2010.07.22 SanDisk Q2 Conference Call

22 June 2010 SanDisk Q2 Conference Call

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

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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 and Judy Bruner, Executive Vice President of Administration and CFO.

[safe harbor]

With that, I will turn the call over to Eli.

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Dr. Eli Harari, Chairman and Chief Executive Officer: Thank you, Jay, and good afternoon everyone.

We are very pleased with our excellent second quarter results, continuing the positive trend of the past several quarters, and setting the stage for a strong finish to 2010.

I will direct my remarks to the prevailing industry-wide demand-supply conditions and our Fab 5 announcement last week with our partner Toshiba.  I will then comment on today’s announcement regarding my decision to retire as Chairman and CEO of SanDisk at the end of this calendar year, and our succession plan. Sanjay and Judy will provide details on the second quarter and the outlook for the
second half of the year.

We believe the NAND flash industry continues to experience a healthy demand-supply balance, as evidenced by modest price declines throughout the second quarter.  In the second half, our customer demand is expected to exceed our supply, driven primarily by strong mobile OEM sales, as well as seasonal improvement in retail demand.  Our own supply situation is looking quite tight in the second half, the result of our OEM business doing much better than we had forecasted just six months ago, and we continue to work closely with our customers in this environment.  We now have greater visibility, and are more confident in the sustained demand from our diversified channels and markets, and therefore we have now approved the final phase of Fab 4 expansion, which will result in additional petabytes in the first half of 2011.

Last week at Yokkaichi, Japan, we signed the Fab 5 agreement with our long term strategic partner, Toshiba.  This represents a major strategic decision for us, one that will allow us to keep pace with the projected strong growth in our flash markets in the coming decade.  Due to long construction and equipment lead-times, this decision is now timely and necessary, and the Fab 5 contribution to our existing supply base will become meaningful starting in late 2011.  The Fab 5 agreement provides us flexibility to participate at up to 50% of the investment and corresponding capacity allocation, with our actual percentage participation being determined at our discretion.  Furthermore, beyond the initial startup ramp and within certain limits, we have the flexibility to time our own production ramp-rate to best meet our customers’ demand profile.

Fab 5 will take several years to ramp to full capacity, at which point it is expected be one of the largest, most efficient and most advanced NAND Flash memory fabs in the world.  It will be capable of supporting extreme ultra violet (EUV) lithography tools when they become available for production, and we also see it as possibly our first fab for 3D Read/Write when this technology becomes ready for commercialization.

Fab 5 will require substantial capital investments, spread primarily over 2011- 2014, as well as startup costs in the second half of 2011.  We have not finalized our Fab 5 production plans beyond the initial minimum commitment and we will provide Fab 5 capex projections in the first quarter of 2011 when we have better planning visibility.  We believe that the much improved strength of our balance sheet and the growing scale and diversity of our business support this important investment in Fab 5.

Moving now to today’s announcement of my retirement from SanDisk and our succession plan.  I consider myself to have been the luckiest guy in our industry these past 22 years as together with our team we built SanDisk from the proverbial idea sketched on a napkin into a great company in an industry that we pioneered.  This year I turned 65.  Also this year, SanDisk is stronger than ever, and poised to do even better in the years ahead.  This is a good time to pass the baton to a new leader.  We are very fortunate that my partner and co-founder, Sanjay Mehrotra has accepted the CEO role, effective January 1, 2011.

Sanjay is 52 years old, and over the last 22 years, he has contributed in numerous major roles as SanDisk grew to its current size and stature. He has tremendous integrity and business acumen, and as a superb memory engineer he is as knowledgeable about Flash storage as any other person in our industry. Sanjay has displayed strong leadership through the years and, in particular, during the recent difficult downturn when we restructured and strategically redirected SanDisk on to its current course.  He has my, and the board’s full confidence and support and is ready and able to lead SanDisk to the next level in the years ahead.  SanDisk’s new non-executive Chairman of the Board effective January 1, 2011 will be Michael Marks, a long-time SanDisk board director and former Flextronics CEO.  At the Board’s request, I have agreed to provide the company with advisory services, particularly technology related, on a part-time basis in the two years subsequent to my retirement.

For myself, I will continue driving SanDisk hard until midnight December 31, 2010.  During the next five months I hope to also meet with many of our shareholders, customers and partners.  Beyond that I currently have no specific plans, and am looking forward to new adventures with my wife – my life’s partner.

I will now pass it over to Sanjay.

Thank you Eli, good afternoon everyone.

First, I would like to thank Eli and the SanDisk Board of Directors for their confidence in asking me to take over the role of SanDisk President and CEO starting January 1, 2011.  Over the last twenty two years, I have benefited from the valuable mentoring and insight provided to me by Eli as SanDisk grew from a start up to one of the most recognized companies in the high tech industry.  It is my honor to have an opportunity to follow in Eli’s footsteps and as successful as SanDisk is today, I am confident that our best days are still ahead.  I look forward to working with the SanDisk team to bring innovative products to market that anticipate our customers’ requirements and drive SanDisk to new heights.

Now moving on to our second-quarter review, our revenue results were strong, driven primarily by continued success in the OEM markets.  Our OEM business grew 181% from the year-ago quarter with unit volume more than doubling during the same period.  Within our OEM business, our microSD cards posted strong unit and revenue growth.  In addition, our embedded storage products business grew substantially, setting a record for both units and revenues, with robust increase in sales of high capacity, 8  gigabytes or greater, products.  In retail, we maintained our focus on continued improvements in profitability and brand premium in all regions.

The ramp of our 32 nanometer technology has progressed well with high yields and productivity.  The mix of 32 nanometer technology using X2 and our third generation X3 architecture was about two-thirds of our total production output. We expect to complete the 32 nanometer transition in the third quarter.  This progress combined with continued high usage of X3 is delivering better cost reductions than we expected for the year. Our X3 designs are now fully mature and we believe that they deliver significantly superior performance and reliability compared to competitors’ X3 products.  Just to reiterate, the use of our X3 in our card and embedded products is essentially transparent to the user and we price it no differently than comparable X2 memory based products from ourselves or competitors.  Addressing our next generation technology, we are on track to start transitioning to the 24 nanometer node later this year.

Our supply chain executed well, delivering record unit sales in the second quarter. We now expect to ship well over 500 million memory units during 2010 with approximately 50% of these units assembled, tested and shipped from our Shanghai manufacturing facility.  The scale up of this factory has improved our cycle time, inventory management, costs and customer responsiveness.

As we look into the second-half of the year and beyond, new product cycles from smartphones, tablets, eBooks and other mobile internet devices should continue to drive the need for increased NAND flash-based storage solutions.  We see a flurry of design activity amongst the PC and other technology leaders to develop iPAD- like products.  We believe that the runaway success of the iPAD, and its future competition, should accelerate the adoption of flash storage in such ultra mobile platforms.  This new generation of tablets represents a fast growing category  which sports a thin light weight form factor, full day battery, is web connected, application driven, always on and rugged and highly reliable.  These key attributes can best be enabled by NAND flash based high capacity storage solutions, including SSD.

Customer engagement with our product roadmap that includes P series solid state drive designed for tablets, netbook PCs and ultrathin peripherals and G series SSD for mainstream notebook PCs continues to evolve well.  We are gaining traction with design-wins at key OEMs and look forward to growth in this important business.

The SanDisk team is excited about the prospects for our business ahead and we look forward to a successful 2010.  With that, I will turn over the call to Judy.

Judy Bruner, Executive Vice-President Administration and Chief Financial Officer: Thank you, Sanjay.  We delivered our highest ever second quarter revenue, gross margin, operating margin and EPS, and our cash & investments stand at the highest level in the Company’s history on both a gross and net basis.

Our product revenue was up 10% sequentially and 79% year-over-year with the growth generated primarily from mobile handset products, imaging products and wafers and components. Our license and royalty revenue was in the range we forecasted, with a 27% year-over-year decline reflecting the current Samsung license agreement.  Our Q2 product revenue channel mix was 65% OEM and 35% retail. Our retail revenue grew 3% sequentially and 7% year-over-year, with the strongest retail growth coming from the Imaging market.  Looking at our retail revenue by geography, on a year-over-year basis, we experienced strong growth in Asia, modest growth in the Americas and a decline in EMEA, reflecting weak economic conditions in Europe.  Our OEM revenue grew 14% sequentially and 181% year-over-year with the strongest growth coming from the mobile market.

Across all channels, the mobile market generated 48% of our Q2 revenue. Turning to a few statistics on pricing and bits, our ASP per gigabyte declined a modest 8%sequentially and 18% year-over-year, and our gigabytes sold grew 18% sequentially and 116% year-over-year.  The average capacity of our products sold grew 9% sequentially and 16% year-over-year.

Our Non-GAAP product gross margin improved sequentially by approximately one percentage point to 42.4%, as our product cost per gigabyte improved 9% sequentially, slightly more than price decline. Gross margin exceeded our previous forecast primarily because we were able to manage the quarter with less retail promotional spend, and our usage of 3-bits per cell memory, or X3, remained similar to the strong level in Q1, whereas we had previously anticipated a slightly lower mix of X3 in the second quarter.

Non-GAAP operating expenses grew only $2 million sequentially and at 14.7% of revenue, expenses are slightly below our long-term financial model range of 15%- 17%.   We continue to prioritize investment in technology and innovation, and we are hiring in order to manage growth and invest for the future.

Our operating margin improved sequentially on a GAAP basis from 29% to 30%, and on a non-GAAP basis from 31% to 32%, second only to the fourth quarter of 2009. Our non-GAAP Other Income of $14 million included gains of $7 million related to the sale of certain investments. Our expected non-GAAP tax rate for the year has come down from 37% to 35.5%, and as a result, the non-GAAP tax rate in Q2 is approximately 34% in order to bring the year-to-date rate to 35.5%.

On the balance sheet, cash and short and long-term marketable securities increased sequentially by $422 million to $3.7 billion.  Second quarter cash flow from operations was $385 million and our 6 months year-to-date cash flow from operations is $713 million, higher than we have previously generated in any full year.  During Q2, we purchased $22 million in non-fab capital equipment, resulting in free-cash-flow of $363 million.  SanDisk Fab 3 and 4 joint venture capital investments have been approximately $265 million on a year-to-date basis, all for technology transitions, and this has been funded entirely by joint venture working capital, resulting in no payments to the joint ventures and no new leases so far this year. Our off balance sheet equipment lease guarantees totaled $966 million at the end of Q2, slightly up sequentially due to the Yen to Dollar exchange rate.  Our inventory dollars ended Q2 below $500 million, the lowest dollar level since Q306 when our business was substantially smaller.  Measured on a petabyte basis, our inventory is between 8 and 9 weeks, which is lean for our vertically integrated supply chain model.

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.

Demand indications from our customers are strong for the second half of the year, and we expect to be supply constrained in the second half.  Incremental supply from Fab 4 expansion will primarily be available in Q4, which will help with end of year seasonality, and we have placed orders for some non-captive supply, which will also primarily benefit Q4, but we do not expect our available supply to be adequate to meet demand. We expect Q3 total revenue to be between $1.175 billion and $1.250 billion.  Within this total Q3 revenue, we forecast license and royalty revenue to be between $90 and $100 million.  Despite supply constraints, we are raising our full year revenue estimate.   Recall we started the year with an estimate of $4.0 to $4.4 billion and after Q1 we raised that range to $4.5 to $4.8 billion.  We now expect total revenue to be between $4.7 billion and $4.9 billion for 2010, including license and royalty revenue between $360 and $375 million.

Turning to gross margins, we now expect our full year cost per gigabyte improvement to be better than 40%, and we expect the pricing environment to remain favorable.  In the second half, we will have some unfavorable gross margin impact from non-captive supply and from the Yen to Dollar exchange rate, which has moved against us in recent weeks.  Based upon all of these factors, we now expect the product gross margin percentage in the second half to be roughly comparable to the first half of the year.  For the full year, this would result in product gross margin more than 4 percentage points above the mid-point of our previous guidance.  Our forecast for non-GAAP operating expenses for the full year remains at approximately $750 million, with Q3 at approximately $195 million.

Our forecast for non-GAAP other income remains at approximately $60 million for the year, and we forecast the non-GAAP tax rate to be 35.5%.

We are pulling in the timing of Fab 4 expansion plans with the completion of Fab 4 expansion still in the first half of 2011. With this pull-in, our forecasted capital investments for 2010 have increased to approximately $1.1 billion, compared to our last estimate of approximately $900 million.  The $1.1 billion is comprised of an estimated $1.0 billion of joint venture fab equipment in Fabs 3 and 4, and $100 million of non-fab capex.  Roughly $300 million of these investments were made in the first half of 2010 and $800 million remain in the second half.  Recall that there are three sources of funding for our capital investments, including joint venture working capital, equipment leases and SanDisk cash.  While our 2010 capital investments have increased due to the pull-in of Fab 4 expansion, the estimated cash requirement for 2010 remains at the low end of the range we provided early this year, or approximately $300 million, due to strong joint venture working capital and certain expansion payments occurring in 2011.

In closing, we are extremely pleased with our Q2 results and we are working very hard to optimize and maximize supply for our customer demand in the second half.  At the same time, we are managing our business and strategic investments to drive future growth, profitability and cash generation.  We will now open the call for your questions.

Q&A

Daniel Amir, Lazard Capital Markets: Thanks a lot. And first, Eli, I wanted to thank for you the years in leading SanDisk and good luck in your next life.

Eli Harari: Thank you. Appreciate that.

Daniel Amir, Lazard Capital Markets: So, first of all, what – considering your non-captive supply here, what will be your non-captive percentage here in the second half of the year? And what you expect now SanDisk’s bit growth to be for this year? And I have one follow up question.

Judy Bruner: Hi, Daniel. This is Judy. In terms of non-captive supply in the second half, we expect it to be in the single digits in terms of percentage of our overall supply in the second half. And I’m sorry, the second part of your question was?

Daniel Amir, Lazard Capital Markets: Bit growth for the year?

Judy Bruner: In terms of our captive supply, our captive supply is growing at approximately 75% in terms of year over year growth. We’re not providing a bit growth estimate in terms of our overall revenue. We’re giving a revenue range of 4.7 billion to 4.9 billion, and that does include this modest usage of non-captive in the second half.

Daniel Amir, Lazard Capital Markets: Now, in terms of the decision on using the non-captive supply, I mean, is the fact that there’s not enough supply available that you wouldn’t want to increase it beyond the single digits? Or is it an issue of you don’t want to sacrifice necessarily the margins because those are obviously lower margin components for you?

Sanjay Mehrotra: Daniel, as you know, our demand has grown rapidly during the course of the year. In fact, we have raised the revenue estimate second time giving – compared to the start of the year now. So we are basically running as fast as we can in terms of really fulfilling the demand, and that includes maximizing our captive supply, but, yes, also tapping into the NAND non-captive sources. So we saw the demand increasing during the second quarter. We placed orders for the non-captive supply. We’ll be
receiving it in third quarter. So in terms of shipments, the impact of non-captive in third quarter will be small, and in the fourth quarter, it will be somewhat larger. But as Judy said, overall, for the second half, still, it will be in single digit percentage.

So there are several factors that we look at in managing our non-captive business. We want to make sure that we are managing it prudently. And some of the considerations include margins, the mix of the product as well as basically the timing of the supply that’s available. So looking at all of that, our picture ahead is single digit percentage in the second half of non-captive utilization.

Daniel Amir, Lazard Capital Markets: Great. And Eli, just one final question. What was the thought process on Fab 5 considering the difference in the agreement compared to Fab 3 and 4 in terms of capacity, output and investment?

Eli Harari: Well, as you know, we went away from the nonbinding MOU that we had signed with Toshiba two years ago, it’s slightly more than two years ago, that was
structured somewhat differently. It was a 25/75% type agreement with another 25 that we could purchase on a foundry basis and, of course, things have changed dramatically since that time. And with the visibility that we have into the future now with our new very – significantly more diversified channel, we felt that we would need basically to structure
the agreement on a 50/50 basis just as we had in the prior agreement.

However, the difference that we were able to achieve here is to give us flexibility since our ramp profile and customer requirements may be somewhat different than Toshiba’s to give us the ability except for the initial ramp up phase which is jointly undertaken and committed to give us flexibility to have a different ramp than Toshiba while still maintaining an equal cost structure and also be able to catch up in that capacity. And, of course, if we did not want to use the full 50%, we have that flexibility as well.

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

Eli Harari: Thank you.

Gary Hsueh, Oppenheimer: Eli, congratulations on leaving the company in such great shape.

Eli Harari: Thank you.

Gary Hsueh, Oppenheimer: Judy, I’ve got a quick question here for you, just help me understand. You’ve talked about inventory numbers coming down at very much higher revenue levels. I was wondering if you could talk about deferred revenue and deferred income, why that number might be higher than it’s ever been before and particularly considering the fact that this is more of an OEM business model now rather than a retail model. I mean, what – help me understand the discrepancy between inventory and deferred revenue and what might be happening here?

Judy Bruner: Sure. Actually, one thing that’s important to understand is that the deferred revenue you see on the balance sheet is actually deferred income, meaning it’s the deferred gross margin, and since gross margins are extremely high, that tends to push the number up. So that’s really the key variable in terms of the amount of that deferred income. Our channel inventory, which is primarily retail and is reflected in that number, is at pretty standard levels at approximately eight weeks of channel inventory.

Gary Hsueh, Oppenheimer: Okay. So you said that your inventory levels were eight to nine weeks, but despite the fact that the deferred income number went up, the channel inventory level is roughly in the same range?

Judy Bruner: Yes. So there’s two buckets of inventory, and the eight to nine weeks I referred to earlier in my prepared remarks is the inventory on our balance sheet that SanDisk owns, and then I am saying that in addition, there is inventory in the retail channels, that we have sold to the retail channels but for which we’ve not yet recognized revenue, and that that stands at about eight weeks, which is a fairly typical level.

Gary Hsueh, Oppenheimer: Okay. Great. Thank you so much.

Atif Malik, Morgan Stanley: Hi. Thanks for taking my questions. Eli, congratulations and good luck.

Eli Harari: Thank you.

Atif Malik, Morgan Stanley: Question on the tablets. You mentioned you have a diversified card base now. So if I look at the tablets that are out in the market, with exception of one, we haven’t seen other tablets come out yet. So when you said second half demand, I’m just trying to get a sense, since you guys are exposed to pretty much all tablets, where – are we expecting a pickup in a broad based tablet demand for NAND in 3Q or in 4Q?

Eli Harari: Sanjay, go ahead.

Sanjay Mehrotra: So therefore, this year – our revenue contribution from SSDs, the pSSD and our other product that go into tablet market will be relatively small. The growth driver for this year is mobile phone. But I can tell you that we are experiencing strong design wins in tablets, and we are continuing to have strong customer engagement and continuing to really look at growth picking up in this category for us in 2011 and 2012 timeframe. So for the year relatively small revenue, the primary growth driver is mobile phones.

But exciting opportunity that is building up, and we are well entrenched with customer engagement in this area and design wins as well.

Eli Harari: I think the iPad and tablets like the iPad clearly represent a major new category. I think everybody’s scrambling – everybody decide they’re competing Apple’s, scrambling to deliver tablet PCs that are more – that can match anywhere close to the iPad. But the amazing thing as you’ve seen Apple announcing this week in the first three months of the iPad achieving 3.3 million units, and it took them 30 years to get the Mac sales to reach 3.5 million in the last quarter, which they were still very proud of.

So the nature of these new platforms, I mean ebook, Amazon just mentioned this week that they’ve sold more ebooks than hardcover books, which is astonishing how quickly – this is just amazing. And, of course, flash is the storage media for all these ebooks, and we are being designed into quite a number of ebooks out there. And we never think about flash as replacing paper, but that’s basically what is happening.

Atif Malik, Morgan Stanley: Okay. I know you guys don’t comment on the pricing specifically, but if demand is going to be more than supply in second half, is there – is it wrong to model pricing going higher in second half sequentially? I understand there could be mix issue where 3 bit per cell could be more, but I mean, is it wrong tomorrow pricing going higher in second half?

Judy Bruner: Let me point out that in terms of our pricing, our ASP per gigabyte, the product mix and the average capacity play into that quite a bit. And by product mix here I don’t mean 3 bit versus 2 bit because as Sanjay said, we price those at equivalent levels. But I mean, for example, OEM versus retail. OEM products tend to carry a lower price per gigabyte, and they also have a lower cost per gigabyte. And also as the average capacities move up, that also tends to lower the ASP per gigabyte. So those factors will play into our ASP per gigabyte and tend to bring it down somewhat always as we move from – as we move forward. But as I said, we do expect a good supply/demand balance and a favorable pricing environment in the second half.

Atif Malik, Morgan Stanley: Thank you. That was clear.

Uche Orji, UBS: All right. Thank you very much. Can you hear me?

Judy Bruner: Yes.

Uche Orji, UBS: Yes. First of all, congratulations, Eli, and good luck with your next phase of your career.

Eli Harari: Thank you. But I just want to comment that I will still be here in the October call. [laughter] I’m still the CEO until – for the next five and a half months.

Uche Orji, UBS: We’ll wish you well again in October, so….[laughter] But let me start off by asking you, as we look at the OEM business, one area that I’m not sure I understand how much of a success you’re making is in the embedded, so if I look at the iNAND business.

So as we look at the OEM business between cards sold into smartphones and the
embedded business, can you talk about what success you’re seeing there with smartphones and also the embedded tablet category? That’s my first question.

Sanjay Mehrotra: So, I’ll take that. And with respect to embedded business, actually is growing very nicely for us, and we are engaged with all handset manufacturers pretty much in terms of our embedded products, and our embedded revenue on a quarter over quarter basis, that includes iNAND products as well as our other products, grew pretty substantially.

In fact, embedded products at this time present approximately 20% of our total OEM business, which has increased from the past levels and with all the design wins we are experiencing with our iNAND products, we see continuing strong growth opportunities on the embedded side, in the smartphone side. And also as I mentioned earlier, our design wins for embedded products in the tablet space and the mobile computing space are doing very well as well.

Uche Orji, UBS: Could you just – this is taking so long in terms of finally getting traction for iNAND. Can you just explain a little bit as to what led to the current traction of finally getting with this? I mean I thought there was some issues in the past as to why it didn’t really gain traction. Was there anything specifically that suddenly kind of reached a tipping point for this to finally start to gain traction? And really the reason I’m asking this also is to really understand what the future progress will be for the embedded business?

Sanjay Mehrotra: We definitely expect strong future progress for the embedded business, and there are really a lot of things that are going in our favor with respect to our iNAND design wins. As we had discussed at analyst day, we have adaptive flash management technique, and these techniques basically allow us to meet the requirement of our customer, tailoring the requirement for our customer with respect to a feature set that enhance – ultimately, the customers’ end device platform. And through these adaptive flash management techniques, we can really tailor our embedded flash solution for the end customer for the end application.

And this really is working well for us. And this is one of the things that is actually helping us win strong customer traction and design wins, which should bode well for the future as well.

And of course, as flash memory scales and technology gets more difficult, continuing to deliver performance gets more challenging, but our system and controller expertise working well with our memory technology really allow us to continue to deliver specifications at our chip level, which are superior to other embedded solutions for many applications, and that, again, helps us. Basically the system expertise, which also includes adaptive flash management, is a pretty powerful asset for us in continuing to do well with iNAND design.

Eli Harari: I’d like to add that four years ago, we acquired msystems, and msystems of course was well known for their mDOC solution, which basically was embedded solutions, and the team that’s really driving the iNAND is basically the team that was – is based in Israel and has really driven that business. And now with a combination of X2 and X3 and adaptive flash management, this is really beginning to blossom.

Uche Orji, UBS: Okay. Let me ask you about supply constraint. Obviously, it sounds like through the rest of this year, you are the supply constraint. Your inventories probably one of the lowest I’ve seen in recent times in a Q2 period. If you step away from just SanDisk and look at the industry, what is your sense as to supply coming in through this year and into next year? And while you’re answering that also, as you transition to – fully to 32 nanometer and then to 24, any sense as to what the mix of 24 will be for Q4 just for us to kind of try and calculate what we think should be your bit growth itself?

Sanjay Mehrotra: So with respect to the mix, for 24 nanometer, as I said in my prepared remarks that 24 nanometer will begin as production ramp late in the year. So if contribution to our bits during 2010 and even Q4 will be fairly small. So your other question regarding the demand and supply picture, based on what we see out there, demand and supply is tight in the industry, and certainly with all the growth of customers and channels that we have enjoyed with broad set of product offerings as well, it’s pretty tight for our business.

And for 2011, in terms of new capacity that can contribute to bit growth, that new capacity, new wafer fab capacity is coming late in the year, so for next year also in terms of third party projections, it’s about 75 to 80% bit growth for 2011 over 2010.

Uche Orji, UBS: But that’s not second half weighted for 2011?

Sanjay Mehrotra: Excuse me? I didn’t quite understand the question.

Uche Orji, UBS: Does that mean then that the growth will be more like back end loaded for 2011 because it looks like between now and the first half of 2011 we’ll still be in a tight situation in terms of supply?

Sanjay Mehrotra: Yes. I mean the bit growth in the first half will be coming through technology transitions, and, for example, in our case, too, continuing Fab 4 expansion. We will plan to complete our Fab 4 expansion this the first half –

Uche Orji, UBS: Okay.

Sanjay Mehrotra: – of 2011 timeframe. So that will be providing bit growth. And the new fab, as I said, will contribute to bit growth late in 2011.

Uche Orji, UBS: All right.

Sanjay Mehrotra: In our case, as you have said, Fab 5, even in 2011, even with capacity coming late in the year, will be in terms of wafer entries less than 10% of our total 2011.

Uche Orji, UBS: All right.

Sanjay Mehrotra: So the primary driver for capacity bit growth next year will be 24 nanometer transition.

Uche Orji, UBS: Perfect.

Eli Harari: In general we do see the industry still acting with a discipline as far as adding new capacity, and certainly this is what is guiding our drive for 2011.

Uche Orji, UBS: Perfect. Just one last question in retail. Any comments as to what you’re seeing within some of the key drivers like digital cameras or any other product areas then? And also you talked about Europe being a little weak. Have you seen any rebound since during the month of July within Europe? And that is my last question. Thank you.

Sanjay Mehrotra: So within the retail business, I mean certainly, video is a trend that is driving demand and imaging we see continuing strong growth and demand and high capacities. Video, HD video and your digital cameras as well as camcorders. More and more camcorder models coming out that are pretty much all flash based now. Those are – that’s really the primary trend in the retail business in terms of the demand aspect. And in terms of the demand from Europe, as Judy said, Q2 was somewhat slow. I mean, the consumer sentiment in Europe or in America is not totally back. However, in Q3, we do expect seasonal uptake in demand that is typically associated with back to school.

Eli Harari: But I would like to add that really we are riding waves of new markets that are growing and frankly outstripping in the growth rate really outstripping the economic conditions in retail in Europe or in the U.S. And the OEM business, mobile, really we’re not seeing that influence of weak consumer sentiment, at least not in the second quarter. And we believe that, in fact, the second half of the year should pick up in retail as well. Demand is not our issue really. It’s how to meet the demand.

Uche Orji, UBS: Right. Perfect. Thank you very much.

Eli Harari: Thank you.

Daniel Berenbaum, Auriga USA: Hi, guys. And Eli, again, congratulations on retiring.

Eli Harari: Thank you.

Daniel Berenbaum, Auriga USA: Sanjay, you talked about selling 3 bit per cell at the same price as 2 bit per cell. How long can that last? Are you concerned about competitors coming in and cutting pricing on 3 bit per cell? Is that part of your expectation for pricing maybe being a little bit weak through the second half?

Sanjay Mehrotra: No, we do not think that pricing with 3 bit per cell will be weak. I mean keep in mind that our 3 bit per cell is high quality, high reliability, and high performance in terms of our end product applications and really designed very well to meet the needs of the customers in the applications, essentially as I said making it totally transparent for the application whether it’s a 2 bit product or 3 bit product. And that again really requires a strong system level expertise, the controller and the memory to work together to really give our 3 bit per cell based product that attribute. So we expect this lead to continue in the foreseeable future.

Eli Harari: Fundamentally, anybody that sells X3 at let’s say 20% or so below X2 loses the entire benefit of lower cost of X3. The whole concept here is that you provide the same performance transparently and gain the benefit of more bits per wafer per die. If you sacrifice it because your performance is inadequate, then there’s no point. And that is why we are not seeing at this stage at least strong competition in the X3 arena.

Judy Bruner: And as we’ve pointed out for several quarters now, our strong mix of X3 has definitely been very favorable for our gross margin.

Daniel Berenbaum, Auriga USA: Okay. And then maybe if we can take that focus to sort of out to next year and tie it in also the 24 nanometer transition. I mean you guys have talked about cost reductions slowing over the course of the next couple of years, and you obviously think that your cost reduction this year is going be better than the 40%, and I assume that that is – that 40%, better than 40% on your captive capacity. So just want to clarify that.

But then as you shift your mix to X3 and as you start the transition to 24 nanometer, number one, are you concerned about the technology road map beyond 24 nanometer, and does then this sort of faster transition also affect how you’re thinking about cost reduction that you had previously guided to for 2011 and 2012?

Eli Harari: I think these are very good questions, and frankly quite fundamental, and also came into consideration in our decision to move with Fab 5. We have in the past been conservative about how scalable is NAND, 20 nanometer or below. We feel that as we get closer to 20 nanometer we’re gaining significantly more confidence that we can drive the technology below 20 nanometer and hopefully also maintain our ability to ship X3 with 20 nanometer and below in the next, let’s say, couple of years. And that is very important for being able to maintain a more aggressive cost reduction than we had previously projected, at least let’s say the 20 nanometer and slightly below 20 nanometer. Beyond that, of course, you start getting into extreme UV, and EUV, and that does require new manufacturing technology. But overall, I would say that we’re getting more and more confident that we can take together with Toshiba, NAND technology to 20 nanometer and at least let’s say the next generation below that. Hopefully with X3, and that makes the ROI decision on Fab 5 a lot better, a lot more attractive.

Daniel Berenbaum, Auriga USA: Okay. And then just one last administrative question, Judy, were there any inventory adjustments in the quarter?

Judy Bruner: No. Changes in inventory reserves, inventory charges are very, very immaterial at this point.

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

Kate Kotlarsky, Goldman Sachs: Good evening. Thank you for taking my question, and congratulations on great results. Quick question for you on the captive versus non-captive supply. You’ve done a great job on the cost side and great to see that margins are actually going to be sort of flattish for the remainder of the year despite the fact that you’re going to be sourcing some non-captive supply. I was curious, what kind of bit growth do you think you would have to see in Q3 for you to consider potentially sourcing more than what you’re currently expecting? Because it certainly seems like the demand environment is very robust, and the industry as a whole, I think, is facing some significant shortages in the second half.

Judy Bruner: So keep in mind there are fairly long lead times to get non-captive supply. At this point, it really would be too late to order any additional non-captive supply for the third quarter. And we are still working on obtaining the non-captive supply that we have built in our forecast for the fourth quarter.

Kate Kotlarsky, Goldman Sachs: Okay. I guess the question was more how significant would Q3 bit growth have to be for to you think about sourcing more for Q4?

Judy Bruner: Well, we’re already trying to source more for Q4 based upon our forecast of bit growth, basically based upon the indications of demand from our customers. So we’re working on that as we speak and, as Sanjay described, there’s several different factors that play into us ramping up and obtaining and using our non-captive supply, and we’re working on that now.

Kate Kotlarsky, Goldman Sachs: Okay. Thank you very much for that. Just a quick question on the pricing environment. I know a question was asked earlier about what we can expect for the second half. I was curious, in your full year guidance what kind of ASP declines, Judy, are you assuming for the full year?

Judy Bruner: We’re really not giving ASP ranges in terms of guidance. You might recall that at the beginning of the year, I said that – I’ll give you a few statistics. At the beginning of the year, I said that we expected our cost reduction to be 30 to 40% per gigabyte and that we expected ASP decline to be less than that. Since that time, we have increased our expectation on cost reduction. We now think it will be greater than 40% per gigabyte. And I would tell you that our expectation on price decline has come down even further from where it was as we started the year. So there’s become a bigger gap between cost decline and price decline, and clearly that is what’s causing our gross margins to improve so substantially. And you saw the numbers today for the second quarter in terms of price decline; it was 18% per gigabyte on a year over year basis. And we continue to expect to see a favorable pricing environment in the second half.

Kate Kotlarsky, Goldman Sachs: Thank you. And just one final question. I wanted to ask about the mobile part of the business. Obviously, that’s a big part of your business now. And I was curious if you could give us some color as to, do you think about the mobile business overall, how much of the business now is smartphones versus feature phones, and what the trends are that you’re seeing in each of the different markets?

Sanjay Mehrotra: We are actually doing very well both on the side of the smartphones as well as on the feature phones. And even in the APAC market, there are a lot of phones getting shipped, low-end phones that are with card slots and there is lot of bundling of low capacity cards that takes place in those markets, and we are a strong player there as well, to major handset manufacturers as well as to other customers in
the region, in APAC region. And in terms of feature phones as well as smartphones we are doing well with respect to our cards as well as our embedded solutions. In fact, our average capacity in the mobile phone market grew very substantially, more than the average capacity for the entire business because of strong success for cards and embedded products of high capacity.

Kate Kotlarsky, Goldman Sachs: Thank you very much.

Craig Ellis, Caris & Co: Thanks for taking the questions. And Eli, congratulations on all the great accomplishments.

Eli Harari: Thank you.

Craig Ellis, Caris & Co: You’re welcome. The first question on the non-captive for the second half, maybe looking out a little bit longer than that. Is the move towards non-captive more of a temporary move in your mind, or, Judy, are we moving towards just a larger percent of non-captive in the mix as you talked about at analyst day?

Judy Bruner: We do expect that we will continue to use non-captive, and it is favorable for us, and keep in mind that the business, our business mix has changed quite a bit, and that it is not necessarily as useful in the OEM part of our business as in the retail part of our business. But we do expect that we’ll continue to make use of our non-captive supply agreements.

Craig Ellis, Caris & Co: Okay. That’s helpful. And then on the cost reduction side, this is the second time the company’s talked about a little bit better cost reduction than it expected. One, can you quantify how much greater than 40% you’d expect cost reduction to be? And, two, can you provide some insight on what the factors are that are leading to the better cost reduction that you’re achieving?

Judy Bruner: I’m not going go any more granular than greater than 40% at this point in time. We’re only halfway through the year. But I will say that in terms of factors that are influencing this, one key factor is our very successful transition to 32 nanometer, in terms of the speed of that transition as well as the yields that we’re obtaining. And then another key factor is continued very strong usage of X3 across most of our product lines.

Eli Harari: In addition to that, we are really getting the benefits of the tremendous economies of scale of Fab 3 and Fab 4. These are very large fabs running at full capacity with exception of the last part of Fab 4, very high volumes, very highly productive, extremely efficient, and that really is what gives us the third element of cost reduction.

Sanjay Mehrotra: And I would just add the fourth element is on the back end, supply chain, our Shanghai factory is really contributing very well to our cost reduction capability and ability to ship and manage inventory and cost, et cetera, pretty well. So our back-end supply chain is doing very well as well, so it’s all these factors combined that we are making strong progress on and getting strong cost reductions on.

Craig Ellis, Caris & Co: Okay. Clearly very good execution. Lastly, second quarter in a row where we’ve got a 65/35 OEM/retail mix. Is that kind of the natural balance of the business now or would you expect that to change meaningfully over time?

Sanjay Mehrotra: I think this is natural balance at this point but, of course, we are continuing to drive to maximize opportunities both on the OEM side as well as on the retail side.

Craig Ellis, Caris & Co: Thank you very much.

Bob Gujavarty, Deutsche Bank: Thanks for squeezing me in, guys. And maybe I’ll take the other side of the coin and congratulate Sanjay on the promotion. [laughter]

Sanjay Mehrotra: Thank you.

Bob Gujavarty, Deutsche Bank: I think the industry looks great from a supply/demand right now. But I know LP has made some noise about getting into the NAND market using charge trap. Do you think they can be competitive using that technology and what you know of their plans?

Eli Harari: As best as we can understand, we believe that they are focused very much on low density memory for multichip packages, which really is not a market we are competing in. So no, we don’t see this really as making any substantial impact on our business.

Bob Gujavarty, Deutsche Bank: Fair enough. And just a quick follow up. Given how pricing’s been relatively stable, do you believe there’s kind of like a pent up demand for NAND, so even if we see potentially some slight oversupply and lower prices that there’s a lot of pent up elasticity to absorb that demand? Does that give you some comfort going forward?

Eli Harari: Markets that have a great deal of elasticity as we’ve said before like SSD are markets that are relatively mature and therefore elasticity really is not very strong. Pent up demand, I don’t know. I think that some products are introduced today with lower bundled capacity or embedded capacity because the shortage of NAND, not so much the price of NAND but the shortage, and the availability of NAND. And if it were available, it could well be that these units would be shipped with high capacity. Customers are prepared to – we have data that shows customers are prepared to pay more for more storage, but suppliers are very concerned that they will not be able to meet the demand, and therefore in some cases we think that there is some products that are coming out with lower than desired supply – capacity because of supply constraints.

Bob Gujavarty, Deutsche Bank: Great. Thank you very much.

Jay Iyer, Investor Relations: Thanks, Elizabeth. Thank you all for joining today. As a reminder, a web cast replay of this conference call will be made available on our website at sandisk.com/ir. Have a good night.

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