Western Digital Corp

NASDAQ:WDC

Earnings Call Transcript 2022-Q4

[Operator]

Good day and thank you for standing by. Welcome to Western Digital's Fiscal Fourth Quarter 2022 Conference Call. 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.

I will now turn the call over to Mr. Peter Andrew, Vice President, FP&A and Investor Relations. You may begin.

[Peter Andrew, Vice President, FP&A & Investor Relations]

Thank you, and good morning, 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 product portfolio expectations, business plans and performance, demand and market trends and financial outlook 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'll now turn the call over to David for introductory remarks.

[David Goeckeler, Chief Executive Officer]

Thank you, Peter. Good morning, everyone, and thanks for joining the call to discuss our fourth quarter and fiscal 2022 results. I'm pleased that the Western Digital team executed well and delivered solid results in light of the ongoing macro and geopolitical dynamics.

We reported fourth quarter revenue of $4.5 billion, non-GAAP gross margin of 32% and non-GAAP earnings per share of $1.78, all within the guidance ranges we provided in April. Fiscal year 2022 revenue totaled $18.8 billion, and we reported non-GAAP earnings per share of $8.22. This compares to revenue of $16.9 billion and non-GAAP earnings per share of $4.55 in fiscal year 2021. We grew revenue 11% and EPS increased 81%, demonstrating progress in unlocking the earnings potential of our business.

In addition to strong financial performance, fiscal year 2022 was a hallmark year for Western Digital from an innovation, product development and execution perspective. In particular, we regained innovation leadership with the introduction of multiple products and technologies for the cloud.

In May, we announced a 26-terabyte drive, leveraging our OptiNAND and UltraSMR technologies as well as ePMR. Impressively, this means we've nearly doubled drive capacity relative to when I joined Western Digital just over two years ago. In Flash, we expanded adoption of our NVMe enterprise SSD from one cloud titan to three as well as qualification at several enterprise OEM suppliers.

From an organization perspective, we have bolstered the company's executive management team, further strengthening our ability to drive operational excellence, innovation and disciplined financial management.

On top of all of these achievements, we reduced debt by $1.7 billion and attained an investment-grade corporate rating, placing Western Digital on a solid financial foundation.

Before I jump into additional detail on the quarter, I wanted to provide an update on our strategic review. As you know, two months ago, we announced that we are reviewing potential strategic alternatives aimed at further optimizing long-term value for our shareholders.

The Executive Committee of the Board, which I lead, continues to oversee the review and Elliott Management is participating alongside us under a non-disclosure agreement, along with other interested parties. We're evaluating a range of alternatives, including options for separating our market-leading Flash and HDD franchises.

We are moving expeditiously, but this work will take time. We will not be answering any questions about the strategic review today giving -- given the ongoing nature and confidentiality of the process. We will provide updates in the future as appropriate.

Now I'll provide updates on our HDD and Flash businesses. During the fiscal fourth quarter, strong demand from our cloud customers for our latest generation energy-assisted drives drove near-record near-line shipments of 111 exabytes. Total HDD revenue declined sequentially due primarily to consumer and client HDD demand.

We commenced commercial shipment of a number of products incorporating our OptiNAND technology. In addition to shipments of our 20- terabyte and 22-terabyte CMR drives, qualifications of our 26-terabyte SMR drive are underway, as we noted at our product launch event in May.

This SMR-enabled drive enables 20% higher capacity than our CMR variants, offering significantly better TCO for our cloud customers and further highlighting the performance-driven benefits of the innovation that Western Digital is packing into a hard drive.

Finally, we are ramping a second cloud customer with SMR technology this quarter and remain on track to lead the industry's transition to SMR-based drives for the cloud. We are very confident in our multiyear product roadmap for capacity enterprise drives, which combine ePMR, OptiNAND, UltraSMR and triple-stage actuators to deliver a cutting-edge portfolio of drives in commercial volumes at a wide variety of capacity points.

We also continue to invest in HAMR and the commercialization of this technology alongside our other HDD technologies that are leading the industry. The breadth and depth of this portfolio strongly positions us to be the provider of choice for the largest and most complex data centers in the world.

Building on the expertise cultivated over decades of bringing to market industry-leading technologies, we are committed to leveraging our innovations to continue driving business results in capacity enterprise into the future.

Turning to Flash. Revenue grew sequentially on an improving product mix and increased flash supply. Growth in Flash during the quarter came primarily from enterprise SSD, with revenue more than doubling sequentially.

Gaming is another key growth market for us, where we continue to demonstrate the strength of our client SSD franchise with exabyte shipment growing nearly 70% year-over-year. We have a leading position in gaming with our WD_BLACK brand being recognized globally for innovation, performance and quality. The latest example of this is our WD_BLACK SN-850 NVMe SSD product certified for Sony PS5 game consoles, which enables players to expand the high-speed storage capacity of their PS5 console and allows them to store and play both PS5 and PS4 games directly from the drive.

On the technology front, BiCS5 represented about half of our Flash revenue in the June quarter, up from 46% in the previous quarter. We are preparing to ramp BiCS6 late this calendar year and into 2023. Based on circuit under array architecture, BiCS6 enables many exciting high-performance products for 5G phones, SSDs and QLC flash.

Let me now offer a few observations on the demand environment. In the cloud end market, we experienced strength in the fiscal fourth quarter as supply constraints at Western Digital and our end customers started to ease. Overall, demand from our cloud customers has been consistently strong and we expect this strength in cloud to carry into the second half of calendar year 2022. We believe the accelerated digital transformation will continue to drive cloud growth and believe we are on track to generate about half of our revenue from this market by fiscal year 2025.

Outside of cloud, our expectations for calendar year 2022 demand growth have moderated since our last earnings call. As the fiscal fourth quarter progressed, we saw consumer spending soften, impacting both retail Flash and HDD demand. This weakness has migrated to the consumer PC end market as we enter the second half of the calendar year.

In client, the market generally expect PC shipments to decline approximately 10% in calendar year 2022. We are seeing our PC OEM customers aggressively rightsize their inventory to reflect current demand conditions, which will impact our business in this market in the second half of the calendar year. After going through that correction, we expect a more normal flow of business going forward as we believe PCs will continue to fulfill broader use cases as the foundation of the increasingly common hybrid enterprise, driving unit demand above pre-pandemic levels in richer SSD content.

All of these PC market dynamics are accelerating the final phase of the shift of client devices from HDD to flash technology. Consequently, the client HDD market is now declining at an accelerated rate relative to the period before the onset of the pandemic. To reflect this reality, we are now taking aggressive action to restructure our HDD manufacturing footprint to reflect this market dynamic.

In mobile, expectations for smartphone units have come down in recent months, led primarily by reduced demand in China. Industry analysts expect the smartphone industry unit volume to decrease by a mid-single-digit percentage year-over-year in calendar 2022. While we are well-positioned in supplying flash memory for 5G smartphones, we are also seeing our largest customers aggressively resetting their inventories for these products. We expect the inventory correction to be primarily impact our fiscal first quarter and return to market demand for the remainder of the fiscal year.

In consumer, we have a premium brand and a great franchise in the marketplace. In particular, we have developed an enviable position and excellent relationships with major brick-and-mortar retailers and online retailers across the globe, including Best Buy and Target in the US, MSH Group in Europe, JD.com in China and Officeworks in Australia. As a result of these strong relationships, our impressive scale, product breadth and trusted brand, we lead most consumer storage product categories.

While macroeconomic factors and COVID measures have impacted consumer demand in the near term, our customers' loyalty and preference for the performance and quality of our solutions are key differentiators, which will position Western Digital well, for the upcoming back-to-school and holiday seasons.

Before turning the call over to Wissam, I want to leave you with a few takeaways. First, at the Investor Day, we laid out the case, where the world of ever-increasing intelligent devices powered by the cloud is creating an astonishing amount of data, of which only a small percentage is stored. Our conviction remains strong and our view on near double-digit revenue growth remains intact.

Over the past several years, the storage market has entered an era of accelerated growth, led by the strength of the cloud market, which drove HDD revenue growth for Western Digital and the industry. In Flash, capital investments for incremental NAND bit growth are becoming more expensive, resulting in a more disciplined investment across the industry.

At Western Digital, our long-standing and growing relationships with hyperscale and OEM customers across the world, coupled with our leadership in commercializing innovations for capacity enterprise hard drives and momentum with NVMe enterprise SSD for data center, has made us a trusted partner. This combination of rapid demand growth in storage, technology leadership and product momentum offer Western Digital opportunities for financial outperformance.

With that, let me now turn the call over to Wissam, who will discuss our fiscal fourth quarter results and provide an outlook for the fiscal first quarter.

[Wissam Jabre, Chief Financial Officer]

Thanks, David, and good morning, everyone. As David mentioned, overall results for the fiscal fourth quarter were in line with our expectations, reflecting the resilience and agility of our business model, against such a dynamic macro environment. Total revenue for the quarter was $4.5 billion, up 3% sequentially and down 8% year-over-year. Non-GAAP earnings per share was $1.78, within the guidance range we provided in April.

For the full fiscal year 2022, revenue was $18.8 billion, up 11% from fiscal 2021. Non-GAAP gross margin expanded 4.3 percentage points and non-GAAP operating margin increased 5.7 percentage points, as we proactively managed our expenses, resulting in non-GAAP EPS of $8.22, up 81% from last year.

Turning to our end markets. For the fiscal fourth quarter, cloud represented 46% of total revenue at $2.1 billion, up 18% sequentially and 5% from a year ago. Within Cloud, Western Digital's continued success in leading the industry transition to energy-assisted hard drives drove the growth. The continued ramp of our 18-terabyte and 20-terabyte drives drove a 7% year-over-year increase in nearline HDD revenue. Sequentially, nearline bit shipments increased 9% to 111 exabytes.

In Flash, enterprise SSD revenue more than doubled sequentially and was up 38% year-over-year. The client end market represented 36% of total revenue at $1.6 billion, down 5% sequentially and 14% year-over-year. On both a sequential and year-over-year basis, client HDD led the revenue decline, while Flash revenue was roughly flat.

Consumer represented 18% of revenue at $0.8 billion, down 9% sequentially and 23% year-over-year. On a sequential basis, the revenue decline due to lower HDD retail shipments. The year-over-year decrease was due to broad-based decline in retail products across HDD and Flash. For the full fiscal year 2022, Cloud revenue increased 40% year-over-year, led by a 38% increase in nearline HDD. Flash product revenue for enterprise SSD applications more than doubled year-over-year.

Client revenue decreased 3% year-over-year as growth in Flash was offset by a 30% decrease in client HDD. Client HDD for PCs and Notebooks represents just mid-single-digit percentage of total HDD revenue exiting the fiscal year. Lastly, consumer revenue decreased 6% for the year, all attributed to a decline in retail HDD.

Turning now to revenue by segment. In the fiscal fourth quarter, we reported Flash revenue of $2.4 billion, up 7% sequentially and down 1% year-over-year. Sequentially, Flash ASPs were up 2% on a blended basis and up slightly on a like-for-like basis. Flash bit shipments increased 6% sequentially and 11% year-over-year.

HDD revenue of $2.1 billion was flat sequentially and down 15% year-over-year. Sequentially, total HDD exabyte shipments increased 1%, while the average price per HDD increased by 19% to $120 as our mix continues to transition towards the cloud. On a year-over-year basis, total HDD exabyte shipments decreased by 10% and average price per unit increased by 24%.

As we move to costs and expenses, my comments will be related to non-GAAP results unless stated otherwise. We continue to exert disciplined financial management to drive better results. Gross margin for the fourth quarter was 32.3%, up 60 basis points sequentially and down 60 basis points year-over-year.

Our Flash gross margin was 35.9%, up 30 basis points sequentially and 40 basis points year-over-year. On both a sequential and year-over-year basis, growth in enterprise SSD for data center applications led the improvement in gross margin.

Our HDD gross margin was 28.2%, up 50 basis points sequentially and down 210 basis points year-over-year. Operating expenses of $760 million were below our guidance range as we continue to prudently manage our expenses.

Operating income was $702 million, representing an 8% increase from the prior quarter and a 15% decrease year-over-year. Our tax rate was 11% for both the fiscal fourth quarter and fiscal year 2022.

Earnings per share was $1.78, compared to $1.65 in the prior quarter, and $2.16 in the year-ago quarter. Operating cash flow for the fourth quarter was $295 million, and free cash flow was an outflow of $97 million.

Operating cash flow was impacted by revenue linearity. The ramp back to normal production output at the flash joint venture, timing of component deliveries to our factories and corporate-related control measures in China contributed to a back-end loaded quarter.

Cash, capital expenditures, which include the purchase of property, plant and equipment; and activity related to our Flash joint ventures on our cash flow statement represented a cash outflow of $392 million in the fiscal fourth quarter. We remain disciplined in investing in manufacturing capacity.

Gross CapEx and cash CapEx for the fiscal year 2022 were $2.7 billion and $1.2 billion, respectively, below our expectation, as we actively managed our capital investments. We made a $150 million scheduled and discretionary debt repayment. Our gross debt outstanding was $7.1 billion at the end of the fiscal fourth quarter. We ended the quarter with $2.3 billion of total cash and cash equivalents.

Our trailing 12 months adjusted EBITDA at the end of the fourth quarter as defined in our credit agreement was $4.8 billion, resulting in a gross leverage ratio of 1.5 times compared to 2.4 times a year ago.

As a reminder, our credit agreement includes $0.9 billion in depreciation add-back associated with the Flash Ventures. This amount is not reflected in the cash flow statement. Please refer to our earnings presentation on the Investor Relations website for further details.

I'll now provide our view of both HDD and Flash businesses for the fiscal first quarter as well as comments on several key items for fiscal year 2023. For the fiscal first quarter, we expect Flash to lead the sequential revenue decline as our customer's right-size their inventory. We expect a relatively modest decline in overall HDD revenue, primarily driven by client and consumer, with gross margin relatively flat.

As we look towards fiscal year 2023, we expect cash capital expenditures to be in line with our target model, within the range of 8% to 10% of total revenue. Total gross capital expenditures are expected to be approximately $3.2 billion.

Regarding Flash CapEx, we remain excited about our technology road map despite what is clearly a volatile period in the memory industry. As we have discussed on prior calls, BiCS6 is more capital intensive technology node that will require an increase in capital expenditures. Our CapEx outlook for fiscal year 2023 reflects our commitment to technology leadership and will accelerate our path to leapfrog from BiCS6 to BiCS+ in the next several years.

I am also pleased to share that the Flash JV Fab 7 manufacturing facility at Yokkaichi plant has been approved to receive a subsidy of up to JPY92.9 billion from the Japanese government, further demonstrating the strategic importance of what is the world's largest NAND manufacturing facility.

Given the macro environment, we continue to actively manage our capital expenditures and supply. We are in discussion with our joint venture partner to adjust capital investments and align our production growth with demand.

In HDD, we will continue to focus our capital spending primarily in heads and media in order to meet the future growth in cloud demand. Offsetting these investments, we are taking aggressive actions to restructure our client HDD manufacturing footprint. We strive to optimize free cash flow generation in response to the macroeconomic dynamics.

For our fiscal first quarter, our non-GAAP guidance is as follows. We expect revenue to be in the range of $3.6 billion to $3.8 billion. We expect gross margin to be between 27.5% and 29.5%. We expect operating expenses to be between $760 million and $780 million.

Interest and other expenses are expected to be approximately $70 million. Our tax rate is expected to be between 28% and 30% in the first quarter and for fiscal year 2023. This increase is due to the tax law changes that became effective for our fiscal year 2023, requiring the capitalization of certain R&D expenses that were previously eligible for immediate deduction from taxable income. These changes are expected to result in an immediate increase in our tax rate of approximately 12 percentage points, which will then decrease gradually over time. We expect earnings per share to be between $0.35 and $0.65 in the first quarter, assuming approximately 319 million fully diluted shares outstanding.

I'll now turn the call back over to David.

[David Goeckeler, Chief Executive Officer]

Thanks, Wissam. Let me just wrap up, and then we'll open up for questions. In summary, we continue to believe that we have built the right foundation for long-term growth. We have reignited our innovation, established discipline in spending and investment and remain consistent in deleveraging our balance sheet. The innovation engine that drives TCO benefits and value to our customers, the multiple channels to deliver our products to market and the large and growing storage markets put us in a great position to capitalize on the opportunity presented by the proliferation of intelligent devices and rapidly accelerating data creation.

While segments of our end markets are now going through an aggressive inventory adjustment as supply chain impacts of the pandemic start to ease and the macro economy softens, secular demand for storage continues to be strong and underpins the digital transformation that continues across all industries.

I also want to thank our employees for their hard work during the fiscal year. Despite ongoing geopolitical and macro challenges, our team worked together to deliver strong financial performance for Western Digital. I am proud of what this team has accomplished and excited to see what we can do together in the next fiscal year.

All right. Peter, with that, let's open it up for Q&A.

[Operator]

Thank you. Ladies and gentlemen, we will now begin the question-and-answer portion of today's call. [Operator Instructions] And today's first question comes from C.J. Muse with Evercore ISI. Please go ahead.

[C.J. Muse, Evercore]

Yeah, good morning. Thank you for taking the question. I guess, first off, just want to clarify here. In terms of what's driving the weakness, is it safe to say that it's entirely consumer client and that on the hyperscale and enterprise side you're not seeing any changes? And as part of that, as you think about this inventory correction on the consumer client side, how long do you think the duration will last? Is this a one-quarter phenomenon? Too early to tell? Would love to hear your thoughts there.

[David Goeckeler, Chief Executive Officer]

Hi C.J., good morning. Yes, I would say, you’ve pretty much got it right. The one thing I would add to that on the Cloud side is, we are seeing some inventory digestion in China cloud. The US hyperscalers continue to chug along. But especially in the PC OEMs is where we saw it first, a very sharp inventory correction really in the current quarter, taking down their demand significantly to reset their inventory for what is the reality for the number of unit sales.

So right now, we think that is a relatively short period of time. Is it one quarter, two quarter, we'll see that as we go through the quarter, but it's definitely very, very sharp in the quarter we're in. And then in the smartphone market, we're seeing it as well. As a matter of fact, it's even developing within the quarter. Just a couple of weeks ago, we had one of our biggest customers take down their forecast in the quarter by over $150 million. So -- and it's all like the message, very strong message we're getting directly from our customers, this is just resetting inventory. So that one, we expect to be a one-quarter phenomena. I think in a larger market, we'll see over the next couple of quarters.

I will say that in the consumer and channel space, given our broad reach and where we operate around the world in the consumer business, we are starting to see some stabilization of those markets. Our channel business, if you look at sell-through for the first 4 weeks of the quarter, has been on plan. And even some regions like Europe, we're starting to see some strength. And I would say consumer is pretty much in the same place, starting to stabilize, not great growth yet, but that part of the market looks better than it did, let's say, two months ago. And it's really the OEMs that are really in a rapid and significant correction of inventory as well as, as I said, some of the cloud business in China.

[C.J. Muse, Evercore]

Very helpful. And just a follow-up question on the NAND side of the house. You talked about rising cap intensity at BiCS6 and what's next. But at the same time, it sounds like you're talking about tempering investments at the JV. So could you walk through how you're thinking about forward CapEx given the changes you're seeing in the end markets?

[David Goeckeler, Chief Executive Officer]

Yeah, I'll make a few comments and Wissam can comment as well. But we've always known that BiCS6 was going to be a more capital intensive node. I mean, again, we're coming off of a BiCS5, which is the most capital efficient node in the history of the -- our road map, so that's not surprising. And we're driving through that transition. We feel very good about the node. It's just it's a more capital intensive note.

Now I will note, as we talked extensively about our Investor Day, our capital intensity in general per bit is the best in the industry, and that's something we really strive for in our road map. So when we're talking about a more capital intensive node, remember, that's a relative issue. We're still in the best position as far as capital per additional bit, and that's a very, very big focus of ours.

Now the more macro question is, we're obviously having conversations across the JV about resetting our bit growth in general, independent of node, given the reality of what the demand environment is. Overall, bit demand is coming down. We're in an oversupply environment, it’s demand driven oversupply, it's not a supply driven oversupply. But we'll reset. We're looking at our CapEx. And we'll make adjustments given what the current situation is. Wissam?

[Wissam Jabre, Chief Financial Officer]

Yeah. If I can add, C.J. The -- we're targeting our cash CapEx per our target model, which is 8% to 10% of revenue. But, of course, as the macro conditions develop, if we need to adjust to that, we will manage dynamically.

[Operator]

Thank you. And ladies and gentlemen, our next question today comes from Aaron Rakers at Wells Fargo. Please go ahead.

[Aaron Rakers, Wells Fargo]

Yeah. Thanks guys. Good morning. So I've got a couple of questions, if I can as well. I just -- I wanted to unpack a little bit more the implied Flash revenue expectation you're making this quarter. With hard disk drive revenue being flat roughly sequentially, it looks like you're talking about a high 20% or 30% sequential decline in the NAND revenue this quarter, the Flash revenue.

With that in mind, I mean, how are you guys thinking about bit shift versus what is your assumption around pricing baked into that expectation? I'm just trying to understand, is this more pricing versus bit shipped? And is this really kind of -- do you think that this guide represents a bottom here?

[David Goeckeler, Chief Executive Officer]

Yeah. I think the way to think about it, as I said earlier, it's kind of a demand driven situation where we're just seeing are biggest customer, and really not all of our customers across the PC space, just resetting inventory and really dropping their demand in the quarter, so they can reset their inventory. So that leads to pricing pressure and volume pressure, so it's both of them. And so as we work through the quarter and they get their inventory to where they need it to, then I think we'll see some of the volume come back as we work through this.

From some of our customers, I have more confidence that this is a one-quarter change. But other ones, I think it may take a little longer than that. So we'll see -- we'll have more information as we work through the quarter and we'll be talking about that through the quarter in the appropriate forums.

As I said before, I will point out, I mean, this is a very dynamic market. I mean this is -- some of this has happened in the quarter. So it's very difficult to bound this, but we think we're very -- we're confident in the guide, don't get me wrong. But I'm happy we guided when we did because the -- it's a very, very dynamic environment out there. But I think our customers are aggressively managing their inventory. And my sense is they'll get through it in a pretty expeditious fashion.

Like I said in the prepared remarks, we've got kind of the supply chain is loosening up. We're getting more components. I think our customers are getting more components. Maybe that's giving them more confidence in how they manage their own inventory. And at the same time, we're going into a softer economy. So everybody is in a big reset and it's especially impacting the Flash business, to your point. The HDD business still get consistent strong growth out of the hyperscalers in the US, and feel very, very good about the portfolio position there and what we're going to drive throughout the fiscal year.

[Aaron Rakers, Wells Fargo]

Okay. And as a quick follow-up, just thinking about the Flash business a little bit more. These last couple of quarters, and appreciating that mix is a factor, but these last couple of quarters, it looks like you've seen a little bit of a slowing of your ability to drive cost down in the Flash business. As we think about BiCS6, how are you thinking about the relative cost down structure of BiCS6 relative to BiCS5? Thank you.

[David Goeckeler, Chief Executive Officer]

Yeah. I mean the -- as we've talked about cost downs, we target 15%. We always know there's going to be some quarters below, some above. Hopefully, there's more on the favorable side, and I think that's been the history, but we've hit a couple of quarters where that's not the case. But if you look at our fiscal year, we delivered right at the 15%, I think, even a tick over. Is that right, Wissam?

[Wissam Jabre, Chief Financial Officer]

Yes, that's correct, David. And one of the things to keep in mind, Aaron, is we did have the fab contamination in the third fiscal quarter. And so this is why -- this is partly why we haven't seen necessarily the same cadence of cost reduction in the last couple of quarters of the fiscal 2022.

[David Goeckeler, Chief Executive Officer]

So Aaron, we feel really good about the BiCS6 transition and what that's going to bring. And I think you'll see in the upcoming quarters, the costs will get back to where we expect it to be. We explicitly drive our road map around this number. We explicitly drive the nodal transition and the road map development around making sure we can deliver the 15% year-over-year and we are very pleased that we just delivered it again in the last fiscal year.

[Operator]

Thank you. And our next question today comes from Joe Moore of Morgan Stanley. Please go ahead.

[Joe Moore, Morgan Stanley]

Great. Thank you. I wonder if you could address, I mean, I didn't hear a specific answer to volume versus prices in NAND in Q3, but I guess what is your inventory balance going to look like at the end of Q3? And I know in the past, you guys have been willing to take fab utilization adjustments to keep that number under control. Have you thought about that in this environment?

[David Goeckeler, Chief Executive Officer]

Yeah. I'll make a few comments. I'll let Wissam make a few comments. And we don't guide to that level of specificity, but they're both roughly down about the same.

[Wissam Jabre, Chief Financial Officer]

Yes. That's where the numbers shape up, roughly among the same.

[Joe Moore, Morgan Stanley]

And your inventory balance?

[Wissam Jabre, Chief Financial Officer]

Well, given that this is mostly demand driven, we expect inventory to be -- to grow a bit this quarter as the supply is higher than the -- where the demand is. However, as we said in the prepared remarks, we are in discussions with our JV partners to take appropriate action if -- to the extent we can to limit that.

[Operator]

Thank you. Our next question today comes from Patrick Ho with Stifel. Please, go ahead.

[Patrick Ho, Stifel]

Thank you very much. Maybe just as a follow-up on the HDD side, taking it on the positive end, Dave, maybe if you could give a little color on your confidence level on the sustainability of the US hyperscalers' spending trends. What gives you the confidence that this will at least carry through the second half of this year and maybe into the early parts of 2023?

[David Goeckeler, Chief Executive Officer]

Yes, a couple of things. One is the message we get from them -- obviously, we have a very, very close relationship and talk on a daily basis. And so the message we get in planning for the second half continues to be a strong and consistent message. We've got a great portfolio around 22 and 26 and SMR.

I think one of the big highlights of last quarter on the HDD side is we got a second hyperscaler that fully qualified SMR. And with our position with UltraSMR getting 20% more out of a drive puts us in a great position for that transition. So it continues to be a very, very consistent message from them about how they plan to consume the product in the second half and going into next year.

And like I said, from the portfolio point of view, we've got lots of new qualifications underway on 22 terabytes CMR, 26 terabyte SMR. And as we go through the fiscal year, you'll see all of those products start to ramp and be adopted at volume.

[Patrick Ho, Stifel]

Great. That's helpful. And maybe as my follow-up question, in terms of following up from your Analyst Day where you did put a big focus on the NAND flash moving to the SSD market for the Cloud segment itself as well. Do you see this shift beginning with BiCS6, or is this more of a BiCS+ type of endeavor where it will be future generations where you see the biggest shift towards SSD NAND?

[David Goeckeler, Chief Executive Officer]

No. I mean, the shift is happening now. I mean, we just delivered a quarter of 105% sequential growth on our enterprise SSD portfolio. Now that's a particularly strong result. But we're very confident that as we work through the next couple of years, we're going to drive our share of enterprise SSD from the 8% to 16%.

We've got a very good plan for that. It's a great market to participate in. Like I said, we broke through with the qualifications and the success has been strong. Now it will be lumpy, not every quarter is going to be up. But the trajectory over the three-year time span is we have a lot of confidence, we're going to drive that to the 16% share in FY 2025.

[Operator]

Thank you. And ladies and gentlemen, before we go to our next question, we do ask that you please limit yourself to one question in the interest of time. Today's next question comes from Wamsi Mohan with Bank of America. Please, go ahead.

[Wamsi Mohan, Bank of America]

Yes. Thank you. Good morning. You're basically shipping well below demand levels, given the inventory correction when you look at the September quarter. Can you maybe help quantify that and help us think through if the digestion that you're calling for is completed, let's say, in September, what's roughly the right base we should be thinking of to drive any sequential growth off of that in -- for the December quarter?

[David Goeckeler, Chief Executive Officer]

Well, I mean, for -- in the PC market, we think the market is -- there was consensus earlier in the year of maybe 325 million units. We think that's going to land more around 305 million units. So, that gives you a sense of the correction that's happening aggressively right now. And we saw -- I think we talked about smartphone demand being down single-digits, mid-single-digits on a unit percentage.

So I think, Wamsi, we're just going through this very sharp step-down right now where everybody resets their inventory, especially as they have -- I personally think, as they have more confidence, that the inventory -- the supply chain is loosening up. It's not completely loosened up, there's still tight areas.

But in general, we're able to get more upsides on products that -- components that even a couple of quarters ago were very tight. So, I think everybody is kind of resetting for that world and they're resetting going into a softer consumer environment. So, I think that gives you a little bit to bracket how we're thinking about it.

[Operator]

Thank you. And our next question today comes from Sidney Ho with Deutsche Bank. Please go ahead.

[Sidney Ho, Deutsche Bank]

Thanks for taking my question. So, looking at your Flash margins, they are still at a pretty decent level in the June quarter, but obviously that will come down in the September quarter. But with margins coming down into, let's say, the next few quarters given where the pricing is heading, do you think your margins will get back to that last trough in 2019 when it was below 20%? Obviously, pricing is out of your control, but are there things in your control that you will make the mix trough be better than the last one? Thanks.

[David Goeckeler, Chief Executive Officer]

Yes, I mean I think that we've done a tremendous amount of work on the portfolio in the last couple of years, and I think that's is going to show up. And the way we think about through-cycle margin, we talked a lot about this at the -- our Investor Day, we're managing for through-cycle margin. We want to drive the higher lows and higher highs. And we think we're set up well to do that given the qualifications across enterprise SSD.

Our very strong position in gaming, that's been a great market for us and a growth area just over the last year and a half. So, yes, I think it's -- I think we go into this situation with a lot better portfolio and a lot better diversity, a lot more places to put our supply, and we think that's going to lead to a better result.

[Operator]

Thank you. And our next question today comes from Toshiya Hari with Goldman Sachs. Please go ahead.

[Toshiya Hari, Goldman Sachs]

Good morning. Thanks for taking the question. I had a multipart question on your HDD business, primarily around utilization rates and CapEx and the restructuring plan that you talked about. In terms of utilization rates, your nearest competitor talked about making some adjustments in the near term. Is that something that you guys are thinking about or doing in HDD?

And on the CapEx side, what's contemplated in your fiscal 2023 outlook, again, as it pertains to your hard drive business? And then on the restructuring, I was hoping you could expand on what exactly you're doing, how much capacity is coming online over the next -- in the medium to long-term? Thank you.

[David Goeckeler, Chief Executive Officer]

Thanks Toshiya. So, let me just add a little context and, Wissam, give a little more detail on CapEx and how we're thinking about this. So, as we talked about that the client HDD market has been interesting over the last couple of years. We went into the pandemic and we saw a big surge in demand for client hard drives. Just in general, we saw a big surge in demand for PCs. That has turned around dramatically. And what we're seeing right now is that business is down over 50% year-over-year. So we're seeing – it's returning to pre-pandemic trajectory, and even going down faster than that now as far as the transition to flash happens. That's a good transition for us, because we have such a great portfolio in client SSD. So we've been playing that transition for years. But it really calls for us to reset our – how much client HDD capacity we have in the system, and that's what we're aggressively undertaking right now.

[Wissam Jabre, Chief Financial Officer]

Yes. So on that, Toshiya, on the restructuring, we're basically, as David said, we're taking – we're reducing our manufacturing footprint on the client side. And the expectation is this should benefit us from a couple of areas, a little bit on the CapEx side, but also in terms of the cost of goods sold. And so if there's any underutilization that was associated with that or would have been associated with that part of the manufacturing capacity, it's being basically managed out. And so that should help us be able to – as we sort of said, in terms of the gross margin transition for the HDD business from the fourth quarter to the first quarter, we're expecting it to be more or less flat. And so based on that, we should probably see even further improvements in the following quarters.

[David Goeckeler, Chief Executive Officer]

On CapEx.

[Wissam Jabre, Chief Financial Officer]

And on CapEx, we typically don't break out the CapEx between HDD and Flash. But as I said, we do plan to stay within our target model of the 8% to 10% of revenue. And if you recall at Investor Day, I did say that the – we typically – we would like to get to a point where for the HDD business we target 4% to 6%, maybe higher than this, in the near term simply because we are investing in the capacity enterprise side of the – of the manufacturing of the house. The one thing though to keep in mind is, we are keeping a close eye to the supply-demand situation, and we do not plan to be investing or building overcapacity short term to be able to maintain that supply-demand balance.

[David Goeckeler, Chief Executive Officer]

So Toshiya, just a few more comments on this so we fully paint the picture. So you're really starting to see this, what we talked about at our Analyst Day. In heads and media, we still have to invest. I mean there's – we need – these big drives have a lot of heads in them, so we're still investing in heads. Media, we transition to capacity enterprise. But we just have the manufacturing ability to produce millions and millions of client drives that we don't need anymore. So that's the part we're resetting, and to get that cost out of the system.

[Operator]

Thank you. Ladies and gentlemen, our next question today comes from Tom O'Malley of Barclays. Please go ahead.

[Tom O'Malley, Barclays]

Hey, good morning, guys, and thanks for taking my question. I just wanted to look at the overall business. Obviously, you've talked about the moving parts into September. But could you talk about when you think you might see the total top line start to recover? I know, there's a lot of moving parts. I know, there's not a ton of visibility right now. But obviously, from a net income pro forma earnings perspective, do you guys see yourselves making losses in the coming quarters? And just if you do, can you talk about the depth in which you're kind of planning for that based on recessionary scenario? Just any color on where you might see this bottom from a total company perspective? Thank you.

[David Goeckeler, Chief Executive Officer]

So first off, we don't see losses, no. So, look, you hit on it. It's just very dynamic right now. Let me paint the picture and Wissam can say, maybe a little bit about the out quarters. We're seeing – I would say, if we went back several quarters, we started talking about it very early this year. The consumer started softening really in Europe when the war broke out, in China with the lockdowns and that progressed throughout the first half of the year.

The consumer business is something that usually is soft. It's seasonally the weakest part of the year. April and May, calendar Q2 is an interesting quarter for that business because it always starts off in April and May and comes on strong in June, that really didn't happen. It stayed soft. And then we started to see the spread into consumer -- consumers purchasing PCs and now smartphones. And so, now we're seeing the OEMs and the PC and the smartphone business, as we talked about, very aggressively reset their inventory levels.

At the same time, we're starting to see the consumer in our channel business, stabilize. So, we're starting to see the early signs of the consumer business stabilizing, the channel business, stabilizing. If I look at sell-through for the first part of the quarter, it was to plan. Sell-in, it's still a little bit behind because nobody wants to build inventory right now. But sell-through has stabilized. And in some regions, like I said, in Europe, we're even seeing Q-over-Q growth in the channel. So it all depends on how we get -- how fast we get through the inventory correction on the OEM side.

And then just to cap that off, in the cloud, we continue to see very consistent demand from the US hyperscalers and we see some digestion in China cloud. And we expect that digestion in China cloud to work its way through this quarter. In general, China has been, I think the word I would say, has been quiet across all the markets. There's not a lot of visibility. We'll see how that comes back throughout the quarter.

But that gives you a little bit of kind of the evolution of how we've seen this and kind of how we see it going forward, as I said. Although the PC and the OEMs are going through – PC and smartphone OEMs are going through very, very sharp correction, we are seeing other parts of the market start to stabilize. So, I don't know, Wissam, you want to add that up? We don't really forecast the out quarters, but anything to say about that?

[Wissam Jabre, Chief Financial Officer]

Yes. I mean we don't forecast the out quarters. We don't see losses. The one – the couple of points I would add to that, David, is we obviously are – with this down cycle, we're starting from a much, much stronger financial position. We've done a lot over the last couple of years to strengthen our financial position. We also launched a very exciting set of products last quarter. So, we have really a very strong portfolio. We have good additions to the leadership team. And so, we're in a much better position to manage through this.

[Operator]

Thank you. And our next question today comes from Timothy Arcuri with UBS. Please go ahead.

[Timothy Arcuri, UBS]

Thanks a lot. I also had a two-part question is on HDD gross margin. And you're still running a couple of hundred basis points lower than your peer. And I'm wondering if you can sort of unpack that. Is this related to the client capacity that you're trying to take out? And then on the NAND side, you answered a prior question saying that -- I think you're implying that the decline is roughly equal between bits and pricing. And I just want to clarify, is that what you meant to say? Because if that's the case, then bits are certainly -- well, I mean, both bits and pricing are down more than your peers. So I'm just wondering if you can sort of handicap why your NAND business is performing worse than your peers. Thanks.

[David Goeckeler, Chief Executive Officer]

So on HDD, I think -- I think the gap in gross margin is now 100 basis points. But first of all, I feel good about the quarter we had on gross margin. We expected -- we expected -- well, let's put it this way. We're able to get the gross margins up in HDD a little faster than we thought. When we talked about last quarter, we thought they would start going up sequentially going into the second half, and we were able to pull some of that back into calendar Q2, our fiscal Q4. That was due to a number of things.

One is pricing continues to be pretty benign to even up a little bit, which is something we've been -- I think the industry has been striving for, again, given all the innovation we're bringing to market. And then we were able to work some on the cost side as well.

Us versus our competitors, remember, everybody has a different mix. And they -- there are some markets, especially the performance enterprise markets that Western Digital exited a number of years ago, and that's a declining but margin-rich part of the HDD market that we don't participate in.

But in general, from a margin perspective, on HDD, I get back to innovation, the portfolio, the 22-terabyte drive, the 26-terabyte UltraSMR drives, those are in a unique position in the industry. And we have a plan as we move through FY 2023. Those will become bigger and bigger and, in fact, the predominant part of the portfolio and what we're shipping as we move through the year. So I think that sets us up in a very strong position to have a really good TCO conversation with our customers as we continue to drive innovation.

Second part of your question was in Flash. Again, this is a very dynamic market. Things have changed even in the last week and half to two weeks. So I think that we're at a different point of when we're forecasting and we are rolling in everything we have heard from our customers. As I said, we have customers that have very, very significant amounts of demand that are changing within the quarter. So we put a guide around that. Obviously, we'll work to make that better, but that's the reality of where the business is today.

[Operator]

Thank you. And ladies and gentlemen, today's final question comes from Mehdi Hosseini with SIG. Please go ahead.

[Mehdi Hosseini, SIG]

Thank you. Thanks for squeezing me in. David, I just wanted to follow up to the last comment. You highlighted earlier in the call that you remain comfortable with near-line cloud demand, especially in North America. And then you just said that demand is very volatile. What gives you confidence that the North American cloud service providers go through inventory digestion later this year and into next year? Is there anything that you can share with us? And I have a follow-up.

[David Goeckeler, Chief Executive Officer]

I think it's just our deep relationship with them and the conversation we have. We also have multi-quarter agreements with a lot of these customers, which gives us more visibility into what their plans are.

We're, obviously, in deep conversations with them about our next generation products, which is very exciting. We're able to bring a market-leading capacity points to them across CMR and SMR. So, again, 22-terabyte CMR is a unique product in the industry. And then we have 26-terabyte SMR, which is, again, a unique product in the industry.

Nobody else can go to those capacity points. And so, we feel very good about where the portfolio is. Those are being adopted and qualified across our customer base. I think the strength of where we're at in the TCO equation we bring to our customers, as well as the visibility that we see and given the relationship gives us confidence as we move through the second half of the year.

[Operator]

Thank you. And ladies and gentlemen, this concludes our question-and-answer session. I'd like to turn the conference back over to the management team for any final remarks.

[David Goeckeler, Chief Executive Officer]

All right. Thanks, everyone. We appreciate you spending time with us here early on a Friday morning. Thanks for all the great questions, and we'll look forward to talking to you throughout the quarter.

[Operator]

Thank you. Ladies and gentlemen, this concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day.