3 March 2009 Morgan Stanley Technology Conference
Atif Malik, Analyst, Morgan Stanley
Judy Bruner, Executive Vice President, Administration and Chief Financial Officer
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Atif Malik, Analyst, Morgan Stanley: Hi. We’re going to get started. My name is Atif Malik. I cover U.S. semi cap, equipment stock, also the memory semiconductor stock at Morgan Stanley. It’s my pleasure to welcome Judy Bruner, CFO, from SanDisk. I’ve asked Judy to give some prepared remarks before the Q&A session. Judy, go ahead.
Judy Bruner, Executive Vice President, Administration and Chief Financial Officer: Okay. Thank you. Okay. Good morning, everyone. Let me start by mentioning that I will make some forward-looking statements today, and those forward-looking statements are subject to risks and uncertainties, and I encourage you to take a look at our SEC filings to get more information.
What I really want to do today is talk a little bit about what are some of the key actions that we are taking at SanDisk to manage through the current down-cycle that is impacting both our industry and the overall economy. I believe that we are planning and managing very actively and very conservatively, and I want to give you some sense of what are some of the things that we’ve been doing.
First and foremost for us, we have been rightsizing our supply base. And we’re very focused on trying to return to a mixed supply model of captive and non-captive supply. We’ve been operating for one to two years now at about a 100% captive, and we need to get back to the more flexible captive/non-captive model.
In that vein, the first action that we’ve taken, and this is a very big one, is that we have agreed to a restructuring of our capacity with our joint venture partner, Toshiba, and in this, we are selling a little bit more than 20% of our capacity to Toshiba. That agreement was reached at the end of January and it is being implemented, as we speak, and should – we are on track and it should be finished by the end of the first quarter.
In that, we will receive value at exchange rates at the end of January was about $890 million. About two-thirds of that value transfer will be in the form of transferring lease obligations from SanDisk to Toshiba, and about one-third of it will be in the form of cash that we expect to receive at about the end of the first quarter. So that’s a very significant move.
The joint ventures, when this is done, will remain 50-50 joint venture. So, essentially, Toshiba is taking on capacity that they will own directly. The joint ventures will own less than the full capacity of the fabs, but will remain 50-50. And that’s important because it means that we remain equal partners in terms of this capacity, and it does not change at all our technology development that’s done between the two companies.
And also important here is that we are going to retain the full economies of the four fabs. So even though we will own less of those four fabs, we get to enjoy the full economies of scale of those fabs in terms of our cost per bit.
A second key action that we’re taking here in terms of rightsizing supply is that we are running our fabs along with Toshiba at approximately 70% of capacity in the first quarter, and we expect to run them below capacity in the second quarter as well. So this is helping to right-size our supply.
As we look at our forecast for demand for the rest of this year, we currently expect that we will need to go back to approximately full capacity in the second half of the year in order to meet our demand forecast.
So that is currently and has been part of our plan. But when you include all of that, including running at close to full capacity in the second half of the year, we expect that our bit growth – our supply bit growth will be less than 50% for 2009. And that’s a very significant reduction from our bit growth in 2008, which was over 180%. So less than 50% is what we expect to grow our bits fab this year in terms of supply.
The third action that we’re taking in terms of rightsizing supply is that we are not engaging in any capacity expansion this year. By that, I mean wafer capacity expansion. We have brought our CapEx budget down significantly, and we’re planning to spend approximately $500 million in terms of capital investment this year compared to over 1.6 billion in 2008.
And of that 500 million, the vast majority of that number will be really maintenance in terms of technology transitions in the fab, and that means finishing the 43-nanometer transition and then beginning the 32-nanometer transition. So, all three of those actions are really geared towards rightsizing our supply.
Let me also talk about our expense actions. We have taken a number of actions to reduce our operating expenses, and we expect our expense profile in 2009 to be about 750 million compared to 911 million in 2008.
We’ve done a couple of different reductions in force. We have frozen salaries. There are no bonuses. We have cut back on employee benefits, and we have significantly reduced our variable marketing spend which we think is the right decision in this environment. We think, in this macroeconomic environment, there’s not a lot of ROI to variable marketing spend beyond the kind of merchandising that we engage in, in the retail stores.
I want to also talk about a couple of actions related to the balance sheet. First, we have filed our tax returns already for 2008, and we are actively working to get a tax refund this year. And I expect that we will get approximately $200 million in cash from the IRS to put on our balance sheet.
Second, you’ve probably noticed that in early February, we filed a universal shelf, and we filed that because our existing shelf was expiring in May of 2009. We have not made any definitive plans in terms of potential capital raise. But we wanted to have that shelf in place so that we have a pass to liquidity, should we decide that we want to add a cushion to the balance sheet. But as I said, we’ve not made any definitive plans at this point in time.
I also want to just touch on pricing. For those of you who are watching the spot market and the contract market, the pricing trends in the industry have been actually quite good. Since the end of December and through the end of February, pricing, spot and contract, has either been stable or up on a week-on-week basis during that entire timeframe. And I would tell you that we have been pleasantly surprised by that level of stability.
Most of the industry analysts are suggesting that supply-demand balance for the NAND industry has reached in the second half of the year, and so this improved pricing environment is clearly a very positive trend as we enter 2009, and based on that, we have been raising prices in certain customer situations.
Now, I still fully expect our ASP per gigabyte to come down from Q4 to Q1, because we had bid lock-in at certain lower prices with OEM customers, as well as with retail, but these recent pricing trends bode well for the industry and for our pricing.
So with that, I want to just say that I think we are positioned well for when this market turns. Despite our cutbacks in expenses, we are preserving our investments in technology, and we’re preserving our investments in innovation. Our partnership with Toshiba remains strong at the manufacturing level and at the technology level, and we are very focused on maintaining the strength of our balance sheet. So I believe that we are very well positioned for when themarket turns. Okay. Thank you.
Atif Malik, Analyst, Morgan Stanley: Thanks, Judy.
Q&A
Atif Malik: Judy, I think, you touched on some of my questions already, but I just wanted to dive in more detail on some of these questions. So let’s talk about the inventories. On your last call, the picture that you painted for the inventories was that they’re going to be flattish for Q1 over Q4, where do we stand on the inventories given that we’ve seen some level of restocking in the channels that’s driving the pricing up?
Judy Bruner: You are asking, I assume about inventory on our balance sheet?
Atif Malik: Right.
Judy Bruner: Yes. Actually, I think I’ve said that inventory would most likely grow from the end of Q4 to the end of Q1, because remember that Q1 is a down seasonal quarter in terms of demand. By the way, I want to point out that demand for us is still growing on a year-over-year basis, but Q4 to Q1 is a down seasonal quarter. So I do expect that inventory will still grow from Q4 to Q1. But inventory will begin to get right size, because of the restructuring of the joint ventures, which should be done by the end of the first quarter and also because we’re now running the fab at about 70% of capacity. So we expect that by the end of this year, we will have brought our inventory levels down to a much healthier level, and that as we enter 2010, it’s very likely that we will need to be purchasing non-captive inventory in order to meet demand.
Atif Malik: Got it. So on the pricing side, what has been the driver for this pricing improvement that we are seeing – that we have seen in January, February?
Judy Bruner: Well, I believe that really all of the key players in the NAND industries have stopped capacity growth. And I believe that most of the fabs are being run at less than full capacity today. So I believe that is clearly helping. And I believe that on the demand side, the demand for NAND product is still growing on a year-over-year basis. In 2008, for example, we still saw a 15% year-over-year growth in unit demand even in a very weak economy and we got close to a 100% growth in average capacity. So even in a very weak environment and even in Q1, our demand is growing on a year-over-year basis.
Atif Malik: So there are some people who are concerned that the incremental supply that your partner could potentially bring up in Q2 because they have more access to your supply. So you don’t see a risk to incremental supply in Q2, Q3 from the capacity that’s standing idle right now as most NAND makers are running less than 100% utilization, it sounds like there’s not too much risk of more supply coming on at least in the next couple of quarters. Is that the right way to think about the incremental supply?
Judy Bruner: I don’t expect that there is going to be any capacity additions to the industry in 2009. I do expect that most likely we and others will go back to full utilization of the existing supply at some point, because I think that we’ll need to do that in order to meet demand. But, when that occurs, when we start to go back to full utilization, it will take probably four to six months before that product from the time that the decision is made until that product actually hits the resale market. But I think that we’ll need to do that in order meet demand. The industry analysts are suggesting that supply growth for this year for the industry will be somewhere between about 60 and 90%, and that assumes that most of the fabs are run at full utilization, I believe, in the second half of the year and that kind of number is much reduced from growth for the industry, probably, 120 to 140% in 2008.
Atif Malik: Sure. Judy, on the gross margins, there are a couple of forces at play here, you’re seeing down the utilization, so how should we think about your product gross margins there? Is it fair to assume the Q4 was the bottom and Q1 is the margin that is going to be negative but still higher than Q4 and then the margins could become positive on the products exiting this year?
Judy Bruner: Well, I did say, on our February 2 call, that for the first quarter we expect our margins clearly to be negative by a considerable amount, but not as negative as in the fourth quarter. So, yes, I do expect that there is an improvement in terms of that percentage. What we really need to get back to positive gross margins is several quarters of fairly benign price movement, while we continue to execute on the underlying cost reduction of our product. And that cost reduction was very good actually in 2008. And we believe we have a very strong roadmap in 2009 as well.
Atif Malik: So for 2009, you mentioned a bit supply growth for yourself of less than 50%. How should we think about the cost per bit decline for 2009?
Judy Bruner: We expect the cost per bit decline in 2009 is in the 40 to 50% range.
Atif Malik: And having 3-bit-per-cell and 4-bit-per-cell, I mean that does give you more leverage versus your competitors on a relative basis, right?
Judy Bruner: Yes, absolutely. I mean I believe that we’re clearly in the lead today with 3-bit-per-cell, and SanDisk and Toshiba are the only producers of 3-bit-per-cell and we are really definitely in the lead in terms of products in the marketplace using 3-bit-per-cell, and we’re using 3-bit-per-cell in most of our products today. 3-bit-per-cell was 15% of our production in the fourth quarter, and we expect it will be about 50% of our overall production in 2009.
Atif Malik: So, Judy, on the balance sheet, I think for the sake of the audience, I just wanted to understand your announcement to raise equity. In terms of priority, how much of it was driven by the macro environment, and making sure you guys have enough cash for this year? And how much was it based on some of the leasing obligations that you guys have in Japan. And some of the covenants that you’ve talked about publicly are tied to these leasing obligations. So in terms of – for the audience, and in terms of priority, what was first and what was second for your decision?
Judy Bruner: Well, really we factor in all of the factors. Again, we have not made a definitive decision as to raising capital. What I said on the last call was that, if we decide to raise capital, it would most likely be in some form of equity rather than debt, because we are conscious of not levering our balance sheet further. And, clearly, factoring into any decision we might make, will be the uncertainty of the duration of the current down-cycle and our desire to keep our balance sheet strong given that uncertainty and given the fact that we do have large off balance sheet lease obligations that we pay attention to.
Atif Malik: Okay. And given what you’ve said, it sounds like, you guys are fairly optimistic about utilization picking up in the second half on better demand. I mean is it fair to say that the probability of the R&I credit agency to potentially downgrade you below the threshold level is quite low at this point given what you guys are seeing in your crystal balls in second half of ’09?
Judy Bruner: Well, I can’t speak for the rating agency. But I will tell you that our current rating was reaffirmed after our fourth quarter results and that rating is one notch above the required threshold in our covenants. So that’s something that we monitor and we’re focused on keeping our balance sheet strong and we’re focused on improving the operating results at the year unfolds.
Atif Malik: Okay. And do you have any base case or bear case, cash burn scenarios for 2009? How should we think about the base case cash burn for 2009?
Judy Bruner: What I’ve said in terms of cash usage for 2009, is that I believe our cash usage will approximate the non-GAAP operating results. So assuming a non-GAAP operating loss, then I think our cash usage would approximate that kind of number.
Atif Malik: Are there any questions in the audience? Go ahead. Can you wait for the mic to…?
Q: As far as you can tell, are any of the companies in the category pricing below variable cost?
Judy Bruner: I believe that for most, clearly for us, that we are still selling above the variable cash cost to produce a megabyte. But keep in mind that the vast majority of the costs in the fab are fixed. So gross margins are negative, but we’re still selling above the variable cash costs to build, and because of that, it’s a tough decision to run the fab at less than full capacity, if you’re still selling above the variable cash cost. But we’re doing that because we want to more quickly right size our supply and begin to reduce our inventory.
Q: So I wanted to pivot off of that question and just ask, do you see other players in the category making a similar decision to try and back down their capacity, so that the business might more quickly come into balance on supply/demand. Pricing might get some lift and so on.
Judy Bruner: I really can’t speak to what decisions others – what factors they’ve weighed, but I do believe that most industry participants are running below full capacity today.
Q: You mentioned that your bit growth this year – production bit growth would be less than 50% you expect. If you add in the inventories that you’ve got on hand left over from 2008, what would your total bits available for sale would be this year, growth in terms year-over-year?
Judy Bruner: Yes. Predicting the demand side of the equation is tougher in this environment than the supply. We have a good handle on the supply. What I can tell you is that we have enough inventory, I think, to be able to meet whatever demand is out there. And I would expect that it will be late this year or early next year before we would need to start purchasing non-captive inventory to meet demand.
In 2008, our revenue growth in terms of bits was 125%. So in 2008, our revenue grew 125% in terms of megabytes and our supply grew over 180% in terms of megabytes. So, therefore, we build a lot of inventory in 2008.
In 2009, we’re saying supply will grow less than 50%. I don’t know yet what demand will be. I clearly believe demand growth will be higher than the 50%, but I can’t – we haven’t provided a prediction relative to the 125% that we experienced in 2008. But, I believe there will be a gap there and that gap will let us bring our inventory down to a much healthier level and get back in a position where we need to start purchasing non-captive to meet that demand.
So let me reiterate that as I said earlier, demand is still growing in units on year-over-year basis and its still growing very nicely in terms of average capacity. Average capacity grew almost a 100% for us in 2008. So consumers are still wanting more capacity in the cards and the USB drive that they buy. Yes.
Q: This is just a real basic question, I guess, on semiconductor production. So if your supply increases by 50% with effectively no non-maintenance CapEx in 2009, what is it that drives that? Is that yield or is that shrink that – how do you get 50% increase without doing anything?
Judy Bruner: Yes. Okay. The way we get that supply growth in bits is through the shrink, because when you go from 56 to 43 or 43 to 32 you’re getting more bits per wafer and, going from 2-bit-per-cell production to 3-bit-per-cell production. So in 2009, we will have a higher proportion of our shift on 3-bit-per-cell MLC as opposed to in 2008.
Q: Okay. So I think I understand that, but just to make sure so just taking some movement from 2 to 3-bit architecture, that’s I guess costless from a capital perspective. It’s merely the implementation of priorly spent R&D?
Judy Bruner: Yes, right. That really does not materially influence the CapEx budget. What drives the capital investment budget is really the shrink and going through the shrinks in the past.
Q: Okay. So and that’s my second question. So you had defined the CapEx as maintenance CapEx and then went on to say that’s I guess 4X and 2X transition.
Judy Bruner: Okay.
Q: It seems to me that that’s – I mean when I think about maintenance CapEx for a non-semiconductor industry, it’s really the CapEx required to sustain current production?
Judy Bruner: Okay. So maybe let me define my use of maintenance. When I use the word maintenance, I meant going through the normal shrink transitions that we need to go through to reduce cost of our bits. Yes.
Q: All right. Okay. I got you. Great. And then just the final question if I may, would you say that either for SanDisk or for the industry, that in a capital constrained environment, 50% supply growth would be sort of a baseline or organic increase in supply year in and year out on a long-term basis?
Judy Bruner: I would say that our bit growth this year, which will be less than 50%, is relatively constrained. And it’s being influenced by two unusual factors. One is the sale of capacity to Toshiba, and the second is that we’re running the fab below full capacity, and that would not be a normal occurrence.
Q: So, it’d be about 85% average for 2009 based on two quarters at 70 and two quarters of 100%?
Judy Bruner: It would be more than 50% in a normal year, if we weren’t running below capacity and selling.
Q: So the supply growth that you’re quoting, is that adjusted for the capacity sales?
Judy Bruner: For SanDisk, yes.
Q: Yes. So what would the like-for-like number be then?
Judy Bruner: We really haven’t given that number.
Q: All right, all right.
Judy Bruner: Yes. Yes.
Q: Are there significant new applications coming along? I think you have solid state disk or whatever the case may be that you think could substantially change the supply/demand equation sometime in the next two years?
Judy Bruner: Yes, good question. I think, clearly, the next big market that we expect will emerge is the market for solid state drives used in notebooks and netbooks, and ultimately in enterprise servers as well. And we are coming to market middle of this year with what we call our third generation or a third generation SSD. These will be SSD products that utilize MLC memory, but meets the performance specs that were previously met just with SLC memory. So we have been working on the controller chip that allows us to bring those products to market. And we’ll be bringing those to market, middle of this year in sizes ranging from 60 gigabyte to 240 gigabyte. So this is a potentially very big market. We believe it becomes more significant for the industry starting in the 2010 timeframe.
Q: What are the drivers that are going to increase demand in the second half?
Judy Bruner: The key drivers, I would say – first of all, the biggest end market for us today is the mobile handset market and that the use of cards or embedded memory in mobile handsets that generates about 35% of our revenue. And that I believe is likely to continue to be the biggest market and probably has the potential to grow in the near term more than the other markets that we’re in. But I’ll tell you at the same time that we’ve seen actually stronger than expected demand in the last quarter both in the imaging space and in the USB space. We saw good unit demand and strong average capacity growth in the fourth quarter; of course, from a revenue perspective we had aggressive pricing in the fourth quarter and in the third quarter. But from a unit demand perspective, we were pretty pleased with that demand in the fourth quarter
Q: Then a question on the royalties and this is a hypothetical case, assuming Samsung NAND revenues are stable or flat from Q4 levels, and if SanDisk layers the three bits per cell IP on to the existing two bit per cell IP, does the net royalty revenue still go down for SanDisk in this hypothetical case?
Judy Bruner: The license agreement that we have in place with Samsung, which was put in place in 2002, I mean really didn’t contemplate three bit per cell, so that license agreement addresses SLC and it addresses MLC, multi-level cell.
Q: Okay. And I think you touched on, in your prepared remarks, are you guys looking at potential supply agreement with Samsung as part of the royalty renegotiation process where you can get access to supply it at a lower rate. Let’s say, next year when the demand is better? Is that on the table, as far as the royalty discussions?
Judy Bruner: I really can’t comments on any current discussions. We do currently have a supply agreement in place with Samsung.
Q: Okay. I think – publicly you’ve said that you do expect a drop in the royalty rate moving forward. And I just wanted to understand how is the company thinking about offsetting this decline in the revenue. Are you guys counting on increased IP contribution from let’s say, Toshiba and other memory module makers in 2010 through your 3D matrix effort or do you think of entering a new market or a new product? How is the company thinking about offsetting this decline exiting this year?
Judy Bruner: We have been pursuing monetization of IP in different areas. We have been pursuing monetization at the card format level, in addition to the chip level. So that’s something I expect will continue. But remember that the bulk of our business is based on product business and that’s where we really are investing. The majority of our R&D and innovation is to come out with new products, including in the newer SSD space.
Q: Judy, you talked about OpEx cut for this year. Can you talk about some of the products that are going to be, like phased out and the company is not going to be working on them anymore? How is the company thinking about these exceptional times where demand is quite low? And so how are you guys positioning yourself for the next year in terms of your product portfolio and does it still make sense for SanDisk to be in the MP3 player market?
Judy Bruner: We have actually pared back on the number of SKUs, the number of products in each of our major product lines. And we believe that makes sense in this environment. And in the MP3 space, we have pared back on the number of devices there as well. But we are still in the audio/video space, and in particular we’re focusing on what I would call the slot media area. We have brought to market preloaded cards with – preloaded with music content along with devices that play those cards. The devices themselves having no memory but just utilizing these pre-loaded cards. We’ve also brought to market a new product called slotRadio, and this is going to be lazy man’s approach to MP3, but you get a slotRadio with a card that has a thousand songs. And you basically are picking songs by genre rather than spending your time downloading music. So we are still investing in that space, but again we will have fewer SKUs and we’ll have fewer SKUs in our other product lines as well.
Q: And Judy you talked about solid state drive as one of the drivers of demand. How should we think about the sweet spot for both density and pricing for consumer as well as enterprise segments for solid state drive?
Judy Bruner: Well, in terms of density, it varies based on the application, sweet spot density for a netbook is much lower than the sweet spot density for a notebook. But, we have products across all of those ranges. I think the issue more for this market to take-off is more about performance and about price. And in terms of performance our new generation 3 SSD, in the testing we’ve done so far, again, we haven’t brought them to market but our testing we’ve seen read, write speeds about five times that of an equivalent hard drive. So that really begins to make a very noticeable difference for the consumer in term of the amount of time that it takes to access a file or save a file and the boot up time is very noticeably faster as well. So performance is a key factor that you want to see a very noticeable difference before you are willing to pay a higher price for an SSD versus a hard drive. And then price is the other factor, and price is coming down, but I don’t think we have the sweet spot yet, in terms of price. And that’s probably going to take another one to two years to really begin to approach that sweet spot.
Q: Can you provide an update on your litigation status with some of the memory module makers, and like Payton I mean ITC ruling. Is there anything at least in the near future that we should be watching for with respect to litigation that SanDisk is involved in?
Judy Bruner: We have said that we have settled with, I believe, eight of the names, parties in our card format litigation, so that – and that is ongoing. And we did have hearings at the ITC not that long ago. So I believe that there will be some decisions coming out there in the coming month.
Q: A quick question, have you already received qualification for your third generation MLC based SSD from PC OEM customers?
Judy Bruner: We have not released these products yet, and so we’ve not – we are in discussions with PC OEMs, but we’ve made not any announcements there.
Q: Are you expecting the products will be qualified some time in middle of this year?
Judy Bruner: Yes.
Q: Okay.
Atif Malik, Analyst, Morgan Stanley: I think that’s all the time we have. Thanks Judy for coming out to the conference.
Judy Bruner: Okay, all right. Thank you, Atif.
SanDisk etc 