Western Digital Q4 2022 Earnings Call Transcript

Participants

Corporate Executives

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

Analysts

• C. J. Muse, Evercore ISI
• Aaron Rakers, Well Fargo Securities
• Joe Moore, Morgan Stanley
• Patrick Ho, Stifel Financial
• Wamsi Mohan, Bank of America Co.
• Sidney Ho, Deutsche Bank Aktiengesellschaft
• Toshiya Hari, The Goldman Sachs Group, Inc.
• Tom O'Malley, Barclays PLC
• Timothy Arcuri, UBS Group AG
• Mehdi Hosseini, Susquehanna International Group

Presentation

[Operator]

Good day, and thank you for standing by. Welcome to Western Digital's Fiscal Fourth Quarter 2022 Conference Call. [Operator Instructions] 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, Financial Planning and Analysis and Investor Relations at Western Digital]

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 at Western Digital]

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 ultra SMR technologies as well as ePMR. Impressively, this means we've nearly doubled drive capacity relative to when I joined Western Digital just over 2 years ago. In flash, we expanded adoption of our NVMe enterprise SSD from one cloud titan 2.3 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 obtained an investment-grade corporate rating placing Western Digital on a solid financial foundation.

Before I jump into into additional detail on the quarter, I wanted to provide an update on our strategic review. As you know, 2 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 elite 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 nearline 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 and 22 terabyte CMR drives, qualifications of our 26 terabyte SMR drive are underway. As we noted, our product launch event in May. This SMR-enabled drive enables 20% higher capacity than our CMR variance 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 multi-year product roadmap for capacity enterprise drives, which combine ePMR, OptiNAND, ultra SMR 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 HCD technologies 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 and 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 SN850, NVMe SSD products certified for Sony PS5 game consoles, which enables players to expand the high speed storage capacity of their PSI -- PS5 console and allows them to store and play both PS5 and PS4 games directly from the drive.

On the technology front, X5 represented about half of our flash revenue in the June quarter, up from 46% in the previous quarter. We are preparing to ramp big 6 late this calendar year and into 2023 based on circuit under array architecture. Big 6 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 4th quarter is supply constraints at Western Digital and our -- 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 our half of our revenue from this market by fiscal year '25. 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 right size 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 comrade -- 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 U.S. MSH group in Europe, JD.com in China and Office Works 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, but which only a small percentage of 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 longstanding and good 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 at Western Digital]

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 manage 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 near line 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 was primarily 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 near line 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 mid 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 continue 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 COVID 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 customers 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 roadmap despite what is clearly a volatile period in the memory industry. As we have discussed on prior calls, Big 6 is a more capital-intensive technology node that would 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 Big 6 to Big Plus in the next several years.

I am also pleased to share that the flash JV Fab7 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 at Western Digital]

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 and 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.

All 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.

Questions and Answers

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

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 CJ Muse with Evercore ISI. Please go ahead.

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

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 and you said 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? This is a one quarter phenomenon, too early to tell, love to hear your thoughts there.

[David Goeckeler, Chief Executive Officer at Western Digital]

Hey C..J. Good morning. Yeah, 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 U.S. 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 as a relatively short period of time ia at 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 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 re-setting inventory. So that one, we expect to be a one quarter phenomenon. I think in the larger market, we will 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 2 months ago and and it's really the OEMs that are really in a rapid and significant correction of inventory as well as I said, some of the cloud business in China.

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

Very helpful. And just a follow-up question on the NAND side of the house. You talked about rising cap in terms of the Big 6 and what's next. But at the same time, it sounds like you're talking about tempering investments at the JV. So could you kind of walk through how you're thinking about forward capex given the changes you're seeing [Inaudible].

[David Goeckeler, Chief Executive Officer at Western Digital]

Yeah, I'll make a few comments and we saw them comment as well. But we've always known the Big 6 was going to be a more capital-intensive node. I mean, again, we're coming off of VIX. 5, which is the most capital-efficient node in the history of the our roadmap. 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. And 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 roadmap. So when we're talking about a more capital-intensive node. Remember, that's a relative issue and we're still in the best position as far as capital per additional bit and that's a very, very big focus of ours.

Another 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 at Western Digital]

Yeah. If I can add the C..J., 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 will need to adjust to that, we will manage it dynamically.

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

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

[Aaron Rakers, Analyst at Well Fargo Securities]

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 that 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 are baked into that expectation? I'm just trying to understand, is this more pricing versus bit shift and is this really kind of -- do you think that this guide represents a bottom here?

[David Goeckeler, Chief Executive Officer at Western Digital]

Yeah. I think the way to think about it is as said earlier, it's kind of a demand-driven situation where we're just seeing our biggest customers and really not all of our customers across the PC space, just re-setting 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 needed 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 an 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, 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 give 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 if they will get through it in 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. I mean 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 good consistent, strong growth out of the hyperscalers in the U.S. and feel very, very good about the portfolio position there and what we're going to drive throughout the fiscal year.

[Aaron Rakers, Analyst at Well Fargo Securities]

Okay. And as a quick follow-up, just kind of thinking about the flash business a little bit more. On 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 kind of drive cost down in the flash business as we think about VIX VI. How are you thinking about the relative cost down structure Big 6 relative to Big 5? Thank you.

[David Goeckeler, Chief Executive Officer at Western Digital]

Yeah, I mean whether -- 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 is more on the favorable side, I think that's been the history, but we've had 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 check over. Is that right, Wissam?

[Wissam Jabre, Chief Financial Officer at Western Digital]

Yes, that's correct, David. And one of the things to keep in mind, Aaron is we didn't have the 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 at Western Digital]

So Aaron, we feel really good about the Big 6 transition and what that's going to bring and I think you'll see in the upcoming quarters, the cost will get back to where we expect it to be. We explicitly drive our roadmap around this number. We explicitly drive the nodal transitions in the roadmap development around making sure we can deliver the 15%t year-over-year and we are very pleased that we just delivered it again in the last fiscal year.

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

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

[Joe Moore, Analyst at Morgan Stanley]

Great, thank you. I wonder if you could address, I mean you -- I don't -- 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 at Western Digital]

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

[Wissam Jabre, Chief Financial Officer at Western Digital]

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

[Joe Moore, Analyst at Morgan Stanley]

And your inventory balance?

[Wissam Jabre, Chief Financial Officer at Western Digital]

Well, given that this is mostly demand driven, we expect inventory to be -- to grow a bit this quarter and 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.

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

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

[Patrick Ho, Analyst at Stifel Financial]

Well, I 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 U.S. 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 at Western Digital]

Yeah, 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 and 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 as we got a second hyperscaler that fully qualified, SMR. And with our position with ultra SMR 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 terabyte 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 volume.

[Patrick Ho, Analyst at Stifel Financial]

Great, that's helpful. And maybe as my follow-up question in terms of following up from your Analyst Day, where you did create a big focus on the NAND flash moving to the SSD market with the cloud segment itself as well. Do you see this shift beginning with Big 6 or is this more of a Big plus type of endeavor, where the future generations, we see the biggest shift towards SSD NAND?

[David Goeckeler, Chief Executive Officer at Western Digital]

No, I mean that 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 results, 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 3-year time span as we have a lot of confidence, we're going to drive that to the 16% share in FY '25.

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

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

[Wamsi Mohan, Analyst at 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 off to drive any sequential growth off of that in -- for the December quarter?

[David Goeckeler, Chief Executive Officer at Western Digital]

Well, I mean for -- in the PC market, we think the market is -- there was consensus earlier in the year, 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, but it's not completely loosened up. There is 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.

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

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

[Sidney Ho, Analyst at Deutsche Bank Aktiengesellschaft]

Thanks for taking my question. So, looking at your your flash margin, they are still at pretty decent level in the June quarter, but obviously that will come down in the September quarter, but with margins coming down in the next few quarter 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 under the control, but are other things in your control that you will make the next trough better than the last one? Thanks.

[David Goeckeler, Chief Executive Officer at Western Digital]

Yeah, 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 -- that is going to show up in 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 yeah, I think it's -- I think we go into this situation with a lot better portfolio and a lot better diversity, lot more places to put our supply, and we think that's going to lead to a better result.

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

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

[Toshiya Hari, Analyst at The Goldman Sachs Group]

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 '23 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 at Western Digital]

Thanks, Toshiya. So let me just say a little context and Wissam will give you more detail on capex and how we're thinking about this. So as we talked about that is 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. And 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 is 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 at Western Digital]

Yes. So on that, Toshiya, the -- on the restructuring, we are 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 is 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 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 at Western Digital]

And on capex?

[Wissam Jabre, Chief Financial Officer at Western Digital]

And on capex, we typically don't break out the capex between HDD and flash. But as I said, we're -- we do plan to stay within our target model of the 8% to 10% of revenue. And if you recall on the Investors 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% or may be higher than this in this -- in the near term, simply because we are investing in the capacity enterprise side 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 at Western Digital]

So Toshiya, just a few more comments on this, so we can fully paint the picture. So you're really starting to see that's what we talked about at our Analyst Day in heads and media, we still have to invest. I mean there is -- we need -- these big drives have a lot of heads in them. So we're still investing in heads and media, we transition up 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.

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

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

[Tom O'Malley, Analyst at 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 and others, 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 a recessionary scenario? Just any color on where you might see this bottom from a total company perspective. Thank you.

[David Goeckeler, Chief Executive Officer at Western Digital]

So first off, we don't see losses. So look, you hit on there, it's just very dynamic right now. Let me paint a 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 earlier this year, the consumer started softening really in Europe when the war broke out and in China with the lockdowns and that progressed throughout the first half of the year. The consumer business is something that usually is soft that seasonally the weakest part of the year, April and May. Calendar Q2 is an interesting quarter for that business because it always starts tough 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 -- consumers purchasing PCs and now smartphones and so. Now we're seeing the OEMs in 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. Now sell-in is 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 U.S. 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 in the OEMs are going through -- PC and smartphone OEMs are going through a very, very sharp correction. We are seeing other parts of the market start to stabilize. So we want to add that up, we don't really forecast the out quarters, but anything to say about that?

[Wissam Jabre, Chief Financial Officer at Western Digital]

Yeah, 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 that we obviously are -- with this downcycle where -- 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 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.

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

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

[Timothy Arcuri, Analyst at UBS Group]

Thanks a lot. I also had a 2-part question. I guess the first 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 were 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 in your peers? Thanks.

[David Goeckeler, Chief Executive Officer at Western Digital]

So on HDD. 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 -- well, let's put it this way, we're able to get the gross margins up in HDD a little faster than we thought and 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 or 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 put -- 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 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, 22 terabyte drive, the 26 terabyte ultra SMR drives, those are in a unique position in the industry and we have a plan as we move through FY '23, 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 a 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 are very, very significant amounts of demand that are changing within the quarter. So we put a guide around that. Obviously, we will work to make that better, but that's the reality of where the business is today.

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

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

[Mehdi Hosseini, Analyst at Susquehanna International Group]

Okay, thank you. Thanks for squeezing me in. David, just wanted to follow up to the last comment. You -- how does the earlier in the call that you remain comfortable with nearline cloud demand especially in North America and then you just said that demand is very volatile. What gives you confidence that the North American Class [Inaudible]i 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 followup.

[David Goeckeler, Chief Executive Officer at Western Digital]

I think it's, yeah, Mehdi, it's just start 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 and the TCO equation we bring to our customers as well as the visibility that we see. And given the relationship, it gives us confidence as we move through the second half of the year.

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

Thank you, 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 at Western Digital]

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

[Peter Andrew, Vice President, Financial Planning and Analysis and Investor Relations at Western Digital]

[Operator Closing Remarks]