchase order cancellation fees for any type of pay agreements you have with your suppliers if it remains weak in the near term? Thank you.

[Wissam Jabre, CFO]

I mean we typically don't forecast these things and we manage the business in a dynamic way. So, I don't expect anything major there.

[David Goeckeler, CEO]

Yes. Again, going back to Wissam's prior comment, that's part of our normal quarterly close process. And if there were any adjustments that were needed to be made, we would have made them at that time. But of course, you got to remeasure it and take a look at it every quarter.

[Operator]

And our next question will come from Krish Sankar with Cowen and Company. Please go ahead.

[Krish Sankar, Cowen and Company]

Hi, thanks for taking my question. To first one, David, you mentioned nearline HDD could improve. I'm kind of curious how to think about pricing trends for nearline HDD in the March and June quarter? And also think about the nearline exabyte growth in the first half of this year in calendar '23 overall. And then I had a follow-up.

[David Goeckeler, CEO]

Yes. I mean, I think the pricing environment has been pretty good throughout this whole cycle. I mean any time you're seeing this kind of underutilization, you're going to see a little bit of pressure on pricing, which is not surprising, I would say we're seeing a little bit more. I mean I think as we look at exabyte growth is -- I think it's pretty clear to say it will be stronger in the second half than the first half.

I mean we're going to now ramp back off of this very low in calendar Q4, and we expect growth as we move throughout the calendar year. As we said, we're anticipating modest revenue growth, maybe low to mid-single digits quarter-over-quarter here going into calendar Q1, our fiscal Q3, we expect margin improvement is, of course, the volume comes back and the underutilization charges drop, and we'll see that continue as we go throughout the calendar year.

So -- but we are coming off of very low levels. I think that exabyte growth in the full calendar year will probably be below 20%, something around that. But again, we got to see how it plays out. We got -- we still got big customers going through inventory digestion, some are coming out of it. We'll know more as we work our way through the calendar quarter.

And we also have a very dynamic situation in China. The China market has been very subdued for quite a long time now. I would say there are some signs of things getting better. We'll see after we get past the new year, how that progresses. But that could be that -- depending on how that comes back, will have an impact as well, of course.

[Krish Sankar, Cowen and Company]

Got it. Very helpful. And then as a follow-up, just kind of curious, you mentioned the cloud inventory digestion. And you also mentioned that for HDD in March, the cloud business stabilized. So curious on the NAND side or even HDD side, when do you expect this digestion to bottom? And then when you think things start improving from a demand standpoint or maybe your own inventory standpoint. Thank you.

[David Goeckeler, CEO]

Yes. That's a very difficult question given how dynamic the market is. I mean I think we're coming off of a very strong quarter of bit growth, 20% sequential bit growth in our FQ2 was a good result. Obviously, it's a very challenging pricing environment. Going into our fiscal third quarter, we see a drop in both bits and pricing. So that's a pretty significant impact on the business. And then current forecast is going into our fiscal Q4, we see the volume pick back up. So that's a little bit a little bit of how we see the dynamics.

The pricing environment will change as supply and demand come more into balance. And we're doing everything we can to manage our supply situation, demand balance so that we keep our inventory situation under control, very important in this kind of cycle. And we'll continue to be very dynamic of how we manage it. It literally changes week over week. And again, one of the things I'm very happy about what we've built in the organization over the last several years is a tremendous amount of agility in the organization to react.

It's important that we react faster than the market is moving. Otherwise, we just get carried along with the market. And I think we're doing a good job with that to get the best result we can out of a difficult market and prepare ourselves from a technology and portfolio position that when things get more in balance and we get to the inevitable upturn that we're very, very well positioned, and we feel good about that from Flash technology. I talked about BiCS8. Again, we'll talk more about that throughout the quarter. I think you're going to be impressed about the innovation that's in that. I certainly was and also about where we're at in the product portfolio.

[Operator]

And our next question will come from Wamsi Mohan with Bank of America. Please go ahead.

[Wamsi Mohan, Bank of America.]

Thank you. If I could just follow up on your comment on underutilization charges will be minimal in HDDs in fiscal 4Q. What's giving you the confidence there that this inventory digestion and particularly in the high cap price will largely be done? I know you're coming off low levels, but it also seems like some of the broader cloud customers are starting to tick down as well in terms of their own demand. So, any color you can share on what you're seeing in the market that's giving you the confidence that those underutilization charges will go away in HDDs by fiscal 4Q. And I have a follow-up.

[Wissam Jabre, CFO]

Well, let me start with the answer, Wamsi. When we look at our inventory exiting the fourth quarter, our inventory appears to be in a better position than our peers. And so obviously, when we consider the utilization and where the demand is and the improvement in demand over time on the HDD side, that's really what drove my comment. And so, based on what we see today, this is how we anticipate things to unfold.

[Wamsi Mohan, Bank of America.]

Ok, thanks Wissam. And Dave, you noted in your prepared remarks a lot of different things that you're doing all the things that are kind of under your control, right, negotiating covenants, cutting costs, lowering CapEx, OpEx. And despite all of these, you are sort of doing these converts. So maybe you can just talk about why this incremental liquidity is needed as your view on the market changed materially or your share assumptions changed materially? Or is this more of a strategic investment and just optionality? Just -- maybe any color you can share around that would be helpful.

[David Goeckeler, CEO]

Yes. It's a number of things. So first of all, it is to give us the flexibility to manage through the depths of the downturn. It's important that we look at -- we have a blend of different kind of financing, both debt and equity. We can't just take all debt. We've got to watch our debt to equity our EBITDA to debt ratios and make sure we manage it all as one package.

And I think so that's part of it. A big part of it is kind of facilitating the execution of our strategic review. These. You'll see in the 8-Ks that are filed. These agreements are very complicated and they're very well thought through to give us the ability to execute a range of outcomes and make sure that we can be in a good position as we move to that stage of the process of not putting a time line on that, but these are set up in a way that give us a lot of optionality and flexibility to facilitate that outcome.

And then third thing it brings additional capability to our company. Reed Raymond is a very sophisticated technology investor that will join our Board. Elliott will have the right to join our Board under an amended letter agreement with them when they clear some issues at their choice.

So, it brings a lot of capability to us as well. So, we feel good about people investing in the business about the opportunity to do this, and it puts us in a very strong position to continue to execute the business, invest in innovation as well as set ourselves up for the next phase of our strategic review.

[Operator]

Our next question will come from Shannon Cross with Credit Suisse. Please go ahead.

[Shannon Cross, Credit Suisse]

Thank you very much. I have a follow-up to the last question and then an additional question. I just want to -- should we assume that you're not going to initially draw down the term loan that you have and that's kind of an insurance policy? And how should we -- I'm just trying to figure out interest expense on that. And then I have a follow-up.

[Wissam Jabre, CFO]

Yes, Shannon. So, the one thing to keep in mind is the -- we still have the IRS settlement payment that's expected to be in the fourth quarter. And so, when the time comes for that, we will make a decision based on what's the most efficient way to pay. If we don't need to draw down on our new facility, then we won't do that because obviously, the additional investment also gives us flexibility and optionality from a liquidity perspective.

[Shannon Cross, Credit Suisse]

Okay. Thanks. And then I'm curious, what changes are you looking at to get down to OpEx at about $600 million a quarter just as you look across your cost basis? Thank you.

[Wissam Jabre, CFO]

Yes. So, when you look at where we ended the December quarter, we were down versus also the September quarter, which was also down versus the previous quarter. So, in other words, from the beginning of the fiscal year until now, we've taken down approximately $100 million. And we guided to be $600 million to $620 million. We continue to take similar actions going through the typical focusing on exiting or reducing all sorts of discretionary expenses.

But more importantly, we're basically focusing on maintaining the critical R&D investments so that we continue to invest in our technology and drive the long-term growth. So more of a similar type of actions as we've taken so far. And that should get us close to the $600 million and below that by the end of the fourth quarter.

[Operator]

Our next question will come from Tom O'Malley with Barclays. Please go ahead.

[Thomas O'Malley, Barclays]

Hi guys. Thanks for taking my question. My question is on the preferred equity convert. We've seen different companies handle them from a dilution perspective where sometimes even out of the money, you'll see them come into the non-GAAP share count. Can you just talk about what you're expecting from dilution there and how you're handling that and the guidance given I really don't see shares getting moved around at all? Thank you.

[Wissam Jabre, CFO]

So, Tom, maybe I'll start with the latter part of your question. as we're guiding for a share loss for this quarter, including the dilution of the preferred -- the convert would be anti-dilutive. And so that's why you don't see them reflected in the share count. However, as we swing to a profit, I would expect us to include them as part of our fully diluted share count. So, they'll have some limited dilution impact.

[Thomas O'Malley, Barclays]

Helpful. And then just on the recovery side into the fourth quarter on some of the bit shipments or the [indiscernible] can you just -- are you just thinking that it will inflect higher? Or are you expecting a material step-up because you outperformed your peers in the December quarter with the growth you saw there. You're obviously expecting a step down in March. But just talk about the cadence. Is it an extreme step down in March with a small step up? Any kind of color on how you're looking at that forecast given you're giving some color there.

[David Goeckeler, CEO]

Yes. I think one of the things we're seeing is one of our big enterprise SSD customers go through a digestion phase in our FQ3 and I think they'll get through that in a quarter and be back to buying. So that should be -- that will get back to a good guy instead of a bad guy as far as the volume. And then we'll -- this is a very seasonally weak quarter for consumers. So, we'll see some step-up there. Client is a little bit TBD is now commercial and enterprise is a little weaker. The consumer side has stabilized.

So, I don't want to put too much of qualification on it. But again, we feel good about our ability to have a very diverse portfolio, very diverse go to market engine. We've talked about this from the channel to consumer to the big OEMs to the web players. And I think, quite frankly, we saw last quarter that go to market engine performed really well. And when we get past a few seasonality things and a few things that are idiosyncratic with big customers, we'll see it kick back in and perform well.

[Operator]

Our next question will come from Jim Suva with Citi. Please go ahead.

[David Goeckeler, CEO]

Hi, Jim.

[Jim Suva, Citigroup Inc]

Thank so much, David. It sounds like with the charge of $250 million now, and you mentioned NAND underutilization starts to kind of go away in Q4. That kind of you're seeing a bottom or the worst of the utilization charges kind of in the March quarter. Is that fair to say? I know you still have to do some adjustments for NAND and wafers based upon how the market goes. But is that fair to say kind of the worst of it and the digestion and equilibrium are kind of hitting in the March quarter?

[Wissam Jabre, CFO]

So, Jim, thanks for the question. My comment around underutilization going away was more related to the HDD side of the business. On the flash side or on the NAND side, I would say it is a dynamic situation. We will continue to assess as we see the demand signal coming. And so, the example I gave earlier was on the assumption that we don't -- that we have only one quarter of underutilization. I wanted to make sure that's well described, so that -- for modeling purposes.

But yes, the comment around underutilization disappearing was mostly related to the hard drive side. And look, on the NAND side, also when we exited Q4, we -- our inventory position was better than some of our peers. And we're taking this action to continue to manage our inventory given where the demand picture is today. but that's an evolving situation, and we will be -- we can -- as David said, this is a decision that we can take on a weekly basis if we need to change the approach.

[Jim Suva, Citigroup Inc]

Thanks, Wissam and David for the details. Thank you.

[Operator]

And your next question will come from Karl Ackerman with BNP Paribas. Please go ahead.

[Karl Ackerman, BNP Paribas]

Thank you. I was wondering -- I wanted to talk about NAND for a second. Does the capital infusion from the convertible stock and draw on your revolver change your approach to ramping BiCS6 and BiCS8. I asked because 90 days ago, you indicated you'd be pushing out to BiCS transition to reduce your CapEx for fiscal '23. But today, you're also indicating BiCS6 will reach cost crossover with BiCS5 in March, and you're also currently in production of BiCS8. And so, I guess, specifically, when should we expect BiCS8 should reach volume crossover to your NAND business? Thanks.

[David Goeckeler, CEO]

Yes. I don't think we're that far along to say -- to issue that kind of guidance, I guess, I would call that. But I think what we're saying is BiCS8 is well along in its technology evolution and it's reached production phase like I said -- I wish we had -- on video, I can show you the BiCS8 product I'm holding in my hands and playing with.

But yes, I would say the investment doesn't change the way we're thinking about our supply situation. What we're trying to do is match our supply situation to our demand and make sure we can manage our inventory and it doesn't get out of control as we go through this process. We're trying to be very dynamic.

And obviously, when you're slowing down the fab. And one of the ways to do that is to slow down the nodal transition. It brings in this whole question of how long we're going to stay on BiCS6, how fast do we transition to BiCS8. And we're working through all of that. Again, that's a bit dynamic. A lot of it depends on what BiCS8 looks like and how it's being productized.

And I think one of the things we're seeing here today is it has reached the productization stage ahead of schedule. And so, we'll have more to say about what that fab mix looks like as we go forward. It's clear we're going to have BiCS6 will be a shorter node. It won't go into every single product if it will go into the products that it needs and then we'll move other products straight to BiCS8.

[Karl Ackerman, BNP Paribas]

I appreciate that. If I may because you are discussing an improvement in HDDs beginning in March, could you discuss whether you need to take further action to rightsized your own inventory of components? Thank you.

[Wissam Jabre, CFO]

The quick answer to this, Karl, is we don't see the need to do that. And so, this is why we don't project it. We continue to manage the inventory situation on a dynamic basis. But as of the end of the quarter, we were comfortable on where we are. And from where I stand today, we don't see the need to do that.

[Operator]

And our next question will come from Steven Fox with Fox Advisors. Please go ahead.

[Steven Bryant, Fox Advisors]

Thanks for taking my question. I just want to follow up on that last question about the inventories. Can you expand on the strategy from here? Because I'm looking at your inventory days and they're up from 102 a year ago to 133 days. And you mentioned there's still some demand question. So, I'm trying to understand why start ramping back HDDs next quarter versus taking an inventory write-down versus other strategies to sort of get your inventories in better alignment and generate some better cash flows? Thank you.

[Wissam Jabre, CFO]

So, let me maybe just clarify on the HDD side, to be clear, when we look at the inventory movement in the December quarter that just ended, we did reduce the HDD inventory quite a bit. In fact, the increase came from the Flash side. So, when we look at the numbers, I think quarter-to-quarter at the company level, we saw around $90 million reduction in inventories. And those were more than $200 million of reduction was in the HDD side. That was partly offset by some of the growth in Flash.

And so, we don't think the inventory situation on the hard drive side is bad. We obviously will continue to monitor as we do on a regular basis. We also are, as part of the $250 million underutilization that we talked about for the March quarter, there are some continued underutilization on the hard drive side, which would allow us to continue to manage inventory very tightly and maintain that discipline on the supply side until, obviously, the demand growth accelerates.

And that's what my comment was about the next quarter, not necessary, in other words, the June quarter, not necessarily seeing as much of hard drive underutilization charges. I hope this clarifies.

[Steven Bryant, Fox Advisors]

Yes. No, that definitely helps filling some of the blanks. I appreciate that. Thank you.

[Wissam Jabre, CFO]

Thank you, Steven.

[Operator]

And our last question will come from Sidney Ho with Deutsche Bank. Please go ahead.

[Sidney Ho, Deutsche Bank AG]

A couple of quick ones. On the gross margin side, if I think about fiscal third quarter, if hard drive underutilization charges goes down quarter-over-quarter and revenue goes up modestly, is it fair to assume that gross margins for hard drive goes up. And if that's the case, does that mean NAND gross margin could go below zero in the quarter. Obviously, there's a onetime charge involved.

[Wissam Jabre, CFO]

So, Sidney, this is a fair way of looking at the transition from Q2 to Q3 with the improved utilization or, let's say, smaller -- lesser underutilization on the hard drive side, we expect to see some improvement in the gross margin quarter-to-quarter. And unfortunately, with the high underutilization charge related to the 30% supply cut on the Flash side, we're anticipating the gross margin there to be slightly negative. And so that sums it up.

[Sidney Ho, Deutsche Bank AG]

Great. And then my quick follow-up here is just maybe you have covered this already. But how would you characterize the inventory level in the channel and the customers for both hard drive and Flash. It sounds like hard drive is in decent shape. But curious, more curious on the flash side.

[David Goeckeler, CEO]

Yes. I would say it's -- actually, the channel has been pretty good on the client -- on SSDs this past quarter. So, I don't think there's anything particularly unusual in the channel. I think the channel performance has been -- was actually one of the bright spots last quarter. So, I don't think we see anything too unusual there.

[Sidney Ho, Deutsche Bank AG]

Thank you.

[David Goeckeler, CEO]

Thank you, Sidney. Hi, everyone. Thanks for joining us on the call. We look forward to talking to you throughout the quarter. Take care.

[Wissam Jabre, CFO]

Thank you.

[Operator]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines at this time.