2009.05.18 JPMorgan

18 May 2009 JPMorgan

JPMorgan Technology, Media & Telecom Conference

Paul Coster, Analyst, JPMorgan
Dr. Eli Harari, Founder, Chairman and Chief Executive Officer

Management Discussion Section

Paul Coster: Okay. Let’s get started. My name is Paul Coster. I’m the Senior Analyst at JPMorgan covering Applied Technologies. It’s my great pleasure to have Eli Harari here today the CEO, Founder, Chairman as well of SanDisk. This time last year this was one of the most interesting sessions. In some ways it kind of denoted a turning point for everyone. It wasn’t a good turning point. Lets hope this year it is a little bit different. Eli, welcome back.

Eli Harari: Thank you, Paul. Good. I am – my legal people tell me I have to read this first, since this is webcast. During our discussion today, I will be making forward-looking statements. Any statement that refers to expectations, projections, or other characteristics of future events or circumstances is a forward-looking statement. Actual results may differ materially from those expressed in those forward-looking statements, including due to the factors detailed under the caption “Risk Factors” and elsewhere in the documents we file from time to time with the SEC, including our Annual and Quarterly Reports. SanDisk undertakes no obligation to update these forward-looking statements, which speak only as of the date hereof.

So welcome here, it’s a pleasure to be here with you, Paul. I just want to make a few remarks. Overall, our first quarter was significantly better than our expectations and I think the street’s expectations. I would say that today our mood is – remains cautiously optimistic. Caution from the point of view of the global economy. That really is not under our control and therefore impacts consumer confidence, but optimistic from the point of view of the things that are under our control, where we think that we’re executing very well. SanDisk is doing a very good job, in my opinion, and I think the outlook for us and for the industry over the next several years, I believe, is quite positive. Actually, very positive. So overall, I would say cautiously optimistic and we can talk some more about it.

Over the last six months, we, SanDisk have taken very aggressive steps to control our own destiny. We’ve dramatically reduced our capital equipment investment- CapEx. We’ll be spending about $500 million total this year, most of that has already been spent in the first quarter and mostly used for technology transition to the 32 nanometer technology. We’ve restructured our manufacturing joint venture agreement with Toshiba which reduced our lease line obligations from $2.1 billion to $1.2 billion, which dramatically strengthens our balance sheet.

We have restructured the company, and have became much more focused on the OEM and retail operations and that’s beginning to show in terms of tremendous focus on specific customers. Also, our OpEx has come down very dramatically because of eliminating duplication. And we’re doing very well on our technology. We are significantly ahead of competition with 3-bits-per-cell, X3, on 43 nanometer, and starting this summer the transition to 32 nanometer. So our cost structure, our expense structure and our capital structure are very very much in line with what we see as the current environment, and are very pleased with the rapidity with which we executed that.

In terms of the market opportunities, we continue to see mobile as an emerging market with huge opportunities for us. We think that this market really is the – going to be the main driver for flash consumption, and I can talk some more about that today. Of course, the solid state disk is an area of interest to everybody, including ourselves, and of course there’s the legacy consumer electronic business.

As far as the industry health in general, I think the industry has had three years of exuberant investment. Paul, you can – you probably have better numbers- but I would say, probably over the last three years, total CapEx invested in NAND flash manufacturing by all players is probably in the range of around $30 billion, three-zero billion dollars. And that has brought a situation of excess supply, excess inventories and plunging pricing- 60% a year for the last three years, which brought everybody down to our knees- frankly an unprofitable operation for all players.

I think the current liquidity crunch and the current [pause] where the industry is, I think, is very, very good for the next three years. If you look at the – this is not just a classical cycle, industry cycle for flash. I think the fact that there is such a great liquidity crunch and, today, lack of return on investment on NAND manufacturing, that bodes very well for the next, I’d say, one to three years in terms of the industry going back to that mode of exuberant CapEx investment.

And coupled with the fact that there’s a lag time between the time that you make the investment and the time it actually hits the market. I think the entrenched players are going to do, in my opinion, quite well over the next one to three years. And this is really cause for significant optimism because I do believe that the underlying markets, both mobil,e computing and consumer electronics are going to continue steady growth through the next three years.

So the outlook, if you go to 30,000 feet as opposed to 300 feet, 300 feet is what’s today’s spot price, 30,000 feet is what is the market outlook for the industry over the next one to three years. At 300 feet, the spot price goes up and down, not that it’s not important, it is important but over the long scheme, it’s the 30,000 feet view that is actually quite positive.

Q&A

Paul Coster: When you say the next one to three years, you feel like this is going to be a good cycle for the industry. What are your criteria there, though? I mean at the moment we’ve got a pretty low hurdle to cross, which is just getting back to product profitability. Is it just – is that the criterion for success for the industry, that the gross margins for the product business are positive again, or is it some real return on caps or you think now that the whole industry is aiming at?

Eli Harari: First things first. First thing is we’ve got to get profitability. Without profit there is no future and there’s definitely no investment. But profit by itself for one quarter or two quarters is not enough. The industry really needs to get to a situation of stable profit, stable growth and where return on investment, looking forward several years out, justifies the $5 billion-type pop that you need to put in a new fab.

We have new management at Toshiba, a new CEO just stepped in, and one of the first pronouncements that he made was that he is going to cut semi-conductor CapEx by about half. We have new management at Samsung that has indicated a tremendous return back to focus on profitability. We – everybody is cutting back and I don’t think it’s just a temporary thing. But, I mean, the liquidity is one thing that is different in this cycle, and a liquidity crunch is one element that is different this cycle than in previous cycles. Nobody is out there that’s going to give you $5 billion to start a new fab unless the return on investment is there, and for that you need to have certainty about the technology, about your cost structure, about your competitors’ cost structures and, of course, the growth of the markets.

We’re pretty confident about the growth of the future markets and we’re pretty confident about our competitiveness in that market. But clearly, our own direction is to not add a substantial amount of new capacity ourselves. To the extent that we are going to invest in the future, it’s going to be more in technology transitions, definitely in differentiation adding future star products, creating new markets, and trying to move more and more to a captive/non-captive mode where we can purchase some – become a consumer of other people’s flash rather than create excess supply.

Paul Coster: I know 8 inch capacity’s been retired and that’s definitely gone, but for the more contemporary fabs isn’t there a lot of spare capacity out there and the moment we get positive gross margins again, isn’t there a risk that people do the sort of the more incremental-type capital investments, ramping up at 30X nanometer at MLC, and we get another splurge of capacity coming on line in maybe late this year or early next year?

Just can you talk through that risk and why you think it’s now mitigated?

Eli Harari: We are assuming that everyone will be one at 100% production capacity, with the existing capacity, in the second half of the year.

And most of that will be directed to 40 and 32 nanometer transitions, but there is no new capacity that is coming on stream, not that anybody has announced. And certainly, any announcement of a new fab will take 18 months to make any impact. So this year, I think Gartner has projected that if everybody goes back to 100% utilization, the growth in bits this year will be between 50 and 60% above last year. That is much, much less than in any one of the previous years. We’ve said that our own growth this year, going back to 100% of our utilization, will give us less than 50% increase in bits. And that’s very good for us; it allows us to manage our inventory, it allows us to walk away from business that is unprofitable and really start to managing for profitability.

Paul Coster: Now on the demand side, do you think mobile phones will be the key driver near-term? And I think it’s over 20, it’s nearly 30% of total NAND goes into the mobile phone market already. Smart phones, though, interestingly our Asia team observed that many of them are not very NAND intensive day one, with the exception, of course, is the Apple which I think consumes about 3 to 4% of the entire industry’s capacity. Where is this growth going to come from on the mobile phone side?

Eli Harari: The iPhone is truly a revolutionary product and it’s changing the way the handset manufacturers are thinking about handsets and the way the network operators are thinking about where their profitability is going to – how they’re going to avoid down points. We have not yet seen, really, the true response of the industry to the iPhone, with the exception of a little bit of the beginning with BlackBerry.

Paul Coster: Which currently has about, like, 500 megabytes of NAND on it and I think.
Is that correct?

Eli Harari: Well.

Paul Coster: Yeah; at the moment anyway.

Eli Harari: The kind of services and the kind of content that will be offered on competing products that we are aware of, that we are seeing that have phenomenal amount of innovation that will match, in many respects, Apple and in some areas actually do a better job than the iPhone, will absolutely drive capacity to the 16, 32 gigabyte in the next one to two years. I think it’s going to start happening in the next six months. But when you take a look at what it takes to store all those third party applications that everybody is emulating the iPhone very, very quickly.

It’s a computer and you can’t run a computer on a gigabyte of storage. So when the prices went down – went up this last most recent, the last, the first quarter pricing – contract pricing and spot pricing going up by about double, the immediate reaction of the handset guys is to say, whatever bundled capacity in cards I have, I have a certain bill of material, budget, I’m going to go from a 2 gigabyte to a 1 gigabyte or 4 gigabyte down to 2-gigabyte to get it out the door; but if you talk to the Verizon or Vodafone network guys, they’re going to drive to sell you in the aftermarket much higher capacity cards because they want to sell you services, and they want to sell you games and they want to sell you maps and so on. So we straddle both sides. We see what happens at the handsets side and what happens on the retail aftermarket side, and overall the picture is quite positive.

Paul Coster: So momentum is very positive. I think many investors are asking themselves what is the true earnings power of this company; and you’ve made a compromise to the business model. You’ve basically cut back on the JV and, of course, that’s serving you well during these tougher times now.

But as things start to ramp, it’s conceivable that you’re sort of taking away a little bit of the up side now, obviously by having – once the market gets tight you’re going to be going to third parties for some of your NAND supply. That will be a nice problem to have relative to where we’ve been, but does this mean that there’s sort of the gross margin outlook is now different for this firm then say three years ago when you were easily above 30% gross margins on the product side?

Eli Harari: That’s a good point and we’ve always said that the margins on non-captive where we have to buy, on the contract market, flash and then package it into a card and sell it, of course is going to be less than in a vertical integration situation even though today it’s opposite because people sell below cost.

Even after the restructuring, please understand that our captive capacity is still very substantial. It adds up to close to 1.5 million wafers a year of 300 millimeter capacity, all at 43 nanometer-capable of 32 nanometer. That, I believe, is the equivalent of Micron plus Intel plus Hynix combined, so it’s not small. It’s very substantial and when OEMs look at our captive supply after the restructuring, they see that we have a very, very strong supply base. The retail, basically today, benefits from that supply base, but in the future retail will have to be one, just like Kingston or PNY, or our competitors where they go and buy non-captive and we’ll go and buy non-captive and if we do a good job we will be able to compete.

The OEM is where we believe we can generate the margins in the future and the stability of the business. But it’s a combination of the OEM and the retail that gives us that flexibility to use non-captive, because you cannot use non-captive and be an OEM supplier. You cannot. You cannot quote, three quarters out, pricing when you don’t know  what it’s going to cost you in the non-captive market.

Paul Coster: Let me sort of focus on two more things and I’ll hand it off to the audience. Middle of this year a key point coming up, at least from an investor perspective, which is the rollover of the contracts, or otherwise, with Samsung on royalties on the licensing agreement. Can you talk about that in any way that will help us think it through the risks and rewards associated with that singular event?

Eli Harari: It is a singular event, because it’s an important part and IP is an important part of our strategy, although not the only thing that drives the company. We are in negotiations, intense negotiations I would say, with Samsung to try to come to a mutually acceptable agreement to renew the license when it expires on August 14, and that is really all that I can say.
Paul Coster: Okay. So last point for me is that I think it’s a couple of times in the – during my era of coverage anyway, I think the company has twice attempted to sort of peg a target operating margin, essentially a target business model. And you’ve had to sort of step away from that at, least temporarily. Can you – you may not be able to state an explicit business model now, or return on capital. But can you kind of give us your generic thoughts about what this company really should be aiming at, with a long-term perspective, so that those investors that are looking at it through the cycle can start to kind of get an understanding of what it is that they should be measuring here?

Eli Harari: Yes. I’m very unhappy with where we are today. And I think all the investors are unhappy. As far as gross margin, it’s basically – I believe we are as competitive as anybody out there, but the business has become a commodity-driven market, driven by excess supply and therefore not by your costs or by any other attributes. So the challenge for us is on the commodity side to be as low a cost as anybody else so that we can make money even in the worst kind of times.

But to de-commoditize as much of our business as possible, create islands of differentiated products, de-commoditize products that will eventually become a continent, okay; as they grow, so this is an area of enterprise and this is an area of things like the slotMusic. And this an area of where you take as an example, let me show you, slotRadio, which is a player that we introduced just a few weeks ago. And this is a very, very simple player that comes with no memory of its own, but comes with a thousand songs on a secured, curated, very high quality on a microSD card. That by itself is no big deal, okay.

You can pre-load a thousand songs, but this card has the intelligence and the security to become a client of a server that is owned by the network operator, and becomes part of the service, the music service for example, that the network operator has. Once you have established that symbiotic relationship, where this card is not just raw storage but actually provides a function, a secure function, and is part of the ecosystem of the network operator, then it can become your secure, your enterprise card. You store all your emails more securely on this little card than you do on your cell phone itself, and you can take it out and keep it with you and it helps the churn rate, selling more and more phones and so on. So you become a much more valuable proposition to the network operators.

The network operators are the healthiest part of the ecosystem today. They are very, very strong, despite – they don’t have liquidity issues, they don’t have cash flow issues and they are desperate to fight the iPhone, self-contained – basically, iPhone controls everything. The Android, on the other hand, they want to have more control of their destiny and the way to do so is to have products where they can keep control.

The other problem that the network operators have is the bandwidth limitations, which are horrendous with data services. And they really want to go into downloading all of these services, all of that content in off-peak hours and they’ve got to do it into something and that’s really the card, that’s very, very critical for them. So I think it’s a natural alliance between what we bring to the table and what the network operators need.

Paul Coster: I have to press you there, though, I mean what you’re basically saying to us is that to get to a target business model that you have in mind, you first of all need to establish some kind of differentiated products and establish this kind of momentum around those. You’ve done several such initiatives over the years. Thus far, whether it’s Gruvi or this, it’s still not – you haven’t quite crossed that threshold point of becoming essentially an Apple, with a sort of brand and sustainable kind of business model in the consumer or enterprise space.

What I’m looking for really, is some sense of what of kind of return on capital you think is attainable here? What kind of operating margin may be attainable long-term? In the past, you’ve talked to 15 to 20% being your target. Is it all contingent upon this unknown sort of outcome from these consumer initiatives?

Eli Harari: No. First of all, I agree that the target have got to be basically really what we – what we set as a target two or three years back is the right target and we have not abandoned that. We never give up. And we are very confident in the direction we are taking and we have patience, I keep saying, patience will be rewarded. There’s a huge amount of activity going on, under the surface, for the last five, six years; this is not kind of like, okay let’s try this. We do throw a lot of things on the wall. Most of those things don’t stick and that means that we are innovating out of the envelope. If everything was sticking, it would be – everybody else would be doing it. So I think, yes, the direction that we are taking is absolutely the right direction and I have tremendous confidence in our ability to deliver it. And we just have to be patient and make sure that we have the wherewithal to stay through.

Paul Coster: Okay. Let me throw open to the floor; I’m sure there’s lots of questions. Yes, sir?

Q: Part of your advantage has been your ability to gain capacity advantages outside of the node shrinks. It seems that mathematically, that’s not scaling as well when it’s – the extra bit-per-cell, is not – percentage-wise it decreases over time. Is there some way to keep that in line with no shrink capacity gains or keep it in parity or in order to maintain your advantage or the value of your IP or is there something else you have to do here?

Eli Harari: It’s a long question, but it relates to X3 and X4 technology; how can you…

Q: You’re not going two to four to eight or?

Eli Harari: Right.

Q: You’re running two, three, four, five?

Eli Harari: Yes, well, not five; yes, these technology transitions. So we have to go power on path, technology transition where we are driving lithography in logical scaling, where we add more bits on every cell. I think to go logical bits-per-cell, it’s all system solutions, they’re using the same technology, and the key is to apply a high level of system integration to three and 4-bits-per-cell so that you get the benefit of the cost, lower cost, but you don’t pay the penalty of inferior performance. I believe we have achieved that with 3-bit-per-cell. 4-bit-per-cell not yet, and that means that we can use 4-bit-per-cell in fewer applications where we intend to, in fact, use them.

But the whole challenge of NAND flash is immense. I mean, this is part of the barriers for entry for new players and existing players, frankly, to stay in business. You’ve seen, just this year, Samsung kind of stumbled with the 42 nanometer. Hynix stumbled with a 48 nanometer, and it’s not for lack of trying. I think the technology is very unforgiving and eventually the NAND technology, I’ve always said, will come to the end of its path and at that point our bet is on 3D read/write technology.

So I think we have the advantage in that we are, always have been, vertically integrated. Always have had the controller and system expertise in-house and therefore it’s easier for us to execute at this logical scaling in addition to the technological scaling. But we are still playing with the same physics as everybody else.

Paul Coster: This one over here, then I’ll come over here, yeah.

Q: As it relates to your discussions with Samsung on the royalty issue, can you sort of share with us what you might think Samsung’s options are as [inaudible]?

Eli Harari: What are Samsung’s options, you’ll have to ask them. I have a tough enough time negotiating with them to also represent their point of view.

Q: You talked about Toshiba being more conservative on CapEx, you talked about Samsung [inaudible] But we have not seen from either company really questioning their goals, number one in the space [inaudible]?

Eli Harari: I think it’s one thing what people say, it’s another what their bankers say. I think you’ve got to meet – where the rubber hits the road is- can I pay for it.

Paul Coster: Let me ask a question – oh, I’m sorry, gentleman over here.

Q: With regard to Samsung, one last question if I may. In terms of the timing, what – any kind of fine print in the existing agreement if negotiations go beyond the expiration of it? And [inaudible] for either side [inaudible] negotiations get to that point does the agreement – existing agreement stay in place until [inaudible]

Eli Harari: Every negotiation has got to continue up to a certain point. Beyond that, you conclude that you are either going to have an agreement or you don’t. If you don’t, you don’t. When – if we don’t have an agreement by August 14, then the agreement terminates and they are unlicensed from that point on.

Paul Coster: Yes?

Q: I have two questions on the leases [inaudible]. Is there anything other than using the leases for capital equipment that you can lower that 1.2 billion of future liability and rolling off, is there anything…[inaudible] is that something?

Eli Harari: The equipment leases, the $1.2 billion of equipment leases, are being paid regularly. Every wafer that we use from the joint venture- part of that is – part of the cost of that wafer goes back to what we pay down, so we – that $1.2 billion is probably paid down – will be paid down over the next three to four years at a rate of, I’m just guessing, around 300, $400 million a year. And I want to remind you that all of these leases are backed by the entire equipment set, which is absolutely leading edge, and I’ve just said, close to 1.5 million wafers a year capacity, so it’s not small, and the back-up value, I believe, certainly covers the lease lines.

Q: And we should think of them [inaudible]

Eli Harari: Yes, the costs of the leases are very low – the interest rate is very low.

Q: And the second question is in relation to your own publicly traded debt, is that something that you’re looking at to repurchase? Would that make sense at all and would something like that have to wait for the Samsung royalties getting sorted out?

Eli Harari: We are not at this stage, eager to convert debt. I think that it’s a very – it’s a 1% interest rate for the company during 2013.

Q: But even at the current prices it’s trading at in the 60s and 70s [inaudible]?

Eli Harari: You know, I said what I…

Paul Coster: You’d have to reconcile that also with the company’s stated intention to raise funds through equity or the – you talked about it on two conference calls ago, didn’t you, about…

Eli Harari: Yes. We said…

Paul Coster: What was the rationale for that?

Eli Harari: The rationale for that was – this was the first quarter – sorry, the fourth quarter conference where we had not yet completed the restructuring of the joint venture with Toshiba and our exposure was $2.1 billion of lease lines, and we wanted to make sure at that time that we had, if necessary, and of course, we didn’t have the first quarter benefits…
Paul Coster: Yeah.

Eli Harari: …it looked pretty – in general, it did not look that good for Q1. So we felt that we wanted to have the security, the safety, if you will, not for 2009. We’ve said all the way that we don’t have a problem in funding operations in 2009. But if things continued the way they looked in January, pretty bad, let’s say, for the next 2009 and 2010 that we wanted to make sure that we had sufficient cash.

Paul Coster: That’s gone from the back burner to – from the front burner to the back burner now. It sounds likes it’s not something that’s a top priority for management?

Eli Harari: It’s, we are – our financial situation is dramatically different today than it was then.

Paul Coster: Okay.

Eli Harari: For the better, of course.

Paul Coster: Yeah.

Q: A couple of questions on the royalties; like is I can’t remember is that one quarter in arrears?

Eli Harari: Yes.

Q: And there was one customer or licensee who had changed the way they calculated it [inaudible]?

Eli Harari: Not changed; they claimed that they have over paid us in 2002 through 2007.

Q: Is that something that SanDisk is disputing?

Eli Harari: Yes. Well, we’re looking into that.

Q: Is that something that could blow through the whole portfolio of licensees or is this just an isolated…?

Eli Harari: No, I don’t believe that.

Q: …incident?

Paul Coster: So NAND spot prices are up quite significantly, an unusual situation as you yourself commented. All good news except in one respect, which is – sort of delivering the crossover price point for SSDs to really start to make a dent in the laptop market. Can you talk about the SSD market? And when do you think that’s going to kick in and what this price situation is doing for it?

Eli Harari: Yes, the SSD market is a nascent market, in its very early stages, very price elastic, but only up to – only from a certain point on. You need to get a certain threshold price in order for it to take off – and if you’re not at that price point, you could play in the enterprise but not in the notebook or netbook market. So you are right, as the price goes up – I mean the spot price or contract price now for 16 gigabit chip, 2 gigabyte, is around 4 bucks, more or less, give or take. So it’s $2 per gigabyte; at the system level it will be slightly more than $2 per gigabyte and that’s – that means a 64 gigabyte SSD would be 130 bucks or so, which is too high. The competition for netbooks is 30 bucks for 80 gigabyte drive.

In enterprise, the cost is okay. They can afford to pay $2, $2.50 per gigabyte, no problem. The challenge for the NAND manufacturers is that as much as we want the  the SSD business to take off, we don’t want to subsidize it. We can only go that far as far as getting it off the ground, and therefore it needs to wait, really, until the next two technology nodes. 32 nanometer- our costs will get a lot better. And 24 nanometers is where we can meet what the market needs, which we mostly think is around $1 per gigabyte- and still be profitable, still generate our margins.

So it’s still 2010, 2011 for the time its take off. Once it takes off the biggest issue will be that there will just not be enough capacity. There will just not be enough capacity.

Paul Coster: All right, I think we’ve got time for one more question, sir.

Q: [inaudible].

Eli Harari: The strength in the first quarter was across both. OEM, it was stronger than we expected, and retail was better than we expected. And within that, I think USB flash drives was stronger than we expected. We’re just – I think we’re a very good supplier. We had 27% ASP declines, some of our competitors were higher and perhaps in that regard we were more – we probably left some money on the table. And we’ve said, we raised prices, we are raising prices and in some respects now, when we raise the prices we are prepared to lose business and we are, in some respects – in some cases losing business and that’s okay, because the business is much healthier now. Yes?

Paul Coster: Just one quick one.

Q: [inaudible]

Paul Coster: We’re losing market share, but…

Eli Harari: We are prepared to lose, to walk away from business that in the past we would not walk away from. We would go for that business. Today we are prepared to walk away from it, and I said that it is resulting in much healthier business for us.

Paul Coster: Okay. All right, great. Thank you very much everyone.

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