2009.04.21 SanDisk Q1 Conference Call

21 April 2009 SanDisk Q1 Conference Call

Eli Harari, Chairman of the Board, and CEO
Judy Bruner, Executive Vice President, and Administration & CFO
Sanjay Mehrotra, President, and COO
Jay Iyer, Director of IR

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Jay Iyer, Director of Investor Relations: Thank you and Good afternoon everyone.  Joining us today are Dr. Eli Harari, Chairman and CEO of SanDisk, Sanjay Mehrotra, President and COO, and Judy Bruner, Executive Vice President of Administration and CFO.

[Safe Harbor]

Dr. Eli Harari, Chairman and Chief Executive Officer: Our first quarter results represent a substantial improvement over the prior quarter.  Demand for our products in the first quarter was stronger than expected and is holding up in April.  NAND component pricing trends, which began a U- turn late in the fourth quarter of 2008, have continued to improve in the first quarter and into April.  Our production cutbacks implemented in the first quarter and continuing in the current quarter, combined with the successful completion of the restructuring of our manufacturing joint ventures with Toshiba in the first quarter, are positively impacting our inventory levels and provide us improved flexibility in managing our business back to profitability.  Our product gross margin in Q1 was substantially better than in Q4, and although we are still in negative territory, we
believe gross margin is heading in the right direction in Q2.  Our focus is on returning to profitability and to that end, we have raised prices for Q2 and, of course, our product costs should continue to decline throughout 2009, in particular due to aggressive ramping of our 3-bits per cell (X3) NAND.

A key factor for improved industry fundamentals in Q1 was that substantial Q4 08 losses reported by all NAND suppliers, including ourselves, brought about industry-wide NAND production cutbacks in the first quarter.  With supply coming into better balance with demand, NAND component pricing stabilized and began to rise – a phenomenon the NAND component market has not experienced in recent memory.

Although this downturn is by no means over, things do look and feel better now than at the beginning of the year.  Third party market research firms are forecasting that even if capacity utilization in the industry increases to 100% in the second-half of 2009, industry-wide NAND bit output will grow by 50% to 60% in 2009, compared to 130% and higher in each of the previous five years.

Sharp reductions in 2009 capital investments announced by the major NAND suppliers, including ourselves, reflect the unhealthy state of the NAND business during the last several quarters as cumulative price reductions outstripped cost reductions in each of the past three years.  Additionally, the current scarcity of financing options due to the global credit crunch, coupled with currently negative return on investment is likely to put a damper on the launch of new NAND wafer fabs until business conditions improve substantially.

In the second half of this year, we expect demand for NAND to continue to grow, particularly for mobile and portable computing platforms, and this should hopefully absorb the industry supply growth projected for the second half.  For our own restructured captive supply, we expect to return to full utilization rates in Fabs 3 and 4 in the second half, however our decision on 2nd half utilization rates will depend on actual market conditions this summer, and we have some flexibility to dial it down if necessary.  We expect to start our 32-nanometer wafer production with 2-bits and 3-bits per cell NAND this summer, and we believe that our memory cost structure should remain highly competitive in 2009 and 2010.

As for demand creation, I believe that the handset business is being transformed on a scale similar to that which the web experienced in its early days and this has far-reaching implications for our mobile storage business.  In the US, you need only pick up any major newspaper – or turn on the TV – to see compelling ads by Apple, touting thousands of third party applications for the iPhone.  These evidence the handsets’ transformation into a powerful mobile computer.  And it isn’t only Apple:  RIM’s newly launched app store, the rapid adoption of the Android platform, Palm’s PreTM, Nokia and Microsoft’s roadmaps – all these show what handsets can become – and in large measure have already become.  These smartphones, along with other mobile internet devices, so-called MIDs, and Netbook PC’s, are increasingly ubiquitous, always connected, and often subsidized by your local network operator.

The opportunity for us is that these devices will have to contend with wireless bandwidth and coverage limitations, making offline local caching of increased amounts of data central to the devices usability.  Paradoxically, the promise of ‘always connected’ devices and cloud computing is resulting in ever greater need for local storage on the devices themselves.  Indeed, we are seeing increasing demand from major players in the mobile ecosystem for our comprehensive mobile storage solutions, including mobile cards, embedded iNAND, and solid-state drives (SSD) for netbook PCs.

Speaking of SSDs, we are shipping our 2nd generation modular SSD, known as SanDisk pSSD, to netbook OEM’s and we continue to make good progress with our G3 SSD platform and are on course for OEM customer sampling this summer.

Regarding our license renewal negotiations with Samsung, these are continuing
and there are no further updates at this time.

To summarize, I believe that we are executing well in the current environment, which remains challenging, although improving.  Our decisive actions during the past two quarters have given us strong competitiveness and market focus, greater financial control, and flexibility in our business.  We believe that the mobile and computing storage markets are truly exciting and offer tremendous opportunities for our growth in the years ahead.

I will turn it over to Judy now.

Judy: Thank you Eli. Our first quarter revenue was higher than we had forecasted, driven by stronger than expected demand, primarily in our OEM channels, but also in retail.  First quarter gigabytes sold grew 9% sequentially, with unit sales down 7% from the holiday fourth quarter and average capacity up 18%.  On a year-over-year basis, our unit sales continued to grow, increasing 11%, and with average capacity up 140%, our gigabytes sold grew 166%.  Our first quarter ASP per gigabyte came down 27%, reflecting price declines that were put in place early in Q1 in both OEM and retail channels as well as our focus on monetizing our inventory.  With an improved supply/demand balance, we began raising prices in the first quarter and we expect the positive impact to be primarily felt in the second quarter.

Our retail business made up 59% of first quarter product revenue.  The sequential decline in retail unit sales from Q4 to Q1 was 30%, very similar to the last two years, and contrary to our expectation that the seasonal unit decline would be more pronounced because of deteriorating economic conditions.  On a year-over-year basis, retail unit sales continued to grow, and were up 14%, with growth driven primarily by USB drives.  Our OEM unit sales grew 18% sequentially and 9% year-over-year.  Most of this growth came from microSD cards sold in the mobile market, in particular to mobile network operators.

License and royalty revenue for the first quarter was $71 million, down $50 million from the previous quarter, with the decline due primarily to lower flash memory revenue reported by our licensees in the fourth quarter of 2008.  In addition, our first quarter royalty revenue was negatively impacted by a reconciliation item from a licensee relating to new computations from them for years prior to 2008, which we are currently reviewing.

Non-GAAP product gross loss for Q1 improved considerably from the prior quarter but was still a negative $67 million or -11% of product revenue.  Cost of sales for Q1 included a charge for Q2 planned underutilization of capacity of $63 million, and benefited from a net reduction in inventory reserves of $34 million.

Our improved pricing outlook resulted in new inventory reserves being less than
the reserves released for product sold during Q1.

Non-GAAP operating expenses of $150 million were less than we had forecasted, reflecting successful restructuring and cost containment actions as well as the postponement of certain expenses.  Sales and marketing is the area where we took
the strongest cost reduction actions, and in addition, Q1 included minimal
investments in merchandising and branding.

Non-GAAP Other Income/Expense was an expense of $6 million, in the range we forecasted, including costs related to the joint venture restructuring as well as a final impairment for the disposition of FlashVision’s 200-millimeter equipment. Our GAAP Other Income/Expense was an expense of $19 million and includes a $13 million non-cash interest charge related to the new accounting requirements for cash-settled convertible debt.

Our non-GAAP tax provision for Q1 is a tax benefit of 28%. On a GAAP basis,
we are not benefiting our U.S. tax losses so our GAAP tax provision primarily
reflects taxes owed in profitable foreign jurisdictions.

On the balance sheet, cash and short and long-term liquid investments decreased sequentially by $154 million to $2.38 billion.  Cashflow from operations was a negative $(114) million including receipt of a tax refund of $179 million, received one quarter earlier than expected.  We still expect to receive approximately another $60 million tax refund later in the year.  The usage of cash by operating activities, which was $(293) million before the tax refund, was influenced by a paydown of accounts payable by $183 million as we reduced expenses, capex, and wafer starts.

Cashflow used in capex-related investing was a net of minus $(52) million.  Our investments in Flash Partners and Flash Alliance are very front-end loaded this year, and we invested $(326) million in the joint ventures in Q1 leaving us with no more than $100 million to be invested during the remainder of 2009.  We received $277 million from the joint venture restructuring, and $13 million related to the closure of the 200-millimeter FlashVision joint venture.  Non-fab related capex investments were $(16) million.

Our inventory balance declined by $46 million, driven primarily by strong memory cost reduction. We are pleased that net inventory dollars came down even after a reduction in inventory reserves.

A significant accomplishment in Q1 was the reduction of our off-balance sheet equipment lease obligations, which now stand at $1.2 billion, down from $2.1 billion at the end of Q4.  This reduction in off-balance sheet obligations reflects the transfer of leases to Toshiba, regular lease payments made by us, and the depreciation of the yen to the dollar.

The dollar amount of long-term convertible debt on our balance sheet was reduced due to the restatement required for the new accounting pronouncement for cash-settled convertibles.  This new accounting required adjusting our income statement and balance sheet results from the initial issuance of the convertible debt in May 2006 through 2008.  In addition, we have moved $75 million of convertible debt to current liabilities.  This debt was assumed in the acquisition of msystems and the debt holders have a call right in March 2010.

I’ll now turn to forward-looking commentary. Please note that non-GAAP to GAAP reconciliation tables are posted on our website for all applicable guidance.

We are forecasting stable to slightly higher pricing for Q2 relative to Q1.  Higher pricing may reduce the typical growth we have seen in the second quarter in unit demand and average capacity, however, the restructuring of our captive supply allows us to more effectively balance profitability and volume.  We are forecasting total revenue for Q2 between $650 and $725 million, including license and royalty revenue between $85 and $95 million.

Our Q2 non-GAAP product gross margin should continue to improve based on stable to slightly higher pricing and reduced product costs, although this will be partially offset by more expensive Yen-based wafer purchases, primarily from late Q4 and early Q1, that will be reflected in Q2 cost of sales.  The Q2 product gross margin will also be influenced by the 2nd half pricing outlook when we get to the end of Q2.  If the 2nd half pricing outlook at that time is for continued benign pricing, then there should be little need for new inventory reserves, and existing lower of cost or market inventory reserves will be released as the inventory is sold.  In such a scenario, we would expect slightly positive product gross margin in the second quarter.

We forecast Q2 non-GAAP operating expenses between $170 and $180 million, including the delay of certain expenditures from Q1 to Q2 as well as higher retail merchandising costs for Q2.  For the full year, we are now expecting operating expenses to be between $700 and $725 million, down from our previous $750 million guidance.  We expect other income & expense for Q2 to be income between $5 and $15 million.

Our total capital investment forecast remains at $500 million for 2009.  Following the $326 million loaned to the joint ventures in Q1, we expect approximately $75 million in Q2 and $25 million in the 2nd half.  Our non-fab capex is expected to be approximately $75 million for the year.

We expect a modest decline in our overall cash balance in Q2. Q2 will not benefit from the large cash inflows that we received in Q1, namely the JV restructuring and the tax refund, however we expect the underlying cash usage from operations and capital investing to be less in Q2 than in Q1.  Maintaining balance sheet strength, while also improving the bottom line, remain key priorities.

We’ll now open the call for your questions.

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Question-and-Answer Session

Daniel Berenbaum, Auriga USA: Yes, thanks for taking my call. Judy, when you are talking about pricing, obviously pricing has been firming when you talk about pricing going up in Q2, are you talking, just to clarify, are you talking essentially about product pricing and what’s happening to pricing on a per megabit basis?

Judy Bruner: I’m talking about SanDisk’s product, average ASP per gigabyte for our  products that we are expecting that average ASP per gigabyte to be stable to slightly up in Q2.

Daniel Berenbaum, Auriga USA: Okay. And, just out of curious, so that hasn’t happened for quite a while back in my model.

Judy Bruner: That’s right.

Daniel Berenbaum, Auriga USA: When can you recall the last and that happened on a per megabyte basis per gigabyte basis?

Judy Bruner: I don’t believe that it’s happened while I have been here for five years.[laughter]

Daniel Berenbaum, Auriga USA: Okay.

Eli Harari: I have been here 21 years I’m trying to remember. [laughter]

Daniel Berenbaum, Auriga USA: So you would then characterize this as the best pricing environment you’ve seen a while. OK. And then along those lines, can you talk about [pause]

Eli Harari: But let’s say, the pricing is still not very good, quite honestly. I mean the pricing is, I mean, we are still reporting negative margins.

Judy Bruner: We would like to see several quarters of benign pricing to get our P&L healthy again.

Daniel Berenbaum, Auriga USA: Right. So then along those lines, it seems like cost reduction in the quarter was quite good again, by my calculations was the best you have seen in at least a couple of years. Can you give us guidance for a full year cost reduction, and then also, since megabit shipments were up in Q1, which again I have to go back to ’06 to see an up Q1 megabit shipments I think, where do you think that your megabyte shipments are going to be for the full year?

Judy Bruner: You are right, that our cost reduction in Q1 was very good. And it was largely the result of seeing the benefit of transition to 43 nanometer in 2008, which then begins to roll through our cost of sales in 2009. We still expect our overall cost reduction on a cost per bit basis to be in the range of 40% to 50% for 2009, that’s a range that we gave on our last conference call. And you are also right, that the 9% increase in bit sales in Q1 is very good, compared to [Eli cuts in]

Eli: Particularly given the outlook at the beginning of the year, you know with the economic meltdown. This was quite surprising to us. Really, it’s actually quite stunning.

Judy Bruner: But I would tell you, we are not prepared to give a full year bit growth guidance in terms of revenue. I will say that in 2008, our bit growth in sales was 125%. In Q1 ‘09 it was a 166% on a year-over-year basis. And clearly we expect our bit growth in sales this year, 2009, to be quite a bit ahead of our supply growth in bits. And that’s what’s helping our business get healthier again.

Daniel Berenbaum, Auriga USA: And then you would expect what would your bit growth in terms of supply? Can you give a projection for that?

Judy Bruner: It will be less than 50% this year.

Daniel Berenbaum, Auriga USA: Still less than 50%. Okay, thanks very much.

Eli Harari: That’s supply, new supply, but we started the year with a high inventory.

Judy Bruner: Sure. We have inventory, we had started the year with high inventory. We still have more inventory then we would like and that’s what is enabling us to achieve much higher bit growth in revenue than the supply growth.

Daniel Berenbaum, Auriga USA: Okay great. Thanks very much.

Gary Hsueh, Oppenheimer & Co.: Great. Thank you. With better visibility and as you said indications of a more benign pricing environment, I mean does it still make sense here to consider an equity offering, that’s still prudent to raise cash, at the expense of a 12% to 20% shareholder dilution, with better expectation for cash flow and pricing and profitability here in Q2 and in the second half?

Judy Bruner: We’ve not made any definitive plans in terms of a capital raise. As you know, we have our shelf in place and we can move quickly, if we believe there is an appropriate opportunity. But at this point, we’ve not made any definitive plans. We are watching the markets and we’re watching our own results very carefully.

Gary Hsueh, Oppenheimer & Co.: Okay.

Eli Harari: And we are very sensitized to the dilution issue.

Gary Hsueh, Oppenheimer & Co.: Okay. But its not fair to characterize the situation by saying the probability of its happening now, is a little bit less, given better results and more benign pricing?

Judy Bruner: There is a lot of factors that will weigh into any decision that we should make and again, we are watching everything very carefully.

Gary Hsueh, Oppenheimer & Co.: Okay, understood. Second question here on products. Could you help me understand how the company is stepping through the product cycle, here and going from MLC to the x3 and eventually the x4 architecture?

You talk about commercialization, can you update us on prospects for commercialization for the x3 in the second half. And is that expected to occur more on the OEM side or more on the retail side? And if you could explain like-for-like coming from MLC, what the impact could be on gross margin. I understand at least on the management side, x3, x4 requires a lot heavier hand in terms of management like ECC and block management, so, I am just wondering if increasing management in DSP needs is going to start to impact on the negative side gross margin on some of those products.

Sanjay Mehrotra: Hi, this is Sanjay, and I’m going to question here. With respect to x3, we are actually very pleased with the progress that we are making on the ramp of production. If you recall, last quarter I reported that in Q4 we had about 15% of our bit production in x3 and that has continued to increase in the first quarter. We have about 25% of our bit production in x3 in first quarter and our goal is to have about 50% of total bits produced in 3-bits and 4-bits in 2009 and we are on track for that.

With respect to 4-bit-per cell, we have said that we would be introducing this in mid this year. We are on schedule for that. The production output of 4-bit per cell will likely be relatively small compared to 3-bit per cell. And as we get into 32 nanometer technology, it is likely that compared to 2 bits and 3 bits per cell, it will become even smaller. The cost benefits of 3 bits per cell by a product level is in the range of 15% to 20% over 2 bits per cell and for 4 bits per cell obviously, it will be compared to 3 bit per cell, it will be a smaller percentage. Hence, overall basically for x3 doing well and we plan to apply it to all of our products actually we have already been shipping it in our retail products, as well as our OEM products.

x4 will be shipping in certain limited applications because x4 is a more challenging technology, and it’s suitability for applications tends to be more in somewhat lower performance products such as our blue label cards, and that’s where we plan to introduce it first.

Gary Hsueh, Oppenheimer & Co.: Okay. So let me get this straight. So, the transition from MLC to x3 is pretty much transparent with the added benefit of 15% to 20% cost savings, but the transition from x3 to x4 is a little bit more niche oriented?

Sanjay Mehrotra: Yes, but in the products that we apply it, x3 and x4, we make sure that those technologies are transparent to the user. So x4, the product that we are trying to apply it to, it will be transparent to user in those products. And we would also add regarding controllers, certainly when you add 3 bit per cell and 4 bit per cell technologies into product requires significant level of controller sophistication. And 4 bit etc and SanDisk has expertise over last 20 years. Developing that we have best position in terms of commercializing these technologies. And from a controller point of view, the cost is really not significant in terms of 3 bit per cell or 4 bit per cell products.

Gary Hsueh, Oppenheimer & Co.: Okay, perfect.

Eli Harari: I Just wanted to add one thing and that is that, as far as the cost reduction number that Judy gave you the 40 to 50% for 2009. If you add that to what Sanjay just said, you could see that x3 is a very important component of our cost reduction effort for 2009 and for that reason we believe very strongly that x3 technology is pretty fundamental, pretty crucial for the entire NAND flash industry to be able to continue aggressive cost reductions.

Gary Hsueh, Oppenheimer & Co.: Great. Great, thanks Eli.

Jim Covello, Goldman Sachs: Thanks, good evening. I appreciate the chance to ask a couple of questions. First, I guess on the comment, Judy, about the recalculation from one of the licensees, could you give us a little more detail about that and when that might get resolved?

Judy Bruner: I would tell you that our license agreements are fairly complex, they require some complex calculations and in this case, the licensee believes that they incorrectly computed, license payments for several years prior to 2008. We have not recognized revenue for this amount and its being reviewed, but I can’t give you anything really beyond that.

Jim Covello, Goldman Sachs: Is the number that you’ve recognized in Q1 reflective of some sort of catch up, or is it that that’s what the lower rate would reflect?

Judy Bruner: What we recognized in Q1 is net of the total amount of the reconciliation item.

Jim Covello, Goldman Sachs: Okay, okay. If I can ask then maybe about the Japanese rating agency, what kind of dialog do you have with them? How much of an issue with this, with the business prospects looking much better, do you feel a lot more comfortable that there isn’t a ratings downgrade issue there, or did you never feel that that was much of a threat, or did they have more of a backward looking view as opposed to a forward-looking view?

Judy Bruner: We have a pretty regular dialog with the rating agency in Japan. We meet with them either in person or by phone typically quarterly and they look carefully at our results every quarter. I am sure they’ll look carefully at the results we just announced today. I would tell you generally I believe our results are better than what third parties were expecting, but I can’t speak for the rating agency.

Jim Covello, Goldman Sachs: Okay, great. If I could just ask one or two more. Relative to the very low CapEx level in the back half of this year. I understand the comments about further cost reductions in the second half of 2009 that’s really a reflection of what you’ve spent up until now, but will you be able to reduce cost significantly in 2010, if with the very low level of CapEx in the second half of 2009 or said another way when you run out of the ability to reduce costs without starting to crank up the CapEx engine again?

Judy Bruner: Well. Let me just comment on one thing there, and then I will turn it over to Sanjay. Recognize that the cash that we spend on CapEx is actually lagged from when the investments are made. This is the way the joint ventures operate and so we will be investing in equipment. And the fact, in 2009 for the transition to 32 nanometer and much of that will end up getting paid for in 2010, just as what we just paid for in Q1 was largely for equipment that was installed in 2008.

Jim Covello, Goldman Sachs: Okay. So the lower CapEx isn’t necessarily reflective of what you are ordering or what the technology transitions would be?

Judy Bruner: It is. The 500 million a year, is an approximate run rate when we are not adding new wafer capacity. It’s just that the payment for the different technology transitions lags when the investment is really made.

Jim Covello, Goldman Sachs: Okay.

Sanjay Mehrotra: The basic cost reduction, I just to add that for 2010, the main driver of cost reduction would be of course continuing to use the 3-bits-per-cell technology in production, but also transitioning to 32 nanometer technology. Just like in 2009, we are getting the full benefit of transitioning to 43 nanometer, as well as x3. 2010, the cost benefit will come from 32 nanometer transition, which will begin mid this year in terms of wafer starts.

Jim Covello, Goldman Sachs: Okay.

Eli Harrari: Jim, let me also add to what Judy was saying. And I said that in the last quarterly earnings conference call, the 32 nanometer equipment set is not much more [expensive] than the 43 nanometer equipment set, because they are so close together. The equipment set that we have in place for 43 nanometer can cover most of the process steps for 32 nanometer. And therefore the additional CapEx required is not like starting a clean wafer start, it’s actually just an enhancement. It’s a very cost effective, CapEx utilization going from 43 nanometer to 32 nanometer.

Jim Covello, Goldman Sachs: That’s very helpful. Final question, then I will go away. In terms of restarting the fabs, I heard what you said, but it was, what would be the barrier to restarting the fabs in Q2, why, given that things are little bit better now, I wouldn’t you restart the fabs in Q2, given the delay between when you’re going to restart the fabs and when you’re actually going to get some product out? Thank you so much.

Sanjay Mehrotra: So, we indicated that our utilization rate in second quarter is somewhat higher than Q1. And we’ve also indicated that in the second half of the year we plan to be at 100% utilization of course. The wafer starts for that timeframe are not logged in and yet, we can always adjust their timing back down, also as Judy indicated that we are meeting our increases in demand projection through of course increases in our new supply, but also continuing to utilize our inventory to sell the products. So with all of that, we feel that the utilization rate in Q2, is at the right level for our business.

Eli Harrari: I think also it’s important not to honestly jump too far ahead of ourselves. One quarter is just one quarter. We really need to see a trend developing over the next several quarters. So I think caution is important. Conservatism is, I think, well placed.

Jim Covello, Goldman Sachs: Thank you so much.

Edwin Mok, Needham & Company: Hi, thanks for taking my question and a good quarter. Just a first question is regarding your guidance. If I use the midpoint of high end guidance it seems implied slow(?) bit growth in second quarter. Is it because you guys expect lower bit growth because of higher prices? or can you share some light on that?

Or are you just being conservative?

Judy Bruner: Sure Edwin, as I said in my prepared remarks, we don’t have much experience with this pricing environment, in terms of prices going up. And we do believe that that could dampen somewhat the bit growth that we have seen typically, historically, in second quarters. So that was taken into account.

Edwin Mok, Needham & Company: I see, great. And then my second question is regarding to non-captive. Do you guys have any non-captive supply in the first quarter planned for second quarter or do you expect to have any this year?

Sanjay Mehrotra: We do not have any non-captive supply in the first quarter or second quarter. And at this point, we are not planning non-captive supply for second half. Although, there are demand scenarios that can be envisioned where non-captive supply may be needed towards later in the year.

Edwin Mok, Needham & Company: Great. Thank you all. My first question is regarding, maybe your customer inventory. So first quarter was quite strong, and you guys had positive bit growth in the first quarter. I guess the two-part question. First question, first part is, is it possible that because you have come (?) with lower price in our first quarter, and you guys are raising price your customer maybe building inventory ahead of that. And then, the second part of the question is, is it, have you seen increased bit per cart for your OEM customer, is that drive up demand for the OEM side. Thank you.

Judy Bruner: I would tell you that I don’t think there is anything unusual in terms of the inventory held by our customers. Retail channel inventory is at a very normal level, it was about seven weeks at the end of our first quarter.

Sanjay Mehrotra: As was previously stated, average capacities, which I believe you were asking for for the OEM side as well. So we saw the effect in first quarter nice increase in average capacities both in our OEM business, as well as retail business. And in the OEM business, the average capacity on a per-product basis increased available 100% on a year-over-year basis.

Edwin Mok, Needham & Company: So is it fair to say that OEM costs, historical OEM costs tend to be more than the retailer costs, and is it fair to say that is it catching up right now, is that the trend that you’re looking?

Sanjay Mehrotra: So our average capacity in retail are certainly higher than OEM but yes I mean on the OEM side the rate of increase has been substantial but the retail side the average capacities have continued to increase as well. Retail average capacities have also increased more than 100% on a year-over-year basis.

Edwin Mok, Needham & Company: Great. That’s all I have. Thank you.

Daniel Amir, Lazard Capital Markets: Thanks a lot and congratulations on a good quarter.

Eli Harari: You’re welcome.

Daniel Amir, Lazard Capital Markets: Couple of questions here, Eli maybe this for you. We’ve seen in the past, these occasional price increases, obviously, it’s been the magnitude here it’s been probably a little sharper than previous times. What kind of gives you the confidence that this is different this time and that the memory market is kind of really learned its lesson, and we’re starting to see more of a longer period now maybe potential price stabilization, compared to the ups and downs that we’ve seen maybe in ’06 and ’07 and ’08?

Eli Harari: Good question Daniel, and thank you. I can’t speak for our competitors, of course, I can say that we have learned the lesson of our, if you will, our over investment, over exuberance in 2006 and 2007, it was certain extent of a 2008 and the restructuring that we have accomplished here is very, very good for us to basically rebalance ourselves and resize ourselves, but I would say that the basic fundamentals that are very encouraging is that the industry as a whole has understood that this thing, this continuing price reductions exceeding cost reductions, eventually it makes the whole business such that there is no return on investment, which can justify new capacity increases.

The one big change that we are seeing this year is pretty dramatic reduction in CapEx almost across the board taking us from I think what Judy said, 130% capacity increases last year and more or like 170% per year increase, in every one the prior years, going down to 50% to 60% this year. That is immense. I mean remember when Samsung had a fire like for two days, about three years ago and that was a big blip on the pricing side? And of course that subsided. We are not talking about here a two day production cut. We are talking about six month production cuts and very, very substantial production in total capacity growth coming to the industry in the meantime of course demand continues to grow.

We do have markets, this is not the DRAM industry, there is nothing very dynamic about DRAM and there is plenty dynamic about NAND. I mean NAND is a young industry and tremendous growth that I try to capture with the mobile, with the third-party applications and with SSDs. So, now I do believe that this 60% or so annual price declines are really not sustainable. I’ve said that every one of the last three years and Moore’s Law is definitely slowing down if you do the calculation for 32 nanometer compared to 42/ 43 nanometer you see that it cannot support 60% cost reductions and therefore I think that the fundamentals dictate that if people want to run a profitable business then this needs to be managed to justify a return investment and today’s return of investment is still negative based on today’s pricing.

So I think it’s very encouraging and I believe that really if somebody decided today if the biggest supplier in this market decided today that they are going to pull all the stops and really drive up, it’s still not going to make much of a difference in 2009 and I think we are really talking about, I think a period of return to much better health. But again demand is the key and without demand [pause]. Demand is the one part of the equation that we really don’t have any idea where it’s going to go.

Daniel Amir, Lazard Capital Markets: Okay. Maybe I’ll follow through with that question. Related to the kind of demand and the pricing, how do we look at the SSD market? I mean obviously now pricing has gone up. So that sometimes is counter to the argument of SSD versus hard disk drives. But what you are seeing on the cost front and on the MLC SSD now, when should we start seeing SSD becoming a bigger or an important portion of the NAND market?

Eli Harari: SSD eventually, of course, we’ve always believed, will be a very substantial part of the NAND market, NAND consumption market, but again it’s a question of, it’s got to be profitable in order to justify investment in major production capacity to meet future demand. What is pretty obvious now is that the SSD market is going to be highly segmented. It’s going to have the enterprise space, which by itself will be segmented, the mid range in notebook and desktop PCs and then netbook and niche. And I think each one of these markets are going to have its own dynamics including gross margins and target pricing that’s required to get those markets to really takeoff.

I think the enterprise space, we are already meeting the price requirements even with SLC NAND. We are not there yet with netbooks and notebooks PCs. And we need to be careful that we don’t get too far ahead of ourselves in terms of the euphoria about such a huge market because it really needs to be thought of from the point of view of both meeting the requirements of the market price-wise, but also the requirements for achieving profitability. And we are going to, for ourselves, we are definitely going to prioritize profitability.
Daniel Amir, Lazard Capital Markets: Okay. Thanks a lot.

Vijay Rakesh, Thinkequity: Thank you, guys. Just a couple of questions here, I was wondering, you said that the inventories are coming down in the second quarter, I was wondering what‘s a good number there? and also wondering what your depreciation for the year looks like for ’09 now?

Judy Bruner: Vijay I don’t believe I gave any guidance on inventory for the second quarter. Really it’s hard to predict at this point, whether inventory dollars will go down or go up in the second quarter, a lot depends on demand, as well as on the level of inventory reserves released or taken during the second quarter. So, we don’t have a specific forecast on inventory dollars for the second quarter.

Vijay Rakesh, Thinkequity: Okay.

Judy Bruner: And I am sorry. What was your second question?

Vijay Rakesh, Thinkequity: And what’s your estimated depreciation for the year?

Judy Bruner: Well, you can see in our cash flow statement, the depreciation for the first quarter, which let me just get it for you, was $39 million. So, I think that’s a reasonable run rate on a quarterly basis. We have split out this time [pause] have split out depreciation and amortization. So, those are on two different lines.

Vijay Rakesh, Thinkequity: Got it. My other question was actually ramp 32 nanometer here, what percentage do you think that will be of your output and let’s say in Q2 and going forward into Q3?

Sanjay Mehrotra: So, we have said that 32 nanometer will actually begin with the ramp this year. We are in the stages of qualifying the technology in our products. So, it’s not part of any Q2 bit production and in Q3, it will be a relatively small portion and towards Q4 and toward the end of the year, it’s beginning to start ramping up to meaningful volume.

Vijay Rakesh, Thinkequity: Got it. Okay, thanks a lot guys. Good job.

Paul Coster, JP Morgan: Yes thank you. A few quick questions, the pricing power that you’ve seen very recently, is it extending across all geographies and all products categories uniformly?

Sanjay Mehrotra: Yes, the pricing that we are addressing, we are taking actions in OEM as well as retail and across geographies.

Paul Coster, JP Morgan: Got it. The operating expense reduction was pretty amazing actually. I think you did a brilliant job. What though are the trade-offs, what is it that the firm has had to sacrifice in cutting back so swiftly?

Eli Harari: I think that, we fundamentally maintain all of our strategic initiatives intact. We are doing fewer things, with less resources, using them, those resources, perhaps more focused. We went from individual business unit structure to an OEM organization, and a retail organization in central operations and central engineering, which used to be our organization before the acquisition of msystems. And that really does eliminate a lot of duplicative functions. It’s basically the trade off between being most effective and most efficient. And we are I believe, we are more efficient now. And we simplified our market focus. We have certainly not slowed down in any of our technology, our 3D Read/Write, our 32 and 24 nanometer NAND, 3 and 4 bits per cell and on innovation, product innovation, applications of the technology to decommoditize more and more of our future business.

Paul Coster, JP Morgan: Okay. Judy, you mentioned that there were some inventory reserves. I think they were released in this first quarter. Can you just go back across that and sort of clarify, what if any impacts that had on gross margins?

Judy Bruner: Sure. I said that there was a net release of inventory reserves of $34 million. So, there was a benefit to cost of sales and to gross margins of $34 million. At the same time, I also said there was a charge to cost of sales in the first quarter of $63 million, which is our estimated cost of the fab under utilization in the second quarter. So, those were the two large unusual items in gross margins in the first quarter.

Paul Coster, JP Morgan: Okay, got it. And then finally, I know you stepped away from this, but do you care to predict, what your future, your target gross, products gross, and operating margins are, now? or is it too soon to do that?

Judy Bruner: I’ll tell you, it’s too soon. We are really taking our guidance one quarter at a time at this point.

Paul Coster, JP Morgan: Okay got it. Thank you.

Bob Gujavarty, Deutsche Bank Securities: Hey, thanks for taking my question. Just a follow-up on the charges. If I look at last quarter, you had about $388 million of inventory and under utilization charges. If I do the math correct, if I take the 63 plus the 34 benefit, net, net has dropped to 30, am I doing the math correct?

Judy Bruner: Yes.

Bob Gujavarty, Deutsche Bank Securities: Okay. And then the other question is, what are you anticipating for under utilization charges, obviously they dropped pretty sharply from Q4 to Q1, and Q2 do you think they will drop further?

Judy Bruner: Our current expectation is that, we will most likely utilize the fabs at full capacity in Q3 and Q4. Although, we have not locked that in as Sanjay said. So, if that turns out to be the case, then we would not take an under utilization charge in Q2, because we are taking it one quarter ahead of the planned under utilization, based on that being a firm plan.

Bob Gujavarty, Deutsche Bank Securities: Okay, fair enough. And then just finally on charges, that clearly if pricing is flat to up, since you value inventory on LCM. I would guess the $34 million benefit, you could see a similar type of benefit in your Q2 gross margin, correct?

Judy Bruner: That could be the case. As I said, the gross margins in Q2 will be heavily influenced by the pricing outlook that we have for the second half of the year when we reached the end of Q2.

Bob Gujavarty, Deutsche Bank Securities: Okay. Fair enough. And thanks, that’s it.

Kevin Vassily, Pacific Crest Securities: Yeah. Yeah, hi. Most of my questions have been answered. Can you walk again through the tax benefit that showed up in the quarter? What was the dynamic behind that appearing this quarter?

Judy Bruner: The tax?

Kevin Vassily, Pacific Crest Securities: The tax benefit, yeah.

Judy Bruner: Yeah. I don’t think there is anything too unusual. On a GAAP basis, we have a valuation allowance and we are not recognizing a tax benefit on our U.S. tax losses. However, on a non-GAAP basis, we are continuing to benefit the loss and we took the benefit at a rate of 28%.

Kevin Vassily, Pacific Crest Securities: Something about this quarter that allows you to think the benefit relative to prior quarters where there were losses [Judy cuts in]

Judy Bruner: We took a benefit on a non-GAAP basis last year as well. What’s different is that on a GAAP basis, the size of our loss at the end of 2008 was such that we will require to take a valuation allowance and we are not recognizing a benefit on a GAAP basis, However, on a non-GAAP basis, we are still recognizing a benefit. There is essentially not a rule on this with respect to a non-GAAP financial statement.

Eli Harari: It’s much easier dealing with electrons than with GAAP/ non-GAAP. [laughter]

Kevin Vassily, Pacific Crest Securities: I would agree with that. Thank you. That’s all the questions I have. Thanks.

Judy Bruner: Okay.

Hendi Susanto, Gabelli & Company: Thank you for taking my questions. Could you give us more color on the transition process of going into a mix production of captive versus non-captive? For example, what will be the ideal mix, what kind of timeline can we expect and initially how long may that take, and lastly what kind of gross margin difference can one expect?

Sanjay Mehrotra: So, like we’ve said in the past. It’s our ultimate goal is to get to a captive/ non-captive mix of 70% captive to 80% captive. And in terms of the timeframe to meet these kind of decisions, we are always evaluating that based on our demand projections and our own captive available supply. Typically, it means a lead time of about three to four months to make decisions related to non-captive purchases and the gross margin impact of non-captive purchase on captive is really very much function of the non-captive supply pricing. Obviously, the cost structure of our captive would be much lower than the cost of the non-captive that we will purchase. Again for 2009, we are not really projecting much use of non-captive.

Hendi Susanto, Gabelli & Company: Okay and second question. Could you give us a range of how much Japanese yen currency impact can be in the second quarter?

Judy Bruner: As I said, the cost of the wafers that I expect will be recognized through cost of sales in the second quarter will be more expensive than the cost that was recognized in the first quarter, and that’s because the yen rates were less attractive for us late in Q4 and early in Q1, and that’s my estimate of the timing in terms of the wafers when they were purchased and then ultimately flowing through cost of sales in the second quarter. And it could have several points of impact on gross margins.

Hendi Susanto, Gabelli & Company: Thank you.

Stephen Chin, UBS: Hi, thank you. This is Steve calling on behalf of Uche. Just a follow-up to the prior question, regarding the balance between non-captive and captive supply, so assuming you guys are able to ramp production back to full capacity by Q3 and Q4. And I would assume there is some type of mix of non-captive purchases. However, in terms of any further upside to demand in that case. What would be the plan for building a capacity in the second phase of fab four, first of all? And I guess, secondly what would be the capital that’s available or the means for financing wafer expansion at this point?

Judy Bruner: I would tell you. At this point, we are not thinking about plans for adding wafer capacity. We really want to get our model back to a mixed model of captive and non-captive and in the range of 20% to 30% non-captive, before we really begin to think about, too much about new wafer capacity. So, I would tell you that’s really a question for another day as opposed to today.

Stephen Chin, UBS: Okay. The other question I have was on the flow-through cost of ramping up the 32 nanometer production line. I would assume if your ramp production by Q2 timeframe. Is there going to be a typical impact to R&D first of all and then flowing on to COGS by Q4?

Judy Bruner: I don’t expect any significant impact on R&D and I would tell you in terms of cost benefit given the lag in our business model, the second half of 2009 will be, I believe, more impacted by the increasing mix of x3 versus x2 and the transition to 32 nanometer, we would probably start to see some impact very late in the year and then falling into 2010.

Stephen Chin, UBS: Okay. And lastly just on the potential price increases that was referred to earlier. Is there a limit on how much you can raise pricing both in the OEM and retail channel under your contracts?

Sanjay Mehrotra: So remember we are always trying to balance our profitability objectives with our total volume, inventory, et cetera. So this is a careful balance and we are reevaluating it on a regular basis and making adjustments as appropriate.

Stephen Chin, UBS: Okay. Thank you.

Eli Harari: Yes, this is a different model versus the Wal-Mart. [laughs] You can I mean basically with higher prices, you lose market share but you have more profitability and we (?) do so, but any way, I think we’ve been balancing this over the last 20 years and we are very, very focused on getting the profitability. I think we have to wrap it up, really I appreciate you joining us today and look forward to talking to you again during the quarter and next quarter. Thank you.

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