2012.01.25 SanDisk Q4 2011 Conference Call

25 January 2012 Q4 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.

I am pleased to report another record year for SanDisk with 17% year over year revenue growth, strong profitability and healthy cash flows. Today, I would like to share my perspective on three key areas of our business:
1. Our strong performance in 2011 in both OEM and Retail channels,

2. Entry and subsequent growth in the enterprise SSD market, enabled by our strategic acquisition of Pliant Technology and our growing success in client SSD

3. Strengthening of our broad product portfolio and technology leadership in NAND Flash.

Starting with our OEM results, we experienced strong growth in the mobile and SSD markets including client and enterprise SSD segments. Revenue from our mobile embedded business almost doubled in 2011, approaching $1.5 billion, primarily driven by smartphones and tablets. Additionally, our embedded business gained traction in digital camcorders, and new product categories such as smart TVs and other connected devices. Adoption of our iNAND products by Tier 1 OEMs in these product categories has been enabled by our strong systems technologies, which include proprietary controller and firmware. I am proud to note that SanDisk iNAND is a key element in mobile device reference designs specified by eight out of the top 10 chipset vendors for both the Android and Windows platforms.

We expect the mobile segment to benefit from several trends, including broadening adoption of tablets, the ongoing penetration of smartphones in emerging markets and increasing consumption of video. Increased adoption of tablets for content consumption and as productivity enhancing tools by both consumers and enterprises should drive strong growth for NAND flash. The ongoing shift from 2G to 3G mobile phones in emerging markets bodes well for increasing NAND flash consumption. Additionally, the increasing consumption of video on mobile devices, enabled by LTE networks, will continue to drive demand for more NAND flash. We believe that our broad removable and embedded product portfolio will allow us to benefit from these growing opportunities.

Switching to our enterprise SSD business, it delivered strong sequential revenue growth in the fourth quarter. Our strength in this new market stems from the leadership of our SAS SSDs and our vertically integrated business model. Today, SanDisk is a leading supplier of SAS SSDs to Tier 1 storage and server customers. Customer response to our SSD solutions has been very favorable and our enterprise SSDs remain on plan to migrate to our captive memory beginning in the second quarter of this year. We are further expanding our product portfolio with our PCIe and SATA SSD products, both of which we have already started sampling to enterprise customers. Overall, I am very excited about SanDisk’s growth prospects in the enterprise market and expect to see accelerating momentum in 2012.

For the client SSD market, the combination of the increasingly attractive price points and a significantly improved user experience is fueling consumers’ transition to SSDs from hard disk drives. We have been successful with our small form factor client SSDs and now they are being increasingly adopted by PC OEMs into their new Ultrabook platforms in both standalone SSD and caching configurations. We have also begun sampling our high-performance client SSDs at PC OEMs. Our client solutions offer compelling value propositions to our customers. Our innovative systems solutions deliver industry leading power/performance characteristics in the smallest package footprint. To achieve this requires deep systems design and implementation capabilities and these are part of SanDisk’s core strengths.

To conclude my comments on SSDs, we expect 2012 to mark the inflexion point of SSD growth for SanDisk with both the enterprise and client markets becoming strong contributors to our revenue growth in 2012 and beyond.

In the Retail channel, we had a successful 2011 holiday season with sequential revenue growth achieved in all of our end markets. Our overall Retail business grew eight percent on a year-over-year basis. I am particularly pleased to report that our 2011 Retail unit sales in emerging markets doubled on a year over year basis. We believe we continued to gain market share in emerging regions including Asia, Latin America and the Middle East, and we are well positioned to benefit from the growing opportunities.

In 2011, our 24 nanometer technology was the primary cost reduction driver and it accounted for the vast majority of our production output in the fourth quarter. We began production of 19 nanometer technology in Q4 and it will ramp throughout 2012. As we have explained previously, NAND scaling is becoming more complex for the industry resulting in a lower rate of cost reduction from technology transitions. The 19 nm technology will generate a lower cost reduction rate compared to what we achieved with the 24 nm transition. Our 19 nm technology enables us to achieve what we believe are the world’s smallest and the most cost effective X2 and X3 memory die in high volume manufacturing in 2012. We will discuss our technology roadmap further at our analyst day in February.

Turning to fab operations, we have just completed the planned capacity expansion within Phase 1 of Fab 5, and we have now equipped approximately 30% of the Phase 1 space. We expect future Phase 1 expansion to begin no sooner than July 2012. This pause is longer than previously planned and is designed to achieve the best balance between prudent capacity expansion and leveraging the growth opportunities ahead of us. We now expect our 2012 captive supply bit growth to be slightly less than it was in 2011. We also intend to rely on some non-captive supply in 2012 to maintain flexibility in our supply mix.

From a near-term perspective, as you are aware, the market backdrop remains challenging, given the current global macroeconomic climate. In the fourth quarter, certain of our mobile OEM customers lowered their NAND forecasts to us due to lower demand for their products. We believe this will impact our revenue opportunity in the first half of 2012. We expect that the diversity of our customer base, growing momentum of our SSD product portfolio and strength of the secular demand drivers will enable us to return to healthy revenue growth in the second half of 2012.

In summary, SanDisk delivered strong Q4 and 2011 results in revenue growth, profitability and cash flows. We bolstered our technology leadership in NAND Flash and product roadmaps, and continued to grow faster than the semiconductor industry with market share gains in our core and new businesses. These results reflect our success in leveraging the extraordinary opportunities that are being created by the confluence of the content, mobility and storage trends and also speak to the success of our expansion into new markets, channels and customers with storage solutions that our customers want from us.

I will now turn the call over to Judy for her financial review.

Judy Bruner, Executive Vice President, Administration & CFO: Thank you, Sanjay. We are pleased to close 2011 with record Q4 and annual revenue and non-GAAP net income. We have now achieved 10 quarters in a row of operating margins above 25% on both a non-GAAP and GAAP basis, demonstrating the strength of our business model and our focus on execution.

For Q4, our gigabytes sold grew 28% sequentially and 83% year over year. And for 2011, our gigabytes sold grew 80%. Our captive supply grew 77% for the full year, and we supplemented this with non-captive purchases, which accounted for approximately 10% of our 2011 revenue.

Our ASP per gigabyte declined 13% sequentially and 36% year over year, with a higher rate of price decline experienced in the latter part of Q4. For the full year, our ASP per gigabyte declined 34%, which we believe reflected a generally balanced industry supply/demand environment. The mix of our product business in Q4 was 63% OEM and 37% retail, up from 35% in Q3, reflecting Q4 holiday seasonality. Our Q4 license & royalty revenue was up 10% sequentially and 20% year-over-year, reflecting growth in both memory and system level royalties, as well as a one-time favorable royalty adjustment of $7 million.

Our retail revenue in Q4 grew 18% sequentially and 8% year-over-year. Sequentially, retail revenue was up in all regions, with the highest growth being in North America, where holiday seasonality tends to be most pronounced. On a year- over-year basis, we saw the strongest retail growth in Latin America, followed by Asia, reflecting stronger economic conditions in those regions and our increasing penetration of emerging markets. Sales in emerging markets comprised 20% of our Q4 retail revenue, compared to less than 13% last Q4. For the full year 2011, our retail revenue grew 8% with strong growth in Latin America and Asia, and low single digit growth in North America and Europe, where macroeconomic trends are relatively weak.

Our OEM revenue in Q4 grew 8% sequentially and 26% year-over-year. The
strongest sequential and year-over-year growth in Q4 came from SSDs and gaming cartridges, and this was true in terms of both percentage growth and absolute dollar growth. For the full year 2011, our OEM revenue grew 25% and the highest dollar growth continued to come from the mobile market.

Looking at total revenue for 2011 by end market, the three largest end markets for us continued to be mobile, imaging and USBs. Mobile was 54% of our revenue, imaging 16%, and USB 9%.

Our Q4 non-GAAP total gross margin was in the middle of the range we predicted at 43%, down one percentage point from Q3, primarily due to the Yen to dollar exchange rate. Our Q4 cost per gigabyte improved by 11% sequentially, and had the Yen rate in our cost of sales stayed constant from Q3 to Q4, our cost improvement would have been 13%, the same as the sequential price decline. Non-captive memory comprised about 11% of our Q4 sales, the same as in Q3. Fab 5 operated very efficiently in the fourth quarter, resulting in no start-up costs. Because Fab 5 has been only partially built and equipped, a Fab 5 wafer still costs more than a wafer from Fab 3 or 4; however the wafer cost is now within a normal range, and as a result, we had zero start-up period costs in Q4. For the full year 2011, our cost per gigabyte improved by 31% including the impact of the Yen, higher non-captive mix and Fab 5 startup costs. For the full year, our non-GAAP gross margin was a strong 44%.

Our Q4 non-GAAP operating expenses were in the lower end of the range we forecasted, with the R&D growth reflecting increased investment in memory development and enterprise SSD engineering, and sales & marketing growth coming from seasonal advertising as well as growth in baseline expenses.

Operating margins for Q4 were 28% on a non-GAAP basis and 26% on a GAAP basis. Our other income included a $19 million gain from the sale of equity investments.

On the balance sheet, gross cash and short- and long-term marketable securities increased by $347 million to over $5.6 billion, and net cash increased to almost $3.7 billion. Cash flow from operations in Q4 was $210 million, and we also received $168 million of repayments from the joint ventures and $61 million from option exercises. We spent $79 million on capex and $4 million on stock buybacks as we began to purchase under the program approved in Q4. We added $220 million of new fab equipment leases, bringing our off-balance sheet lease guarantees to a total of $732 million.

Inventory came down slightly in dollars due to the strong Q4 sales, receivables stand at 32 days, and channel inventory ended Q4 slightly below 5 weeks, lower than Q4 last year. For the full year 2011, our fab and non-fab capital investments totaled $1.4 billion and our net cash outlay for capex was only $259 million. We also made cash investments in 2011 for the acquisition of Pliant and for future technology, and after these investments, our free cash-flow was $377 million for the year.

I’ll now turn to forward-looking commentary.

This year, we expect our Q1 revenue to reflect the seasonality typical of a consumer business. This seasonality impacts our revenue from the retail channel and from our consumer-based OEM customers, and it has been somewhat masked in the last two years as we were gaining share in the OEM channel.    This Q1, our revenue will also be impacted by demand weakness from certain mobile OEM customers and the somewhat higher rate of market price decline seen in late Q4 and early Q1. We are forecasting full year 2012 revenue of $6.2 billion to $6.6 billion with first quarter revenue of $1.3 billion to $1.35 billion. We expect the majority of our 2012 year- over-year revenue growth to be in the second half as overall demand improves and as the continued strong ramp of our SSD sales becomes even more significant. As the SSD business grows as a percentage of our mix, particularly in the enterprise segment, we believe that seasonality will be less pronounced in future years. We are prudently pausing the Fab 5 capacity ramp as of the end of January and will restart no sooner than July. With this, we expect growth in our captive bit supply to be less in 2012 than in 2011. We expect to continue to supplement our captive supply with non-captive purchases, particularly in the second half of the year. Given estimates of industry supply and demand growth, we expect that full year price decline will reflect an overall balanced supply/demand environment.

We forecast our total non-GAAP gross margins for Q1 as well as for the full year 2012 to be in the range of 39% to 42% compared to 44% in 2011. There are two primary factors that account for the forecasted decline in total gross margin from 2011 to 2012. First is the Yen to dollar exchange rate. We have locked in approximately 60% of our Yen requirements for 2012, and based on the cost of those contracts, as well as current market rates, we forecast an approximately 5% increase in the dollar cost of our Yen-based wafer purchases. A 5% appreciation in the Yen impacts our gross margins by approximately 2 to 3 percentage points. The second factor is that the 19 nanometer transition will generate less cost reduction than the 24 nanometer transition. We expect cost reduction from technology transition to be higher in the first half of the year which will still be benefiting from the 24 nanometer transition. In the second half of the year, we expect the key drivers of gross margin to be the 19 nanometer transition, a higher mix of non-captive memory and an improved pricing environment.    Thus we expect our gross margins to be in the same forecasted range across the year. Compared to 2011, our 2012 costs will be positively impacted by the elimination of Fab 5 startup costs and the absence of costs related to the 2011 earthquake and power outage, partially offset by a higher mix of Fab 5 wafers which will remain more costly than Fab 3 and Fab 4 wafers until the current Phase 1 becomes closer to full capacity.

Non-GAAP operating expenses for 2012 are forecasted to be approximately $975 million, remaining in the lower end of our 15% – 17% long-term expense model. Operating expenses in Q1 are expected to be similar to the level in the quarter just ended. We expect non-GAAP Other Income of approximately $5 million per quarter or $20 million for the year, and we forecast the tax rate to be approximately 32% for 2012, about a point lower than in 2011. Our 2012 forecasts for revenue, gross margin and operating expense lead to forecasted operating margin of 23% – 27% for 2012. This provides a continued strong rate of return on investments for future growth.

Our 2012 capital investments are expected to be in the range of $1.1 billion to $1.6 billion with the key variable being the length of the pause in the Fab 5 capacity ramp. This capex forecast includes a higher level of non-fab capex in 2012 as compared to 2011. We expect to continue to take advantage of attractively priced operating leases for fab equipment, and the joint ventures will continue to contribute to the cash investment requirements. Our total cash outlay for capital investments in 2012 is expected to be in the range of $400 – $700 million.

In summary, we expect solid revenue growth and continued strong profitability and free cash flow for 2012. We will now open the call for your questions.

Q&A

Daniel Amir, Lazard Capital Markets: Thanks a lot and congrats on a good 2011. A couple of questions here. The first is, how do you view kind of the, based on your guidance here, the impact of the SSD business in terms of your revenue ramp as the year progresses, as it looks like that you’re really building in a much stronger second half with better pricing? Is that surrounding your SSD assumption? And then I have one follow-up. Thanks.

Sanjay Mehrotra: So yes, with respect to the second half, we certainly are looking at our SSD business, both in Enterprise as well as Client to continue to ramp nicely during the year. It will continue to grow as a percentage of our business total revenue throughout the 4 quarters, and particularly become even a larger percentage of our revenue mix in the second half. So yes, I mean, our SSD growth is definitely baked in here in terms of the second half growth. And the other part is also our continuing momentum in the design wins in the mobile, reference designs that I referred to in my comments. And some of these designs, particularly with respect to embedded products, start getting into production during the course of the year and really get  into full play in the second half of the year. So those are some of the key factors. And of course, the emerging market growth for us is very important, has been building up nicely, and that too will continue to contribute nicely to our growth.

So in terms of revenue, in terms of growth opportunities, yes, those are the 3 main drivers: the SSDs, our design win momentum and strong engagement with the customers, leading to launch and shipment of new platforms in the mobile system, and third, the emerging market growth.

Daniel Amir, Lazard Capital Markets: Okay. And the follow-up question is considering the current environment of the NAND market, compared to 2010, it looks like we’re starting the year a bit in a softer space. Can you give kind of the factors? I mean, is this due to supply related, more supply? Is it more that there’s a bit of demand softness, especially in the smartphone market? How do you, how would you categorize it?

Judy Bruner: Daniel, I’ll take that. We did see a bit of accelerated price decline late in the fourth quarter, and this was impacted, we believe, in part, by some softness in terms of demand for certain large OEMs in the mobile space. And it also tended to vary a bit by product or form factor and in particular, the 8-gigabyte memory product tended to have higher price decline late in the fourth quarter.

So we think they’re, it’s not completely atypical to have higher price declines late in the fourth quarter. This has happened before, but it was a little bit faster than we had expected, and has us entering 2012 at a somewhat lower price point, because of that acceleration late in the fourth quarter.

But we do believe that for 2012, while the pricing environment we expect will be better in the second half than in the first half, we expect overall for the year that there will be balance. And of course, we are very carefully managing our own supply-demand balance, and that is part of the reason that we have decided to extend the pause of Fab 5 and restart no sooner than July, whereas previously, we were going to restart in May.

James Schneider, Goldman Sachs: Good afternoon. Thanks for taking my question. I understand that you have a decision point coming up on the future expansion of Fab 5 and how fast that will ramp. I was wondering if you could give me any more parameters in terms of the range of captive bit supply you expect to grow. You talked about less than the 77% you did this year, but any kind of better range on what the bits for the year will be, and how filled up you think Fab 5 will be at the end of this year?

Sanjay Mehrotra: So I will take that. With respect to Fab 5, as we mentioned, that Fab 5 has added about 10% to our Fab 3 and Fab 4 capacity bit growth with the Phase I expansion that we just completed. Now if we restart the expansion in July, and again we have not yet made the decision, it will be made on a month-to-month basis based on our demand assessment. If we restart the expansion in July, then for the year, we would expect Fab 5 to add another 10% to our total wafer capacity at this point. And once again, if we, of course, decide to start the ramp later than July, then it’s going to be adding less than 10%. And with the assumption of starting the ramp in July, our bit growth for 2012 will be less than last year’s captive supply bit growth of 77%.

James Schneider, Goldman Sachs: Okay, fair enough. And then relative to your X3 product mix, that’s been a very strong margin driver for you for the last couple of years now. From this point going forward, in 2012, by how much on an incremental basis do you think you can expand your X3 mix without giving us a specific number on what it is today?

Sanjay Mehrotra: So X3 mix for 2011 overall for our business was more than 50%. And as SSD business grows for us in 2012, both on the Client and the Enterprise side, we would expect X3 percentage, on a total basis, in 2012, to be somewhat less than in 2011. Yet we expect to have really strong presence with X3 and all of our products, I mean, primarily in cards and certain embedded products as well.

James Schneider, Goldman Sachs: That’s helpful. Thanks so much.

Judy Bruner: I would just add to that, that while we expect our X3 mix to come down some in 2012 because of the growing mix of SSD products, that does not necessarily correlate to a lower gross margin because the SSD products have a strong gross margin, even utilizing X2.

James Schneider, Goldman Sachs: I understand. Thanks so much for the color.

Srinivasan Sundararajan, Oppenheimer: Hi. Good results on Q4. Just wanted to ask you what would be the total level of CapEx spending in 2012 for both Toshiba and SanDisk in terms of a dollar figure?

Judy Bruner: We can’t speak to Toshiba, but for our capital spending in 2012, I said that it would be in the range of $1.1 billion to $1.6 billion. And the reason for the somewhat large range there is because of their potential variability in when we restart the expansion of Fab 5.

Srinivasan Sundararajan, Oppenheimer: Okay. And in terms of the PCIe model, when do you propose to release that for the SSDs?

Sanjay Mehrotra: We have already sampled our PCIe products to Enterprise customers, and we plan to begin shipping that product following their qualification in a matter of few months. You know that Enterprise customers do take long time to qualify our products, but we are very pleased with our execution on PCIe products following the acquisition of Pliant.

Srinivasan Sundararajan, Oppenheimer: Just one last follow-up. Are you somewhat decided on what would be your future architecture that is between Bit Cost Scalable and 3D, or you’re still investigating that?

Sanjay Mehrotra: So Bit Cost Scalable, BiCS, and 3D memories, we are continuing to invest in R&D, and we actually made good progress in 2011 on those. And as we have always said that these are technologies that are for the future post-NAND kind of era, and they are a few years away from production but we are continuing to make strong progress with those technologies. And let me just point out we are also making very good progress with NAND scaling for the future.

Srinivasan Sundararajan, Oppenheimer: Thank you.

Alex Gauna, JMP Securities: Thanks for taking my question. Let me echo my congratulations. I was wondering if you could give some color on the average density of the SSDs you are shipping today, and maybe what the OEMs are indicating for you on kind of the price elasticity of demand front. I know they always want drives cheaper, but are there any break points that could, for example, if you can reach them that could accelerate adoption trends? Thank you.

Sanjay Mehrotra: So with respect to the average capacity on SSDs, I’ll just break it out into 3 different sections. One is our small footprint at more entry-level SSDs generally used in caching kind of opportunities, and those vary in capacity at this point anywhere from 16 to 64 gigabyte in capacity. That’s what we are shipping. For example, for Ultrabook designs for side-by-side for caching with flash, those are the capacities.

Then the high, the high-performance SSDs, we are shipping them in capacities for client applications, consumer applications, we are shipping them in capacities of 64, 128 and 256 gigabyte.

And on the Enterprise side, of course, the capacities tend to be much higher. And generally, about 400-plus terabyte average capacity there, gigabytes, I’m sorry. 400-plus gigabyte capacities in Enterprise on an average. You had one more question that’s just sweet spot?

Alex Gauna, JMP Securities: Really on price point.

Sanjay Mehrotra: You want to know the price point, I think you’re asking, right?

Alex Gauna, JMP Securities: Yes.

Sanjay Mehrotra: Yes. So in client side, we have always said that as flash gets below $1 a gigabyte, it opens up more opportunities. And we certainly look at 2012 to be that inflection point for SSDs. And we are very excited about this opportunity. I think flash is getting to price point. It’s really offering strong value proposition for this market to take off in the client SSDs. If you actually look at the third-party studies on client SSDs, this market by 2015 time frame is expected to grow to $10 billion or so market, going from, maybe last year at around $3 billion total. So we are really looking at huge opportunity ahead on client SSD here, gaining share in this market. And as this market builds up, it drives strong revenue for us. And by the way, same thing on Enterprise SSD side, that market is expected to triple to something like $7 billion or so by some estimates by 2015 time frame.

Alex Gauna, JMP Securities: So, and I’m assuming you’re getting there on a 2-bit-per-cell type of configuration. What about the industry interest in 3x and your belief in the suitability of that technology to the SSD market?

Sanjay Mehrotra: So yes, you’re absolutely right that this market, I mean, the Client SSDs and Enterprise is 2-bits-per-cell market. Enterprise actually has some single-level cell as well. And in the future, we will be looking at opportunities for 3-bit-per-cell on the client SSD side. Enterprise SSD, I fully expect that to continue to be on 2-bits-per-cell, given the high performance, the high reliability requirement of enterprise application.

Alex Gauna, JMP Securities: Thanks so much.

Vijay Rakesh, Sterne Agee & Leach: Yeah. Hi guys. You guys mentioned you fixed the yen-dollar on 60% of your purchases. When did you fix it, at what point?

Judy Bruner: We fixed those contracts primarily in Q4 and primarily at rates of about 78.

Vijay Rakesh, Sterne Agee & Leach: Okay, got it. So if the yen probably depreciates a little, that should probably favor you through the year then, right?

Judy Bruner: If the yen depreciates, yes, that would be favorable for us for the 40% that’s not fixed.

Vijay Rakesh, Sterne Agee & Leach: Got it. And also on the non-captive side, how much leverage do you have to, anyway, can you bring that down as you look at the demand side or as Fab 5 comes on?

Judy Bruner: Yes. I mean, the beauty of us using non-captive in our model is that we can vary that, and we currently expect to utilize less non-captive in the first half and more non-captive in the second half of 2012.

Vijay Rakesh, Sterne Agee & Leach: Got it. And then what kind of ASP and cost declines are you looking for in NAND for the year?

Judy Bruner: We’re not providing a specific cost decline percentage for next year. As we said, the cost decline that comes from technology transition, which of course is a major provider of cost decline, is slowing down for us and for everyone in the industry, as the flash memory continues down the scaling path. So that is a factor, but there are also many moving parts in the actual cost decline percentage, including, of course, for us, the yen, as well as our non-captive mix and also things like product mix.

In fact, product mix is increasingly impacting the cost-per-gigabyte computation and even the ASP-per-gigabyte computation. As you think about it, we have a very broad range of products all the way from wafers to cards and USBs to very complex products like SSDs. And so the mix of products that we sell in a given quarter really can impact that particular percentage computation. And actually, if you step back for a minute and look at this from a high-level, I would encourage you to really measure us based on our margin performance. Think about our gross margins and our operating margins and less about the specific cost decline and ASP decline percentage in any given period. And I think we have performed very well there.

Vijay Rakesh, Sterne Agee & Leach: Great. Thanks.

Uche Orji, UBS: Thank you very much. Sanjay, as we look at the issue of the slowing cost curve as you move to 19-nanometers, I have 2 part questions here. One is, is there anything you think could be done in industry to accelerate that further, especially with X4 not yet commercialized? Is that something that could help? And then as you provided guidance for gross margins, which obviously incorporate the slowing cost, the implications for me is that, that ASP reduction will also slow or mix will change. Which is most important in driving margins or holding margins stable in a slowing cost reduction environment?

Sanjay Mehrotra: So with respect to the cost decline capability of the technology, we’ve always said that the flash memory is getting more and more complex. Flash memory scaling is becoming more challenging. It’s not just about lithography scaling, it’s also about the device reliability and device performance that has to be managed. And you these considerations are applying to the NAND industry to all suppliers of NAND flash. So we do believe that the cost reductions received, achieved purely from flash memory scaling will decline. They have moved to a different stage now compared to the years past. And again, that trend applies to everybody. And of course, we continue to work very hard our engineering teams. And in collaboration with Toshiba in R&D, we are continuing to work aggressively on scaling of NAND flash for future, and we believe that we have a couple of generations ahead of us for sure in terms of scaling of NAND flash.

In parallel, we of course continue to also work as part of our three-pronged strategy for R&D on BiCS and NAND and making good progress, as I mentioned, earlier in that regard. Over the long term, I think you will see that in terms of managing the margins, the price declines of the industry will be in line with the cost declines. And those are good ways to really look at our industry, it keeps the industry fundamentals healthy. And having price declines in line with the cost declines allows us to grow the market opportunities. It will help grow the SSD opportunity, as well as other opportunities for content, high-capacity content in mobile devices. So that’s how I look at it in terms of technology initiative in the industry and the cost reduction outlook, as well as in terms of gross margin pricing, very much dictated by the cost reduction capabilities of industry.

Uche Orji, UBS: Right. Okay, that’s helpful. Just one more question on the capacity slowdown that you or the pause in capacity addition. Do you think from what you know in the industry, do you think you are going to lose market share this year in terms of your production? In which case, what I’m saying and you hinted that everybody is seeing for the trends you’re seeing. Do you think that you will be, will be willing to sacrifice your market share if it came to that? Or do you think that the across industry, based on what you know today, this slowing down of capacity addition is an industry-wide phenomenon?

Sanjay Mehrotra: So I would say here that when we make our decisions for capacity expansion, we base those on our demand projections. So we are not just following others. We are making our decisions for capacity expansion based on our demand and not achieving any bit share. Having said that, if you look at the third-party estimates for the industry bit growth, in 2012, I think they are in the range of 70% to 75%. And what we have said is that if we do resume our Fab 5 ramp from July onwards, our 2012 bit growth will be less than last year’s, and last year’s was 77% captive supply bit growth.

So at this point, to us, in terms of our own demand assessment and our own outlook for Fab expansion, it points to us definitely being in line with the industry bit supply growth. Having said that, I do want to point out that of course, we have opportunities for non-captive supply as well to further drive our revenue to a higher market share. And I believe in 2011, SanDisk actually gained revenue share, and combination of captive and non-captive helped us do that, and then always managing the mix of our business to really deliver the maximum revenue and the profit opportunity as well, to really optimize the business and continue to focus on revenue growth, profitability and cash flow. I think we did excellent in this regard in 2011, and I believe that this is something we’ll continue to focus on going forward as well.

Uche Orji, UBS: Thank you very much.

Tristan Gerra, Robert Baird: Hi. Good afternoon. Given the industry expectation for a decline in 3-bit-per-cell mix in 2012, is there any potential implication for your licensing revenue? And also if you could talk about your R&D spending, going forward, so 3-bit-per-cell versus MLC, and how prevalent the technology might be in future geometry nodes.

Judy Bruner: So Tristan, first, the mix of our X2 versus X3, if that was your question, no, that doesn’t have any implication for our license and royalty. And the second part of your question was, if you could just repeat it, regarding R&D expenditures?

Tristan Gerra, Robert Baird: Yes, in terms of whether you will continue to dedicate as much in terms of spending on X3 for future geometry node or should we look at the shift in emphasis back on MLC going forward.

Judy Bruner: Yes, we will definitely continue to spend on development of X3 as well as X2. Both are extremely important to our business. And of course, in terms of our overall R&D spend, a fair amount of our R&D spend is related to future technologies continuing to scale NAND, of course, on both X2 and X3 and then also BiCS and 3D, as we have discussed. And we’re continuing to pursue this three-pronged R&D strategy, and we believe, as Sanjay said, that we have made good progress in 2011. And as in 2011, the majority of our growth and expenses in 2012 will come from R&D.

Sanjay Mehrotra: And I’ll just underscore that X3 is, of course, a major competitive advantage in terms of cost leadership for SanDisk and in 2011, we did more than 50% of the bits. So, of course in the future, we will continue to leverage X3, and it will continue to remain a very big part of our cost leadership going forward as well. And yes, we will continue to invest in X3.

Tristan Gerra, Robert Baird: Okay. And then just a quick follow-up in terms of inventories in the channel, and when would you expect things to normalize there? And how would you view the inventory levels currently?

Judy Bruner: Actually, we think the inventory in the channel today is actually quite normal, if not on the low side. And that is true both for the retail channel inventory and the channel inventory that we see in the OEM side of the business. So we think that channel inventory is in good shape.

Tristan Gerra, Robert Baird: Great. Thank you.

Atif Malik, Morgan Stanley: Hi. Thanks for taking my question and a nice job on the quarter. Judy, if I look at the history of the company, always sounds conservative on the cost reduction start of the year. But just looking at last year, the underlying cost reduction from scaling in X3, and based on my calculation, was in the 44% to 45%, somewhere in that neighborhood. Now I look at this year, 19-nanometer, physically from scaling from 24-nanometer can give you 37% year-over-year cost reduction. So I’m just trying to understand the gross margin guide for the full year, from an underlying cost reduction point of view, what is the company assuming?

Judy Bruner: Again, as I said earlier, we’re not going to provide a specific range in terms of cost decline. But we do see, and it is the case, that 19-nanometer will generate less cost reduction than did 24-nanometer. So that underlying level of cost reduction from technology transition is slowing down. That’s true for us. It’s true for everyone in the industry. And as I said before, I would really focus on the gross margins and less on the specific cost decline percentage.

Atif Malik, Morgan Stanley: That’s fair. Second one for Sanjay, the Enterprise storage and server market is heating up. There are vertically integrated players and non-vertically integrated players. What is the strategy or the secret sauce for SanDisk in this market, particularly on the IP side and then on the distribution side as you have new OEM customers?

Sanjay Mehrotra: Our strategy is definitely to continue to leverage our vertical integration model and leverage all the expertise that Pliant brought to us, decades in terms of man years of experience in the Enterprise hard disk drive market, applying it to flash now, and really deliver the high response that the networks, the data centers and the server applications require today, in terms of predictable performance, in terms of very high reliability and a strong value proposition.

So we, having, as we have said many times before, having flash memory technology engineers who are developing the future flash memory roadmap and understanding the intricacies of flash device consideration with the Enterprise systems engineers from the Pliant team as part of SanDisk and continuing to advance our roadmap on fabs and PCIe as well as SATA for Enterprise, is really a great combination. And I really believe that vertically integrated players like ourselves are the ones that are going to shine here.

And again, SanDisk is the one that have maximum system expertise over the years, and we believe we are best positioned for this market for the future. And of course, as this market becomes bigger and bigger for us, we will and we are, continuing to expand our channel presence in terms of distributors, working directly with the customers and enabling other channel presence as well. So we are really focused on this. We are executing very well, and we look at this as a strong driver of opportunity for us going forward.

Atif Malik, Morgan Stanley: Great. Thanks.

Craig Ellis, Caris & Company: Thanks for taking the question and nice job in 2011.

Sanjay, SanDisk has a track record of moving into a market, and after a start, gaining a very substantial market share. You did that with cards, USB drives, you’ve done it with embedded NAND. So as you look at the Enterprise SSD market and as you look at the Client SSD market, what market share level will you be satisfied with? Say, at the end of this year and at the end of 2013 in those businesses?

Sanjay Mehrotra: I’ll answer it a little bit differently. I’ll say that we are looking at this to become, in a few years’ time frame, about 25% of our revenue opportunity. And of course, we aren’t going to stop at any given market share. We will continue to drive, maximize the opportunity, keeping in mind our revenue growth as well as our profit considerations here.

And we are already on a rapid clip, a rapid rate of growth, both on the Client side as well as on the Enterprise SSD side. Overall, for 2011, it was a very small percentage of our revenue. But for Q4, our Client plus Enterprise SSDs were about 5% of our revenue in Q4. And for 2011 [2012], I would expect this to become about 10% for the entire year. And obviously, by end of the year, I would expect it to be at the bigger percentage of our revenue than that. So in terms of market share, I think we will continue to drive our market shares higher over the course of the next few years.

And that of course is exciting about SSD for us is we have been rather small in SSD so far, and now this market opportunity is getting very big and we’re going to be gaining share in this and a multiplicative effect is what drives SSD becoming a bigger and bigger percentage of revenue opportunity for us in terms of growth rate.

Craig Ellis, Caris & Company: That’s helpful color. Thank you. And switching gears to another theme in your prepared comments, you mentioned that in emerging countries’ smartphones have been an area of growth for you, can you just help us understand where SanDisk is positioned with some of the larger kind of handset manufacturers? And as you look at that opportunity, to what extent do you see it as an embedded opportunity versus a bundled or an after-market card opportunity?

Sanjay Mehrotra: A very good question. We are very well positioned. As we have said, with the major players in the ecosystem, engaged with major handset manufacturers, and we are certainly engaged with the handset manufacturers that supply to the China market as well. So we are engaged with them, and we look at the budget smartphones as becoming an increasingly attractive category in the future because the feature phones will get replaced by budget smartphones in these emerging markets. The experience that smartphones provide and the opportunities are only continuing to grow rapidly. And these smartphones, the budget smartphones for emerging markets generally will have lower capacity of flash embedded with them, and they, and we will generally all will have card slots, and there will be a strong rate of bundling also with the budget smartphones.

If you look at the embedded capacities in these budget smartphones, generally, they will tend to be, as I said before, on the lower end, maybe 2-gigabyte, 4-gigabyte kind of capacity there. And bundling of cards with those budget smartphones will also be at lower capacities.

By contrast, the smartphones are becoming more and more, are coming more and more , the high-end smartphones with higher average embedded capacity of flash. And the bundling there is, of course, is with, is reducing because the average capacity of flash is considerably increasing in those smartphones. They are getting embedded, as you know. You see the 64-gigabyte iPhone now and there are, of course, other high-end smartphones getting embedded with high-capacities as well.

Craig Ellis, Caris & Company: That’s certainly a trend. Thanks for that. If I could just ask one last one. Judy, when I look at the midpoint of revenue guidance, it looks like it’s up 13% year-on-year, and the midpoint of operating expense guidance is up 15%. So should we be thinking about some new development activity in R&D? Sanjay has talked about some technology that’s in development, but why would operating expense growth be more substantial than revenue growth?

Judy Bruner: You’re correct. Good question. This is actually primarily because of the investments required for our three-pronged technology strategy: scaling NAND, investing in BiCS and investing in 3D, as well as stepping up our investment in R&D in the SSD space.

And keep in mind that in terms of enterprise SSDs, that was part of our expenses for only about half of the year in 2011 versus a full year in 2012. And actually, I have been saying for a while that it may not be the case that we could operate at the very low end of our 15% to 17% expense model and as we pursue the three-pronged technology strategy. So I’m actually quite pleased with the expense guidance which remains in the lower half of that 15% to 17%, and is focused primarily, as I said, on funding R&D growth.

Craig Ellis, Caris & Company: Good luck with 2012.

Jagadish Iyer, Piper Jaffray: Hi, thanks for taking my question. Judy, Sanjay, two questions. First, when you gave the bit growth guidance for this year, are you assuming that you’re planning to expand the Fab 5 Phase II, or is it not? Please. And if so, is there going to be a start-up cost associated with that in the second half?

Judy Bruner: As we said, even if we restart Fab 5 expansion in July, which is the soonest we would restart it, then we still expect that our captive bit supply growth will be somewhat less than it was in 2011. And keep in mind, as you think about that, in 2011, we had approximately 9 months of capacity expansion. We had 3 months in the beginning of the year of expanding Fab 4 and then we had 6 months in the second half of expanding Fab 5.

And in 2012, if we restart in July, the most we would have would be 7 months of capacity expansion: January for Fab 5 and then the second half of the year. And also, keep in mind that 24-nanometer, of course, results in a higher amount of bit growth than does 19-nanometer. So that tech transition in 2011 being primarily 24, and in 2012 being primarily 19 is another contributing factor to the changing bit growth in terms of captive supply.

Jagadish Iyer, Piper Jaffray: Okay, thanks. that’s helpful. Sanjay, another question I wanted to find out, there is a recent news flow about competition trying to introduce their own version of PCIe SSD controllers for modular scalability. I just wanted to get your thoughts on how serious is this competition. Can you give some thoughts on that one, please? Thanks.

Sanjay Mehrotra: Overall, definitely there is competition in PCIe, and we are just starting in this market, and we have very good architecture, again, leveraging the expertise from our fabs, product experience, fab high-performance designs, and that’s where we plan to extend some of the architecture and some of the concepts to the PCIe market as well. So I think there’s a lot of opportunity, there are a lot of, it’s a very dynamic market. There will be different solutions offered. We believe we have a very strong roadmap, and feedback on the products that we have sampled is very good from our customers.
Jagadish Iyer, Piper Jaffray: Thank you.

Mark Newman, Sanford Bernstein: Hi. Congratulations again on a good quarter. Sanjay, you mentioned on SSDs that you’re planning to get to around 25% of revenue, I believe, in the next few years. I just wondered, I totally agree that there is a lot of growth in this SSD market going forward. I just wondered, for SanDisk specifically, where do you see the biggest opportunity in SSDs? Is it more on the Enterprise leveraging the technology you got from the Pliant acquisition? Or do you see more opportunity on the Client PC SSDs? And also related to that, how do you see the SSD gross margin differing from other products in the portfolio, both Enterprise SSDs and also Client PC SSDs?

Sanjay Mehrotra: So for SSDs, we see our strong opportunity building up both in Enterprise as well as on the Client side. As I mentioned earlier, the Enterprise SSD market is expected to grow to $7 billion or so by some estimates. And these estimates only keep going higher over the course of last few quarters. So bottom line is huge opportunity in that number of $7 billion or so is by 2015 time frame for the Enterprise SSD industry for the industry.

The Client SSDs, on the other hand, by 2015 time frame, there are some estimates of that market becoming something like a $10 billion market as well. So obviously, both of these markets are growing fast. Both of these markets from now till 2015 are expected to triple or so. And we will be growing in both of these markets. And since we have been small player earlier and as we gain share, we could plan to drive our opportunity in SSD in both of these markets. Regarding the margin aspect, Enterprise SSD will certainly give us higher margins than the average of our business. That tends to be the nature of the Enterprise SSD market, and the Client SSDs will be margins in line with the rest of our business.

Mark Newman, Sanford Bernstein: I see. I mean, I understand the market size projections. I was just looking to see if you are more confident on growing your share in the Enterprise or more on the, or more on the PC. It seems like you’ve been talking more about the Enterprise side, which is fine because it’s good for gross margins. I was just interested if you also thought that, that was going to be more of an impact to a kind of larger part of that 25% revenue being from Enterprise, so if you had any comments about that kind of mix for SanDisk specifically.

Sanjay Mehrotra: We’re not going to comment on the mix. We’re not going to break that out, but I can tell you that we are confident on driving the opportunity and the growth on both sides of this business.

Mark Newman, Sanford Bernstein: I see, great. And a quick follow-up question. I mean, related to the demand, obviously, we’re in a slightly, as you said, slightly seasonally weak demand right now. And looking at the potential opportunity in SSDs over the next few years building up, when do you see the seasonality, when do you see demand getting stronger? Was it early Q2 or is it later Q2?

Judy Bruner: Are you just, I want to make sure I understand, Mark, are you talking about Q2 of this year? Is that what your question is?

Mark Newman, Sanford Bernstein: Yes. I’m just wondering because you made some comments on the demand being a little bit weak right now and which has impacted the price. So I just wondered, a lot of investors have been asking, “When do we think that the demand is going to strengthen again?” A lot of it is going to be due to seasonality picking up. Obviously Q3 is typically seasonally a higher quarter because a lot of demand from consumer electronics, smartphones, et cetera. I just wondered what you saw happening, and if you think it’s going to be the pickup late Q2 or if it’s going to be earlier in Q2 for when you see demand strengthening again?

Judy Bruner: Yes. Currently, our expectation, as I indicated, is that the majority of our year-over-year revenue growth is in the second half of the year, or said another way, that we expect relatively minimal year-over-year revenue growth in the first half of the year. We do expect sequential growth in revenue from Q1 to Q2, but we expect modest year-over-year revenue growth. And one of the reasons for that, as we indicated today, is the demand weakness that we see from some of the large OEMs in the mobile space. And that impacts both cards and embedded, and we are clearly taking advantage of the diversity of our customer base. But when it comes to some of the embedded revenue, that takes some time to get into, to get qualified into new reference designs and replace some of the slower demand that we see with some of those large customers. So our best guess at this point in time, to answer your question, would be that the pickup would be more later in the second quarter as opposed to earlier in the second quarter.

Mark Newman, Sanford Bernstein: OK. Thanks very much. Appreciate it. Good luck for this year.

Bob Gujavarty, Deutsche Bank: Great. Thanks for squeezing me in. Just to follow up a little bit, I’m curious if you would characterize here the demand issues. Do you think it’s just a demand issue, or do you believe it’s perhaps the wrong customers? And the reason I say that is you’ve seen certain customers in the marketplace taking a lot of share in Q4. I think we all know who the big 2 are. Is it a case of SanDisk needing to increase their exposure to the right customers? Or is it simply just a little bit of inventory and that once that’s worked through, things get back to normal?

Sanjay Mehrotra: As we have said before, we are not overly reliant on any one customer, and we are actually very pleased with our position of engagements with broad set of customers and we are always focused on supplying all of the leading players in the mobile ecosystem. And now as we build up the SSD opportunity, we are doing the same thing there as well. And so as we explained that some of the mobile OEMs, with whom we had a high share, some of their models did not do as well in the market, and that is one of the factors in terms of impacting some of the demand from these customers.

But what we are excited about is that their designs for the future platforms with various reference designs, as well as with respect to the smartphones and mobile phone ecosystem, we are well engaged in these opportunities, again, across the board, will continue to build up in 2012.

Bob Gujavarty, Deutsche Bank: Great. And just a really quick follow-up, when you mentioned the slower pace of cost declines for you yourself and the industry, does that kind of have to do with just adding, maybe going from, going to double or triple patterning with immersion tools and because EUV is clearly not ready, is that just adding process steps and slowing down the cost reduction, is that part of it?

Sanjay Mehrotra: So that definitely will be a factor. It depends on the technology implementation of different suppliers for flash memory. And absolutely, that will be one of the factors in terms of cost. The other aspect is the scaling of the flash memory cell itself. It’s not simply lithography-based scaling. The device considerations have to play an important role on how you scale the flash memory for future generations.

Bob Gujavarty, Deutsche Bank: Great thank you.

Jay Iyer, Director of Investor Relations: Thanks Bob. Thanks Sanjay. Thanks Judy.

We want to thank everyone for joining our call today. We look forward to seeing many of you at our upcoming analyst day meeting on February 16. A webcast replay of today’s call should be available on our investor relations website shortly. Thank you and have a good evening.

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