2009.05.27 Samsung Agreement Call

27 June 2009

SanDisk Corp. and Samsung Agreement Call

Jay Iyer, Investor Relations
Dr. Eli Harari, Founder, Chairman and Chief Executive Officer
Judy Bruner, Executive Vice President of Administration and CFO

[Jay gives introductions and reads Safe Harbor]

Eli Harari: Thank you, Jay. And welcome to this conference call. This morning, SanDisk and Samsung Electronics announced the signing of a definitive agreement to renew the cross-license of our semiconductor patent portfolios. In addition, the companies signed a flash memory supply agreement under which Samsung will continue to make available to SanDisk a committed portion of its flash memory production output. The new agreements become effective when the current cross license and supply agreements expire on August 14, 2009, and will run for seven years from that date.

We are very pleased with the agreements that we announced today. We believe that they represent good value for our shareholders, and enable both parties to focus on the growth markets at hand. We’re excited about our opportunities in mobile, computing, and consumer flash storage markets. Furthermore, access to Samsung’s flash capacity under competitive terms gives us greater flexibility in managing our future capital expenditures for captive capacity. We look forward to a constructive relationship with Samsung in the years ahead. With that, we will now open up the call for your questions.

Q&A

Edwin Mok, Needham & Company: Hi, thanks for taking my questions. My first question is regarding this agreement. Can you talk about it? Does it include kind of system-level patents that you guys talked about before that was included in that ITC lawsuit with the 25 companies that you guys announced last year?

Eli Harari: I’m sorry Edwin, I didn’t get your question. Can you repeat?

Edwin Mok, Needham & Company: Sorry, in this agreement with Samsung, does that include the system-level patents that was – that was part of that lawsuit that you guys filed against I think I guess it was 25 companies back in – last year that you guys made that lawsuit?

Eli Harari: Yes, I understand. Yes, it does.

Edwin Mok, Needham & Company: It does, great, and there was an unfavorable ruling on ITC related to that, I guess, on two patents. I’m just curious, does that actually impact your agreement with Samsung, and does that impact your position to survey agreements? Does that have any influence on that?

Eli Harari: No.

Edwin Mok, Needham & Company: I see, and then, can I ask if one of these company that is under the – that lawsuit, if they decide to buy a product from Samsung, and rebrand it into own brand and sell it that way, does that preclude them from, does that satisfy the patent requirement to you guys?

Eli Harari: I believe so, yes, I believe so. They – Samsung is licensed to sell a product to anyone, including to third party re-labelers.

Edwin Mok, Needham & Company: Great, great that was very helpful, and then, finally, just one more question. Regard in terms – on the press release it says that it is expected to be approximately half of the previous agreement that you guys have. I’m just curious, this – did you guys change the way you structured in terms of fixed fee versus variable fees in the term agreement that you guys had before with Samsung? Is it kind of the same fix versus favorable mix or was that changed on this agreement?

Judy Bruner: Edwin, both agreements are fairly complex and both agreements contain both running royalties as well as certain fixed payments.

Edwin Mok, Needham & Company: I think you guys talked about before that, the royalty was with Samsung was more related to a revenue level that Samsung generates from certain product that they sell using your patent, right. Is that still in the same way then?

Judy Bruner: Yes, the new agreement still contains variable running royalties.

Edwin Mok, Needham & Company: That is relate to Samsung’s revenue, right?

Judy Bruner: Correct.

Edwin Mok, Needham & Company: Okay.

Judy Bruner: That is related to Samsung’s flash memory revenue.

Edwin Mok, Needham & Company: Great, that’s all have thanks for clarifying that.

Craig Ellis, Caris & Company: Thanks for taking the question and congratulations on getting the deal done Eli.

Eli Harari: Thank you.

Craig Ellis, Caris & Company: You’re welcome. The first question is on the supply element to the agreement. You have that in the existing agreement. Can you talk about the extent to which you see the company utilizing that agreement as we go forward?

Eli Harari: The supply agreement we view as a very, very fundamental element of the cross-license. It over time over the next seven years we hope will have very substantial value for us, and we plan to take advantage of that. As you know, we have supply agreements, which we believe are very good supply agreements with Toshiba, Samsung and Hynix, and we have said a number of times that our strategy is to reduce our own captive CapEx investments going forward, and bring ourselves back to the captive, non-captive model and for that the supply agreement with Samsung will play an important role hopefully of course, subject to our requirements.

Craig Ellis, Caris & Company: Okay, and then, the next two questions are really I think for Judy. Judy you mentioned the potential for an equity raise back in January. How does the fact that this deal has been signed impact the company’s thinking on the potential need for that $300 million equity raise you had mentioned?

Judy Bruner: Clearly the new license agreement that we’ve signed further improves our financial position and our liquidity, but of course, our shelf is still in place should we choose to use it in the future.

Craig Ellis, Caris & Company: Okay, and then, lastly, how do we think about operating expense? You – I think the target is 700 million for the year, 700 to 725 with reduced risk that you’ll have onerous legal expenses after August 14. Does that mean there’s potential for that target to come down?

Judy Bruner: On our last conference call, I gave a range of 700 to 725, which I had lowered from 750. And I would say now with this agreement signed, I would expect, we would be at the lower end of that range.

Craig Ellis, Caris & Company: Okay. Thanks for all the Q&A guys.

Eli Harari: Thank you, Craig.

Gary Hsueh, Oppenheimer & Company: Great, thanks for taking my question. Maybe other people might have got this already figured out, but what’s a reasonable expectation for your licensing and royalty revenue run rate in the December quarter once industry units and ASPs recover, and baking in this – halving of the rate with Samsung?

Judy Bruner: You know, we’re not going to give any specific dollar guidance on license and royalty revenue at this point in time. We really are focusing our guidance, our revenue guidance, one quarter at a time at this point, but I will tell you that the fourth quarter, the December quarter would, for our revenue, be based approximately half on the current agreement, the older agreement, and half on the new agreement.

Gary Hsueh, Oppenheimer & Company: Okay, Judy. I’m just trying to get a sense of what the baseline should be with the new agreement once the industry posts a relatively modest recovery in the second half. Is it 120 to 130, or should we start handicapping the 120 to 130 kind of per-quarter run rate down and de-rate that according to halving of the rate with Samsung. What’s the – what’s a realistic baseline, I guess, is what I’m trying to get to?

Judy Bruner: I think the best way for you to try to estimate is based on our guidance that the effective rate of the new agreement taking into account fixed payments and running royalties, we believe that the effective rate of the new agreement is approximately half of the effective rate of the old agreement in recent years, and that new level would begin in our revenue halfway through Q4 because it’s recognized a quarter in arrears.

Gary Hsueh, Oppenheimer & Company: Okay great, that’s pretty clear, thanks.

Judy Bruner: Okay.

Daniel Berenbaum, Auriga USA: Hi, guys. Good afternoon. Thanks for taking the call. Just to follow up on an earlier question talking about the running royalties. Is it purely tied to Samsung’s revenue, or is it also tied to units or bit growth?

Judy Bruner: The running royalties are based on revenue.

Daniel Berenbaum, Auriga USA: Purely on revenue, not – on nothing else. Okay.

Judy Bruner: Correct.

Daniel Berenbaum, Auriga USA: And is there any reason that it’s a seven-year agreement? Was there a discussion about different time periods? I’m just curious, why seven years?

Eli Harari: Seven years, the current agreement is seven years as well. And we wanted to make sure that both companies have plenty of runway to plan their future business, so seven years is a good timeframe.

Daniel Berenbaum, Auriga USA: So it’s just based on the example set by the previous agreement?

Eli Harari: Yes, and this is quite normal, quite standard for these kind of license agreements. It’s either five years or seven or 10 years.

Daniel Berenbaum, Auriga USA: Okay, and then, just one other question on the supply agreement, is there any sort of take or pay involved in the supply agreement, or is that – is just the availability there just an added benefit from the IP license? And then also, can you talk about the pricing, obviously not specifically on the supply agreement, but is there fixed pricing associated with the supply agreement or favorable pricing or can you give us some color there?

Eli Harari: The supply agreement is based on our needs. We do have as you know, a very strong partnership with Toshiba, which Samsung fully understands, and that is taken into consideration so that the foundry agreement that we have with Toshiba is a very important one, and of course, the agreements with Samsung and Hynix are very important to us, but the pricing basically has to be competitive with the market. There is no take or pay if we don’t need the product then we don’t have to take it, but it’s a two-way street. In order to make this a valuable asset for us, we have to invest the resources to make it happen. And if you don’t continuously take advantage of it, eventually it will atrophy.

So it behooves us if we want to have the benefit of that, in times we will need it, to continue to exercise it, to qualify new technologies, and take advantage of it through as much of the seven year license. We have said that we have no need currently for non-captive foundry supply, but we do expect that over the seven years and very likely 2010, we will start to need to take advantage of that.

Daniel Berenbaum, Auriga USA: So do you need to then is there some notification period, so that Samsung can plan its capacity for its other customers – is there some notification?

Eli Harari: Yes, yes. And of course, once there is a purchase order in place and a commitment to fulfill that, then it is take or pay. I mean, you – we do have to honor further purchase orders that are accepted.

Daniel Berenbaum, Auriga USA: Of course, okay. Great, thank you very much.

Eli Harari: Yes.

Atif Malik, Morgan Stanley: Hi, thanks for taking my questions. I’m just trying to understand, is there a linearity to this 50% reduction in royalty? I mean, is the rate cut lower with the first year, and when you talk about the average over the seven years, and if you can just give some color on the linearity?

Judy Bruner: You know, I really can’t give much more in terms of detail. I would tell you that I think the best way to estimate is as I’ve described, and then, we’ll just be giving you guidance on a one-quarter-at-a-time basis but the new agreement will go fully into effect mid-August of 2009.

Atif Malik, Morgan Stanley: Okay, and then, my understanding is that you said the royalty revenues are a percentage of the Samsung NAND revenues. Do we have to worry about the bit distribution of Samsung in that revenue mix, how much two-bit or three-bit per cell, or we just take a half the rate cut that we were modeling previously for the Samsung revenues? Or do we have to worry about the how much three-bit or how much two-bit-per-cell in that revenue mix?

Eli Harari: Let me try to answer that – a little bit long winded – but the 2002 agreement that is coming to an end now, was signed at a time where SLC one-bit-per-cell was 100% of revenues, and in fact, only companies were shipping MLC for SanDisk at that time. It’s only 1995 – I’m sorry in 2005 that Samsung started shipping a lot of MLC, and the agreement in 2002 was very much – had MLC as something in the future.

Today of course, the vast majority of bits shipped are two-bits-per-cell MLC, and we fully expect that it will go to two [he means three] bits, and to a much lesser extent, four-bits-per-cell. The new agreement takes that into consideration and licenses Samsung to any number of bits-per-cell.

Atif Malik, Morgan Stanley: I see it, and one quick one. Does the new agreement include four-bit-per-cell?

Eli Harari: Yes, any number of bits includes four.

Atif Malik, Morgan Stanley: Okay, and what is your best guesstimate on production year for 3D technology?

Eli Harari: We have said that we view 3D read/write technology as a strategic technology, and we are definitely heavily investing in the development of switchable, that is, read/write element. And we have been making good progress, but we are not there yet, so this is not ready yet for productization and realistically, it’s still several years out.

Atif Malik, Morgan Stanley: Okay. And one last one on the cost reduction, with the new or modified supply agreement, I mean, assuming a normalized cost reduction of 40% per year. Is it – I mean, you guys have a new idea on what that cost reduction could improve to for next year, assuming it’s a normal year?

Eli Harari: Well, we’d rather not talk about that. That’s not part of the license agreement. I mean, license is driven by revenues regardless of cost reduction or technology.

Atif Malik, Morgan Stanley: Okay. Thanks.

Scott Hurlman, Robert W. Baird: Hi, this is Scott Hurlman calling in for Tristan. Thanks for taking my question. One question I had was historically, it seems like the percentage of revenue that you’ve derived off of other people’s – or the percentage of licensing off other people’s revenues has kind of decreased slightly over the years. Is that kind of built into this same thing where maybe you start at, let’s just say, 5% of revenue now and that slowly decreases over the life of the agreement?

Judy Bruner: Scott I would tell you that in recent times, the Samsung – the existing older Samsung agreement has represented approximately two-thirds of our license and royalty revenue. I’m not sure if that’s exactly what you’re getting to, but it has been approximately two-thirds, and it’s that piece that we now estimate with the new agreement, will have an effective rate of approximately half of the rate in the old agreement in recent years.

Scott Hurlman, Robert W. Baird: Actually I was thinking- has the percentage of the revenue that you’ve Samsung’s NAND revenue, has that stayed flat over last – over the life of the agreement? So if they did a billion and a quarter from one quarter to the next quarter is – are you going to derive the exact same amount of revenue, or does that start to decrease over the life of the agreement?

Judy Bruner: You’re asking about the new agreement now right?

Scott Hurlman, Robert W. Baird: Or the old agreement – well I guess I’m – I’m looking at the new agreement.

Judy Bruner: Okay. In the new agreement I think that the computation that I gave you is a reasonable computation for the duration of the agreement, the best we can estimate at this point.

Scott Hurlman, Robert W. Baird: Okay, and then, I just wanted to make sure that I was understanding this correctly is that it’s kind of like you flick a switch and it goes to the new agreement, and that happens halfway through this fourth quarter.

Judy Bruner: Correct. If the new – we flip to the new agreement halfway through the third quarter, but we recognize revenue one quarter in arrears so it will impact our royalty revenue halfway through the fourth quarter.

Scott Hurlman, Robert W. Baird: Okay, and then, does this have any impact on future CapEx plans for this year or next?

Eli Harari: To the extent that we take advantage of that guaranteed capacity that it is competitive then it definitely should have quite substantial reduction in the requirements of our CapEx that’s – that’s what I’m talking about in terms of giving up that flexibility to move to our captive/non-captive mix.

Scott Hurlman, Robert W. Baird: Right.

Judy Bruner: But I would add as Eli said we are not currently in need of non-captive, and our CapEx budget for this year is not impacted.

Eli Harari: Is not impacted. And basically the whole point with these guaranteed capacities is that when you have excess supply you don’t need that capacity. When you have – where you have allocation when we have shortage that’s when you need it, and it’s very important to have that capacity guaranteed to you. However, you can have it guaranteed, but if you are not actually exercising it, if you are not qualified to use it I mean, internally qualified and with your own customers, then there is a significant lag time before we can bring it on board.

Scott Hurlman, Robert W. Baird: Right, and then, two quick questions, one is are you doing any R&D development with anyone outside of Toshiba, and then also, does this licensing agreement cover any patents that would be issued over the seven year life of the agreement, or is it only patents that have been issued currently?

Eli Harari: So the first one R&D outside Toshiba of course, we don’t want to comment because this is not part of this conference call. On the new patents that are issued to SanDisk or to Samsung over the next seven years of course, those are included. However, once that seven-year patent license comes to an end, then that’s what is called a guillotine license, which means you do not have the right, either party does not have the right for the life of those patents.

Scott Hurlman, Robert W. Baird: Okay, thanks.

Daniel Amir, Lazard Capital Markets: Yeah, thanks a lot. Congratulations on signing the deal.

Eli Harari: Thank you.

Daniel Amir, Lazard Capital Markets: Quick question, is there any dollar royalty cap for this deal meaning that above a certain amount Samsung would not need to pay anymore royalties above a certain amount, $1 million per year?

Judy Bruner: Daniel, the specific terms of the agreement are confidential. So, all I can tell you is as we said, there are certain fixed payments, and there are running royalties and we estimate the dollar value as I described.

Daniel Amir, Lazard Capital Markets: So, was the – can you comment whether the previous agreements had such a clause?

Judy Bruner: I really can’t give you that those details for the old agreement either.

Daniel Amir, Lazard Capital Markets: Okay. All right, thanks a lot.

Bob Gujavarty, Deutsche Bank: Great, thanks for taking my question. Just one question on the Samsung supply agreement. Are those prices more a market based, or is it based on a cost-plus method? The reason I ask is clearly people have sold product below cost at times, and I’m just curious how the supply agreement would work.

Eli Harari: Yes. It’s based on market competitive pricing, we should not be at a disadvantage through exercising that right.

Bob Gujavarty, Deutsche Bank: Got it, and then, the other one, Judy, I think you mentioned that Samsung was about two-thirds of the royalty revenue. Is that over the last year, or is that over the life of your royalty payments in that agreement, or can you just kind of size your two-thirds comment?

Judy Bruner: Over the last several years.

Bob Gujavarty, Deutsche Bank: Last – last several years, okay, and then, finally, just a quiet kind of question. Now, that you have a lot of different sourcing agreements, can you give us kind of your thoughts on the pecking order, clearly captive is the most cost effective, and then, can you kind of rank the how you would source your other agreements kind of beyond guidance, the captive?

Eli Harari: You know and this is obviously a business decision, and I really would rather not get into that, except to say that the agreement that we have for non-captive supply from Toshiba has the benefit that it uses basically our technology, this the product that we are forcing from our captive supply and therefore, increasing our availability through that channel, has a least resistance, if you will, provided that is competitive of course.

Bob Gujavarty, Deutsche Bank: Are you…

Eli Harari: As far as the others, I’d rather not get into that.

Bob Gujavarty, Deutsche Bank: Your sourcing your pecking order may change quarter-to-quarter, depending on market conditions and business conditions and those kinds of things basically?

Eli Harari: Obviously we have our purchasing people would try to maximize the competitiveness of the company, but as I said, it’s very, very important that the viability of the source of supply it cannot just be willy-nilly turned on and off. You really do have two areas of responsibility.

Bob Gujavarty, Deutsche Bank: Okay fair enough. Thank you.

Kevin Cassidy, Thomas Weisel Partners: Thank you for taking my call. So, on the 3D technology, do you expect to license that in the future, is Samsung interested in that?

Eli Harari: 3D technology is still in development. We think it could have very substantial potential in the future, and we – it’s premature really to discuss a licensing strategy if any for the technology. First order of the day is to get it to work.

Kevin Cassidy, Thomas Weisel Partners: Okay and that technology isn’t based on any of the MLC technology already?

Eli Harari: It’s not based on the any of the standard, yes, it’s based today what we’re developing is a array of polysilicon diodes that are layered one on top of each other with a switching element. We’ve discussed that in the past and it’s still in development. It is a derivative of the diode array OTP, one type programmable, technology that we acquired when we acquired Matrix Semiconductors several years back.

Kevin Cassidy, Thomas Weisel Partners: Okay. Thank you.

Steven Chin, UBS: Hi, this is Steven Chin calling on behalf of Uche. Thanks for squeezing me in here. First question is on the royalty rate again. I guess Judy is there any additional color you can provide in terms of whether or not you guys would adjust the royalty payments or the rate along the way due to extraordinary circumstances? And the reason why I ask is because I think a couple years back I think you guys did adjust the rate I think it was downwards for Samsung at one point because of actually stronger growth or maybe it was the ASP environment. Can you talk to that please?

Judy Bruner: I think that what you’re remembering in the old agreement was something that was built into the agreement from the beginning. It was not based on any extraordinary circumstances, but relative to the new agreement, really we believe that the best way for you to estimate it for the duration of the seven year agreement is to assume an effective rate of about half of the recent effective rate of our old agreement. And keeping in mind as I said, that the – the existing Samsung license and royalty has been running at approximately two-thirds of our total license and royalty revenue.

Steven Chin, UBS: Okay great and just one last quick one. I guess this would be more for Eli. Eli, just given that you now have this royalty agreement nailed down, how does this change your perspective on going back to the discussion with Samsung regarding potential merger in the future?

Eli Harari: The two are unrelated.

Steven Chin, UBS: If I recall I think this royalty renegotiation was one of the criteria for SanDisk to be interested in talking with Samsung again. Does this change your view potentially on future discussions?

Eli Harari: You’re quite right that in the negotiations that we held with Samsung last September, the IP cross-licensing segment was one of the conditions that our Board felt
that we needed to satisfy, and that is indeed satisfied today.

Steven Chin, UBS: Okay, thank you.

Jay Iyer, Investor Relations: Thanks, Steven. I think that concludes the call. Thank you, all again for joining our call today, and have a good evening.

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