Q4 2009 Wrap

Q4 results were, as expected- a blowout. This Q4 was SanDisk’s best-ever quarter for product revenue, margins, and cash flow. Revenues/ EPS came in $1.24 billion/ $1.18 vs consensus $1.16 billion/$0.68.

The full Q4 2009 cc transcript can be found here.

Q4 Numbers

A few items jump out.

Product gross margins @ 36%- are right where they need to be.

Cash flow was great. SanDisk has morphed into a cash machine. Free-cash-flow for Q4 was $431 million.

Operating expenses appear to be under control- down 25% in 2009 compared to 2008.

Nothing was wrong with Q4’s EPS. While EPS of $1.18 was helped by $95 million in inventory reserve benefits, this was just frosting on the cake. Without the inventory benefit EPS still would have still been a most healthy $0.92.

Eli’s comments on Q4 numbers:

“ Q4 was our best-ever quarter for product revenue, margins, and cash flow, reflecting a dramatic reversal in our results when compared to the fourth quarter a year ago. Pricing held up well throughout the fourth quarter, and product margins benefitted from a 20% sequential reduction in cost per gigabyte.

A year ago, the fourth quarter of 2008 marked the bottom of the industry down-cycle with all flash memory manufacturers operating at negative margins and reporting heavy losses. By the fourth quarter of 2009, all NAND suppliers, including ourselves, were reporting vastly improved results, partly resulting from production cutbacks in the first half of 2009. Despite the recession, global demand for NAND flash continued to grow, and by the second half of 2009 flash manufacturers returned to 100% capacity utilization. This turnaround happened considerably more rapidly than expected, demonstrating the remarkable ability of this young industry to self-correct: that is an important factor that we have discussed with you in the past.”

Judy’s comments on Q4 numbers:

“ Our fourth quarter results reflected strong growth in both OEM and retail channels, with retail revenue up 41% and OEM revenue up 40% sequentially. OEM represented 56% of our fourth quarter product revenue, the same proportion as in the third quarter, and for the year, our product revenue was equally balanced at a 50/50 mix of retail and OEM.

Our fourth quarter retail revenue was down 6% year-over-year, with the decline due primarily to increasing amounts of our mobile business going through mobile network operator stores that we now count as OEM. Our fourth quarter OEM revenue was up 215% year-over-year, with the mix from the mobile market increasing to more than 80% of our OEM revenue.

Our total fourth quarter product revenue grew 54% year-over-year with units up 55%, ASP per gigabyte down 23% and average capacity up 29%. On a sequential basis, our ASP per gigabyte declined 2%, and our total average capacity was up 18%, driven primarily by the OEM mobile product mix.

License and Royalty revenue of $100 million in the fourth quarter included Samsung royalties based half on the old license agreement and half on the new license agreement.

Q4 Product gross margin of 44% on a GAAP basis and 45% on a non-GAAP basis was higher than we had anticipated due to less price decline and stronger cost reduction, which was 20% per gigabyte. In addition, we received a higher than expected benefit of $95 million from selling products which carried previously taken reserves. The reserve benefit came primarily from lower-of-cost-or-market reserves taken on inventory built in 2008, but also reflected the sale of inventory that had been reserved as excess or obsolete. Without these inventory reserve benefits, our underlying product gross margin was 36%, a level that generates strong profitability on our product business and a very good return on invested capital…

On the balance sheet, cash and short and long-term liquid investments increased sequentially by $432 million to $3.0 billion. Fourth quarter cash flow from operations was the highest ever in a single quarter at $388 million, and free-cash-flow was even higher at $431 million. Cash flow from investing included a $57 million receipt of excess cash from the Flash Partners joint venture, zero outgoing capital payments to the joint ventures and a modest outflow for property & equipment.”

It’s also worth noting that license and royalty revenue was a healthy $100 million and inventory has returned to normal levels.

Guidance

2010 is shaping up as a nicely profitable year for SanDisk. Factoring in SanDisk’s penchant for conservative guidance, 2010 could well end up as a very profitable year.

How profitable SanDisk’s year will be will come down to product gross margins and the strength of NAND pricing.

Judy on guidance:

“We are expecting a normal level of seasonally reduced demand in the first quarter, coupled with the impact of Q1 being a regular 13-week quarter compared to our 14-week Q4. We are forecasting total revenue for Q1 between $875 million and $950 million, which includes license and royalty revenue between $80 and $90 million, fully reflecting the new Samsung license agreement. For the full year 2010, we forecast total revenue between $4.0 and $4.4 billion, including license and royalty revenue between $320 and $360 million.

Turning to gross margin, we expect that first quarter cost decline may be a bit less than price decline as we expect more modest cost decline in Q1 than we generated in the previous two consecutive quarters of very strong cost reduction. For the full year 2010, we expect that the annual cost decline which Eli estimated at 30% to 40% will be greater than the annual price decline, allowing product gross margin to expand from our 2009 underlying product gross margin which was in the teens on a full year basis. We are forecasting a non-GAAP product gross margin for Q1 and for the full year of approximately 31%, plus or minus 3 percentage points.”

Doing the math, given SanDisk’s guidance, 2010 EPS should come in roughly between $1.80 and $2.90. Given SanDisk conservatism, I wouldn’t be surprised by $3.00. If NAND supply remains very tight and NAND price declines are minimal, I suppose SanDisk could hit $4.00- but that’s probably pushing it.

SSDs

SSDs are the looming story. SanDisk had a few things to say in the cc. I expect we will get a lot more color at the investor’s day on February 26.

Eli on SSDs:

“Solid-state drives (SSD) are making well publicized inroads in enterprise storage and we believe it is only a matter of time before the tipping point is reached for the broader adoption of Flash SSD in notebook and netbook PC’s. The iPAD, as well as the Kindle, are already past that tipping point, as these class of devices are very thin and are required to deliver long operating time on a battery charge, therefore doing away altogether with rotating disk drives or DVD players, and relying exclusively on NAND flash for mass storage.”

and from Q&A:

“ Eli Harari: I think if you look again at the iPad, iPad is a very thin product. It’s designed absolutely to operate with flash memory. 64 gigabyte storage, no way that it can support a hard disk drive and of course doesn’t have a DVD and I think that there is a whole class of devices like this, where consumers will appreciate the other attributes of flash memory in terms of very low power, it’s very responsive, you know tremendous responsiveness, and small form factor to pay the premium.

If you look at the iPad price quote going from 32 gigabyte to 64 gigabyte- a $100 incremental cost to the consumer, which is not that much, that still translates to about $3.00 per gigabyte and I would kind of venture to bet my annual salary that there will be a big number of customers that want 64 gigabyte at $3.00 per gigabyte- and yet you hear a lot of people saying need $0.50 per gigabyte in order for SSD to take off.

I think when SSD becomes commoditized- yes it will need to be playing at these price ranges, but we have tremendous opportunities over the next several years.

But to answer your question I think this is an ongoing process, I’ve said the enterprise of course is already willing to pay the additional cost per gigabyte of flash. And I think that by the end of this year and certainly into 2011, we are going to see more and more notebook computers and people asking and being willing to pay a lot more than $0.50 per gigabyte.

And of course within two years we ought to be able to reach the $1.00 per gigabyte and I think that will be another important, I don’t want to say tipping point, but another important milestone for SSD adoption. In the mean time the SSDs are getting much, much better for us as well as for competitors and I think that this is a market that’s here to stay and its going to go on becoming very important part. By 2012, I have seen some estimates that this will be, that SSDs will consume maybe 15% to 20% of the total NAND bit output and I think that that’s about [pause] I am comfortable with that kind of range of numbers.”

For those that like word counts, Eli mentioned Apple’s iPad five times in the conference call- each time unprompted. One reason for Eli’s iPad SSD commentary, may be SanDisk is selling product to Apple for the iPad.

Another reason may be that Eli wants to make the point that the definition of what an SSD is needs be expanded. I’m inclined to agree.

It was also interesting and promising that SanDisk believes that (SanDisk/Toshiba) X3 will be viable for SSDs:

“ Uche Orji, UBS: I see. In terms of the acceptance of the 3 bit per cell you cannot, the way you”ve described it, it sounds like there has been no problem in terms of the performance of those cards in the marketplace. When should we expect that this could be good enough to use in things like SSD like X3 cards now? X3 products in things like SSD. Are there any issues why they’re not being used in those kinds of products or just controller-related issues?

Eli Harari: The industry is just basically this year moving from SLC, single bit to MLC, 2 bits per cell. Because the birth pains of this product in a very, very challenging kind of application environment that we have talked about in the past. We believe that it will require very substantial understanding, very powerful understanding if you will, of system level expertise including not just ECC but all kinds of algorithms that we have developed and perfected over the last few years to make SSD, to make it possible to work from, sorry, 3 bits per cell into SSD and that eventually it could become a very important element of that.

Now that may not apply, let’s say for enterprise drives where SSD drives where performance is very, very important, but as far as handling things like endurance and read and write speed, I think that eventually we will be able to achieve market requirements in SSD with a 3 bit per cell but it is still to be proven. Our first focus this year is really on commercializing our third generation, G3, 2 bits per cell MLC and this is really our key focus.”

The following comments on X3 seem most relevant given the recent reports that Intel/Micron have ceased production of their X3:

“ Bob Gujavarty, Deutsche Bank Securities: Great. And if I could just, one final quick one, you mentioned in the last conference call, given your lead in 3 bit per cell, you’re able to kind of sell the lower cost product at the equivalent 2 bit per cell ASP and that’s good for SanDisk. Is that trend continuing for you?

Sanjay Mehrotra: Yes. Basically what we have said was that implementation of 3 bit per cell technology in our products is officially seamless from the point of view of the consumer. The consumer cannot really tell the different difference between a 3 bit per cell and 2 bit per cell. And therefore in pricing our products we generally don”t have a difference between 2 bit and 3 bit per cell.

Eli Harari: But I would like to add that we do believe that not all X3 is made equal and that our expertise in systems and controllers and providing the complete solution and the fact that we are now in our third generation X3 technology that makes a difference. And that the fact that our X3 products are transparent to the user is because we have learned how to manufacture these to design those to have basically equivalent performance to X2.

That’s not the case of what we see in the market for some of our competitors and this is very similar to the early days of MLC, 2 bits per cell, when our competitors were having some difficulty matching our performance with MLC, and therefore, during that transition period portrayed MLC at the time, in fact the same applies to X3 today, as somehow not up to par with 2 bits per cell. We don’t agree with that.”

****

SanDisk sold off following earnings. Media consensus seems to be that this was due to a “disappointing outlook.” Personally I’m more inclined to lay most of the so-called blame, to the broad tech sell-off.

If reports are to be believed some deep pocketed folks were betting against SanDisk and did what they could. Nothing new there.

That said, SanDisk is going to have to prove that it can play the profitability game. So far so good in 2010. NAND pricing continues strong. Apple’s iPad is only helping.

From the Bank of America/ Merrill Lynch DRAM/NAND report of 26 January:

“Tablet PC will likely spur new NAND demand worth $1bn

Apple’s new tablet PC (thought to be named iPad) is now expected to create fresh NAND demand worth at least US$1bn a year (10mn units of tablet PC x about $100 NAND cost per unit to have about 64GB SSD). This represents about 6% of our current global forecast for the NAND industry for 2010 (ex-tablet PC impact). Netbook PC (mainly for low-end PC applications) that uses only 10-20GB SSD has not been a big catalyst behind NAND demand in the past two years. Ironically, most netbook and small notebook PCs, even those from Asus, Samsung and Toshiba, have been based on HDD rather than NAND so far.”

I had hoped to get to Fab 5 today, but that is going to have to wait.

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