2011.07.23 SanDisk Q2 2011 Conference Call

23 July 2011 Q2 2011 SanDisk Conference Call

Sanjay Mehrotra, President 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. Joining us on the call today are Sanjay Mehrotra, President 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 Sanjay.

Sanjay Mehrotra, President and CEO: Thank you Jay and good afternoon everyone. We are pleased to report record revenue in Q2, representing 17% year-over-year growth. This revenue achievement reflects the continued progress in our channel and customer diversification strategies and brand leadership. Our joint venture fabs in Japan operating at high efficiency levels coupled with the benefits of the 24- nanometer transition enabled excellent cost reductions, which drove our strong second quarter profitability.

The mobile market, which accounted for 57% of our business, grew 40% year-over- year primarily due to a six-fold increase in iNAND revenue. Design pipeline for iNAND is excellent and we believe it now captures a large majority of the high- capacity embedded designs in a wide variety of mobile devices. We broadened the iNAND portfolio with the launch of the high performance iNAND Extreme. Together with the iNAND, iNAND Ultra and other embedded solutions, our embedded product portfolio is now well segmented to address the needs of all mobile and consumer electronics markets, from feature phones to high-end tablets, and from eBook readers to connected television, set top boxes and Blu-Ray players. iNAND products utilize Adaptive Flash Management, that increases system responsiveness for faster application loading, web browsing and multitasking. SanDisk works closely with the major mobile OEMs, chipset and operating system vendors to ensure tight integration between host and storage devices. This engagement is crucial to achieving a more enjoyable user experience and it is a key reason why we believe iNAND ranks among the leading embedded solutions in the market.

Our retail revenue grew year-over-year, driven by strength in Latin America, Middle East and Asia. We are pleased with the robust growth in sales of our imaging cards, particularly with the mix shift we realized toward Ultra and Extreme products. These high performance cards have a powerful brand appeal as they work very well with the advanced features of the latest digital camera models, and additionally, they command a pricing premium in the market. We also saw year-over-year revenue growth from USB drives. Looking forward to the second half of the year, our retail teams are busy preparing for the upcoming back-to-school and holiday seasons and we believe we are well positioned in our key accounts.

On May 25th, we announced the completion of our acquisition of Pliant Technology,
a leader in enterprise class SLC and MLC solid state drives (SSD). Pliant has now
become SanDisk’s Enterprise Storage Solutions (ESS) business and we welcome the Pliant team to the SanDisk family. The integration of the two businesses is progressing well.Our serial-attached-SCSI (SAS) protocol-based SSDs using both SLC and MLC NAND flash have gained very good traction with enterprise customers. In June, we launched six new 6 gigabits per second SAS SSDs with capacities ranging from 100 gigabytes to 800 gigabytes. The new drives position us as an industry leader in performance, performance predictability and reliability in enterprise grade SSDs. I am proud to point out that the new SAS drives have been qualified and integrated in HP’s Qualified storage drive offerings and volume shipments have already begun. According to industry analysts, SAS based SSDs are estimated to account for the biggest segment of the approximately $4 billion enterprise SSD market in 2014 and our recently acquired capabilities in this space bode well for our future prospects.

We are also developing our first PCIe protocol- based SSDs, another large SSD market opportunity, and you will hear more from us on this front in the coming months. SanDisk’s entry into the enterprise business is an exciting new endeavor and it provides a new, high-margin growth opportunity for us over the next several years.    As we focus on executing and advancing our ESS product roadmap in close collaboration with our customers, I am pleased to note that the ESS business is in the initial stages of what we expect will be a fast revenue ramp.

In the client SSD segment, our modular solid-state drives (SanDisk pSSD)
continue to do very well in ultrathin notebook products and in tablets. Our modular
SSD revenue more than tripled on a year-over-year basis. We believe that our 19-nanometer flash will enable an attractive price point for the consumer, which should spur rapid SSD adoption in high performance PCs in 2012. SanDisk is well positioned to benefit from this trend with a broad line up of consumer SSD products and a supply chain that can meet the high volume NAND flash requirements of this market.

We are excited about the opportunities that the Enterprise and Client storage markets provide for our SSD business in the coming years. We believe that leadership in these markets will favor those who provide high volume, high quality, and low cost advanced NAND flash. SanDisk is well positioned to deliver on all these fronts given our NAND flash cost leadership, leading edge flash manufacturing capacity, deep system expertise and fundamental IP – all powerful elements that we have built over the last two decades.

Last week, along with our joint venture partner Toshiba, we opened Fab 5, our third 300-millimeter wafer fab in Yokkaichi, Japan. Production has begun and we expect first wafer output from the new fab in August.    As we have said before, we expect Fab 5 to increase our current captive wafer supply by no more than 10% by the end of 2011.

We have not made any decisions to expand Fab 5 beyond our current commitment within Phase 1 and future expansion needs will be driven by our assessment of our customers’ demand profiles.

The opening of Fab 5 is a significant event for us and we expect the facility to provide us with high quality, cost competitive supply to drive our growth in diversified end markets over the next decade.

Turning to the industry, we expect the supply and demand environment to be balanced for the second half of the year. For SanDisk specifically, we believe we will remain slightly supply constrained for the third quarter.

In closing, our first half 2011 performance was strong and we are pleased to report record Q2 revenue. We continued to solidify our position as a globally recognized franchise in both retail and OEM channels. We broadened our growth prospects with the formation of the enterprise storage solutions business, adding yet another market segment and a new set of customers to our portfolio. The fundamental drivers of our business remain vibrant and I believe SanDisk is uniquely positioned to address and benefit from the growing need for flash based storage solutions.

With that, I will turn the call over to Judy for her financial review.

Judy Bruner, Executive Vice President, Administration & CFO: Thank you, Sanjay. We are pleased to report another quarter of strong top and bottom line results, with record revenues of $1.375 billion, up 17% year-over-year, and non-GAAP operating margin of 29%. Our gigabytes sold grew 14% sequentially while ASP per gigabyte declined a modest 7%, and on a year-over-year basis, gigabytes sold increased 72% and ASP per gigabyte declined 31%. The OEM mix of our business grew to 68% of product revenue, up from 66% in the first quarter. Our retail business increased 2% sequentially and 9% year-over-year with growth coming primarily from emerging markets where our teams have successfully been increasing our market presence and share. In terms of end markets, our sequential retail growth was concentrated in the imaging market, and year-over-year retail growth came primarily from the mobile market. Our OEM business increased 8% sequentially and 22% year-over-year driven by our embedded mobile products for phones and tablets, as well as by solid state drives. Our License and Royalty revenue grew sequentially and year-over year, to $93 million.

Our non-GAAP gross margin for the second quarter improved sequentially by 2 percentage points, to 41% for our product business and 45% in total. There were four key factors that impacted our sequential gross margins, two of them negative and two of them positive. Gross margins were negatively impacted by Fab 5 start-up costs, which moved from R&D to cost of sales in early June and also by an increase in our non-captive usage. The two key factors sequentially improving gross margins were first the absence of charges related to the Q1 earthquake and power outage and second and even more impactful our underlying cost reduction exceeding price decline. With all of these factors included we generated a sequential cost per gigabyte improvement of 10%. On a sequential basis, the Japanese yen rate had a very small impact on our gross margins. On a year-over-year basis, our non-GAAP product gross margin declined by 1 point, while the combined negative impact of the yen exchange rate, Fab 5 start-up costs and increased non-captive usage was approximately 8 points of margin. The negative impact from these three factors highlights how strong our underlying cost reduction has been relative to price reduction over the last year.

Our non-GAAP operating expenses in Q2 were $220 million, in the range we expected, and up $32 million sequentially. Most of this increase was in R&D, driven by Fab 5 start-up costs, investment in BiCS and other technology development projects, and the inclusion of one month of Pliant expenses. The sequential increase in G&A expenses reflected deal costs from the Pliant acquisition and increased spending to scale various G&A functions.

In summary, our business model remains very strong, with Q2 non-GAAP operating margin increasing to more than 29% of revenue. Our non-GAAP tax rate for Q2 came down to 32.5%, from 33% last quarter, due to one-time favorable items.

On the balance sheet, cash and short- and long-term marketable securities decreased by $228 million to $5.28 billion. Our Q2 cash flow from operations was a positive $269 million, and our investment during the quarter included $153 million in the Fab 4 Flash Alliance venture, $18 million in the Fab 5 Flash Forward venture, $28 million
in non-fab capex, and a net $303 million cash outflow for the Pliant acquisition. The total cash paid for Pliant, net of the cash they had on hand, was approximately $324 million, including a $15 million loan provided in Q1 which has been reclassified on our year-to-date cash flow statement and $6 million of payments that were recorded in Q2 operating cash flow. For the first half of the year our fab and non-fab capex investments totaled approximately $460 million, and our net cash outlay was $361 million, with the difference funded by joint venture working capital. Our off-balance sheet lease guarantees for fab equipment totaled $738 million at the end of Q2. Inventory dollars on the balance sheet increased sequentially with turns remaining similar to last quarter which is quite lean for our business.

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.

Our assessment of the NAND flash memory market is that supply and demand will be roughly in balance in the second half of 2011. For SanDisk, we are generally still in short supply and we are working closely with our customers to match our supply to their requirements. Our forecasted total revenue for Q3, inclusive of license & royalty, is $1.375 billion to $1.425 billion. For the full year, we now expect total revenue of $5.6 billion to $5.7 billion, the high end of the $5.3 to $5.7 billion range we provided at the beginning of the year.

Our Q3 non-GAAP gross margin will reflect a full quarter of Fab 5 startup costs as compared to one month in Q2. We expect the mix of non-captive memory to be higher in Q3 than in Q2, and if the Japanese yen remains at current levels, this will also put some sequential pressure on margins in the second half for the portion of our wafer purchases that is un-hedged. Our Q3 non-GAAP product gross margin is forecasted at 38% to 40% and total non-GAAP gross margin including license and royalty is forecasted at 42% to 44%. Currently our gross margin expectations for Q4 are similar to Q3, leading to overall second half gross margin forecasts higher than our previous expectations.

Our non-GAAP operating expense forecast for the third quarter is $230 to $240 million with the increase coming primarily from a full quarter of Pliant expenses and certain increases in sales and marketing spending. For the full year, we now expect total non-GAAP operating expenses between $875 and $900 million, up from our original guidance for 2011 of $850 million due primarily to the acquisition of Pliant and the technology investments that we entered into with Toshiba in Q1. We expect Q3 Other Income of $5 to $10 million and a non-GAAP tax rate of 33%.

Our estimate of 2011 capital investment in fab and non-fab equipment remains unchanged at $1.4 to $1.6 billion, and the estimated cash requirement for these investments remains at $800 to $900 million for the year, of which we have spent $361 million in the first half.

In summary, we are extremely pleased with our second quarter results and our outlook for continued revenue growth and robust profitability in the second half of the year. We will now open the call for your questions.

Q&A

James Schneider, Goldman Sachs: Good afternoon and thanks for taking my question. I was wondering if you could provide a little bit of an update about pricing trends you’re seeing, in general, for the market overall right now. Maybe give us an update on what percentage of your shipments were TLC NAND and what relative differences you’re seeing between TLC and MLC pricing right now.

Judy Bruner: Hi. Let me start with the pricing. First, I want to point out that there was a fair amount of variability in pricing during the quarter really starting at the end of Q1 in response to the earthquake tragedy in Japan. And so in response to that, there was actually somewhat of a surge in pricing and then pricing began to normalize later in the second quarter. And if you look at various pricing indicators that are published out there and look at them on a year-over-year basis, the price decline on a year-over-year basis is not out of line with the cost reduction that the industry is able to generate. So we believe that, that is indicative of the industry being in relative supply-demand balance.

Sanjay Mehrotra: As regarding X3, the utilization of X3 for our business continues to be slightly above 50% in terms of our total bit utilization. And as we have always said, SanDisk, through its deep system expertise built over last 20 years, is really able to utilize X3 across multiple product platforms and get it to deliver the reliability and the performance and specifications that others may be delivering with X2 memory in the industry.

So really, when we sell our X3 in the marketplace, our X3 products compete very well with the X2 products from others and we hold pricing power with our X3 products. Certainly, in some cases, particularly related to certain, let’s say, embedded product platforms et cetera, we may have situations where as part of the incentive for the customer to move towards X3, which is our competitive advantage, we may have some sharing of the benefit there.

James Schneider, Goldman Sachs: Thanks that’s helpful. And then as a follow-up, post the Pliant acquisition, can you talk a little about how you see the SSD ramp for you from here, when SSDs’ shipments might be more than 5% of revenues? And then as you look out a couple of years, how big as a fraction of your total sales it might be?

Sanjay Mehrotra: So we are not going to break out the specifics in terms of exact timeframes of when it exceeds certain percentage of the revenue. For 2011, while we are making great progress with SSD, particularly related to our modular SSD and thin form factor platforms, and now with the acquisition of Pliant, the SSD opportunity really is building up nicely for us in the enterprise storage as well. But for 2011, it remains a relatively small portion of our revenue, although an increasing portion. And we certainly look at building this into a meaningful, strong revenue base for the company in the future. And we expect a broad set of SSD product offerings to start driving growth of SSD revenue in a more meaningful way for us in 2012 and beyond.

James Schneider, Goldman Sachs: OK thanks very much.

Daniel Amir, Lazard Capital Markets: Thanks a lot. A couple of questions here. First of all, Judy, can you give us of any idea on in terms of the gross margin guidance, how should we look at kind of the different parts that are impacting the margins here in Q3? And also kind of the take how you raised your Q4 gross margins as well from your previous expectation. Is that really related more to the captive, non-captive mix or the Fab 5 starting costs or anything else? Thanks.

Judy Bruner: Sure. As we look at the Q3 gross margin, as I indicated, we will have a full quarter of Fab 5 startup costs in the third quarter relative to just one month in the second quarter. So that’s a key factor. And then also, we would expect that our non-captive usage will likely increase in the third quarter relative to the second quarter. And I’ll let you know that in the second quarter, our non-captive was between 5% and 10% of our overall mix and it probably will be closer to 10% in the third quarter. And then I also mentioned, of course, that about half of our wafer purchases are unhedged, that’s a strategy that we entered into and that we communicated at the beginning of the year. And so there is potential variability there in the second half as well, based on the yen to dollar exchange rate.

So those are the key factors. Of course, sort of the key unusual factors. Of course, there’s also our underlying cost decline, which is being driven primarily by the 24-nanometer transition and then of course, price decline. And as I indicated, we believe that the industry and ourselves are in relative balance in the second half, in the third quarter in particular.

And then you asked about the fourth quarter? And generally, we will still continue to have Fab 5 startup costs in cost of sales impacting gross margins in the fourth quarter. At this time, I don’t want to be too much more specific about the other factors for the fourth quarter.

Daniel Amir, Lazard Capital Markets: Okay. Great. And one other question. In terms of kind of the outlook on the retail market, it looks like the retail business has kind of positively, I’ve seen a strong quarter here in the June quarter following a year where it’s been a bit challenging. Are you seeing now a turnaround in the retail business? Is it really driven by emerging markets? I mean, if you can give any commentary around the retail business, that would be helpful. Thank you.

Sanjay Mehrotra: I think certainly, emerging markets are contributing to strong growth of our retail business. In fact, on a year-over-year basis, the retail business in the emerging markets grew faster than the rest of the business, and it contributes about 20% of our total retail business at this point. And we are doing really very well in terms of gaining shares in the emerging markets. And as I said in the prepared remarks, it’s China, India, Brazil, Middle East, a lot of markets that are developing nations where SanDisk is doing well, we are well entrenched in terms of our sales and marketing efforts and channel penetration in those regions. And the gains in our sales of retail are also coming from nice mix shift toward our high-performance cards. Our Ultra and Extreme products are doing very well, in general, across all markets.

So even in those pockets, where, let’s say, consumer sentiment is somewhat weak and not fully bad, like North America market and certain parts of Europe, SanDisk really continues to do well in terms of market share. And so some of the key factors also include our brand premiums, our brands command a premium in all geographies as well. So we are very pleased with how we are driving our retail business, how we are maintaining and growing our shares in the regions of the world, as well as the complete product portfolio of mobile, of imaging cards, USB flash drives that’s continuing to do well.

Do you have a follow-up?

Daniel Amir, Lazard Capital Markets: That was my follow-up. That’s fine. Thank you.

Ada Menaker, MKM Partners: Hi this is Ada Menaker for Dan Berenbaum. Could you go over some of the puts and takes in demand drivers for the remainder of the year? What could make things better, what could make things worse?

Sanjay Mehrotra: So on the demand driver side, certainly, mobile phones and tablet categories will continue to drive majority of our demand in the second half of the year. SSD revenue, as we said, will continue to grow nicely for us as well. We continue to see that demand for our modular SSD and with our enterprise SSD as well now, in enterprise storage with customer design wins and increasing customer penetration will continue to do well as well. And we will expect typical seasonality in the retail business in the fourth quarter as well.

Ada Menaker, MKM Partners: And for the follow-up, could you talk about the progress TLC is making in embedded?

Sanjay Mehrotra: Embedded, as we have said, we have strong design wins on the embedded side. And embedded business particularly the iNAND business, is growing very well for us and we expect this to continue to be a strong driver of our revenue base in the future as well.

And again, for embedded, either we have design wins in mobile platforms and tablets and of course, we are doing well there, but there’s even other applications and that includes, like connected TVs, set-top boxes, e-book readers, et cetera. We are actually driving on all fronts and getting momentum on embedded there with our leading-edge eMMC products.

Atif Malik, Morgan Stanley: Hi thanks for taking my question and congratulations on generating a record quarter. I have a series of simple questions. The first one, what percentage of your business is commodity and what percentage of your business sticky or application-specific? And the reason I ask the question is Hynix reported yesterday and they had a pretty similar OEMs-to-retail mix, 70:30, similar to yours, but they showed a more significant price decline of 19% in the quarter. So what percentage of your product business you consider as commodity and what is more sticky or application-specific?

Judy Bruner: Well, I’m not going to give you a specific percentage in terms of commodity or non-commodity, but let me point out that our embedded business within our OEM channels, as you know, has grown significantly over the last couple of years, and is definitely now over 40% of our OEM business. And so embedded definitely has a lot of stickiness with our customers. And also, we do a very good job of really differentiating our products in terms of performance levels. So we have our good, better, best, and we’ve had that for a long time in retail, that’s part of what gives us our price premium in retail. And now, we’ve really taken that strategy to other parts of our business, including our embedded business, as Sanjay pointed out. So really, I think those are 2 key areas of differentiation for us. Also, keep in mind, we’ve really diversified our customer and channel base over the last couple of years, and that allows us to really optimize where we sell our product in any given period.

Sanjay Mehrotra: And I’ll also point out that we definitely continue to focus on increasing differentiation and value-add of our products, particularly with respect to content. We do have product offerings that you, for example, heard about Cricket, Muve Music, you’ve seen our Service Delivery Cards doing well in that area. Of course, these are small, and these kind of trends take a long time to really build up into a meaningful opportunity. But we really continue to engage with all the leading key players in the ecosystem to continue to drive increasing differentiation. Of course now, the enterprise storage business will be a meaningful and strong, highly differentiated, high-margin opportunity for us going forward, because this really requires very high level of quality, requires you to have good control of flash memory technology and manufacturing, and a product roadmap that meets the customer requirements, very demanding enterprise customer requirements, and where they put you through long cycles of qualification. So that’s another large differentiated opportunity that’s building up for us, which is definitely by no means is commodity, and we are well positioned for growth in that market.

Atif Malik, Morgan Stanley: Great. And Judy, just a quick follow-up. Thanks for providing the color on the margins for the fourth quarter. So if I assume everything and all else being equal, cost reductions are in line with price declines for next year, what kind of improvement in product gross margins can you get from the one-time event this year reversing into next year? Basically, where will we be at the end of the year in terms of the negative impact from one-time events except, minus the yen impact?

Judy Bruner: It’s clearly too early to give any specific gross margin guidance for next year, and I don’t pretend to be able to predict the movement of the yen for next year. But the other factors, Fab 5 startup costs should be a favorable trend for us in 2012. There may be a little bit of Fab 5 startup costs that continue in the first quarter in gross margins, but largely, they should go away next year. And so that will be favorable for us.

And then, non-captive, of course, is another thing that’s difficult to predict at this point in terms of our non-captive usage for next year, in part, because we’ve not made any decision as to further expansion of Fab 5 beyond the initial phase of expansion that we’re doing within Phase 1 of Fab 5. So there’s a number of unknowns at this point in order to predict any kind of gross margin. But the Fab 5 startup costs should be a favorable trend.

Atif Malik, Morgan Stanley: Good. And one last one. There’s some investors, Sanjay, that are confused at offerings like iCloud by Apple will lower the amount of NAND content that you need on your storage devices like smartphones and tablets, but with Apple MacBook, with the new MacBook Series, is actually increasing the amount of NAND content in this MacBook Air. So I just want to get just your thoughts on these offerings by Google and Apple, what impact will this have on the growth of the NAND content?

Sanjay Mehrotra: We really look at the cloud as a win-win for SanDisk. When you look at clouds, as there are more connected smart devices across the globe, you need, there will be more content on the cloud, and certainly, it will require faster access to that content on the cloud, which means increasing opportunity for flash storage on the cloud. Because flash is what, ultimately, can really deliver the high-performance, as well as all the other benefits related to power, et cetera, and high reliability that flash is known for. So first of all, with respect to cloud, we look at it as a great opportunity for flash on the cloud. As the cloud gets bigger, flash opportunity will get bigger, and with our recent acquisition of Pliant, we are really excited about addressing that opportunity. And now regarding the mobile devices, we believe that mobile devices will also continue to require an increasing amount of flash in order to really give you, deliver you the experience that consumers have come to expect. Because as there are more smart, connected devices and more data content on the cloud, there will be more mobile Internet traffic, which will create bandwidth limitation from the network where storage in all the mobile device will play a key role in really making your access of content fast from anytime, anywhere.

Specifically about iCloud, let me just point out that iCloud actually helps you really update your data in all of your devices, particularly Apple devices, your iPhone, your tablet, your Mac, it helps you update the data. It really helps you do it effortlessly and seamlessly. So we look at it as a duplication of flash between the multiple devices you own. So that obviously drives higher capacity, higher requirement for flash in the mobile devices. And this feature of being able to update your latest content in your mobile devices also means that creating content and sharing content becomes easier and simpler to use, which will also mean that you will have, you’ll be generating more content and driving even higher need for flash storage. So we really look at these trends as very positive from the point of flash on the cloud, as well as flash in the mobile devices, and we see increasing trend of flash utilization on both fronts.

Atif Malik, Morgan Stanley: Thank you.

Win Cramer, Avian Securities: Thanks guys. Good day and congrats on the quarter. A couple of questions. I believe last quarter at the Analyst Day, you talked about cost savings for the year being roughly 30%, but it looks like you’re tracking ahead of that. Has that since changed?

Judy Bruner: Actually, the cost savings is still in that range. You’re right, I did talk about a range of 30% plus or minus 3 points for the year. And our first half is basically in that range of 30% year-over-year cost reduction. I would point out that actually, we’re in that range and doing well against that metric despite the fact that we had the earthquake and power outage in Q1, which, of course, was not known or predicted at the time that I gave that range. So we feel quite good about our cost reduction this year.

Win Cramer, Avian Securities: Thank you. As my follow-up, could you possibly break out, as a percentage of your OEM business, what is going towards tablets in Q2 and possibly in Q3?

Judy Bruner: Really, we aren’t breaking that out. And I would tell you that it is difficult to break that out because many of our products, iNAND as an example, get used in either a phone or a tablet from the same customer. And sometimes also go through distribution, and it’s not known which end-phone or which end-tablet they go into. But we are designed into a large number of tablets, and tablets is actually, we know, a very big driver of the growth in our mobile business, which is now 57%, as Sanjay pointed out, of our total revenue.

Win Cramer, Avian Securities: Thank you.

Bob Gujavarty, Deutsche Bank: Great. Thanks for taking the question. Just a quick one on Pliant. Are you able to source the NAND for Pliant products internally? And the second part of that question is, if not, could it potentially be a gross margin additive once you transition those products to your own NAND?

Sanjay Mehrotra: So we use, currently, non-captive memory for Pliant products, and over time, we do plan to transition to our own flash memory. And obviously, that will definitely provide benefits to the gross margin of the enterprise products. And that is one of the key synergies of this deal, of the Pliant acquisition. It really gives us the benefit of being able to produce very high reliability and lowest-cost flash and apply it to our benefit on the enterprise products.

Bob Gujavarty, Deutsche Bank: Great. And just a quick follow-up. This maybe a little bit, maybe too long a question for this forum, but it’s a bit more strategic. SanDisk traditionally has been kind of a branded-products company. You pursued price elasticity to drive unit demand of your own branded products. And that made sense. But in this world where the OEM business is perhaps growing in importance, your price elasticity doesn’t drive necessarily your unit demand because the OEM determines the final price of the product. So my question basically is, does your pricing strategy change given the shift from retail to OEM where perhaps you need to be a little less focused on price elasticity because of those different dynamics?

Judy Bruner: One thing that I would point out is that you’re talking about price elasticity with respect to unit demand and there is a link there and a factor, but keep in mind that price elasticity is often really referring to the average capacity of the product in response to declines in ASP per gigabyte. And we believe that the elasticity factor in terms of growth in average capacity is strong in both the retail and the OEM segments of our business. But clearly, in terms of our pricing strategy, we are managing our pricing very carefully to try to maintain our margins and try to pass on, over time, the benefit of the cost reductions that we’re able to generate for our products.

Bob Gujavarty, Deutsche Bank: Fair enough, maybe just to, maybe to put it more simply, though, if an OEM, if you pass along a price decline to a retail customer in a SanDisk product, the customer receives that benefit directly. If you pass along a price decline to an OEM, the customer may not see it. The OEM may just pocket it. So how do you, how does your strategy change in that environment? It’s fundamentally a different channel and a different customer base.

Sanjay Mehrotra: We definitely continue to drive for higher value for our products. And pricing strategy is definitely determined, of course, by competition as well, and our desire to continue to grow the applications for flash memory, create new market opportunities as well. So really, where pricing strategy is a fairly complex topic, and we certainly not going to get into discussions on how we approach it, and there are many fundamentals that influence pricing, competition, industry environment, but we are always focused on driving profitable growth of our business.

Bob Gujavarty, Deutsche Bank: Great. Thank you.

Doug Freedman, Gleacher & Company: Great. Thanks for taking my question and congratulations on a strong quarter. Judy, you mentioned that while we don’t know what’s going to happen to the yen next year, we’re now halfway through the year, and you did have a pretty meaningful hedge on this year. Any thought on putting on a hedge for next year and when would you make that decision?

Judy Bruner: Actually, that’s something that we’re studying right now, and we’ll be making the decision sometime in the second half. I can’t say exactly when, but that is something that we are focused on evaluating currently.

Doug Freedman, Gleacher & Company:  Okay. Great. If I could, I understand what’s happening in the consumer SSD space. You guys made some pretty bullish comments about expecting it to be a very nice growth market. Can you talk a little bit about what you think the shape of that curve might look like from a demand perspective? Is this something that, are we going to reach a certain price per gigabyte delivered to the consumer that will cause a rapid shift in the percentage that OEMs will move rotational drives towards SSDs? Or is this something that you think is going to move a few percentage a year? If you could give us some color on the conversations you’re having with your customers, that would be helpful.

Sanjay Mehrotra: So as we have said before, based on our interactions with customers, we believe that flash needs to enable a dollar-a-gigabyte price point to the consumer in order to begin to accelerate the SSD demand on the client side. And we believe the technology advancement and the cost reductions will help enable to get there next year. And of course, as in the future, there is continued price benefits, enabled by cost reductions through technology advancements. It will continue to drive increasing adoption of SSDs in the years beyond 2012 as well. So I think it really is more about getting to a dollar-a-gigabyte and delivering the specs and attractive capacity point, which we believe will start happening on the notebook, PCs, et cetera, starting next year, where you’re going to start seeing greater rate of replacement of hard disk drives by solid state drives.

Doug Freedman, Gleacher & Company: Is there any way I can get you to help us on what percentage you think next year’s replacement rate might be?

Sanjay Mehrotra: What I can point to is third-party reports, which say that in the client PCs by 2014 or 2015 timeframe, 20% of the disk drives will be solid-state based. Of course, this will continue to depend on the pricing environment of the NAND flash in the years ahead as well.

Doug Freedman, Gleacher & Company: Great. Thank you.

Kevin Cassidy, Stifel Nicolaus: Hi. Thanks for taking my question. I’m just wondering on Fab 5, as those new wafers come out, what’s the qualification process? Are these, will these die already be qualified to go into SSDs or will they be sold more on a retail level?

Sanjay Mehrotra: So as the Fab 5 production starts, we will work on qualifying the products in most of our end products. Yes, initially, a lot of the products do tend to go into the retail side, but we really very quickly move it over to OEM side of the business as well. Regarding SSDs, over time, we definitely plan to use Fab 5 supply in SSDs as well.

Kevin Cassidy, Stifel Nicolaus: Okay. Can you give us an idea of the timeframe? Is that, when you say it’s short, is that 3 months or 1 month or…?

Sanjay Mehrotra: So these are our competitive details here. But the point is that we have enough capacity from Fab 3, Fab 4. And as you can see, we are somewhat supply constrained, and as Fab 5 output begins to come, we will definitely be utilizing that Fab 5 output across the product platforms. At the end of this year, the Fab 5 output will still be no more than 10% of our total output. So I would expect that through the remainder of this year, SSDs will primarily be using Fab 3 and Fab 4 output.

Kevin Cassidy, Stifel Nicolaus: I see. And maybe if you could just give us an idea of what the decision process will be for Phase 2 of the buildout, and how much lag time do you need to know before you make the decision?

Sanjay Mehrotra: Regarding Phase 2, we will make a decision based on our continuing assessment of customer demands. And again, when we say Phase 2, I want to be, actually, clear here to avoid any confusion. Right now, we are expanding capacity in Phase I. And as Judy pointed out, that even within Phase I, we have still lot of available space where we have not put in place plans for further capacity expansion yet. So we have plans in place for capacity expansion only in part of the Phase 1 at this point. And once the current plan of capacity expansion in Phase 1 is complete, we’ll be less than 50% utilized in the Phase 1.

So the second part of Phase 1, the decisions related to capacity expansion, will likely be made sometime this fall. And again, they will be made based on our assessment of customer demands. Fab 5 has been, the building of Fab 5 will be in 2 phases: the Phase 1 and Phase 2. And what we call the Phase 2 of Fab 5, the building has not yet started construction. So I hope I am clear in terms of the Phase 1 aspect and Phase 2 aspect. What we call Phase 2 at Fab 5 has not started construction of the building yet. Within Phase 1, we have partial expansion started in and committed to, and the remainder of the expansion within Phase 1, we have not decided on the timing of it yet. We expect to make the decision sometime this fall.

Kevin Cassidy, Stifel Nicolaus: Great. Thank you for the clarification.

Ryan Goodman, CLSA Asia-Pacific Markets: Hi thanks for taking my question. Longer-term question, just curious if you think that NAND is becoming less commoditized going forward, just giving increased complexity of the technology. And if you do, I’d be curious how do you differentiate in tomorrow’s market? And on top of that, how do you monetize the differentiation and impact the P&L? And then finally, do you think the industry could see some consolidation down the line for those vendors who may fall behind in the technology?

Sanjay Mehrotra: So regarding differentiation with NAND, as we have talked about before, Adaptive Flash Management techniques are really the key competitive advantage for SanDisk that we have pioneered here over the course of last few years. And those are really the techniques that are giving us meaningful penetration and strong position on the embedded side of the business. These are the techniques that actually allow you to understand the customer’s application and tweak, if you will, the features of the NAND flash memory or NAND flash solution to really ultimately help the customer deliver the best experience to their devices as well. So we really feel very good about our continued roadmap of advancements in the Adaptive Flash Management techniques. So that’s one example of how we are driving differentiation and strengthening our position on the embedded side. Other examples, of course, our opportunities related to content and certainly, opportunities on the enterprise side, also leveraging in the client SSD side, thin form factors, that we have been utilizing. So I think our strategy of continuing to drive differentiation is working well.

Regarding second part of your question, on consolidation, et cetera, I mean, clearly, flash will become more difficult to produce in the future and system expertise will be an important part. And I think that will clearly help determining relative position of different peers in the marketplace in the future. We feel very good about our position in that regard with our strong system expertise.

Ryan Goodman, CLSA Asia-Pacific Markets: And then just on monetizing the differentiation. So the Adaptive Flash Management, should I be thinking of, and other things along those line, should I be thinking that this is going to be more of a share gain tool? Or is this something that could slow price declines where you can get paid more through your ASPs? Or should I be thinking more in the historical sense that, I guess, keeping up with the technology is more of a cost saver than helping on the revenue line?

Judy Bruner: I would just add that I think the differentiation that Sanjay has been talking about does have the ability to help us on the share side in terms of stickiness, and also help us on the margin side in terms of maintaining that, higher and more consistent margins over time. So those are clear goals for us as we try to further increase the differentiation of our products through all the different avenues that Sanjay described.

Sanjay Mehrotra: And again, we have several value-add product techniques and product portfolio. So it really depends from product to product, as well as from customer to customer in terms of how we position it in terms of share gain, pricing power, et cetera.

Ryan Goodman, CLSA Asia-Pacific Markets: Okay. And then, just one other question, quick follow up on the royalty business. I saw that went up a little bit this quarter, and then going kind of flattish for a couple of quarters. Can you just give some color on that? Like what, I don’t know if you can give an exact percent, but about what portion of that is tied to revenue trends versus just being fixed licensing payments and how we should be thinking about that in terms of growth over the next few years?

Judy Bruner: I would tell you that the majority of it is tied, over time, to revenue of our licensees. And so generally, there’s a large portion of it that will vary with revenue in the industry.

Ryan Goodman, CLSA Asia-Pacific Markets: Okay. Thank you.

Brian Peterson, Raymond James: This is Brian Peterson filling in for Hans (Mosesmann). Just a question on the guidance. It’s a little bit lower than I would’ve been looking for. Can you maybe size how much of that is due to constraints?

Judy Bruner: Sure. You’re talking about the revenue guidance, I assume. As we said, we do believe that we are supply constrained, and we are purchasing more non-captive or utilizing more non-captive in the third quarter than we did. And so that has factored into our guidance. Keep in mind that we did, as we indicated last quarter, lose some supply in the earthquake and power outage at the end of the first quarter. And that is impacting us. It has caused us to lower our estimate of our bit growth, our captive bit supply growth this year from what we had indicated early in the year in the mid-80% range to now closer to 80%. And so that is a factor in our guidance.

Brian Peterson, Raymond James: Thank you.

Harlan Sur, JP Morgan Chase & Co: Thank you for taking my question. On the Pliant acquisition and products, along the same lines as the prior caller, do you plan to bring the controller design in-house or are you going to continue to use the ASIC partner? And as you’ve rolled out your 6-gig SAS drives, what has been the key differentiator on why these drives are gaining more traction versus competitive solutions out there in the market? I mean, my understanding is that, for example, firmware is key for these enterprise drives. I’m just wondering if that’s one of the kind of key differentiators.

Sanjay Mehrotra: So regarding the 6-gigabit SAS drives, and we recently announced the HP win there. Certainly, we are leading the industry with those. And yes, I mean, there are several key differentiators. The SAS drives’ firmware is a very important factor, and in fact, the Pliant’s team has tremendous amount of firmware expertise, not just related to the flash management, where SanDisk brings a lot of value as well, but also, related to the host application and the customer requirements and understanding of the workloads of various enterprise applications and helping the customer tweak the solution and really deliver reliability and performance and the prediction of performance, which are very, very important in enterprise applications. So yes, firmware plays a very key role there, and Pliant has tremendous amount of expertise and experience of the several leading team players of many, many years of experience there.

Also, on the ASIC side, some of the other enterprise storage solutions hardware, they have PDAs. Pliant uses it’s solution with its own ASIC and that, again, is the competitive advantage in that space. And now, with the, our acquisition of Pliant, certainly, our deep understanding of the future roadmap of flash memory and the technology constrictions associated with that, and being able to apply those early enough in the enterprise storage cycle, will be yet another strong benefit for us.

Harlan Sur, JP Morgan Chase & Co: Thanks Sanjay and just one follow-up, and I apologize if you articulated this earlier in the call. But can you just give us an update on the 19-nanometer qualification? And is the team still on track to ramp towards the back half of this year?

Sanjay Mehrotra: So 19-nanometer is on track, and we will be starting production of 19-nanometer in third quarter. The volume of 19-nanometer used for this year will be relatively small, and it will be small toward the end of the year as well, 24-nanometer will remain the vast majority of our output toward the end of the year. And we are in the process of very early stages of 19-nanometer and the internal qualifications, et cetera.

Harlan Sur, JP Morgan Chase & Co: Great. Thank you very much.

Uche Orji, UBS: Thank you very much. Just a few really short questions. Judy, your cash level has been building quite steadily. I’d just like to understand how you plan to deploy that cash and whether a buyback is something that you have looked at as with the use of cash, just given where, from a validation (?) standpoint, it’s frustrating (orchestrating?)?

Judy Bruner: Sure. As I’ve indicated before, we’re a very capital-intensive business, and we have a fair amount of capital expenditures ahead of us as we build Fab 5 over the next several years. So capital use for our capacity is the #1 use of that cash. And then in addition, we, from time to time, do make strategic investments in other areas and the Pliant acquisition is a good recent example of that. And there can be other kinds of technology investments, such as the technology investment that we made in the first quarter with our partner, Toshiba. So those are the primary intended uses of our cash, which is at a comfortable level. In terms of buybacks, we have done buybacks from time to time, and I don’t rule out that, that’s something that we could do in the future. We do not, at the present, have a buyback plan in place.

Uche Orji, UBS: All right. If I look at the, your ASP future decline, and what we see is around minus 7%. How much of that was from, whether mix of OEM and embedded versus actual price erosion in retail? And as I look at all these new demand drivers you are talking about, should we start to conclude that it’s possible that the ASP will fall less aggressively with cost? I mean, it sounded like there’s a lot more product that you have, getting designed into, which would suggest that it should be less of a commodity in that sense. So I just want to understand how would we should think about how does the pricing volatility for your business should track with this expanded areas of activities for SanDisk.

Judy Bruner: Sure. No, I absolutely believe that the diversity of our customers and our channels and the broad range of products that we now offer to our customers helps us to better manage that price decline over time and to minimize the impact. And so yes, I believe that all of that is contributing favorably to our pricing and our profitability.

Uche Orji, UBS: And then the final part of my question is how much of the amount of the percent is from the mix versus the retail?

Judy Bruner: I would tell you that we don’t break it out specifically, but the retail decline is oftentimes less than it is in OEM.

Uche Orji, UBS: Okay. And then finally, just on inventories are up 6 days to approximately 6 days, how much of this was from Pliant? This was your product, you would have given comment while being supply constrained.

Judy Bruner: I’m sorry, Uche, I couldn’t quite [inaudible].

Uche Orji, UBS: You’re inventories are up about 6 days, I just want to how much of that increase was from Pliant versus you building up products into the third quarter. I’m just trying to reconcile…

Judy Bruner: The inventory, you’re asking about inventory. Yes, right. So the dollar increase in the inventory, you’re right, but some of it is the Pliant inventory, and some of it is getting some recovery in terms of Fab output that came relatively late in the quarter and will be used in Q3 in the second half. As I pointed out, our inventory is actually quite lean in terms of our business model and our vertically-integrated business model.

Uche Orji, UBS: Sure. Thank you very much. And then just finally, Pliant, how much was the revenue contribution in Q2 and the estimate for Q3?

Judy Bruner: Yes, we’re not going to break out the Pliant revenue. And keep in mind that Pliant was only part of SanDisk for 5 weeks during the quarter.

Uche Orji, UBS: Okay. Great. Thank you.

Brett Piira – Caris & Company: Okay. Thanks guys. This is Brett Piira for Craig (Ellis). On the cost reduction side, can you quantify how much it will be in 3Q and 4Q, just similar to 2Q or more or less? Give us the direction.

Judy Bruner: Well, I indicated a little earlier that I believe we’re still on track for the overall cost reduction for this year that I guided to at our Analyst Day of in the range of 30% plus or minus 3 points. And we are at approximately 30% year-over-year for the first half.

Brett Piira – Caris & Company: Okay. And then on the embedded side, with handset tablets, just generally speaking, have any programs been pushed out unusually or still on track with, given the macro backdrop?

Sanjay Mehrotra: There are many models of smartphones, tablets, et cetera, that are out there. And as we all know, that certain models are successful in the marketplace, others sometimes may not. And we are really engaged with major OEMs on the plethora of model designs with our embedded products. So from time to time, this does happen that certain model launches, et cetera, do get pushed out, but this is really something that we manage on an ongoing basis, all the time throughout the quarter, working closely with our customers to understand their demand trends and making any adjustments that we may need to fulfill their requirements. And this is where definitely the flexibility of having a diversified set of customers, really helps us manage our demand and manage our business as well.

Judy Bruner: Craig, I want to just go back to your question on cost reduction to make sure that I clarify that when I say that our cost reduction for the year and also for the first half is expected to be about 30%, and it was about 30% year-over-year in the first half. But that is in, on an all-in basis, meaning including the impact of Fab 5 startup costs, non-captive purchases, the yen exchange rate and the charges related to the earthquake and power outage, right? So our underlying cost reduction is clearly stronger than that. But all in, our guidance still stands, and we still feel good about it for the year in terms of approximately 30%.

Jay Iyer: Thank you, Craig. And I think that brings us to the conclusion of the call. We want to thank everyone for joining us today, and I apologize, it went into overtime. The webcast replay of today’s call should be available on our Investor Relations website shortly. Thank you, and have a good evening.

**** end of call ****

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