Western Digital Q3 2022 Earnings Call Transcript

Participants

Corporate Executives

• Peter Andrew, Vice President of Investor Relations
• David Goeckeler, Chief Executive Officer
• Wissam Jabre, Chief Financial Officer

Analysts

• C.J. Muse, Evercore ISI
• Aaron Rakers, Wells Fargo & Company
• Joe Moore, Morgan Stanley
• Tom O'Malley, Barclays PLC
• Analyst
• Patrick Ho, Stifel Nicolaus
• Sidney Ho, Deutsche Bank Aktiengesellschaft
• Mehdi Hosseini, Signal Hill
• Nik Todorov, Longbow Research
• Nam Kim, Arete Research
• Jim Suva, Smith Barney Citigroup
• Steven Fox, Fox Advisors
• Christian Schwab, Craig-Hallum
• Mark Miller, Benchmark Co.
• Kevin Cassidy, Rosenblatt Securities

Presentation

[Operator]

Good afternoon, and thank you for standing by. Welcome to Western Digital's Fiscal Third 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.

Now, I will turn the call over to Mr. Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations. You may begin.

[Peter Andrew, Vice President of Investor Relations at Western Digital]

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 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 will now turn the call over to David for introductory remarks.

[David Goeckeler, Chief Executive Officer at Western Digital]

Thank you, Peter. Good afternoon, everyone, and thanks for joining the call to discuss our fiscal 2022 third quarter results. We delivered excellent performance in the quarter, with revenue of $4.4 billion and non-GAAP gross margin of 31.7%, both of which are at the higher end of our updated guidance ranges we provided in early March. Additionally, we reported non-GAAP earnings per share of $1.65, which exceeded our revised guidance. I am proud of the team's execution as we navigated dynamic geopolitical and macroeconomic environment as well as ongoing supply challenges. On top of that, we successfully managed through a fab contamination event that is now fully resolved.

Overall, the Western Digital team did an amazing job of meeting our customers' growing and evolving storage needs. This has all been made possible by the operational and technological improvements we have made over the last couple of years that enable us to unlock the true earnings power of the Western Digital model.

Looking ahead, we are optimistic about the business outlook for calendar year 2022. We believe the secular demand for storage in our new product ramps in HDD and Flash, combined with the seasonally stronger second half of the calendar year, will drive growth across our end markets. With 40% of the world's data stored on Western Digital products, our innovation powers the global technology ecosystem from consumer devices to the edge to the heart of the cloud. Our vision is to create breakthrough innovation inspired by the convergence of human potential and digital transformation that enables the world to actualize its aspirations.

At Western Digital, we have established an admirable position in the large and growing storage markets. Our proven ability to develop a diversified portfolio of industry-leading products, coupled with our broad routes to market, puts Western Digital in a unique position to capitalize on the promising growth opportunities ahead of us.

I'll now turn to an update on our HDD and Flash businesses. Our HDD revenue was as forecast and in line with typical March quarter seasonality led by growth in capacity enterprise drives. Robust demand in the cloud end market for 18- and 20-terabyte drives generated a nearly 40% increase in nearline revenue from the same period last year. Of note, our 20-terabyte drive exabyte shipments approached high single-digit percentage of total capacity enterprise shipments.

During the quarter, qualification of OptiNAND-based hard drives progressed as planned across multiple cloud and OEM customers. Combining OptiNAND with our SMR leadership uniquely positions Western Digital in the marketplace. Putting it all together, we have positioned our innovations in OptiNAND and SMR to drive business results in our capacity enterprise business for the rest of this calendar year and into the future. Our largest cloud customers are aligned with this strategy and are accelerating adoption of SMR products within data centers later this year. We are laser-focused on bringing new cutting-edge features and functions to our products for cloud storage. We will provide more details around these exciting innovations at our Investor Day on May 10.

Turning to Flash. Our overall business was impacted by our ability to ship product due to the fab excursion. In light of this event, coupled with the supply chain challenges facing all companies across the industry, I would like to thank our customers and the Western Digital teams for working together diligently to mitigate the impact of supply chain disruptions. From a product perspective, client SSD demand improved in the quarter as our PC OEM customers successfully worked through their own supply chain issues.

Gaming is another growth market for us, where we continue to have success with exabyte shipment nearly doubling year-over-year. We have a leading position in the marketplace with our brands, including WD_BLACK, SanDisk and SanDisk Professional, recognized globally for cutting-edge innovation, performance and quality. An example of this is our WD_BLACK SN770 SSD product, which leverages our cutting-edge BiCS5 technology, an in-house DRAM-less controller architecture. This SSD product is one of the fastest and best drives available in the market. We have received excellent reviews from tech journalists, which is a great testament to the company's strength in both our BiCS technology leadership and our ability to develop innovative solutions, enabling our customers to unlock the potential of their PCs.

Qualifications of BiCS5-based products for client and consumer end markets were largely completed, and we are making great progress in qualifying our next-generation BiCS5 enterprise SSD products. We expect these products to drive revenue growth and mix improvements into the future. Lastly, BiCS5 represented nearly half of the Flash revenue, up from 41% in the previous quarter.

Let me now offer a few observations on the demand environment. In cloud, we see continued strength in calendar year 2022. The increase in cloud capital investment for data center build-outs is expected to propel growth for our HDD and Flash products in this growing end market. In client, PC end demand growth has been solid for the last 2 years, and we are starting to see some normalization in the PC market. We expect PC unit demand to remain significantly above pre-pandemic levels, with the return-to-site trend driving a mix shift towards commercial and enterprise PCs with richer client SSD content versus consumer-oriented PCs.

In mobile, we have a strong position in 5G phones and we see demand for the latest 5G flagship phones remaining solid, with NAND content doubling from prior generation smartphones. In other emerging applications, demand from gaming and VR/AR devices remains robust. Industry analysts expect VR headset sales to grow at a 47% CAGR over the next couple of years.

In consumer, we are experiencing short-term demand weakness outside the U.S. tied to the geopolitical events in Europe, as well as COVID-related lockdowns in China. However, we are confident in the strength of the business as we are entering a seasonally stronger second half of the calendar year with a number of new innovative products.

We feel good about the overall demand in calendar year 2022. We are continuing to navigate the macroeconomic and geopolitical factors I mentioned earlier. While these transitory issues are affecting both revenue and gross margin in the near term, we expect them to subside over time. We are confident that the growth and profitability opportunities in front of us have not changed.

In closing, I want to acknowledge the hard work and unrelenting spirit of our employees that goes into creating our game-changing products. In particular, I want to thank our employees in China for their efforts to work through all the supply chain and logistics challenges during the lockdowns.

Before turning the call over to Wissam, I wanted to make a quick announcement that Western Digital and the IRS have reached a tentative agreement to resolve a long-running tax matter, covering the fiscal years 2008 through 2015. With offsetting tax benefits, we expect the ultimate net amount will be in the range of $500 million to $600 million. While this settlement will result in a previously unforecasted cash payment in fiscal year 2023, it does highlight the work that I and the rest of the Western Digital team have undertaken in the last 2 years to instill strong financial discipline and provide greater financial flexibility upon which we are building a foundation for future growth for the company. Wissam will go into more detail in a minute.

Let me now turn the call over to Wissam, who will discuss our fiscal third quarter results and provide a more detailed outlook for the fiscal fourth quarter. Wissam?

[Wissam Jabre, Chief Financial Officer at Western Digital]

Thanks, David, and good afternoon, everyone. As David mentioned, overall results for the fiscal third quarter were better than our revised expectations. Despite the incredibly dynamic macro environment that David discussed, our results reflected the resilience of our business and our ability to continually deliver solid financial performance. In addition, we completed a debt restructuring with our lenders in the March quarter, marking continued success in paying down debt and providing increased financial flexibility and stability.

Total revenue for the quarter was $4.4 billion, down 9% sequentially and up 6% year-over-year. Non-GAAP earnings per share was $1.65, above the revised guidance range of $1.30 to $1.60 we provided in early March. We are pleased to have delivered such strong results in the face of the challenging environment.

Turning to our end markets. Cloud represented 40% of total revenue at $1.8 billion, down 8% sequentially and up 25% from a year ago. Within cloud, Western Digital's leadership position at the 18-terabyte capacity point and ramp of 20-terabyte drives drove a nearly 40% year-over-year increase in nearline revenue. This growth was partially offset by lower enterprise SSD and smart video hard drive revenues.

The client end market represented 40% of total revenue at $1.7 billion, down 7% sequentially and 2% year-over-year. The sequential decrease was primarily due to typical seasonality in both Flash for mobile and client hard drives. On a year-over-year basis, growth in Flash was offset by a decline in hard drive. Lastly, Consumer represented 20% of revenue at $0.9 billion, down 17% sequentially and 8% year-over-year. On a sequential basis, the decline was primarily due to lower retail Flash shipments. The year-over-year decrease was roughly evenly split between hard drive and Flash products.

Turning now to revenue by segment. We reported Flash revenue of $2.2 billion, down 14% sequentially and up 3% year-over-year. On a blended basis, Flash ASPs were down 1% sequentially. On a like-for-like basis, Flash ASPs were down 2% sequentially. Flash bit shipments decreased 14% sequentially and increased 9% year-over-year. During the quarter, we recognized the majority of the bit supply impact caused by the fab contamination.

Hard drive revenue was $2.1 billion, down 3% sequentially and up 9% year-over-year. Sequentially, total hard drive exabyte shipments increased 1%, while the average price per hard drive increased by 4% to $101. On a year-over-year basis, total hard drive exabyte shipments and average price per hard drive increased by 20% and 22%, respectively.

As we move to costs and expenses, my comments will be related to non-GAAP results unless stated otherwise. In the March quarter, total fab contamination charges of $203 million were excluded from our non-GAAP results. Gross margin for the third quarter was 31.7%, down 190 basis points sequentially and up 400 basis points year-over-year, including approximately $59 million in COVID-related expenses. Our Flash gross margin was 35.6%, down 50 basis points sequentially and up 560 basis points year-over-year.

Our hard drive gross margin was 27.7%, down 290 basis points sequentially and up 270 basis points year-over-year. Hard drive gross margin included COVID-related impact of approximately $51 million or 240 basis points.

Operating expenses of $740 million were below our guidance range as we tightly managed our expenses. Operating income was $650 million, representing a 26% decrease from the prior quarter and a 58% increase year-over-year. Earnings per share was $1.65, up from $1.02 in the year-ago quarter. Operating cash flow for the third quarter was $398 million, and free cash flow was $148 million.

Cash and 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 $250 million. We remain disciplined in investing in manufacturing capacity and expect gross capex for the current fiscal year to be around $2.9 billion. We expect cash capex to be around $1.3 billion as we actively manage our overall spending.

In the fiscal third quarter, we made a discretionary debt repayment of $150 million. Our gross debt outstanding was $7.25 billion at the end of the fiscal quarter. We ended the quarter with $2.51 billion of total cash and cash equivalents. Our trailing 12-month adjusted EBITDA at the end of the third quarter, as defined in our credit agreement, was $5 billion, resulting in a gross leverage ratio of 1.4x compared to 2.6x a year ago. As a reminder, our credit agreement includes $1 billion in depreciation add-back associated with the Flash Ventures. This is not reflected in our cash flow statement. Please refer to our earnings presentation on the Investor Relations website for further details.

Before discussing our outlook, I wanted to provide some more details on the settlement with the IRS that David mentioned. As previously disclosed in our quarterly SEC filings, the company has been in a significant long-running situation with the IRS regarding taxes owed for fiscal years 2008 through 2015. As you can see in our GAAP statements, we took a tax charge in the fiscal third quarter, primarily based on our latest assessment of the situation.

In the last few days, we reached a tentative agreement to settle the transfer pricing issues in dispute. The actual amount to Western Digital will have to pay and exact timing of the payments have not been determined yet. However, we currently expect to make a cash payment in the range of $600 million to $700 million sometime in the first half of fiscal 2023. Please note that this is the cash out number. We currently expect that the ultimate net amount will be in the range of $500 million to $600 million after accounting for certain offsetting tax benefits expected to be recouped over the next 3 years.

Finally, in the fourth quarter, we will make a GAAP-only adjustment to the reserve associated with this settlement. You will find additional details in our 10-Q, which we plan to file next week.

I'll now provide our view of both hard drive and flash businesses for the fiscal fourth quarter. As we indicated on our last earnings call, we continue to expect hard drive revenue to increase driven by growth in nearline hard drives. We also expect Flash revenue to increase sequentially in the fourth fiscal quarter as our flash supply improves.

For our fiscal fourth quarter, our non-GAAP guidance is as follows: we expect revenue to be in the range of $4.5 billion to $4.7 billion with sequential revenue growth for both hard drive and flash businesses; we expect gross margin to be between 31% and 33%; we expect operating expenses to be between $770 million and $790 million; interest and other expenses are expected to be approximately $70 million; our tax rate is expected to be approximately 11% in the fourth quarter; we expect earnings per share to be between $1.60 and $1.90 in the fourth quarter, assuming approximately 317 million fully diluted shares outstanding.

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

[David Goeckeler, Chief Executive Officer at Western Digital]

Thanks, Wissam. Looking ahead, we remain optimistic about our business outlook for the calendar year as customer demand across our end markets continues to be generally strong. Despite the supply chain challenges and macroeconomic factors we discussed earlier, it is evident that we have the right foundation for long-term growth, the right technology portfolio in place to meet evolving customer needs and the broad routes to market necessary to scale our business.

Over the last couple of years, we have planned and executed significant changes to improve our focus, sharpen execution and set strategic goals to place Western Digital in a position of greater strength. And I'm excited that we are witnessing the positive impacts of those changes.

Before I wrap up, I want to remind everyone, we have an Investor Day coming up on May 10, and I look forward to seeing you all there. Let's start the Q&A.

Questions and Answers

[Operator]

[Operator Instructions] Our first question will come from C.J. Muse with Evercore.

[C.J. Muse, Analyst at Evercore ISI]

I guess the question relates to your June quarter outlook. I would love to hear how you're thinking about any kind of ongoing implications to both the NAND contamination issue, what kind of impact that might have on your bit availability. And then secondly, in terms of the China lockdown, the impact on your HDD media side and whether that's pushing out any shipments beyond the June quarter.

[David Goeckeler, Chief Executive Officer at Western Digital]

Hey, C.J., thanks for the question. Yes, on the flash side, so first of all, as we said, the flash contamination issue is behind us in the fab. We expect bit growth next quarter. We won't be all the way back, but we'll -- we expect to accelerate from where we were this quarter. As far as the situation in Penang and China, we did have that facility shut down for a couple of weeks. At the end of last quarter, we've mostly recovered that as far as the -- as being able to meet demand for this quarter. I would say that as a general statement, it's -- I think it's very difficult for everybody to meet what true demand is right now in the market. So between component shortages and the situation in China, it makes it really tough.

But I think we were able to navigate through the situation quite well, quite -- frankly, the team there did a fantastic job and has kind of recovered. There were some incremental costs as we saw in the HDD margin line that we didn't expect. But all in all, I think we navigated through the situation fairly well. For the coming quarter, yes, we're still dealing with the situations in China, but we think we'll be able to navigate through, although it is very, very dynamic. But we factored in all the risks into the guide, and we're comfortable with where the number's at.

Wissam, anything to add?

[Wissam Jabre, Chief Financial Officer at Western Digital]

Not much, David. I think you've covered it well.

[Operator]

Our next question will come from Aaron Rakers with Wells Fargo.

[Aaron Rakers, Analyst at Wells Fargo & Company]

I'll stick to 1 as well. I -- just kind of thinking about the gross margin guidance into this next quarter, I think it was 31% to 33%. I was curious if you could help kind of unpack the variables. Maybe give us some color on how you're thinking about the flash gross margin relative to the hard disk drive gross margin. And I guess within hard disk drives, how much COVID-related expenses, are you still embedding? Just any other variables you can help us appreciate on both those 2 segments.

[David Goeckeler, Chief Executive Officer at Western Digital]

So, I'll take -- I'll start on it, and Wissam can add. So on the drive business, last quarter, we talked about the 200 basis point to 300 basis point impact that we were expecting. I think we took a little that in this quarter than we had expected. Some of that was some cost we didn't expect, like I just talked about in Shenzhen. I think I said Penang earlier, but Shenzhen. And -- so in that business, looking forward, I think we see it as pretty much -- we've pretty much hit the bottom. We basically see it flat going forward. In the flash business, we expect some acceleration of gross margin given the supply-demand balance situation.

So Wissam, anything to add to that?

[Wissam Jabre, Chief Financial Officer at Western Digital]

Yes David, just maybe to follow-on on the comments or Aaron's question with respect to COVID, where we see the COVID costs going into next quarter are expected to be a little bit less than what we've experienced in the fiscal third quarter.

[Operator]

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

[Joe Moore, Analyst at Morgan Stanley]

Just following up on the contamination issue. Is the 7 exabyte number that you guys talked about still the right kind of number to think about the lost production? And how does that split across the March and June quarters?

[David Goeckeler, Chief Executive Officer at Western Digital]

Joe, yes, that's still the right number. I mean the team will always work in kind of an evolving situation to see what they can do with the material that we had to take out. But I don't think it will be super material to the numbers. So 7 is a good place to work from. And we haven't split it up over the quarters, but the majority of it we took in the previous quarter.

[Joe Moore, Analyst at Morgan Stanley]

Okay. And your joint venture partner, I don't want to speak for them, but like just in terms of assessing the industry situation, would have lost proportionally the same amount?

[David Goeckeler, Chief Executive Officer at Western Digital]

Yes. I'm not going to speak for them. But we have joint manufacturing facilities, for sure.

[Operator]

Our next question will come from Patrick Ho with Stifel.

[Peter Andrew, Vice President of Investor Relations at Western Digital]

Patrick, are you there? Why don't we skip over and try to get Patrick back in.

[Operator]

Okay. Our next question will go to Tom O'Malley with Barclays.

[Tom O'Malley, Analyst at Barclays]

You're seeing a really -- you're seeing a really strong trend in the HDD pricing side. Is that entirely related to the mix more towards nearline? Or are you seeing any underlying trends in other parts of the business as well? Anything helpful there would be really good.

[David Goeckeler, Chief Executive Officer at Western Digital]

I'll put a much larger frame on it, Tom. I think what's happening, and we see it show up in a number of ways, and there's a lot of COVID implications and costs in it, too. But I just -- I think we're just seeing the industry change from a world where there was always capacity enterprise drives available. Hard drives were available. It was about putting as many as you could in places where you could fill up factories and get good absorption and not have to pay incremental cost for that. That's kind of decline of the client era and the rise of the cloud era. We're pretty much through that, we're in the last legs of it. And I just think you're seeing a lot of industry dynamics change. You're seeing long-term agreements come in much something that last year was kind of a new concept that we were working through. Now it's becoming much more mainstream with our big customers just to give us visibility to making investments in this business.

Essentially, we don't have a lot of capacity anymore to shift from client to enterprise and the cloud, and we're having to invest in that, and that's causing the whole industry to shift the way it thinks about this technology and my point of view. I think it starts with we're still driving a strong TCO model for our customers. That's where it all starts. Every generation of technology, we're able to bring down the TCO for our customers.

In the past, I think as we did that, the reward for our side of it was more volume, to soak up that capacity. Well, that's not the case anymore. Now we have to invest in new volume, so the industry has to change. So we're bringing a lot of TCO value. And I think you're seeing the industry move to providing more visibility, thinking about value-based pricing more -- and how do we move that value equation in a way that we can continue to drive the TCO down and drive a better pricing environment. So that's the big picture. And then, of course, there's a lot of costs in the system right now and inflation input costs are going up, and we're working through pricing if we can mitigate parts of that. That's happening as well.

[Tom O'Malley, Analyst at Barclays]

Helpful. And if I could just sneak just another quick one in. On the flash side, obviously, you had a lot of disruptions during the quarter. It looks like the implied cost was relatively flat. When you're looking into the out quarter, you're obviously saying gross margins are up. You should see some pricing tailwinds given the industry. But Wissam, maybe any sort of color on the cost versus pricing impact in the quarter. I know you don't like to get specific, but obviously, given the situation, anything would be helpful here to kind of move on the moving pieces.

[Wissam Jabre, Chief Financial Officer at Western Digital]

Yes, of course. Yes, Tom. So we do expect that our long term -- to continue to reach our long-term target of cost reduction, which is 15% year-on-year. The -- we did see a bit of a headwind in the current quarter, but it's really impacted by a few factors that we expect will anticipate in the next couple of quarters. So we saw, for instance, we continue to ramp our BiCS5 technology, as well as just like everybody, we're seeing some inflationary pressure as well as the start-up of our Yokkaichi Fab7. But we still expect for this fiscal year '22 to be at least 15% year-on-year in terms of cost reduction. And as I started with, we do expect to continue to meet that target going forward.

[Operator]

Our next question will go to Timothy Arcuri with UBS.

[Analyst]

This is Jason on for Tim. So, could you please provide any color on the trajectory of your HDD gross margins through the second half of this year? I'm asking because we're expecting some benefit that we'll get for the -- on the stronger -- likely stronger pricing environment in the end of the first half.

[David Goeckeler, Chief Executive Officer at Western Digital]

Yes. We do expect -- as we talked about last quarter, we're pretty much in the same place, which is we expected the decline we saw this quarter -- we actually expected gross margin to be a little lower next quarter. Now we think that will be flat. And then we expect that to improve in the second half for a number of reasons: Mix, input costs that are changing a bit and also some pricing benefit. So yes, we expect next quarter to be the low and then we expect to improve from there.

[Operator]

Our next question will come from Patrick Ho with Stifel.

[Patrick Ho, Analyst at Stifel Nicolaus]

I apologize before. Dave, maybe if you could give a little bit of color. You gave some very encouraging commentary regarding the data center and cloud spending into the second half of the year. One, are these because of the long-term agreements you're signing with customers? And maybe secondly, along with that question, how do you see the customer base in terms of this transition from 18 to 20? Is it a new set of customers? Or are your 18 customers quickly transitioning over to 20 terabytes?

[David Goeckeler, Chief Executive Officer at Western Digital]

Yes. So let me unpack that a little bit and thanks, Patrick. So -- the -- it's largely the same customers that will move from 18 to 20. I mean I think, as I said earlier, the TCO equation improves as you go -- as you keep driving forward. So it's a very part of what we do. I mean this is -- I talk about innovation a lot around here, and the innovation we've driven around ePMR and now OptiNAND and SMR, those are all things that we layer into our products and allow our customers every time they move a generation forward, they get better TCO equation. So there's reasons to keep moving forward. So that's kind of the way that works a little bit. By the way, we'll come back and talk about SMR a little bit more. We're continuing to see more momentum towards SMR. That is the future of the cloud HDD business, is SMR. All the big players are now moving down that path, which is a technology we've been investing in for quite some time.

On your other question on -- look, the LTAs don't drive the spending and the LTAs help smooth out the spending. I think the whole idea with the LTA is to give -- we have a strong relationship with our big customers and to give better visibility 2, 3 quarters out. I've talked about this a lot in the past, the business used to -- if I think back a year ago or 2 years ago when I came into the business, the business was just transacted quarter-to-quarter and even within the quarter.

And clearly, given the investments we need to make to continue to drive investments in heads and media to fund -- to fuel the exabyte growth, we're going to need more visibility than that. And so the LTAs have been adopted. And we strike those with our big customers on multi-quarter timeframes, and then we stick to them. And that's been very good as far as smoothing out any ups and downs in builds on their side. And so, as far as the second half environment, our big cloud customers continue to tell us and signal a strong demand environment in the second half of the year. So we'll be excited about driving to them with -- starting with 18 and then transitioning to 20 as we move through the year.

[Operator]

Our next question will come from Krish Sankar with Cowen.

[Analyst]

It's Eddie [Phonetic] for Krish. For HDDs, when do you expect the crossover between 20 terabytes and 18 terabytes? And can you please tell us if you did see slowdown in the VIA market for HDDs over the last quarter?

[David Goeckeler, Chief Executive Officer at Western Digital]

Yes. I would imagine the 20 crossover will be in the second half of the year. I mean we're deep into the 18s right now. I mean, 18 is probably 80% of the portfolio of shipping. So it's the sweet spot of the market. As we move through the year, we'll start to ramp 20. So towards the end of the year, early next year -- we can circle back on a specific date, but that's the way we're thinking about it. The surveillance market, smart video market, that's been soft all year. So we continue to see that with the lockdowns in China. We expect that once that ends, there'll be some snapback and some recovery of pushed out demand there. But right now, given the COVID situation, I think that, that market is not going to change until the COVID situation changes.

[Analyst]

And if I can squeeze one in. Is surveillance margin accretive?

[David Goeckeler, Chief Executive Officer at Western Digital]

Is it -- margin. I don't think we break out of that level. I don't know, Wissam, do you have a comment on that, or Peter?

[Wissam Jabre, Chief Financial Officer at Western Digital]

Yes. Actually, David, we don't break out down to that level of detail.

[Operator]

Our next question will come from Sidney Ho with Deutsche Bank.

[Sidney Ho, Analyst at Deutsche Bank Aktiengesellschaft]

A couple of short ones on the flash side. How are you thinking about your full year bit shipment growth for calendar '22? I know you don't want to go quarter-by-quarter, but for the full year. And then the follow-up question is gross margin for flash, and you talked about maybe up a little bit for next quarter. Are you actually expecting much price increase? How much is mix a factor? And maybe talk about -- Wissam you talked about the Yokkaichi start-up costs. Can you kind of quantify what that number is?

[David Goeckeler, Chief Executive Officer at Western Digital]

I will let Wissam handle the gross margin question. The bit growth -- look, our bit growth will be down this year. We're not going to put a fund number out there right now. But given the fab excursion, we'll be down this year. And then we'll make it up over the next year or so, a year plus. It will take a while to fully come back to our fair share of bits. Our strategy has been very consistent for a long time. We invest to maintain share. And you see us doing that, including recent fab announcements with Kioxia.

Wissam, do you want to talk about gross margin a little bit in flash?

[Wissam Jabre, Chief Financial Officer at Western Digital]

Of course, David. So Sidney, thanks for the question. The -- when we think of the flash business, I think to address maybe the part of the question around the Yokkaichi start-up cost, they're not very significant and actually, they're much lower than the K1 fab start-up, we're talking about really a brownfield expansion here versus a greenfield expansion. To the part of your question with respect to our flash gross margin that's sort of embedded in the guidance. Of course, mix always plays a part in any gross margin, whether it's actual or projected. So -- but as I said earlier, we're still expecting to meet that 15%-plus year-on-year cost reduction for flash in the fiscal year 2022. I hope this helps.

[Operator]

Our next question will come from Mehdi Hosseini with SIG.

[Mehdi Hosseini, Analyst at Signal Hill]

Yes. And just as a follow-up to the previous question, how should I think about the impact of FX exchange rate on the flash gross margin?

[Wissam Jabre, Chief Financial Officer at Western Digital]

So maybe I'll -- thanks, Mehdi, for the question. Then maybe I'll just talk about the FX in general. So our approach is we do -- we use a layered hedging approach, which means it's -- there's much more coverage in hedge on the shorter term versus the longer term. And so that smoothens out the impact of FX over time. And the way also to think of it as any incurred cost within the quarter typically will not really impact the P&L until approximately 90 to 120 days later, given the manufacturing cycle times and lead time for delivery of product. And so the -- whatever we're seeing at least in the past short term in terms of currency fluctuations, will not be that impactful to the numbers. What we saw in -- what we're sort of expecting -- actually, what we saw in this quarter and what we're anticipating for the fiscal fourth quarter is less than 1% impact on all of our cost of goods sold. Not on -- that basically talks about all of the costs of goods sold, maybe not only the flash portion.

[Mehdi Hosseini, Analyst at Signal Hill]

Okay. Can I not answer a question? Is FX more like a clarification?

[David Goeckeler, Chief Executive Officer at Western Digital]

So far, Mehdi.

[Mehdi Hosseini, Analyst at Signal Hill]

Just back to David, given your LTAs and you sound confident that the cloud demand is going to sustain into the second half. How should we think about nearline exabyte growth prospect in calendar year '22 versus '21?

[David Goeckeler, Chief Executive Officer at Western Digital]

Exabyte growth in '22 versus '21, I can get you -- let me look this up real quick. If I have a pie -- look, I mean, Mehdi, if I look at it -- looking at over -- we keep coming back to 35% growth in the -- in exabytes in the cloud. That's been a pretty consistent number. I'd have to go back and put it in -- I tend to look at it more in fiscal years and calendar years, but I can follow up with you on a calendar year number.

[Mehdi Hosseini, Analyst at Signal Hill]

Okay. And I look forward to meeting you at the Analyst Day.

[David Goeckeler, Chief Executive Officer at Western Digital]

I look forward to it. It's going to be fun.

[Operator]

Our next question will come from Nik Todorov with Longbow Research.

[Nik Todorov, Analyst at Longbow Research]

David, you talked about SMR quite a bit on this call. Maybe can you unpack how should we think about the impact on SMR on mix, pricing and margins, and HDD. Maybe can you touch on what kind of workloads are the cloud guys looking to deploy some more initially?

[David Goeckeler, Chief Executive Officer at Western Digital]

Well, I'll defer the workloads until our Investor Day. We'll go into a little more detail there. But look, I think big picture, we see this last quarter, I think -- well, I know I said we had 2 big cloud titans that we're working on SMR and we expected significant shipments towards the end of the year. Within the quarter, we had another one and another one come to us about adopting SMR. So I think that -- I think that it's very clear to me that the capacity gains that can be achieved with SMR, we've been investing in this technology for a long time and this idea that you can get an extra 10% or more. And again, we'll talk about that next week -- or in a couple of weeks as well. It's very attractive, especially given the size of the drives now and how big they are, you're talking big numbers, multiple terabytes that are being added through the changes.

Now, the thing that gives me a lot of conviction on this is because it requires the -- on the host side, you have to do some software work. And nobody wants to do software work if they can avoid it or if the return is not good enough. And the fact that the big players are coming in, they're saying, look, we're going to invest in this, and we're going to pull SMR into our data centers, tells me that this is the next leg of growth in this industry. So again, we'll get to our Investor Day to talk about what it means on the portfolio, but I get back to just another way that allows us using innovation to drive a better TCO equation for our customers. And when we can drive better TCO, then we can leverage that into a conversation about value-based pricing. And that's exactly what we're doing, and that's -- it's exactly where the industry is going. And like I said, LTAs are a part of that, about getting more predictability. But the fact that we can continue to drive down the cost of storage, continue to drive a better TCO with every generation of products, to do that through innovation, that gives us opportunity to create margin and create value.

[Operator]

Our next question will come from Nam Kim with Arete Research.

[Nam Kim, Analyst at Arete Research]

How should we think about some of your hyperscaler moving into their own enterprise SSD build? Do you expect such DIY enterprise SSD to impact your business negatively or just have a limited impact? Any color would be great.

[David Goeckeler, Chief Executive Officer at Western Digital]

I think various of our customers have DIY projects. I think that's fine. They still -- first of all, I don't know if anybody does 100% fab, because everybody wants diversity in their supply chain. But even DIY provides us opportunity to provide, well NAND, so not just the full enterprise SSD. But like I said, even anybody that's doing DIY is also going to be buying enterprise SSDs as well for part of their footprint. And the numbers here are getting so large that whichever way you play or both. It gives us the opportunity to play in both of those franchises, quite frankly, with our big customers, providing enterprise SSDs and then providing NAND into their projects. So, I think it's a reflection of how important enterprise SSDs are to the future of a very modern cloud data center. It's extraordinarily important technology, and we're very happy to be involved with the biggest customers and qualified at the biggest customers with our technology.

[Operator]

Our next question will come from Jim Suva with Citigroup.

[Jim Suva, Analyst at Smith Barney Citigroup]

Thank you. And I look forward to seeing you all next month. But before that, it's great to see that the contamination issue is kind of behind us, of course, working through that. With that being said, the cost of all that, is that solely borne by Western Digital? Or does your supplier kind of remunerate you for that, or make up for it in future pricing or some type of insurance? And most critically, what are you doing? Have you put in something to make sure such thing doesn't happen again?

[David Goeckeler, Chief Executive Officer at Western Digital]

Yes, I'll give some input when we so can maybe provide more details if we have them. But look, we -- the issue is fully behind us. The team has done a fantastic job of root causing it down to the very, very bones of what the issues are, and then putting in place -- obviously putting in place screens and other things to make sure it doesn't happen again. Or if it does happen again to make sure we catch it proactively. As far as the costs are split by us and our JV partner and as far as the ability to recoup any of those, I mean, I think we'll look at that. Once we get fully passed anything, we'll look and see if there's anything that will happen there. Anything to add to that, Wissam?

[Wissam Jabre, Chief Financial Officer at Western Digital]

I think -- no, David, I think you've covered it well.

[Operator]

Thank you. Our next question will come from Steven Fox with Fox.

[Steven Fox, Analyst at Fox Advisors]

I was wondering if you could just talk a little bit more about the hard disk drive pricing. So as you mentioned, your ASPs were up 4% in the quarter. But can you talk a little bit about the like-for-like pricing currently and for the rest of the year, how you're approaching it maybe differently by the different segments. And whether it's being impacted by the sort of extended lead times you've talked about in terms of where you're maybe putting more bits than maybe you were a year ago.

[David Goeckeler, Chief Executive Officer at Western Digital]

I think, like I said, we're working on -- I want to repeat the same thing. Again, pricing starts with value. We have to deliver value, and we're constantly innovating to deliver more value. But we're clearly working on pricing to see -- to defray some of the input costs and all the logistics costs has impacted. So that's going on across the portfolio. And then, we're having conversations with our customers about the value we're providing with these next generation of drives about what that value is and how do we move to a value-based pricing model. I don't know if there's a whole lot more to say about it than that. I don't know, Wissam, anything from your perspective?

[Wissam Jabre, Chief Financial Officer at Western Digital]

No, not on this, David.

[Operator]

Our next question will come from Christian Schwab with Craig-Hallum.

[Christian Schwab, Analyst at Craig-Hallum]

I just have a quick question on disk drive gross margins. Given the positive impacts of mix and decreased input costs and increases value pricing, if we have a China COVID shutdown end, is there any reason why the disk drive business can't be operating at 30% [Phonetic] plus growth exiting calendar year?

[David Goeckeler, Chief Executive Officer at Western Digital]

I'm sorry, you broke up when you said the number.

[Christian Schwab, Analyst at Craig-Hallum]

Is there any reason you could -- you wouldn't be exiting the calendar year with gross margins at 30% plus again?

[David Goeckeler, Chief Executive Officer at Western Digital]

Yes. I mean, so I think we broke those numbers out. Wissam, I think he's got the details, he had it in his remarks. But I mean, if you just took all the COVID cost of business right now, I think we'd be about 30%, right, Wissam?

[Wissam Jabre, Chief Financial Officer at Western Digital]

Yes. So that's very true, David. I mean the -- we did have in the quarter around 240 basis points related to the COVID costs. We've talked about slightly impacted, of course, by COVID lockdowns. We continue to see some inflationary cost pressures short term with supply chain disruptions. The -- I mean, to your question, I wouldn't necessarily want to talk about where the margins are going to be in Q4. But would it say that we do expect the margins to be better from here in the second half of the calendar year '22.

[David Goeckeler, Chief Executive Officer at Western Digital]

Yes. It was -- I mean we're not going to commit to your number, but just as a general point, I mean, look, there's just been a lot of a lot of additional costs on the business. We've talked about it for many quarters now, logistics costs and now increased input costs that have really hit us this past quarter. And you would think as the world comes out of the pandemic, I think which is the major crux to your point, as this starts to unwind and logistics gets back to a steady state, and some of the input costs get more reasonable, we stop paying expedite fees for certain components and things like that because there's just a more smooth flowing supplier ecosystem. It will unburden a lot of costs on the business.

And again, I think this is masking somewhat, although not completely, a major fundamental structural change that's going on in the business, which I've talked about a lot, which is the HDD market is a growth market, and it's a growth market where we're going to need to invest capital to build additional heads and media capacity. And when that happens, I think the economic equation changes, and we get -- the key thing in that kind of world is can you still innovate and can you still bring new things to the product that makes it more valuable to your customer? And I think that is what we've really been focused on, from ePMR to OptiNAND to SMR, we're just really focused on innovation, bring a better value proposition that will be able to build a better product for our customers, and we'll get into that value-based pricing thing. So if we get both of those going and we can get the cost out because of the pandemic, I think we'll -- we feel very good about the business.

[Operator]

Our next question will come from Mark Miller with Benchmark Company.

[Mark Miller, Analyst at Benchmark]

I'm just wondering in terms of mix, NAND mix, how is that progressing in terms of mobile versus the other segment you ship into? Are you seeing increasingly more shipments in the mobile? And where do you expect that's going?

[David Goeckeler, Chief Executive Officer at Western Digital]

There's a couple of dynamics to this. I think over the -- looking -- the past couple of quarters, we had a higher shift -- higher mix towards mobile as we were ramping BiCS5. We talked about it in the prepared remarks, we've gotten past our qualifications of BiCS5 in the consumer market, and in our client SSD market. So we see an acceleration of mix into those on BiCS5. And then there's a lot of hard work going on to qualify our enterprise SSDs on BiCS5. And as that happens throughout this year, then you'll see an acceleration of that market as well into BiCS5. The reality is we have demand on enterprise SSD. We can't meet because it's on BiCS4 right now. So as we get that into BiCS5, you'll see the mix change, and you'll see the enterprise SSD mix accelerate through the second half of the year, which will provide a tailwind to business. This -- we'll talk about this a little bit more at Investor Day as well to put one more plug in to see all of you on the 10th.

[Operator]

Our next question will come from Kevin Cassidy with Rosenblatt Securities.

[Kevin Cassidy, Analyst at Rosenblatt Securities]

Yes, looking forward to May 10 and May 9. I just wondered if you could give us a little more details on the Fab7 ramp. What what's -- you've mentioned brownfield as production. And can I just understand a little better what that means? Is it -- you start off with only 20,000 wafers a month or, any numbers like that you can give us?

[David Goeckeler, Chief Executive Officer at Western Digital]

So first of all, let me clarify the brownfield. I think what the point Wissam was making there was that K2 expenses will not be at the level of K1 because K1 was a greenfield and K2 is a brownfield. So -- the same situation with Y7, which ramping in Yokkaichi, obviously a brownfield launch there as well. Wissam may have some information about how the expenses roll out. As far as how the wafer scale, we'll start ramping that, I think, on our newer nodes, but we'll have more to say about that when we start getting the tools in there and all of that.

I don't know, Wissam, anything to add?

[Wissam Jabre, Chief Financial Officer at Western Digital]

Yes. The -- just maybe to clarify thanks, to clarify the -- my comment on brownfield versus greenfield was exactly just to really highlight that the costs aren't as high as we've seen in K1. They weren't really -- they're not very significant. But of course, it's a bit of a headwind to the gross margin.

[Operator]

Thank you. Speakers, I'm showing no further questions in the queue at this time. I would now like to turn the call back over to Mr. David Goeckeler for any closing remarks.

[David Goeckeler, Chief Executive Officer at Western Digital]

All right. Thanks, everyone. We appreciate you joining us. As we've said a couple of times, we look forward to seeing -- hopefully, we'll see you on May 9 as was pointed out for some new product launches. We'll have some exciting new technology coming out then. And then on the 10th -- May 10, May 9 and 10, on the 10th, we'll have our Investor Day, which we've been looking forward to for quite some time. So we will see you there. Thanks, everyone.

[Operator]

[Operator Closing Instructions]