Seagate Technology (STX) released its Q2 FY2020 quarterly report on February 4. The results were mixed, although the outlook was better than expected. However, there were also other issues that will have to be addressed at some point as time goes by. What these issues are will be covered next.

Seagate managed to beat earnings estimates, but fell short on revenue. Net income increased by double digits QoQ, but decreased YoY. Revenue displayed a similar pattern, although the swings were less pronounced. Gross margin also recovered in Q2 from the sizable drop in Q1. However, Q2 gross margin remained lower compared to a year ago. Non-GAAP gross margin of 28.7% was slightly above estimates.

(GAAP)

Q2 FY2019

Q1 FY2020

Q2 FY2020

QoQ

YoY

Revenue

$2,715M

$2,578M

$2,696M

4.57%

(0.7%)

Net income

$384M

$200M

$318M

59.0%

(17.2%)

EPS

$1.34

$0.74

$1.20

-

-

Gross margin

29.3%

26.0%

28.1%

-

-

(non-GAAP)

Revenue

$2,715M

$2,578M

$2,696M

4.57%

(0.7%)

Net income

$432M

$278M

$359M

29.1%

(16.9%)

EPS

$1.51

$1.03

$1.35

-

-

Gross margin

29.9%

26.7%

28.7%

-

-

Source: Seagate Form 8-K

Seagate's forecast was slightly better than expected. The outlook for Q3 calls for non-GAAP EPS of $1.35, plus or minus 7%, and revenue of $2.7B, plus or minus 7%.

One of the things that stood out in the Q1 quarterly report was the sizable drop in margins. However, Seagate managed to turn this around in Q2. Gross margin improved by as much as 200 basis points. The credit goes to a shift in product mix towards mass capacity drives. From the Q2 earnings call:

"Non-GAAP gross margin was 28.7%, up 200 basis points sequentially, reflecting a more favorable product mix with a higher contribution from mass capacity drives."

A transcript of the Q2 FY2020 earnings call can be found here.

Gross margin in Q2 also benefited from higher volumes and cost reduction. Q3 may once again get a lift from some or all of these three factors.

"I'd say in fiscal Q2, the improvement in gross margin is coming partially from the 16-terabyte, but as we said, actually tripled the volume during the quarter but also from an overall cost reduction on several other drives. So, looking at Q3, we will have for sure an higher volume in 16-terabytes that will help our gross margin, but of course depends on the overall mix of the entire volume that we move into the quarter."

Apparently, Seagate shipped one million 16-terabytes HDDs, which is currently the highest-capacity drive in mass production.

"In nearline, we are leading the industry's transition to 16-terabytes, which is the largest capacity drive available in mass volume today, offering the best total cost of ownership opportunity for our customers. In the December quarter, these products represented the highest revenue and highest exabyte shipments of any of our drives."

HDDs with even higher capacities are coming. The first HAMR drive is expected to become available in late 2020.

"We are on track to release the industry's first commercially available HAMR drive in late calendar 2020 at the 20-terabyte capacity point."

Higher volumes of high-capacity drives allowed Seagate to set a new record in the amount of exabytes shipped. Seagate sees room for further growth in exabytes shipped.

"I didn't say that we were in a digestion phase then, but I think we've seen that cyclicality before. It's dangerous to say that will happen exactly again, because there has been a different reason for the cyclicality every time it hits. That said, I do think that the demand is growing. I think that the customers are broadening. And I also think that their ability to use higher and higher capacity points is actually getting bigger. So once upon a time, people couldn't use more than 4-terabytes and while most of the market was on 8s and you're starting to see people get shifting over to bigger capacity points as well. So I do think exabyte growth is still going to continue. I don't think I'm calling the top of the peak at 10% yet."

Demand for more storage is on the rise.

"In general, we're seeing a change in typical seasonality as HDD demand shift away from consumer-oriented legacy markets and towards mass capacity storage driven by data growth in the cloud and at the edge. The demand environment has continued to steadily improve particularly for high capacity nearline drives. With the positive customer momentum we have established for our 16-terabyte byproducts we continue to expect both revenue and profitability to grow in fiscal 2020 with the second half revenue slightly higher than the first half for this fiscal year."

However, while demand for storage may not be a problem, other areas may become one if they continue on the same path.

Seagate is seeing changes in its product mix. In just one year, mass capacity and legacy traded places as can be seen in the table below. Mass capacity increased to 49% of revenue from 39% a year ago. In contrast, legacy declined from 53% to 43%. Note that Q2 revenue decreased by 0.7% compared to a year ago. Revenue growth in mass capacity was barely enough to compensate for the shrinking of the legacy business. Nearline accounted for the bulk of mass capacity with 49 out of 71.3 exabytes.

Q2 FY2019

Q1 FY2020

Q2 FY2020

Revenues by market

Mass capacity

39%

47%

49%

Legacy

53%

46%

43%

Other

8%

7%

8%

HDD exabytes shipped

Mass capacity

47.2

63.9

71.3

Legacy

40.2

34.5

35.6

Total

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Seagate: Progress And Regress - Seeking Alpha