2009.10.20 SanDisk Q3 Conference Call

20 October 2009 SanDisk Q3 Conference Call

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


Jay Iyer, Director of Investor Relations

Thank you and good afternoon everyone.  Joining us on the call 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.  Eli is dialing in from our Shanghai office.

[Safe Harbor]

With that, I would like to turn the call over to Eli.

Dr. Eli Harari, Chairman and Chief Executive Officer:  Thank you, Jay. Good afternoon from our plant in Shanghai so I will keep my remarks brief.  You will hear a lot more from Sanjay and Judy.

Q3 was an outstanding quarter, substantially better than we expected.  One factor has been the favorable industry conditions, which we see continuing into Q4.  Other contributing factors were our focus on improved profitability, successful diversification into new sales channels and really excellent product cost reductions.  Our decision late last year to participate more aggressively in the OEM space began to pay off in Q3.  OEM unit demand took off, and the OEM channel became our #1 revenue generator.  OEM growth is diversified and global.  In addition to growing our traditional embedded iNAND and bundled OEM cards, we are gaining traction in the markets for private label cards, flash components, and flash wafers.  Our OEM orders for Q4 are very strong.  We believe that our high quality captive NAND output is allowing us to develop long-term relationships with top tier OEM’s and, given how large these OEM opportunities are, there is substantial room for us to further grow our OEM business in 2010.  Concurrently, our branded retail business continues to execute well with a focus on profitability and we believe we are maintaining share in all retail geographies even after raising prices during the year.  SanDisk is uniquely advantaged through the strong retail position and a growing OEM business, both on a global basis.

On the supply side, this year is different from the past few years in that no major new NAND fab capacity is ramping as we head into the fourth quarter, and therefore the inventory overhang that the industry experienced in previous first quarters should be mitigated in the first quarter of 2010.  Equipment lead times for advanced semiconductor equipment such as immersion scanners are currently between six and nine months lead time, and such equipment, we believe, will be directed first to upgrade existing capacity to the most advanced technology nodes, where the return on investment far exceeds the return on investment in new NAND fab capacity.  Given these factors we expect NAND supply and demand to be in reasonably good balance in 2010.

For ourselves, we currently expect our capex focus in 2010 to be weighted primarily to completing the conversion of our captive capacity to 32 nanometer technology and beyond that we expect to begin to access our non captive supply sources.

In summary, our diversified OEM and retail business strategy is working well for us.  We emerge from this downturn with highly competitive technology and operations and a strong balance sheet.  We are optimistic about our prospects for Q4 and for 2010.

I will turn it over to Sanjay now.

Sanjay Mehrotra: Thank you Eli and good afternoon everyone.  Third-quarter results were exceptionally strong and demand continued to strengthen throughout the quarter, with OEM being the growth driver.  Total OEM revenue grew sequentially by more than $200 million with units sold increasing by 72%.  We saw significant increase in interest in both our low-capacity and higher-capacity embedded and removable flash products.  The strong OEM revenue growth was driven by two primary sources: first, significant increases in sales of removable cards and embedded flash to our existing mobile customers and, second, as Eli discussed earlier, sales of flash cards to private label customers and sales of wafers and components to new customers.  Revenues from the new sales channels accounted for approximately one-third of the total sequential growth in our Q3 OEM revenues.  This broadening of our sales channels is a long-term strategy designed to expand our reach in parts of the global markets and to further diversify our revenue base.

The mobile phone market continues to be the key growth driver for the company and it accounted for 38% of our total revenue during the third quarter.  With Smartphones becoming increasingly important to the growth in the overall mobile market, we are pleased with the increased design win traction for our embedded flash products in these phones as well as with increasing bundling of high-capacity cards with certain high volume phone models.  We saw strong increase in sales of 16 GB cards for the mobile market, and revenue from the iNAND product line more than doubled sequentially.

Retail units grew sequentially with a strong improvement in profitability.  We recently introduced the world’s highest-performance 32 gigabyte SanDisk Extreme SDHC card and 64 gigabyte SanDisk Extreme ProTM CompactFlash memory cards demonstrating our continuing product leadership.  We continue to leverage our broad product portfolio and our large scale to deepen our relationships with our most strategic retail accounts in all regions.  In fact, we recently were awarded best supplier awards from three of the largest U.S. retail customers.

Expanding further on operations, I am pleased with our execution across the board.  For our total retail and OEM business, we sold 45% more units in Q3 than in the prior quarter, setting a new record for quarterly unit volume.  Our supply chain organization responded with speed and flexibility to the significant increases in customer demand that arrived in the latter half of the quarter.  In addition, active management of our pricing and focus on profitable growth by OEM and retail business teams helped deliver strong revenue and gross margin improvement  for the quarter.  We continue to make excellent progress on our product cost reductions and through Q3 of this year; we are ahead of plan and we now expect to exceed 50% cost reduction for the full year.

From a manufacturing production standpoint, we have been operating our fabs at full utilization rates since July and expect to maintain that going forward.  For the first time this quarter, our bit production of three and four bits per cell technologies was more than half our total fab output.  We began retail shipments of 8 gigabyte and 16 gigabyte SDHCTM cards and Memory Stick Pro DuoTM cards based on four bits per cell (X4) technology during the quarter – another industry first in the area of multi level memory technologies.  Our captive backend assembly and test facility is also functioning at full capacity and it continues to be a source of significant competitive advantage for us.

Our results for Q3 reflect the impact of favorable industry trends and the impact of pro-active measures implemented by us early this year, including the restructuring of our supply base, reduced capex spending, streamlining of our operating expense structure, entry into new channels, supply chain improvements, and very active management of our pricing.  All of these measures are paying off with the results demonstrated in both our P&L and our balance sheet.  The SanDisk team is excited about the improved fundamentals in our business and we look forward to a strong Q4 and positioning ourselves well for 2010.  With that, I will turn the call over to Judy.

Judy Bruner: Thank you, Sanjay.  SanDisk delivered impressive results in the third quarter across all key measures.

We generated the highest revenue since the fourth quarter of 2007, with 14% year-over-year revenue growth, fueled by the strength of product sales which were up 18% year-over-year.  As Eli and Sanjay have both commented, the OEM channel was the star this quarter, growing to 56% of our product revenue from 41% in Q2.  Retail sales were flat to the previous quarter with consumer spending still cautious and with our focus on the more profitable segments of the retail market.  In U.S. retail, our USB unit sales increased more than 50% sequentially due to the Back- to-School season.  Overall, worldwide retail units sold increased 5% sequentially while OEM units sold increased 72% from Q2.  Compared to our previous forecast of Q3 revenue, retail sales were as expected, and OEM sales were much stronger.
We hit our stride with the new OEM channels in the second half of Q3, and we generated stronger than expected sales in the mobile handset market with significant growth of bundled cards and an even higher growth rate for our embedded mobile iNAND products.  We implemented price increases for selected products in both the retail and OEM channels, and the 3% decline in our blended ASP per gigabyte was primarily due to the mix of products sold.  As expected, with pricing stable, average capacities were also approximately constant.  The average capacity of products sold increased 3% in the OEM channel and declined 1% in the retail channel.

License and Royalty revenue of $121 million in Q3 was very similar to the second quarter and slightly more than we had estimated.

Product gross margin for Q3 of 39% was much better than forecasted, and benefited from three primary factors:

1. First, we were able to maintain higher prices than we had anticipated.

2. Second, the higher OEM sales volume in Q3 meant that we were able to recognize product cost reduction faster, essentially pulling into Q3 some of the cost reduction we had expected would take until Q4 to recognize.  Our cost reduction on a per gigabyte basis was in the high-teens in Q3.

3. Finally, the third key factor in our Q3 gross margins was that our higher sales volume meant we sold more product that carried previously taken lower of cost or market reserves, benefiting gross margins by $139 million.  Excluding the benefit from inventory reserves, our underlying non-GAAP product gross margin was 22.3%, a very substantial improvement from 7.7% in the second quarter.

Non-GAAP operating expense of $179 million in Q3 was within our guidance
range and up $19 million from Q2 with increases in sales and marketing and G&A
tied primarily to the volume of sales and profits, and increases in R&D coming
primarily from technology investments.

Our third quarter non-GAAP operating income was $263 million or 28% of revenue, and even if one takes out the benefit from inventory reserves, the underlying operating income was $124 million or 13% of revenue.  Our non- GAAP tax rate increased from 35% to 36% on a year-to-date basis due to the increase in profitability.  Our GAAP tax provision is $6 million, or a rate of approximately 3% for Q3, a result that stems from now expecting taxable income in the U.S. for 2009 combined with the tax valuation allowance recorded in 2008 due to the loss in that year.

On the balance sheet, cash and short and long-term liquid investments increased by
$246 million to nearly $2.6 billion.  Cash flow from operations was a strong $238
million and we utilized $18 million for capex and other investments, thus generating free cash flow of $220 million for the quarter.  On a year-to-date basis we have generated positive cash flow from operations of $100 million and free cash flow of $8 million, thus returning to free cash flow ahead of our expectations.

I’ll now turn to forward-looking commentary.  Please note that non-GAAP to GAAP reconciliation tables for all applicable guidance are posted on our website.  Before providing our guidance, I’d like to point out that our fourth quarter this year will be a 14 week quarter, so there will be one extra week of revenue and expenses in Q4.

We believe that the industry supply/demand balance remains in good shape and this bodes well for pricing in the fourth quarter.  Of course there will be some impact on our pricing from Black Friday and other holiday promotions.  We forecast increased retail demand for the holiday season, and our OEM backlog for the fourth quarter is higher than we have ever seen in the past.  We are forecasting total revenue for Q4 between $1.1 billion and $1.2 billion, which includes license and royalty revenue between $100 million and $110 million.  Within the license and royalty revenue forecast for our Q4, the Samsung royalties will be based half on the old license agreement and half on the new license agreement.

We expect our Q4 non-GAAP product gross margin exclusive of inventory reserves to continue to improve as we believe cost reduction will more than offset price reduction.  Compared to the Q3 underlying non-GAAP product gross margin of 22%, we expect the Q4 underlying non-GAAP product gross margin to be between 25% and 30%.  In addition we expect to sell the remainder of the inventory for which we have previously taken LCM reserves, and we expect the total benefit to Q4 gross margin to be approximately $40 million.

We forecast Q4 non-GAAP operating expenses to increase to $190 to $200 million, reflecting holiday merchandising expenses, revenue and profit dependent expenses, and a 14 week quarter.  We forecast non-GAAP other income for Q4 of approximately $10 million, and we expect the non-GAAP tax rate to be 36%.  The GAAP tax rate is extremely difficult to predict, but our best estimate for Q4 would be 20-30%.

In terms of the balance sheet and cash flow, we expect our Q4 cash outflow for capital equipment and fab investments to be less than $50 million, which would bring the total cash outflow for capital spending in 2009 to something less than $475 million, compared to our original estimate for the year of $500 million.  Operating cash flow in Q4 will not be as favorable as it was in Q3 since the majority of our royalty payments are received in the first and third quarters, however, we do expect positive cash flow from operations and free cash flow for the fourth quarter and the full year of 2009.

I’d like to end by emphasizing that the pro-active measures we have taken this year, coupled with strong execution, have contributed to a significant turn-around in our results, and we believe that we will be able to further improve our profitability and cash flow in 2010.  I’d also like to let you know that we plan to hold an Investor Day in the first quarter of 2010, sometime after our Q4 earnings release.

We’ll now open the call for your questions.


Daniel Amir, Lazard Capital Markets: Thanks a lot and congratulations on the good quarter. A couple of questions here. First on the retail and OEM strategy, it seems like that the OEM has now become a bigger part of your business, which historically you’ve been predominantly a retail company. How do you think that impacts in the long-term the strategy of the company and the gross margins outlook, considering that the, that OEM does have higher gross margins than retail?

Judy Bruner: Let me start out with that Daniel and then turn it over to Sanjay. What I would tell you is that the gross margin that we experienced between OEM and retail are actually quite comparable. OEM sales tend to have a lower ASP per gigabyte but they also tend to have a lower cost per gigabyte, as you think about the costs associated with selling in the retail channels, such as packaging and channel costs and so on. So the gross margins are actually fairly comparable between the two channels for us.

Sanjay Mehrotra: And we like the balance between retail and OEM, and as Eli pointed out in his script, it really uniquely advantages us and we want to ride the business on both fronts, and we believe we are very well-positioned to continue to do so in the future.

Daniel Amir, Lazard Capital Markets: Okay, and the follow-up question is just on your cost basis, it looks like more than 50% is now three bit or four bit. How should we look at exiting the year in both three bit and four bit and your 30X productions?

Sanjay Mehrotra: So with respect to three bit and four bit, in the fourth quarter the production of three bit, four bit [pause] bit production will be somewhat higher than the third quarter of 50%. All in all for the year, we will be achieving approximately 50% of three bit and four bit, and with respect to 32 nanometer, we are ramping and satisfied with the ramp. 32 nanometer in terms of total bit production will contribute approximately 10%, slightly above 10% of the fourth quarter, and most of that will be in three bit per cell technology.

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

Vijay Rakesh, Thinkequity: Hi guys. Good quarter. Just a couple of questions. It looks like your X3 and X4 is now more than 50% of your shipments, like you said. But the margins are still kind of, you know, having pulled a little bit, I was wondering what the contribution there is and as you have this crossover, is that the upset that you will see on the margin side, on the product margin side?

Sanjay Mehrotra: As we have said, the benefit of three bit per cell technology over two bit per cell is in the range of 15% to 20% at product level and we certainly continue to enjoy that. The crossover with respect to 32 nanometer over 43 nanometer, we expect to achieve that in the fourth quarter and the 32 nanometer ramp together with the mix of three bit per cell will continue to give us a strong competitive position in 2010.

Vijay Rakesh, Thinkequity: Got it, and exiting Q4, where is, how is X3, X4 as a percentage of shipments?

Judy Bruner: I’m sorry, we couldn’t hear you. Can you say that again?

Vijay Rakesh, Thinkequity: Sure. Exiting Q4, where will X3 and X4 be as a percentage of shipments?

Sanjay Mehrotra: So at this point for next year, we are not providing specific guidance but we continue to focus on increasing our X3 bit mix next year. Of course, it will depend on the ramp-up of 32 nanometer as well as the mix of three bit per cell within 32 nanometer.

Vijay Rakesh, Thinkequity: Got it. Okay, great. Thanks a lot.

Daniel Berenbaum, Auriga USA: Hi guys. Thanks for taking my call. A couple of questions. It looks like inventory went up in the quarter by almost $100 million and I’m just sort of curious, was that build in WIP (work in progress) or was there a reason for that build? Did you do that intentionally to try to get ready for a Q4 ramp? And then how should we think about inventory going forward?

And then along those lines, was there anything in there that is limiting your revenue? I noticed that you talked about adding sales channels and it sounded to me like you are selling wafers and I’m curious, is that strategic to get rid of some inventory or are those somehow related?

Judy Bruner: Okay, Daniel, several questions there, so help me if I don’t answer all of them, but your first key question was to help understand why inventory dollars were up in Q3, and I would like to point out here that a key factor was the fact that we sold a lot of inventory that had been previously partially reserved, that was carrying reserves. As I mentioned on the call, gross margins saw the benefit of selling inventory that carried $139 million of reserves and if you look at the balance sheet, our inventory is up about $94 million quarter to quarter, so actually our gross inventory before reserves is down. We lowered our gross inventory but a lot of what we sold was carrying reserves, and so that is impacting the net inventory and you see the net inventory dollars up.

But we are very comfortable with the level of inventory that we have. We’ve actually reduced it in terms of number of weeks that we are holding. It’s all very high quality inventory and we believe we need it to satisfy demand.

Sanjay Mehrotra: And your other part of the question was related to the new channels. So here the customers are not just wafers. These are wafers and components, as well as third party retailers that we are cultivating these new channels. In fact, we have been cultivating these new channels through the course of 2009 and the results of this came to fruition in Q3, where as we said, significant increases in our product sales to these new channels and to these new customers.

We look at this as a very strategic move by SanDisk. We look at it as a long-term move for us. For us, we are a global leader in flash cards but there is a significant part of the market that is out there that is supplied by these third-party retailers, so we are leveraging the opportunity of using our products and selling those products to them and then having them resell it, essentially it increases our sales reach, diversifies our business, and further globalizes the business.

And from the point of view of the customers themselves in these new channels, we really bring the value of a strong product portfolio, strong IP, technology leadership, as well as high quality production with strong delivery. So this is really we believe strategic for both us as well as our new channel customers.

Daniel Berenbaum, Auriga USA: Okay, Sanjay, help me understand this on a very simplistic level. Are you [pause] who are you selling cards to? Are you selling components to your competitors?

Sanjay Mehrotra: We are selling components, as I said, we are selling components, wafers, as well as flash cards to some of these new customers and some of these new customers do include third-party retailers that compete with us in the channel. However, we look at this as SanDisk has market leadership with our brand and there is share of the market to be had by others and by providing our products to them and having them resell, we are essentially increasing the reach of our products and complementing our strong global retail brand.

Daniel Berenbaum, Auriga USA: Okay, thanks.

Uche Orji, UBS: Let me just follow-up on the last question. I mean, in terms of how you manage the private label, the first question is how do you make sure that [pause] where do you draw the line between your brand equity and selling fairly good products to private labels and people end up saying why do I need to pay for a SanDisk card when I can get this one? Because the general impression you get is that private label cards are cheaper than the branded card, so can you just help me understand how you manage that conflict?

Sanjay Mehrotra: So when we sell to these new channels, the private label or wafers or components, we obviously do keep our profitability objectives in mind and so when these products are sold to these customers, we are definitely targeting increases in revenue as well as increases in the gross profits for our business.

Uche Orji, UBS: Okay. I understand that. Let me ask a different question. If I look at the mobile phone business, I think you said something like 38% is now from mobile phones. Now how much of that is [pause] what is the split between micro cards and the embedded? So if I can understand how that is split, that is one.

And then two, the impression we get is card prices are rising with NAND flash pricing, maybe not one for one but certainly there are cost pressure now on the NAND Flash cards. Is there a risk that the handset companies will start bundling lower density cards and therefore cut down the big shipments into that segment of the market?

Sanjay Mehrotra: So I think you had a couple of questions in there. I will take the latter one first, with respect to shipments of lower capacity, we certainly with the pricing of the cards going up, we certainly see that yes there is a tendency by the handset manufacturers to be bundling lower capacity cards. In fact, that presented a strong opportunity for us with our strength on the 1 gigabyte and 2 gigabyte production, and we saw a lot of bundling of 1 gigabyte and 2 gigabyte and we were able to successfully supply into that market.

On the other hand, with the smartphones increasing, the high capacity cards are actually selling well as well. As I noted, we saw a significant increase in our 16 gigabyte cards in the mobile phone space. So really we are able to supply well and grow the demand both on the lower capacity cards going into bundling for even entry level phones, as well as supplying high capacity cards, which go into bundling for the smartphones.

Now with respect to [pause] and of course we are continuing to sell well in the retail channel with our mobile cards as well. With respect to the mix of the business, that was the other part of your question, embedded within the mobile space represented approximately 15% of our total mobile business and this is continuing to grow and we are very pleased with the design wins and the traction that we are seeing with our iNAND products here.

Uche Orji, UBS: Okay, and then just one last question, Eli, in terms of how we should think about the retail market. Historically we’ve all kind of looked at an elasticity model where card prices go down and demand and bit shipment goes up. It kind of looks like that is not what is happening here. Card prices are going up and yet demand continues to remain strong. Let me understand if this is a change in the way you think the consumer looks at this product. Is there something that has made that model break down or should we expect that model to come back sometime in 2010?

Eli Harari: We think that parts of the retail market has reached, particularly the more mature part of the market, legacy imaging, for example, USB, have reached price points that are good enough, that is, where consumers don’t [pause] have accepted the price point, there’s no pressure to bring the prices further down and we are also [pause], so elasticity begins to work actually in our favor in that we are able to bring our costs down but the price remains more or less stable.

There are also, as you get to a price point that is very close to the price of a roll of film or a number of, you know, a bundle of CDs, you are beginning to see really tremendous expansion of people that no longer download from the card and basically we are moving into the consumable model and that we think will drive unit demand, particularly on the low end.

In addition to that, I’ve got to tell you that if you are here in Shanghai, there is not one trace of a recession here. I mean, this economy here is absolutely booming and there are great parts of the world where the demand for our product is very, very robust and I believe will be so through 2010.

Uche Orji, UBS: That’s helpful. Thank you very much.

Kevin Cassidy, Thomas Weisel Partners: Congratulations on a great quarter. I just want to understand a little more on the four bit per cell. That’s on 43 nanometer process now?

Sanjay Mehrotra: Yes, that’s correct.

Kevin Cassidy, Thomas Weisel Partners: And will you be transferring that to 32 nanometer or is that going to only be three bit per cell?

Sanjay Mehrotra: So next year, some of our production will ship in 43 nanometer four bit per cell and as we ramp 32 nanometer next year, our focus will be on two bit and three bit cell technology.

Kevin Cassidy, Thomas Weisel Partners: Okay, and are there any limits to the applications that four bit can ship into?

Sanjay Mehrotra: Yes, as we have said before, the four bit per cell, it gives the benefit of lower cost but in terms of its applicability to various product platforms, it’s limited. That’s why we have introduced this on our standard SD high capacity cards as well as the memory stick pro dual cards.

The three bit per cell technology of course applies across all of our product platforms, and we expect, we plan to continue to drive that as the workhorse technology next year.

Kevin Cassidy, Thomas Weisel Partners: Okay, and if I could ask one more question about that. The three bit per cell you said combined the wafer starts were 50%. Can you say what the actual revenue was?

Sanjay Mehrotra: It’s actually the production output for the year that is approximately 50%, not wafer starts but production output. And in terms of the revenue portion [Judy cuts in]

Judy Bruner: The revenue portion was a little less. We can’t tell you exactly, precisely but we did get strong benefit in the third quarter from cost reduction from three bit per cell and I expect that we will continue to increase that cost reduction from three bit as we move forward, including in Q4.

Kevin Cassidy, Thomas Weisel Partners: Okay, great, thanks.

Eli Harari: I’d like to add, let me just add that the performance that we see from both X3 and X4, three and four bits per cell, is such that wherever we apply that technology, we have essentially identical performance to the two bit per cell and we do not actually identify a product as being X3 or X4 driven and the pricing is identical between X2, X3, or X4.

Kevin Cassidy, Thomas Weisel Partners: I see, great. So compared to your competitors, you should have the lower cost at the same resale?

Eli Harari: Yes.

Kevin Cassidy, Thomas Weisel Partners: Thank you.

Jim Covello, Goldman Sachs: Thanks for taking my question. Eli, I heard what you said on the supply side relative to the issue on the lithography tools. How do you see the supply increases coming in this cycle? Is really the only issue the gating factor? Is the lead times on the immersion litho tools? Or is there still some reluctance to add capacity, given what we just came from? I mean, eventually the industry will add more supply. How do you think that is going to happen over time?

Eli Harari: Hi Jim. There’s definitely reluctance to go back to the pain that we suffered, that the industry has suffered over the last two years due to this exuberant investing in, you know, the three years preceding this downturn. So I believe that that is totally the number one factor, the fact that I think the industry needs to see several good quarters of profitability and margins exceeding, in my opinion, exceeding 30% or so on the products gross side.

And I think definitely the industry is not there yet. I think we are just beginning to see the early stages of recovery. It’s looking to us very solid and very strong and very early, but overall I am very encouraged by at least the outlook for 2010, possibly 2011 and that basically comes from, you know, there is a very, very effective cost reduction through technology transition but there is much more uncertain internal investment on new fab capacity.

With regard to equipment lead times, if you don’t have equipment on order, you know, scanners right now, you essentially are out of new wafer capacity for just about all of 2010. So even if you wanted to put several billion dollars into a new fab, the suppliers, the lenses aren’t there off the shelf, ready to be delivered. So I think that, and in fact, as I’ve said  any new scanners out there will first be applied to upgrade existing capacity. If there’s 8 million wafers total industry capacity, around 8 million wafers of NAND, 300 millimeters equivalent, I’d say it would take quite a substantial investment of new scanners to just convert that 8 million wafers into 32 nanometer node and again, that equipment life competes with the DRAM guys and with the logic guys, so I think that the industry is set for a pretty stable situation in my opinion for 2010 and possibly 2011.

In the meantime, we see the demand continue to grow and at some point in time, of course, there will be a lot of pressure to break the mold, so to speak, and to make some major investments. But for a brand new fab, again that’s an 18 month proposition.

Jim Covello, Goldman Sachs: That’s incredibly helpful. If I could just ask one follow-up on that. How much do you keep an eye on what your competitors are doing? How much of a game of chicken is this in terms of you don’t want [pause] very clearly from the day people make the decision to add capacity until when that comes online, we are going to have a long period here, an extended period of healthy supply/demand. But if Samsung or Hynix or Micron/Intel decide to go ahead and start increasing their orders, you know, over the next couple of quarters, is that something you watch or you are just not as worried about what the competitors are doing there? Thank you.

Eli Harari: Of course we watch them very carefully and we are of course very worried about behavior that really financially, there’s no return on investment. It’s more a situation of opportunism. But of course, we can’t control it and what we have to do is to control our own destiny and there our strategy is very straightforward. We have a lot of capacity, and as I’ve said, our focus is to upgrade that capacity to 32 nanometer and mostly three bits per cell next year; the year after that, 24 nanometer and really move to leverage some of the non-captive supply that will be available to us where we actually [missed word] actually reducing the industry supply by us not increasing it and sucking up some of that excess.

But it’s going to be a test, in my opinion, for the industry for the main players to see how each one behaves over the next one to two years.

Jim Covello, Goldman Sachs: Thank you so much.

Paul Coster, JP Morgan: Thank you. Eli, I may have missed that last comment a little bit but did you say that you’re unlikely to seek third party non-captive supply next year?

Eli Harari: No, no, I didn’t. I said just the opposite, that before we go and rush and put, and build the next fab, we will try to maximize existing capacity that other people have put in place that are contractually committed and available to us.

Paul Coster, JP Morgan: Okay, got it. All right, and the other. I just want to go back to the negative elasticity comment. It doesn’t seem to matter anymore but it looks like the, you don’t need SSDs to kick in in 2010 for the market to grow and for supply/demand to be in balance. What is your latest thoughts regarding the adoption curve and timing of SSDs in view of the increased ASPs?

Eli Harari: ASP pricing definitely is pushing out SSD adoption but that’s just as well because as I said, the market is right now in good balance. If SSD were to take off anytime in the next six months, it would exacerbate the supply situation. We do believe that SSD is going to be a very important market and we do believe that in around 2011, 2012, the industry will not have sufficient supply to meet the demand from SSD that will be developed by that time. SSD is coming along, as you know, very well in enterprise. That’s still a small driver of capacity, mostly SLC, but we are actually quite optimistic about SSD and our role in SSD, but it’s probably a 2011 type of event.

Paul Coster, JP Morgan: Okay, thank you.

Tristan Gerra, Robert W. Baird: Just to follow-on on SSD, there seems to be an increasing gap between overall NAND flash reliability and what the tier one PC OEMs are demanding in terms of SSD performance, so in addition to the pricing issue currently, how do you reconcile the two if you see SSD ramping a year from now in the mainstream?

Eli Harari: Yes, there is an SSD gap, if you will, and there is definitely not all SSD product created equal or are equally reliable, and the OEMs are very, very good at testing, properly testing SSD devices. So the industry is in the early stages, early, if you will, still in its infancy. You’ve seen the issues that we’ve had with our third generation but frankly I believe that all the major manufacturers of SSD are seeing similar birth pains. But we know what the issues are and we know what needs to be done architecturally, and NAND will be up to the task. I have no doubt about that, that on a monthly basis, we are making progress, improving our performance and our quality and reliability and so do our competitors.

The operating system guys, Windows 7 is beginning to be much more flash friendly, so I don’t see that reliability or quality or endurance as being in anywhere near a show stopper for SSD. They are just kind of more birth pains, and I would expect that by some time in 2010, those issues will be mostly behind the industry, including ourselves.

Tristan Gerra, Robert W. Baird: Okay, that’s very helpful. And also a quick follow-up. You talked about 32 nanometer and 43 nanometer mix crossover this quarter for the three bit per cell. When should we expect the crossover on the costing points between 32 and 43?

Tristan, could you clarify that question, please?

Tristan Gerra, Robert W. Baird: In terms of where you start having lower production costs of 32 nanometer three bit per cell relative to 43. Does this happen at the same time in Q4 or does that take a little bit longer?

Judy Bruner: Let me make sure I understand your question, Tristan. You are asking when will we have, when will 32 nanometer three bit per cell be less costly than 43 nanometer three bit?

Tristan Gerra, Robert W. Baird: Right, and that relates obviously, you know, to the efficiency of the production as you ramp yields.

Sanjay Mehrotra: So as we said, that the crossover in terms of cost for 32 nanometer technology is in fourth quarter. So that means the 32 nanometer three bit per cell technology compared to 43 nanometer three bit per cell technology will become more cost-effective in fourth quarter.

Tristan Gerra, Robert W. Baird: Okay, great. Thank you.

Eli Harari: Fourth quarter, we mean this current quarter.

Judy Bruner: Correct.

Tristan Gerra, Robert W. Baird: Thank you.

Craig Ellis, Caris & Company: Thanks, nice job guys. Sanjay, just following up on the cost reduction point, can you be a little bit more specific than greater than 50% cost reduction this year? And then given the progress that you are making with three bit and four bit per cell, is there any reason why we wouldn’t expect mid-40s to 50% cost reduction next year?

Sanjay Mehrotra: So with respect to cost reductions, you know, cost reduction for the year will be greater than 50%, as I said, but we are really not providing any further color at this point on that. And regarding next year, we are not providing guidance with respect to the cost reduction either at this point.

But of course, that will be determined by the ramp-up of 32 nanometer as well as the ongoing mix of two bit per cell, three bit per cell technologies and 32 nanometer. We’ll be able to provide you more color on this in the Q1 timeframe.

Craig Ellis, Caris & Company: Okay, and then just taking a step back and thinking about the seasonality of the business, Judy, can you help us understand how you think about the inherent seasonality of the business as you think about the first quarter?

Judy Bruner: Sure. I really think about it, there’s two primary factors that I think about. One is that our sales generally, whether they go through retail channels or OEM channels, most of our product is ultimately destined for the consumer. And so because of that, our business is subject to the seasonal buying patterns of the consumer, again, whether through retail or through OEM, so that’s one factor to consider.

At the same time, a second factor, and Eli really touched on this today, is that the industry, the NAND flash industry supply/demand balance is in a much difference place than we’ve ever experienced before and we believe that that bodes well for industry fundamentals and pricing as we head into 2010.

Craig Ellis, Caris & Company: Okay, so just taking a step back and thinking about that, what it could mean is that pricing could be more resilient than would be typical in the first quarter but you still have to deal with the same bit growth issues fourth quarter to first quarter?

Judy Bruner: I think those would be reasonable takeaways.

Craig Ellis, Caris & Company: Okay. All right, thanks Sanjay. Thanks Judy. Thanks Eli.

Bob Gujavarty, Deutsche Bank Securities: Thanks for taking my question. I was just curious, I mean, you’ve been able to achieve some great cost reductions and I think you had a bit of a headwind in terms of the exchange rate moving against you. If that was, just hypothetically, if that would reverse out, would that just add more tailwind to your cost reductions?

Judy Bruner: I’ll take that, sure, yeah, if that were to turn around, that would certainly help our cost reduction and our gross margin. I will point out, however, that in the last one to two months, the Yen has appreciated relative to the dollar and that does have some, put some negative pressure on our cost reduction and our gross margin, primarily beginning in the 2010 timeframe because as we think about Q4, much of the inventory that we will sell in Q4 was purchased at slightly better rates, so there’s been about I’d say a 5% appreciation of the Yen to the dollar in the September/October timeframe. But there will be some impact on Q4 and we have taken that into account in the guidance that I gave today.

Bob Gujavarty, Deutsche Bank Securities: Okay, very helpful, and just a quick kind of comment about inventories. I know, I understand your explanation for your inventories on your balance sheet. What’s your sense in terms of what gives you comfort that there’s not a lot of finished goods inventory of cards or die bank inventory at customer sites? Could you give a little bit of color on maybe how you sanity check that?

Judy Bruner: Sure, I mean, we track very carefully the inventory that is in the channel, in the retail channel, as well as inventory of course that we hold in hubs for some of our large customers, so we monitor that very carefully and I will tell you that channel inventory at the end of our third quarter was at about 7.5 weeks, so a very comparable level to the end of the previous quarter.

Bob Gujavarty, Deutsche Bank Securities: Great, thanks and congratulations on a great quarter.

Edwin Mok, Needham & Company: First question is just I guess two accounting questions. First, Judy, how much more previously written down inventory do you have that you can potentially sell as of the end of last quarter? And also I noticed receivables went up last quarter. Is that because of the different mix because you are selling more to OEM now?

Judy Bruner: In terms of the inventory that we are still holding that was previously reserved, I expect that we will sell really the rest of that in the fourth quarter and that that will result in a benefit to gross margin in the fourth quarter, as I said in my prepared remarks, of approximately $40 million. There can be variation on that number plus or minus depending on exactly what sells through but that would be my best estimate at this point in time.

And then I don’t expect to have a continuing benefit from that next year because we will really have worked through it in the fourth quarter of this year. With respect to receivables, I think you are asking about accounts receivable on the balance sheet, is that correct?

Edwin Mok, Needham & Company: Yes, that’s correct. I noticed it went up quite a bit. Is that because of mix or [pause].

Judy Bruner: No, it’s really primarily because of the volume, the increased sales in the third quarter. And so there’s nothing unusual in the accounts receivable.

Edwin Mok, Needham & Company: Okay, great. And then a question for you, Sanjay, regarding costs, can you help us in terms of comparing costs between 32 nanometer and 43 nanometer? Let’s say for three bit per cell for both generational technology and let’s say your RAM capacity at the same level of, same amount of production? How much cost savings do you get from converting from 43 to 32 nanometer?

Sanjay Mehrotra: So I will answer it in comparing 43 nanometer wafer levels per gigabyte costs with the 32 nanometer wafer level per gigabyte cost, assuming the same kind of technology, like three bit per cell on each of those wafers. And assuming a similar mature yields, and that comparison is, will give 32 nanometer at the wafer level, approximately 35% cost benefit over 43 nanometer. Again, comparing apples and apples, with the assumption of mature yields.

So keep in mind that this is not the same as year-over-year cost reductions because year-over-year cost reductions will certainly be influenced by the ramp-up of 32 nanometer, as well as the mix in the products of two bit versus three bit.

Edwin Mok, Needham & Company:Great, that was helpful. And then finally just a question regarding [Eli cuts in]

Eli Harari: Let me just add a little bit. One of the advantages of the 32 nanometer X3 is that it allows us to put a 4 gigabyte die, that is 32 gigabit chip into microSD, which today to get 4 gigabyte into microSD, we need two 16 gigabit chips from the 43 nanometer X3. So going from a two die stack to one die in the same form factor has significant cost reductions also on the back-end, the assembly and test and yield of that product.

Edwin Mok, Needham & Company: Okay, great, yeah, that was very, very helpful. One last question regarding, I guess for you, Eli, regarding just your channel sales. It sounds like you guys have done [sell] a bit more component and maybe wafer even to some of your newer channel customers. I guess I have two questions around that. One is do you see that as an issue long-term as you become effectively a competitor to your partner, Toshiba? Do you have a differentiating product against them, maybe because you are selling more three, four bit product versus them selling two bits? And then finally just kind of tied to that question, regarding the private cards, are you selling to like a region that you normally don’t do business or do very little business? Is that why you guys are selling to private card customers?

Sanjay Mehrotra: So let me take that. I just want to point out that our sales to some of these private label customers actually represent a small part of their total requirements. So that means there is definitely more opportunity for us ahead but they will continue to, of course, buy from other suppliers as well.

And as I said before, the benefit that we bring to them is again our strong product portfolio and product positioning, as well as high quality production output. But I would also like to clarify here that what we are selling to these third party customers are our standard cards. With respect to the premium cards, such as high performance cards. Those are the cards and products that we supply under the SanDisk brand only. So we believe that this is long-term strategic move by us. It’s a nice growing opportunity and as I said before, provides strategic benefits to both sides and of course, as long as there is strategic benefit to both partners, we look at this as a long-term sustainable business.

Eli Harari: But let me also add on the OEM side, it’s not the private label cards. The traditional OEM business, which is embedded or going into bundled opportunities with very large OEMs. These large OEMs are looking at the landscape and realizing that the market has shifted from a, really a buyers market, to a sellers market and they are looking over the next one to two years to assure themselves of high quality supply leading edge NAND, and there’s not too many places that they can go to. So we’ve had a relatively receptive, actually highly receptive open arm acceptance by these large OEMs who want to bring us as another high quality source of supply. We are still a very small part of their business but they are, you know, they see that they will need that kind of capability at least during the next period of possibly shortages. And we are taking full advantage of that to build those long-term relationships.

Edwin Mok, Needham & Company: And quickly, Eli, about the competition with Toshiba?

Eli Harari: We compete, of course, in the market with Toshiba. Toshiba is very strong in OEM and rather weak in retail. We are very strong in retail, of course, strengthening now in OEM. This is not a zero sum gain. The markets are growing and I think that we can hold our own and this is the nature of the understanding. We have tremendously good technology development and manufacturing cooperation but as far as competition, it’s an open market competition.

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

Gary Hsueh, Oppenheimer & Co.: Thank you for taking my question. I’ll try to make it quick. My big question here on the new OEM channels that you have established and qualified, given the fact they are mostly sell-in, does this really exacerbate or mitigate kind of the seasonal weakness that you historically have seen more on the retail side of the business in Q1? I could argue both sides but I would like to kind of see what you guys think about whether or not this OEM retail channel that you’ve built up now helps or hurts seasonal weakness in Q1.

Judy Bruner: Well, Gary, as I said before, most of the product that we are selling, whether it’s going through an OEM customer or through a retail customer is ultimately destined for the consumer, so in that regard I don’t think it changes too much the seasonal buying patterns of consumers that we are subject to.

I will say, however, that generally the OEM business does result in faster revenue recognition for us than the retail business does and allows us to move the inventory faster. But ultimately I think consumer buying patterns are still a factor in our business.

Gary Hsueh, Oppenheimer & Co.: Okay. Yeah, Judy, I just wasn’t sure what to make of it because you are able to accelerate revenue recognition just suggests to me that you might see a greater vacuum in terms of seasonal weakness in Q1 but I’m not sure that’s what you are really saying though.

Judy Bruner: We’re really not providing guidance for Q1 today and, just Q4.

Gary Hsueh, Oppenheimer & Co.: Okay. And my second question, just to kind of make this real quick, is just there have been reports that in the September quarter, you ordered externally memory controller chips from a third party in Taiwan for 3 bit per cell. Is that at all impacting kind of your gross margins in the fourth quarter, which I assume when it’s taking place in terms of shipment and revenue recognition? And is that more a testament about issues with the memory controller technology at 3 bit per cell or more a testament about not enough foundry supply for the memory chip itself?

Sanjay Mehrotra: I am not going to comment on any specific rumors here but as we said in the third quarter, our unit demand increased 45% and that certainly, and a lot of that materialized within the quarter itself, so that certainly put pressure on our supply chain and our supply chain really responded very well in continuing to use our products, our memory in meeting that demand.

Gary Hsueh, Oppenheimer & Co.:Okay, so if it happened, it was just a momentary blip, just to kind of fulfill near-term demand?

Sanjay Mehrotra: You know, I’m not going to comment on that. Again, those are rumors that are out there. I’m not going to further elaborate on that.

Gary Hsueh, Oppenheimer & Co.: Okay. Appreciate it, thank you for your help.

Daniel Berenbaum, Auriga USA: Thanks for letting me back in. Judy, I just wanted to come back to my favorite topic, which is free cash flow. So you guys obviously generated some free cash flow this quarter, you’ll generate free cash flow next quarter, but with the seasonal roll-off coming into Q1, I mean, can you talk about normalized cash generation and can you talk about what kind of capex, both your capex and investments in the JV that you would need to sustain this kind of growth, and just how we should think then about free cash flow across a normal seasonal year or across a cycle?

Judy Bruner: Okay. You know, let me say up front I am not going to give guidance today for any specific cash flow metrics for 2010. I have said that I do expect positive cash flow from operations and free cash flow in the fourth quarter of ’09. But clearly free cash flow remains a key objective for us and as I think about next year in terms of capex, we have not at this point made any commitments for new wafer capacity expansion, and if that were to remain the case, then capex spending would generally be at comparable levels to what you have seen this year, which is for capex to invest in the technology transitions which fuel our product cost reduction and for which we believe there is a very high ROI for us.

But so again, free cash flow is a key metric that we are focused on but we are not prepared to give 2010 guidance today.

Daniel Berenbaum, Auriga USA: So you would think sort of about total investments if you maintain that, no capacity expansion, then total investments would be kind of in the $500 million range, similar to what they were in 2009?

Judy Bruner: With no new wafer capacity, yes, that would be a reasonable range on an annual basis for technology transitions and other related capex investments for the company.

Daniel Berenbaum, Auriga USA: Okay, and then along those lines, assuming that demand continues to grow, in that scenario where you don’t add any capacity and you have to go to your non-captive capacity, how does that affect the cost reduction roadmap? Does that slow the cost reduction roadmap or are there agreements in place where you would expect your cost reduction roadmap to remain the same?

Judy Bruner: Well, purchasing non-captive doesn’t change the cost reduction roadmap of our captive supply base but it would of course affect the margins of the total business in terms of the mix and it is of course true that product sales based on using non-captive supply would have lower gross margins than sales using captive supply. But we clearly, as we make decisions in the future to purchase non-captive, we’ll be looking carefully at the cost and ensuring that that will generate profitability for us and add incrementally to the bottom line.

Daniel Berenbaum, Auriga USA: Okay, and then maybe just last question on cost is if I just look back towards the full year of 2007 when you were at $3.9 billion, kind of midpoint of your guidance gets you close to around $3.5 billion for 2009, and your opex as a percentage of sales is much lower than it was, even at that higher revenue level in 2007, so you guys have obviously taken a lot of costs out of the company. Are there any costs that have to come back in as revenue grows. In other words, would you like to be spending more on advertising, more on branding, or conversely are there more costs that come back out as we move forward because of efficiencies?

Judy Bruner: There will be some upward pressure on opex as we move forward in order to support growth in the top line and the various initiatives that we are investing in on the technology front and in sales and marketing, as you described. But at the same time, we are going to try to limit that growth in opex until we get back to a more sustainable and good level of profits.

Daniel Berenbaum, Auriga USA: Okay, great. Thank you.

Jay Iyer, Investor Relations: Thank you for joining us on the call today.  A webcast replay of this conference call will be posted on sandisk.com/IR shortly.  Have a good evening.

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