Ladies and gentlemen, thank you for standing by, and welcome to Western Digital's Fourth Quarter Fiscal 2020 Conference Call. [Operator Instructions].

I would now like to hand the conference over to your speaker, Mr. Peter Andrew, Vice President of Investor Relations. Please go ahead, sir. .

Thank you, and good afternoon, everyone. Joining me today are David Goeckeler, Chief Executive Officer; and Bob Eulau, Chief Financial Officer. .

Before we begin, let me remind everyone that today's discussion contains forward-looking statements, including product portfolio expectations, business plans, 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-Q 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. .

Thanks, Peter, and thanks, everyone, for joining us this afternoon to discuss our fourth quarter and fiscal year 2020 results. I hope that you and your families are staying healthy and safe. .

As I reflect on my first full quarter as CEO of Western Digital, I am extremely proud of the way our team has navigated the complexities and uncertainties inherent in this unprecedented environment.

As a company, we continue to adapt to provide continuity and high-quality products for our customers, deliver value to our shareholders and, importantly, prioritize the health and safety of our employees.

We have a unique view into many drivers and trends that play both domestically and internationally due to the breadth of our portfolio of innovative flash and hard drive solutions going into cloud, OEM channel and retail end markets.

We look at our business holistically, but it is especially important now to understand the nuances, challenges and opportunities in each market we serve. .

So before we dig into the results for the quarter and full year, I want to talk about how the COVID-19 pandemic and other macro trends are impacting the business. I'll then update you on how we are thinking about our strategic priorities for the fiscal year 2021, before turning it over to Bob for a financial update, which will be followed by Q&A. .

Western Digital has successfully managed through this unpredictable time with limited business impact from the pandemic. We made important investments and changes to minimize manufacturing and logistical challenges that were primarily impacting our hard drive business. Bob will discuss the financial impact of these later in the call.

And we have maintained our focus on delivering for customers throughout. .

From an end market standpoint, demand was mixed in the quarter. And if there's a common theme among our end markets, it's uncertainty. In the second half of fiscal 2020, customers were focused on ensuring they had enough supply to meet heightened demand. As expected, demand in our cloud business was strong due to the work-from-home trend.

At the same time, healthy demand for our flash-based notebook solutions drove record revenue in our OEM end market. Finally, in retail, while we have a robust distribution channel with over 350,000 points of purchase around the world and well-established brands, we were impacted by COVID-related lockdowns at many of our brick-and-mortar customers.

We did see the business recover as the quarter progressed due to easing of lockdowns and the transition to online buying with curbside pickup. .

As we look to the first half of fiscal 2020, one, uncertainty remains. We remain vigilant given the resurgence of the virus and its potential to disrupt our supply chain, including our ability to keep full teams working in our manufacturing facilities. Apart from COVID-19, we're managing through other macro trends.

The global economic contraction is generally -- is generating an uncertain demand environment, and we are closely monitoring trade-related geopolitical developments, which are pertinent to a global business like ours.

These near-term headwinds will eventually subside, and we are confident that the strength of our portfolio and strong customer relationships are well aligned to where the growth is, in the cloud and on the edge.

We've continued to make strategic technology and product investments in both flash and hard drives to drive long-term revenue growth and gross margin expansion. .

Now turning to our financial results. In the fourth quarter, results were generally in line with our guidance. We achieved this while partially offsetting higher-than-anticipated COVID-19-related costs, which Bob will discuss in more detail.

We reported revenue of $4.3 billion and non-GAAP earnings per share of $1.23, mainly driven by growth in the cloud and record results for our client SSD portfolio for notebooks. .

Looking back at the full fiscal year 2020, I am pleased with our performance. Our end market diversity and breadth, broad customer base, channel reach and innovative leadership all positioned Western Digital to benefit from the multiyear growth in data creation and storage.

For fiscal 2020, revenue totaled $16.7 billion, and we reported non-GAAP earnings per share of $3.04. We continue to align our portfolio with a sharp focus on growth and margin improvement. .

Importantly, over the last year, we brought to market several exciting new innovations across both flash and hard drives that I'd like to touch upon. .

Starting with flash. As you know, we believe flash is the greatest long-term growth opportunity for Western Digital and is an area where we've already had a tremendous foundation with consumer cards, USB drives and client and enterprise SSDs.

As I mentioned on the Q3 call, the migration to flash within game consoles is yet another example of flash penetrating deeper into the edge and endpoint. The adoption of 5G and the build-out of the edge to support a new generation of real-time services is another exciting development.

We see an expanding TAM for flash that underpins a multiyear growth opportunity. .

To capitalize on this opportunity, we launched BiCS5, our 112-layer flash product in retail last quarter, which delivers exceptional capacity, performance and reliability, all at an attractive cost. The ramp has gone very well with impressive yields, and we are just at the beginning stages of this product ramp.

While we focus on ramping BiCS5, BiCS4 has continued to provide the right balance of performance and cost reduction. BiCS4 represented over 60% of bits shipped in the quarter. .

Earlier this year, we celebrated the first production wafer shipment from our K1 fab, our new manufacturing facility for 3D BiCS flash memory. This is another important milestone reflecting the successful 20-year partnership we've had with Kioxia. Another major highlight has been the ramp of our enterprise SSD product line.

Enterprise SSD revenue in the quarter grew nearly 70% sequentially, and our revenue share increased to the low double digits. This will remain an important area of focus within our flash portfolio. .

Now turning to hard drives. We continue to lead the industry in aerial density using innovations across the entire drive, algorithms, firmware, mechanical heads and media. We were the first in the industry to ship energy-assisted drives for mass production and expect a strong ramp into the fiscal second quarter and beyond.

In short, we are going through important product transitions in both our flash and HDD businesses that we think set up Western Digital well for the future. .

Recognizing that these are uncertain times, we believe that the most important thing we can do is keep our foot on the proverbial innovation pedal and execute on the road map across the business. We have an extremely talented team working on new products that will continue to drive leadership in flash and hard drives. .

Looking ahead, our strategic priorities are centered around driving innovation for customers and value for shareholders.

First and foremost, we will focus on driving long-term shareholder value as we bolster our flash and HDD portfolios, including ramping 2 important product lines to high volume, our SSD products and our energy-assisted capacity enterprise drives.

Secondly, we will accelerate our transition to BiCS5, delivering additional performance for our customers and notable cost advantages for Western Digital. Third, we will continue to sharpen our execution from a product road map and strategic business objectives.

And finally, we are evolving our portfolio to drive growth, margin improvement and cash generation while also paying down debt and investing in the future. In the near term, we expect to remain challenged by the pandemic and the global economic contraction.

Internally, we're also navigating multiple substantial product transitions, which will require sharp execution focus. But we are very confident they will set us up well for the long term. .

With that, I'll turn the call over to Bob to share our financial highlights and outlook. .

Thanks, Dave, and good afternoon, everyone. As Dave mentioned, the COVID-19 pandemic has created a challenging global economy that has continued to impact Western Digital's performance, in large part due to the high level of uncertainty that both we and our customers are facing.

While this uncertainty isn't going away in the near term, we'll continue to adapt, and we believe Western Digital is well positioned for the future. .

With that, I'll walk you through our fourth quarter and fiscal year 2020 results. For the fourth quarter, revenue was $4.3 billion, up 3% sequentially and up 18% from a year ago. Non-GAAP earnings per share was $1.23. For the full fiscal year, revenue was $16.7 billion, up 1% from fiscal 2019, and non-GAAP EPS was $3.04. .

Looking at end market. Client Devices revenue was $1.9 billion, up 5% on a sequential basis and up 19% year-over-year. Within this end market, our robust family of client SSDs, which are ideally suited for remote learning and work-from-home applications, achieved another record quarter of revenue.

Notebook and desktop-related hard drive revenue declined slightly sequentially as the market continued to transition to SSD-based products. Smart video was weaker than our expectations due to continued headwinds associated with the pandemic. In gaming, we began shipping our flash solutions for the upcoming new game console launches.

And finally, mobile flash revenue was down sequentially, but up year-over-year off a low base. .

Moving on to Data Center Devices and Solutions. Fourth quarter revenue was a record $1.7 billion, up 11% sequentially and up 32% year-over-year. For the full fiscal year, revenue of $6.2 billion was up 24% from fiscal year 2019.

Capacity enterprise hard drive revenue was down slightly on a sequential basis, while enterprise SSD revenue grew nearly 70% sequentially and more than doubled from a year ago. .

Next, Client Solutions revenue was $687 million, down 16% sequentially and down 9% year-over-year due to COVID-19-related lockdowns. Despite this, we were encouraged to see demand pick up in June as countries began to ease lockdown restrictions and as brick-and-mortar locations shifted more of their operations online.

This strength continued into July. Given the unprecedented circumstances, we executed very well in this business in a difficult environment. With over 350,000 points of purchase around the world, we continue to have incredibly strong distribution breadth and brand recognition. .

Turning to revenue by product category. Flash revenue was $2.2 billion, up 9% sequentially and up 49% year-over-year. Flash ASPs were up 1% sequentially on a blended basis and up 3% on a like-for-like basis. Bit shipments were up 8% sequentially. Hard drive revenue was $2.1 billion, down 3% sequentially and down 4% year-over-year.

Total exabyte shipments were down 2%. On a sequential basis, the average price per hard drive increased 2% to $87 as mix continued to shift to the cloud. .

As we move on to cost and expenses, please note all of my comments will be related to non-GAAP results, unless stated otherwise. Gross margin for the fourth quarter was up 1 percentage point sequentially to 28.9%, slightly below our guidance range. The major item that impacted our gross margin was COVID-19-related costs of $96 million.

This almost exclusively impacted hard drives -- the hard drive business and was primarily related to reduced factory utilization and higher logistics costs. For clarity, this item was included in our non-GAAP gross margin. .

Our flash gross margin was 30.5%, up 4 percentage points from last quarter due to cost reductions and slightly favorable pricing. Our hard drive gross margin was 27.2%, down 2.1 percentage points from the prior quarter.

The biggest driver of the lower gross margin was the $96 million in COVID-19-related costs, representing a 4.7 percentage point impact on our hard drive gross margin. .

Operating expenses were $713 million, well below our guidance range, primarily due to our decision to cap variable compensation expense given the current economic environment. Non-GAAP earnings per share was $1.23. Operating cash flow for the fourth quarter was $172 million, and free cash flow was $261 million.

In fiscal 2020, we generated $1.1 billion in free cash flow. .

Capital expenditures, which include the purchase of property, plant and equipment and activity related to flash ventures on our cash flow statement, were an inflow of $89 million due to the timing of funds flowing to and from the joint ventures.

In the fourth quarter, we distributed $150 million in dividends to our shareholders, which was our final distribution prior to suspending the dividend. We also made a standard $63 million debt repayment in the fourth quarter. I would note that we have already made an optional debt repayment of $150 million in July. .

Our liquidity position continues to be strong. At the end of the quarter, we had $3 billion in cash and cash equivalents, and our gross debt outstanding was $9.7 billion. Our debt-to-EBITDA ratio was 4.2x in the fourth quarter. And our adjusted EBITDA leverage ratio, as defined in our credit agreement, was 2.8x.

As a reminder, our credit agreement includes an approximate $1 billion in depreciation add back associated with the joint ventures, which is not reflected in our cash flow statement. Please refer to our earnings presentation on the Investor Relations website for further details. .

Moving on to guidance for the fiscal first quarter. We are somewhat challenged in the near term as a result of the uncertainty of the pandemic and being in the midst of a global economic contraction. Despite this uncertainty, we continue to execute and focus on our great products, deep customer relationships and large and growing markets.

We are working on a number of substantial product transitions that will set us up well for the long term. .

We expect revenue in the first fiscal quarter to be in the range of $3.70 billion to $3.9 billion. Growth in Client Solutions is expected to be more than offset by a decline in both Data Center Devices and Solutions and Client Devices. We expect non-GAAP gross margin to be between 25% and 27%.

This range includes approximately $80 million in costs associated with the K1 fab. This should be the peak quarter in fiscal 2021 for K1 period expenses. We expect operating expenses to be between $700 million and $720 million. Interest and other expense is expected to be between $70 million and $80 million.

The tax rate is expected to be between 22% and 26% in Q1 and for the full fiscal year of 2021. We expect non-GAAP earnings per share to be between $0.45 and $0.65 in Q1, assuming approximately 304 million fully diluted shares. .

Gross capital expenditures, which includes our portion of the joint venture leasing and self-operating funding, is expected to be approximately $3.1 billion in fiscal year 2021. This includes approximately $1.3 billion in cash capital expenditures. We will continue to monitor capital expenditures very closely given the current business environment. .

In summary, we are executing well in a challenging environment, and results are generally in line with our expectations. We are taking decisive steps to successfully navigate through the current macroeconomic environment while ensuring we focus our resources to address the significant long-term growth opportunities that are ahead. .

I'll now turn it back over to Dave. .

Thanks, Bob. While we continue to navigate through a complex and dynamic environment, I am confident that Western Digital can lead the market for years to come.

As I've said, I came here because I have a very strong conviction that Western Digital can play an increasingly vital role in the digital transformation, and that conviction has only strengthened in the past 5 months.

We have deep flash and HDD product portfolio, operational scale and great customer relationships, combined with the ever-growing demand for data creation and storage. .

All in all, it's a great place to be, and I'm extremely thankful for the hard work that our talented global team puts in on a day in and day out basis.

We are operating in uncertain times, but Western Digital's strong, consistent performance reflects our ability to maintain our market leadership by delivering technological innovation with the quality, performance and cost effectiveness that our customers rely upon. .

With that, I'll turn the call over to the operator to begin our Q&A. .

[Operator Instructions] Our first question will come from Wamsi Mohan with Bank of America. .

I was hoping you could give us some sense on your 18-terabyte ramp. It appeared that you were expecting that ramp before in the September quarter. It looks like it might have been pushed out further. Can you talk about what's going on there? And I have a follow-up. .

Yes. No, it hasn't pushed out. The ramp is on plan, as we've talked about. We plan on producing in excess of 1 million units this quarter.

It's a very important quarter for us on that ramp, Wamsi, because it's the quarter where we get the yields up, which gets us the margin profile we need to go into the second quarter of the fiscal year at full production capacity. So it's on track where we want it to be. We feel good about it, and this is going to be an important quarter for us.

But it's something we know how to do in ramping a drive platform. .

Okay. And I was wondering if you can maybe bridge this quarter-on-quarter gross margin outlook, what the main puts and takes there are. How much are you thinking that the HDD side is going to contribute given that some of the capacity enterprise weakness was -- capacity enterprise seems like a little bit weaker than what people were thinking. .

Yes. I'll make a few comments, and I'll turn it over to Bob to make a few comments. And I think if you look at gross margin going forward, there's a number of headwinds. We still have the COVID costs. We don't expect them to be as high next quarter as they were this quarter, but they're still there, the logistics cost, especially.

It's just a very dynamic environment there that changes week by week. We've got the ramp of the 18-terabyte drive that we just talked about. So in the beginning phases of that ramp, you're going to -- it's a headwind on gross margin till we get up the ramp. That's why this is such an important quarter for us that we work through that.

And as I said, that's on track. And then on flash, we've got an easing pricing environment. So that's going to impact gross margin there.

Bob, any -- did I miss anything?.

No. I think those are the keys. I mean on the hard drives, obviously, volumes are a little lower. So we'll be amortizing our fixed costs over a smaller volume as we go up the yield ramp on the 18-terabyte drives. Now on the flash side, as Dave said, I mean, we've got some price and mix headwind.

And we also -- as I mentioned in my comments, we have costs up a bit on K1, which amounts to about 1 percentage point on the flash side. So it's just we have multiple challenges this quarter. But I think long term, we're going to be really well positioned once we get up these product ramps. .

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

Just kind of building off that last question a little bit. I mean when you look at the hard disc drive gross margin at 27.2% and you adjust, looks like -- adjusted ex-COVID, looks like it's close to about 32%. I think it would be helpful just to kind of frame what the expectation is for COVID impact in this quarter.

Is it -- probably not as high, but are we still carrying 3 percentage points plus of kind of headwind on gross margin? Just kind of any framework there.

And on top of that, what are you seeing in pricing dynamics in nearline right now in the market?.

So I'll take the second one. Bob can talk a little bit more about the first. The -- all the businesses transacting at 14T, it's a very competitive point in the market. There's no doubt about that.

We're at the -- we're kind of at the tail end of one generation, moving to the next one, and that's why getting up the AT&T ramp is so -- 18, 16 ramp is so important for us. And that will position us well and be able to drive accretive margins to the portfolio on that point.

But we expect that as we get 18 out there and the conversations with customers, it's a different TCO proposition for our customers. And that leads to more value for both of us. So we're heading to a better spot. I don't know. Bob, do you want to characterize COVID a little bit in this quarter? It's kind of -- it's a little tough because it's so dynamic.

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Yes. Yes. It's not going to be as significant as last quarter. And last quarter, we did offset the COVID cost a bit by pricing. But it obviously did not fully offset it. That's a big number. As we look at Q1, we don't think we're going to have the kind of absorption variances that we had last quarter.

You may recall in the earnings call in April, I said that we had some challenges on volumes in April. So we already knew we had that headwind last quarter. We don't have that issue this quarter. So I would say the costs will be down, but I don't want to be too specific. We think we've got it covered in the guidance range that we articulated. .

Okay. And then as a follow-up, I know there's a lot of discussion around cloud digestion, kind of mixed data points out there.

Relative to the 30% implied nearline capacity ship growth this last quarter, what is your current assessment of the demand from a capacity ship standpoint nearline through the back half of this calendar year? Any kind of views on that front?.

Yes. We feel like we're definitely going into a digestion phase. If we look at -- we're coming off of 3 really strong quarters of exabyte shipment, and the demand signals we're getting are going to be -- are a little bit down for the next quarter or 2. We think that -- I mean, the long-term trend is obviously still good.

We're using the cloud more every day. But there's been a lot of product shipped in there in the last couple of quarters. And what we're seeing from them is, they're all not the same, right? We have all of them. So they're all at different points.

But when you add it all up, you see next quarter, there's a negative bias on demand there from what we see looking backwards. .

So down sequential? Sorry. .

Yes. .

Our next question will come from Karl Ackerman with Cowen. .

I wanted to follow up to Aaron's last question just on exabyte growth. You obviously -- you actually had a pretty strong quarter for exabyte growth within data center this quarter. But it does sound like the outlook is down sequentially, as you just indicated.

I was hoping if you could juxtapose what you're seeing across both on-prem and private cloud environments versus public cloud as it relates to, I guess, both your hard drive portfolio but also your enterprise SSD portfolio. That's my first question. .

And for my follow-up, I was hoping you could -- you've obviously been a little bit smaller player in the enterprise SSD market of late, which has enabled some of the significant share gains. And quite frankly, you've completely turned around your technology portfolio within that enterprise SSD market.

Is your expectation going forward for September that you should outperform end market demand given some of the share gains you've seen lately?.

So on the enterprise SSD, you're right. We've done a lot of work to launch a new product in enterprise SSD. We've got a couple of new products. The first one is out, and it's targeted to the cloud providers. The product targeted to the OEMs is yet to ship. So that will happen in the next couple of quarters.

So we really are in a big product transition there. So it's hard for me to draw a conclusion to your question about on-prem versus the cloud given enterprise SSD because we're mainly focused on the cloud side right now, working our way through quals and all those kinds of things.

Given that the product is new, given that we're going through a lot of qualifications, over a multi-quarter time frame, I expect us to get better and better. It's going to be a little lumpy as we move through that. So if I look at the number of quals going on in the organization, it's across all technologies.

We have twice as many quals going on as we had a year ago this time. So that gives you an idea of where -- how the portfolio is refreshing, and we're driving that into the market. .

On the hard drive side, I guess I can talk about the OEMs in the private data center more of just as an overall market. I mean, well, let me save that response for a different time because that's more PC-related. But I don't know if I have a tremendous amount of insight.

Bob, I don't know if you do on the hard drive side versus on-prem versus in the cloud, if we could draw any strong conclusions for that. .

No. I think we're seeing softness in both areas as we move forward into Q1. .

Our next question will come from Mehdi Hosseini with SIG. .

The first one, on the hard disk drive. One of your competitors had referenced weaker demand trends, especially for client noncompute out of China.

And when I just do a back of envelope, if that is what's happening and impacting your client noncompute, it seems to me that your exabyte shipment for that particular segment may have been down by more than 20% on a Q-o-Q basis. And I was wondering if you could elaborate on it. And I have a follow-up. .

Yes. I'll elaborate on the general market. I don't know if I can follow the back of your envelope that fast. But look, I think the channel was -- let me talk about the channel in general and smart video as a part of that. That was a real slog this past quarter. I mean the team worked really hard on it.

We thought we saw TAM shrinkage there, significant TAM shrinkage of $100 million or so a year throughout the quarter. So it was -- we look at -- to us, that's a good indication of overall demand that's out there, and it was tough and related to that, and we see that going forward kind of a negative bias on that market.

So I don't know, Bob, if you have any additional comments on the smart video, in particular. .

No. I agree in the short term. If we look over the longer-time horizon, that is going to be another area of growth in the hard drive business. So we really see the capacity in enterprise business and the smart video business growing as we look over multiple years. .

Yes. I mean I think this overall theme you're hearing from us, which is as we look at -- I mean, as we look forward into the next quarter, we see some challenges given COVID, given the state of the economy, given all the demand we've seen in the first half and the inventory rationalizations and digestions that are going on.

But in all of those markets, we see very good long-term trends. And so it's a question of how fast that comes back. But all of the -- I think the pandemic has shown us the amount that all of us are relying on technology, and I think our portfolio is as well positioned for that world as it has been in some time. .

Great. And just my follow-up question has to do with your -- the flash. You highlighted the fact that your revenues were up 70% or so. But I heard that commentary suggests there is an unfavorable mix shift into the September quarter.

Perhaps you could help us better understand the dynamic if you were to elaborate on the mix of your NAND, how SSD and smartphone application are trending? And it seems to me that maybe the game console is happening later in the year. And if you could elaborate on it, it will be great. .

Yes. So I think there are a bunch of pieces in there, Mehdi. So game console is definitely a growth area, and we're very fortunate to be participating in that. And as you know, we haven't been in the hard drive side of that business for quite a while. So it's all upside from our perspective.

And then I would say, overall, there may be slight mix changes as we go quarter-to-quarter. We are seeing some pressure in terms of price, and that's factored into our guidance as well. .

Yes, Mehdi. This is Peter. Also don't forget, we do have a little bit of a step-up in the K1 cost. But as you go Q-to-Q, that will be another pressure on the flash gross margins. .

Okay.

But in terms of the end market and mix as it relates to flash, there is -- you shouldn't assume a significant change?.

I think the biggest change is the one I mentioned on game consoles becoming more significant. But otherwise, it will be up and down here and there, but I don't think it'll be that material. .

Our next question will come from C.J. Muse with Evercore. .

I guess first question, as it relates to your overall revenue guide for September of down 11% sequentially, should we be thinking that each business is down similar to that rate? Is one doing better than the other? Could you shed a little light on that, please?.

Sure. I mean I think we're seeing retail -- last quarter, we started off in the retail business, which is roughly 20% of the business is really challenged, and it got better as the quarter went on and June was good. It wasn't quite all the way back to normal, but it was strong. And we've seen that continue through July.

And we're expecting that business to be positive in the quarter going forward. And if you look at all the other businesses, the cloud, again, we talked about that, we see a digestion phase there. We see the OEMs kind of really watching inventory and managing that tighter. And then I talked about the channel.

So as we said, long term, we see good things where the portfolio is going. But in the near term, that's how we see the 4 major businesses. .

And so if I just read between the lines, given the commentary on retail, that would suggest NAND might be a little bit better than HDD?.

I wouldn't draw specific -- yes. .

I don't know if I'd go into that level of detail. .

Okay. And I guess a question on the flash side and to follow up on Mehdi's question. For the June quarter, I guess I was a little bit surprised by the lower ASP uplift but higher bit growth.

I guess can you comment on what drove that? And I guess just to follow up, should we be assuming similar mix as the June quarter, coupled with an uplift in gaming, to -- as we build out our ASP kind of assumptions?.

Yes. So I'll make a few comments. I'm sure Bob will make a few comments. I mean part of the ASP, looking back, was retail where ASPs were -- for flash were more challenged. So that's a big piece of that number. I think going forward, you shouldn't expect a tremendously different mix.

Minus what you said, gaming, was it -- and it was good to see gaming start to ramp up. We expect that to continue to ramp through the second half of the year and take a low double-digit percent of our supply. So that's a good story. .

Yes. And I don't have a lot to add. I mean I think in the transactional businesses, we've definitely seen more pricing pressure than we've seen from the OEMs. Although overall, we think prices will be down this quarter. .

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

I wonder if you could talk about in the NAND business, just how comfortable you are. I mean last year, you -- when things got kind of weak, you guys took underutilization actions to kind of clean up inventory. You're not doing that now.

Does that suggest supply/demand is in a healthier place? Or just anything you can kind of tell us about the state of your inventory, customer inventory and your plan there. .

Yes. I'll make a few comments, and Bob can make a few comments. Yes, I think we feel good about the amount -- the industry keeping supply/demand in balance. I mean, clearly, we've got a -- in a recession, we have a drop in demand. So we're seeing some pricing implications of that.

But we feel like the -- kind of where supply/demand is, is fairly balanced going forward. We're certainly watching our CapEx investments very closely and managing more tightly with our partner. But Bob, do you want to say anything about inventory? Or... .

Yes. I mean I joined the company right in the middle of the last trough. And I can tell you the supply and demand imbalance is nothing like it was then today. So I think everybody is behaving pretty rationally.

We still see the industry growing bits and then -- bits, both supply and demand, in the neighborhood of 25% to 30%, and that's our intention as well. .

Okay. And then for my follow-up, it sounds like you're pretty comfortable on the adjusted EBITDA covenant calculations for September. But obviously, memory can be uncertain beyond that.

Can you talk about your comfort level overall on the covenants? And is there anything -- any actions you could take if things got worse to sort of make sure you don't have any issues there?.

So I'm very comfortable. In fact, if you go back like to the trough I was just talking about, we never really got that close to breaching the covenant on the adjusted basis. So I really don't think there's much of a risk there. .

Joe, also just to put a little bit more transparency into the credit agreement metrics, please make sure you take a look at the slide deck that's on our website. We've got a lot more detail on that metric in there. .

Our next question will come from Ananda Baruah with Loop Capital. .

I guess the first one for me is with regards to the gross margin guidance. Could you give us a sense of which part of the business you expect to contract more of the hard drives versus the flash? It sounds like on flash, there's slight mix, and on retail, Bob, as per your remarks, slight pricing pressure. They're not from OEM contract yet.

And then it sounds like on the hard drive business, it's probably more mix related. Is there anything in addition to that? And then could you just give us a sense of magnitude for each of these businesses? And then I have a quick follow-up. .

Yes. I mean I'll touch on it again. I don't want to get into too many specifics. As you know, we only guide gross margin for the company overall. But we're definitely seeing pressures on both sides, both on the hard drive and on the flash. Like we said before, we've got significant product transition going on, on the hard drive side.

We've got a yield curve that we're working our way up. And we've got the COVID-19 pressures that they won't be as bad this coming quarter, the quarter we're in now, as they were last quarter. But we definitely have pressures on the hard drive side.

And I would say on the flash side, we're seeing pressures primarily on price and a little bit of mix and then the K1 costs that we talked about as well. .

Right, the K1 costs. And guys, any -- you mentioned about going through a period of digestion in cloud that dovetails with your top competitors' remarks and also with the remarks of the hyperscalers.

Any context you can provide around just sort of do you think that means this cycle is through? Or does digestion to you guys really just mean like a period of digestion and then you think, "We can get back to some semblance of growth again in the near future?".

Yes. I mean, look, I mean, we see -- we -- it's a long-term growth market. I mean we see 30%, 35% CAGR exabyte growth in that market for years to come. We're coming off of a couple of quarters of significantly above that. It's not surprising we would go through a little bit of time where all of that capacity gets deployed.

But I think just look at the world around us, I mean, we're all using the cloud more every day. I think the last 5 months have accelerated the amount of transformation that was going to happen in using of cloud technology significantly. So I don't -- I'm not exactly how we would both define a cycle.

But I see a really good long-term trend in this, and I see us well positioned as well. That's why this coming quarter is important for us to get the 18, 16 platform ramped, get the 1 million units produced, get those shipped to put ourselves in a good position for that continued growth. .

And just the one thing I would add. I just think there's been a lot of supply chain disruption this year, both in terms of our own production, our customers trying to make sure they get supply. Now our customers are working off inventory levels.

So I just think between the pandemic and the recession and concerns on supply, it's been a very challenging year. .

Our next question will come from Mitch Steves with RBC Capital Markets. .

I just wanted to follow up a bit on the gross margin side.

So when you talk about COVID-19 issue kind of being a little bit better than you guys saw or better than last quarter, how do we think about the bigger drivers of your gross margins going back to 30%? Is there really going to be a NAND improvement on pricing? Or is it going to be a lot of supply chain issues? I'm trying to get an understanding of what's really moving the margins so dramatically on a quarterly basis.

.

Yes. I'll maybe paint a big picture of that, and Bob wants to go into a little bit of detail. So I mean, it's both important on both sides. But one is, on flash, first of all, continue to BiCS5. BiCS4 is a great node for us, giving us cost reductions and performance we need.

The BiCS5 transition, I think the team made really, really sound choices on going to that technology. As we talked about, the yields have been impressive. We're kind of ahead of internal plans on that node. So continuing to drive that technology road map that gives us cost advantages is the first part of it.

And then secondly, it's optimizing the portfolio on top of it for the markets we play in for optimizing gross margin. That's -- as you see us moving more to enterprise SSD, things that we think are going to drive higher margins. So that's a big part of it on flash. And of course, then you got pricing on top of that, which is a market concern. .

On the hard drive side, again, it's -- gross margin to me is led by innovation. So we ramp the 18-, 16-terabyte platform, that's a better TCO for our customers. That's a better value proposition for them. That's higher gross margins for us.

So that's why we're so focused on getting that -- getting up the production ramp on that and why we feel good about that platform. So those are the main drivers from my perspective.

Bob?.

Yes. I don't think I have much to add. I mean I think it's clear, we've got room to improve in both the hard drive area and in the flash area. And we've got the products to make it happen. .

Got it. And then just one other small one, just on the smartphone cycle. I mean it's been very clear that some of the bigger products got pushed out, right, so their time -- that they're going to ramp up more in Q4 into the Q3.

Can you maybe give us an understanding of how that impacts you? And how you guys think about the push-out as it relates to the flash business?.

I guess I can start. .

I'm sorry, I didn't understand the question. What was... .

It was on mobile. .

Okay. I'm sorry. .

I'll start. So as you know, we've been underweight in mobile for quite a while. We continue to be underweight in terms of mobile. Now if that business is lower than what's anticipated, our competitors need to find homes for those bits.

So we're not completely insulated from the challenges on the mobile side because they do need to move into other markets in order to move the bits. But I think in terms of our strategy of focusing on the other areas, I think it's worked out pretty well. .

[Operator Instructions] Our next question will come from Sidney Ho with Deutsche Bank. .

On the NAND side, SSD side, I know you probably don't want to comment on how much do you think NAND price is going to come down.

But hypothetically, if prices start to decline more rapidly than your cost improvement over the next few quarters, say, 10%, 15%, 20% a quarter, how would you respond to that kind of pricing environment in terms of inventory utilization, CapEx and so on and so forth?.

Yes. I guess I can start. I mean -- and first of all, our view on cost reduction is still around 15% a year. So we don't see that changing. We think that's what you're going to see in the 3D era because it's so much more capital-intensive. And what we think you're going to see is a competitive marketplace where people are behaving rationally.

I mean that's -- a lot of the reports that we've seen over the last couple of weeks, it seems like everybody is trying to make sure we don't end up in an oversupply situation. And we're going to be cautious, as I said, in terms of how we invest in our capital.

Some of the CapEx we're funding right now is related to equipment we put in place last fiscal year. So we'll keep a very close eye in terms of what's going on in terms of the balance of supply and demand. .

Yes. I mean I don't like to deal too much in hypotheticals. But we've got a lot of conviction in that market. If you just look at gaming really coming on in the second half of this year, as you said, the 5G cycle may move around a little bit, but it's still out there.

So there's a lot of demand drivers, and we believe in that 30% CAGR in that market on the demand side. .

Our next question will come from Shannon Cross with Cross Research. .

I was just wondering if you could take a step back when you were coming up with your guidance sort of from a higher level.

How much of it is coming from a lack of visibility versus maybe specific conversations with your customers? And then if you're looking at where there might be an opportunity for upside, where would that be?.

Yes. I would say, in general, we look at a wide range of data points. I mean some of the businesses are like a retail business, what's the trend that's going on there and what do we see and what may be disruptions. For example, in the period ahead, we typically see a back-to-school cycle. It's unclear what that's going to look like.

So that puts some variability in the forecast. But we talked to our -- our teams are very, very close to our customers. So we're talking to them on a near daily basis and getting a very -- a sense of what -- how they're thinking about their end markets and what the signals they're giving us for demand.

And we're factoring all of that in to kind of what they're telling us and what we see as the bias. And then we're wrapping in new product quals. I mean we talked about it in our prepared remarks. .

We're going through a bunch of very substantial product transitions. Now we feel really good about that, but we got to get through it. There's risk in those. So we make a risk-adjusted view of which of those are going to hit, which of them are not, which ones may move around for various reasons.

I think I said it earlier, we have twice as many quals going right now as we did last year, and the number is over 450. So there's a lot of activity across the portfolio. The big ones, there's probably 2, 3, 4 dozen really big ones. So we factor that in as well. And we understand when they're going to hit and put some judgment around that.

We wrap it all up into the guide. So if some of those quals move around, they could be in a positive or negative, there's enough of them that hopefully that balances out. But we put together our best view of what we think is going to happen over the next quarter. .

Our Next question will come from Patrick Ho with Stifel. .

Dave, maybe just following up on some of the NAND questions. You talked about the strong demand you're seeing for the BiCS5 product.

Given some of the market dynamics that are going on right now, and you mentioned some price erosion and maybe a little bit of inventory that's been built and some digestion, how do you see that potentially affecting the ramp of the BiCS5 product? Does that push it out somewhat? Or are we going to see maybe a potentially steeper BiCS4 decline as BiCS5 ramps up?.

Yes. I want to be careful. I don't think I talked about BiCS5 demand in the sense of BiCS. So I don't -- our customers just look for the NAND products, and it's up to us to build the right technology for that. And as we drive the road map forward, we can get more advantageous cost for us.

And what we're saying on BiCS5 is the development of the technology is going well, and the yields are going well. We've got the product in the retail channel already, and we are working on all the engineering work to put it into the whole product portfolio.

So we will look to accelerate that work as much as we can to get as many things on that node as possible. But there's a lot of work to do there, right? Before we -- BiCS4 is a great node for us. It's providing us the performance and cost advantages that we need. As I said, I think 60% of our bits this quarter were beyond BiCS4.

You're going to see us -- BiCS4 will be our major node for several quarters to come as we work on the transition in the portfolio to BiCS5, which will then carry us for another several years. .

Our next question will come from Srini Pajjuri with SMBC Nikko. .

I have a question about the cost on the NAND side. Bob, can you talk about as BiCS5 ramps, I think previously, you said your cost decline expectation is about mid-teens or so, annual. As BiCS5 ramps, do you still expect that? And then also on the K1 cost, you said $80 million this quarter is the peak.

And if demand continues to remain weak, how should we think about that $80 million coming down over the next few quarters?.

Yes. So I guess a couple of questions in there. First of all, we still believe over a number of quarters, we're going to average 15% year-over-year cost declines, and we think that's pretty sustainable. We've been able to achieve that with BiCS4. We think we'll be able to achieve that with BiCS5, and we'll continue to work through the transition.

As Dave was just saying, it's going to take several quarters to ramp up on BiCS5. It's not going to be overnight, we throw a switch and we're on BiCS5. And BiCS4 has worked out really well. BiCS4 will be an even bigger percentage of the total next quarter than it is this quarter. So we still have a ways to go on BiCS4. .

And then in terms of the K1 costs, we do believe this is the peak. There's a lot of equipment getting installed. As you know, it's a long cycle time. So we've got to get products through the cycle. And then we'll be able to capitalize or inventory more of those costs and bring down the period expenses as we move forward.

So I think we're getting to the point where our volumes are getting up there where the period expenses will start to go away. .

Our next question will come from Vijay Rakesh with Mizuho. .

Just 2 questions. I was wondering on the hard disc drive side, on the 18-terabyte, I know you mentioned it's a big product for you. Will you be shipping -- and you said more than 1 million units here.

So do you expect that to ramp to a couple of million in December quarter? How does that ramp?.

And also, on the NAND side, it looks like that $80 million cost for Q1 start-up in September is almost like 300 bps of a gross margin headwind. So is that a clear -- 350 bps of gross margin headwind looks like.

So is that the majority of the gross margin headwind on NAND? Or is pricing a bigger factor in there?.

Do you want me to start?.

Yes. You start with K1. .

Okay. Yes. Let me start on K1. So we've been averaging around $60 million a quarter the last 4 quarters in terms of period expenses for the K1 fab. And then as we said, in the September quarter, we're going to go up to $80 million. So incrementally, it's about $20 million. On the flash revenue, that's somewhere in the neighborhood of an incremental point.

And as I just finished commenting on, as we start to ramp volumes, and we are, we'll start to absorb those costs. And I think we'll definitely see that number coming down in the couple of quarters following the September quarter. So I think we're in good shape there. .

And then in terms of volumes on the hard drive side, I mean, we're -- we definitely have plans to produce over 1 million units of 18- and 16-terabyte product. And we'll get as many of those out the door as we can this quarter. .

Yes. We're not putting a number out there for the December quarter. But I think as we said, we want to get ourselves in a position where we're up the yield curves and we've got the manufacturing capacity to really step on the gas on that node. We're doing that now.

We're working -- so this quarter, the important number is to get the production up so that we can get up that curve. And of course, we'll ship as many of them as we can. .

Thank you. Ladies and gentlemen, I'm showing we're at the bottom of the hour and drawing to a close. I would now like to turn the call back to management for any further remarks. .

Okay. Well, thank you, everybody, for taking the time to listen to Western Digital today. We look forward to talking to you throughout the quarter. Good night. .

Thanks, everyone. .

Thanks, folks. .

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect..