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SanDisk Corporation (NASDAQ:SNDK)

Q3 2008 Earnings Call

October 20, 2008 5:00 pm ET

Executives

Lori Barker - Senior Director of Investor Relations

Eli Harari - Chairman and Chief Executive Officer

Judy Bruner - Executive Vice President, Administration and Chief Financial Officer

Sanjay Mehrotra - President and Chief Operating Officer

Analysts

Craig Ellis - Citigroup

Edwin Mok - Needham & Company

Daniel Berenbaum - Cowen & Company

Analyst for Jim Covello - Goldman Sachs

Daniel Amir - Lazard Capital Markets

Vijay Rakesh - Thinkpanmure

Gary Hsueh - Oppenheimer & Company

Bob Gujavarty - Deutsche Bank

Analyst for Tristan Gerra - Robert W. Baird

Operator

Good day and welcome to the SanDisk Corporation’s third quarter 2008 earnings conference call. At this time, I would like to turn the conference over to Miss Lori Barker, Senior Director of Investor Relations. Please go ahead, Madam.

Lori Barker

Thank you. Good afternoon and welcome to SanDisk Corporation’s financial teleconference for the third quarter of 2008. I’m Lori Barker, SanDisk’s Senior Director of Investor Relations. Joining me is Dr. Eli Harari, Chairman and CEO of SanDisk, Sanjay Mehrotra, President and COO, and Judy Bruner, Executive Vice President of Administration and CFO.

The agenda for today’s teleconference is as follows: Eli will start with an update on the industry and SanDisk’s overall strategy. Judy will follow with a review of our third quarter financial results and future guidance and Sanjay will also join us for the question and answer session at the end of the call.

Any non-GAAP financial measures discussed during this call as defined by the SEC in Regulation G will be reconciled to the most directly comparable GAAP financial measure. That reconciliation is now available along with supplemental schedules on our web site at sandisk.com. After the completion of this call, an audio replay of this conference, a copy of today’s prepared comments and quarterly metrics will be made available on SanDisk’s Investor Relations Web Site at sandisk.com.

During our call today we will be making forward-looking statements. Any statement that refers to expectations, projections or other characterizations of future events including financial projections and future market conditions, is a forward-looking statement. Actual results may differ materially from those expressed in these forward-looking statements. Certain factors that may cause actual results to differ are detailed under the caption “Risk Factors” and elsewhere in the documents that we file from time to time with the SEC, including our Annual Report on Form 10-K for fiscal 2007 and our quarterly reports on Form 10-Q. We undertake no obligation to update these forward-looking statements, which speak only as of the date hereof.

Now I’d like to turn the call over to our CEO, Eli Harari.

Eli Harari

Thank you, Lori and thank you for joining us. Today, I’m going to talk to you about four key topics -- the first one is industry conditions and SanDisk’s competitive positioning; the second one is today’s announcement with Toshiba about restructuring our joint venture manufacturing agreements and other proactive steps that we are taking to maintain our competitiveness and further strengthen our balance sheet; then I’ll talk about IP developments; and I’ll conclude with our perspective on Samsung’s proposal.

Our industry continues to experience excessive inventories, operating losses and weakening balance sheets, as a result of NAND fab investment decisions that were made well before the current global economic crisis. Recently, major NAND manufacturers announced shut-downs of 200-millimeter NAND wafer fabs and push outs of new 300-millimeter capacity. This is a positive step for bringing supply into balance with demand so that pricing can stabilize and so that profitability can return.

Although this correction will not be felt overnight, I believe that patience will be rewarded. Meanwhile, demand for NAND flash megabytes continues to grow as current pricing trends are accelerating the adoption of NAND in new markets such as GPS, video capture, high-end handsets, and solid-state disks in computing applications.

SanDisk is in an exceptionally strong competitive position. Fab 4 is ramping 43-nanometer technology at a remarkable rate and with excellent yields, and we believe that the massive scale of Fabs 3 and 4 combined applied at 43-nanometer and 3 bits per cell now provides us the lowest cost NAND in the industry.

In the first quarter of 2009, we expect to start customer shipments of 32-gigabit NAND with 3 bits per cell architecture that achieves a smaller die size than a competitor’s 34-nanometer NAND with 2 bits per cell architecture. In the second quarter of 2009, we expect to start customer shipments of the industry’s first 64-gigabit die employing 4 bits per cell X4 technology, manufactured again on 43-nanometer technology. By mid-2009 SanDisk and Toshiba expect to commence the transition from the 43-nanometer to the 32-nanometer technology node, including 3 bits per cell designs.

While such a low-cost supply base is expected to be a significant competitive advantage for us in 2009 and 2010, the global economic crisis is slowing demand growth in the near-term and this is the underlying cause for excess supply, severe pricing, and hence our disappointing results. On the marketing and sales end, we believe that our diversified OEM and global retail sales channels provide us a measure of resiliency in the current tough market conditions.

I will now discuss our actions to align ourselves with the business outlook for 2009. In a highly significant development this morning, SanDisk and Toshiba announced a non-binding memorandum of understanding, MOU, under which we will sell to Toshiba approximately 30% of our current captive capacity at Fab 3 and Fab 4. We expect to receive cash and reduce equipment lease obligations in an aggregate amount of approximately $1 billion dollars.

We will have the option to purchase from Toshiba, on preferred foundry terms, a portion of the transferred capacity. This agreement will accelerate our previously stated intention to move from the current 100% captive supply to 80% captive, 20% non-captive, which we believe going forward will provide us the flexibility to better manage our inventory up or down with market demand.

For future capacity expansions and technology transitions in Fabs 3 and 4, we will continue to have the option, at our discretion, to participate at up to 50% of such capacity additions. We expect to sign a definitive agreement in the current quarter and implement it in the first quarter of 2009.

We now expect our 2008 capital investment outlays to be approximately $500 million below the $2.4 billion in our original 2008 plan. In 2009, we now expect our CapEx investments to be approximately $1.3 billion, down from the previously planned $3 billion and this investment will mostly be geared towards supporting the manufacturing technology upgrades that I discussed earlier, which further extend our technology leadership.

In addition to restructuring our supply commitments and reducing our CapEx, we are taking actions to lower our operating expenses. These actions will be implemented in the current quarter and will include canceling or exiting a number of product and marketing activities, and will result in employee reductions in R&D, sales & marketing, G&A and Operations. We will continue to invest in the areas that are most strategic for our future, including advanced NAND and 3D read/write development, mobile storage, solid-state disk, and slotMusic.

Shifting now to IP matters, earlier this year we won a binding arbitration ruling in the Samsung-msystems case involving license rights to the msystems patent portfolio that we acquired in 2006. An arbitration panel ruled that Samsung breached its agreement with msystems and had therefore forfeited its perpetual license rights to msystems patents, including patents covering X4, that’s 4 bits per cell NAND, and patents that teach important system level flash technologies. Samsung appealed this ruling in federal court but subsequently withdrew and asked the court to enter judgment against them. The net effect is that absent a patent cross license renewal by August 2009, Samsung will not be licensed to either msystems or SanDisk’s patent portfolios.

The final topic I want to address is Samsung’s proposal. As you know, Samsung indicated an interest to acquire SanDisk for $26 per share. SanDisk’s board made it clear to Samsung in a letter dated September 15 that it is open to a transaction at the right price with the right process and the right protections for SanDisk’s shareholders. Our board strongly believes that Samsung’s indication of interest significantly undervalues SanDisk, both in the absolute and in light of the synergies and the value of our IP to Samsung. Samsung stands to gain enormous value from owning our patents and our know-how; in particular, the hundreds of second generation patents for mobile storage that we developed in-house or acquired in the past decade. These second generation patents extend well into the next decade, and therefore the intrinsic value to Samsung is highly strategic and long-term.

The future of the mobile storage industry we believe is in All-Bit-Line ABL-multi-level cell 3 bits per cell MLC, 4 bits per cell MLC, managed NAND, 3D Read/Write, advanced controllers, mobile security, and solid-state drives. SanDisk holds many of the fundamental patents and know-how for these technologies and Samsung knows it. This is why owning these patents and the know-how is so critical for Samsung’s future profitability.

The SanDisk board of directors remains open-minded about a potential transaction with Samsung. Our board is focused on the right price and the right protections for our shareholders, including the renewal of the Samsung IP patent cross license in case a transaction does not close. This was formally and publicly communicated to Samsung and as of this time, there have been no further communications between the two companies on this topic.

We will not be taking questions on this matter during Q&A; however I direct you to our press release dated September 16th for a more complete discussion of our board’s stated position, which remains our current position.

In conclusion, we are building our business for the future and adapting quickly to the near-term realities in our markets by taking strong proactive steps to sharpen our focus and strengthen our balance sheet. I firmly believe that SanDisk will emerge stronger than ever in the next recovery.

I will turn it now to Judy.

Judy Bruner

Thank you Eli. Our third quarter revenue was in the upper end of the range we expected, with strong bit growth driven by a higher-than-anticipated price decline, which negatively impacted gross margins. We made the decision during the quarter to price more aggressively than we had planned in order to move inventory and maintain our market share.

Our third quarter product revenue was flat to the second quarter with megabytes sold up 44% and ASP per megabyte down 30%. Third quarter revenue was up sequentially in mobile, USB, GPS, and audio/video products, and down in imaging and gaming products.

On a year-over-year basis, megabytes sold increased 105% and ASP per megabyte declined 63%, resulting in product revenue down 25%. This year-over-year decline in revenue was driven by the NAND pricing environment and despite the recessionary market conditions, our unit sales grew 9% year-over-year and average capacity increased 89%, demonstrating continued growth in demand for NAND storage in consumer applications.

Revenue in the retail channel grew 3% sequentially to 63% of our product revenue, while OEM revenue was down 4%. Our North America retail revenue grew 12% from Q2, driven primarily by back-to-school sales of USBs and growing demand for mobile handset cards. Europe retail revenue was down sequentially and Asia-Pacific retail revenue was flat, as weak macroeconomic conditions spread beyond the U.S. However, we grew international market share both sequentially and year-over-year. On a year-over-year basis, Q3 retail revenue was down 29% and OEM revenue was down 18%.

License and royalty revenue for the third quarter of $132 million increased 3% sequentially and 11% year-over-year. Royalty revenue based on NAND component revenue was down sequentially and growth came from new licenses.

Non-GAAP product gross profit for Q3 was a negative $121 million and was impacted by the 30% price decline and inventory related charges of $109 million, up from charges of $70 million in the second quarter. Third quarter inventory charges were primarily for lower of cost or market, for both on-hand and channel inventory. Pricing was more aggressive than we had planned and we took our prices down to match the market in order to stimulate average capacities and avoid excessive inventory buildup. The restructuring of our fab joint ventures will accelerate the rightsizing of our captive supply and allow us to return sooner to a more flexible model in which non-captive supply allows us to more easily increase or decrease inventory purchases.

Non-GAAP operating expenses of $217 million were down 3% sequentially with increases in advertising and merchandising offset by decreases in legal and engineering project expenses. Our headcount increased by 429 to 3,751 due to assembly line workers at our Shanghai factory being converted from temporary to regular status. We have been increasing the proportion of our assembly and test done in-house, and our captive cost per unit is now substantially lower than our contract manufacturing cost.

Other Income & Expense was approximately zero compared to $21 million of income in the prior quarter. Q3 interest income was offset by a $12 million charge for the decrease in value of stock held in a foundry supplier, Tower Semiconductor, and a $10 million impairment charge related to our wind-down of the FlashVision joint venture, resulting from limited demand for 200 millimeter equipment.

On the balance sheet, cash and short and long-term investments increased sequentially by $104 million to $2.6 billion. Cash flow from operations was a positive $136 million, driven by the bi-annual receipt of royalty receivables and a decrease in product receivables and inventory. Inventory decreased $83 million or 10% sequentially as incremental inventory reserves and the lower 43nm cost per megabyte more than offset an increase in inventory megabytes. Channel inventory ended Q3 between 8 and 9 weeks, similar to the level at the end of Q2. The decrease in product receivables was the result of strong collections and the issuance of price protection and promotion credits consistent with the current pricing environment. Capital investments included a $93 million loan to the Fab 4 joint venture for capacity expansion and the purchase of $45 million of SanDisk capital equipment, offset by the return of $74 million from the 200mm joint venture and $39 million from the sale of 200mm equipment that we owned directly. We also guaranteed $237 million of incremental operating leases for Fab 4 equipment.

I’ll now turn to forward-looking commentary. Please note that non-GAAP to GAAP reconciliation tables are posted on our website for all applicable guidance. Given weak global macroeconomic conditions, we are expecting less seasonal lift in Q4 unit sales than we have seen historically, and we are expecting a continuation of aggressive industry pricing. With the uncertainty in global markets, we are forecasting a wider than usual range for total revenue of $725 to $875 million. This includes license and royalty revenue which is expected to be lower in Q4 than in Q3.

We expect product gross margins to continue to be negative in Q4 and likely into the first half of 2009. We expect fourth quarter non-GAAP operating expense to be between $250 and $260 million, including a restructuring charge, seasonal increases in advertising and merchandising and increased legal expenses related to the ITC trial starting next week. We expect to cut our non-GAAP operating expenses to approximately $800M for 2009, and we will finalize and implement our restructuring actions this quarter.

Last quarter I indicated that we might face a non-cash impairment charge related to goodwill and intangible assets. Given the increase in our stock price at the end of the third quarter, we did not record any impairment. However, if our market cap were to be lower than our net assets at the end of any future quarter, this could lead to a non-cash impairment charge.

We expect Q4 capital investments to total approximately $300 million including approximately $250 million of fab investment related to the Fab 4 capacity expansion just completed and approximately $50 million of SanDisk non-fab related CapEx. For 2009, we expect to reduce our total capital investment including fab and other CapEx to approximately $1.3 billion, down more than 50% from the $3.0 billion we described at our analyst day early this year. We expect the $1.3 billion to be financed about two-thirds with new operating leases and joint venture working capital, and about one-third with cash. The proposed restructuring of our fab joint ventures will result in us receiving approximately $1.0 billion of value, split roughly 50/50 between cash proceeds we expect to receive from Toshiba and relief from currently existing operating leases. I’d also like to take a moment to let you know that we have cured the non-compliance that was created on some of the joint venture operating leases when we were downgraded last quarter by Standard & Poors. We will pay an increased spread on those leases, but the cost is not material to our future results.

In terms of cash usage, we do expect to use cash in Q408 due to anticipated losses, the timing of royalty revenue payments, and investment in CapEx and inventory, however we expect that the restructuring of the fab joint ventures will help to replenish cash in early 2009.

In summary, we are taking aggressive actions on multiple fronts to achieve a more appropriate supply model and restructure our internal operations, all with a focus on strengthening our balance sheet, improving the bottom line and emerging an even stronger competitor when the NAND market recovers.

Operator, may we open the call for questions, please.

Question-and-Answer Session

Operator

(Operator Instructions) We will take our first question from Craig Ellis at Citigroup.

Craig Ellis - Citigroup

Thanks. The first question is to Judy -- Judy, on the royalty guidance for the fourth quarter, can you be a little bit more specific than just down quarter on quarter?

Judy Bruner

I’m not going to give a range for the royalty revenue in Q4 but we expect that it will be down due to the pricing environment in Q3. We expect that our licensees’ revenue that is applicable to the royalties would be impacted by the aggressive pricing that existed in the third quarter.

Craig Ellis - Citigroup

Okay, and then the follow-up question is for Eli -- Eli, you had indicated that you wouldn’t talk about the Samsung deal but can you talk a little bit about value creation for shareholders? Obviously the board thinks the $26 price under-values the company but when does the company feel like it can deliver results that would drive the stock price well north of $26 into the level that the company or the company’s board thinks that the stock price is worth?

Eli Harari

Again, I cannot discuss, as we said, the Samsung proposal but I can tell you that the actions we are announcing today that we have been working on and we will implement this fourth quarter are definitely taken with mind to manage our business to keep our strength and at the same time to take some of the cuts, some painful cuts, that we believe we have to do in order to maintain a very strong balance sheet, have a focus on the programs that are very strategic to our future.

So without commenting of course on the share price or anything of that nature, I can tell you that I am optimistic that once this -- that like I said, the steps that the industry is taking and that we are taking are sowing the seeds for return of balance between demand and supply and that whenever that happens, I believe that we will be very competitive and at that point, I think things can change for the better. They have in the past. This is not the first time that we’ve been through a down cycle. This one is perhaps more severe than previous one and certainly the macroeconomic environment is quite unique. But we are strong and we have now a very strong balance sheet and are prepared to take the necessary actions to manage for a better future.

Craig Ellis - Citigroup

A follow-up on that, if I may though -- the company will be relying more on external sourcing for its components and that invariably means a higher cost of goods sold and therefore a lower product gross margin and therefore how should we think about the way the company views its target gross margin model doing forward if the percent of components is higher coming from external sources?

Eli Harari

You know, we have in the past had the 70-30 model, as you’ll recall, that gave us the flexibility that was very valued. The market today is much bigger. We are -- we believe that certainly today’s environment demonstrates that that model does have its benefits. There’s no question that there will be -- no question in my mind that there will be periods in the future of allocation where we wish that we had more captive supply or in fact that we could be denied to have all the supply we want from non-captive sources. But this is really the trade-off that we want to make to allow us to manage our inventories also in downturns, not just in up-turns, and also to bring some balance between our investments in brick-and-mortar capacity, captive capacity and in our investments in innovation and in products and new market creation. So this is really is a direction that I think is very significant for the company and I think it’s really a great step forward, really important step forward.

Lori Barker

Thanks. Next caller, please.

Operator

And we will go next to Edwin Mok with Needham & Company.

Edwin Mok - Needham & Company

Thanks for taking my question. First is just quickly on the Toshiba deal, I’m just curious, when are you actually going to get the cash from Toshiba?

Judy Bruner

We expect that we will receive the cash in Q1 of ’09.

Edwin Mok - Needham & Company

Great, and then on the operating [inaudible], you mentioned that you expect around $800 million on OpEx in 2009. Do you expect to fully recognize that savings by the first quarter of 2009 or is that [inaudible]?

Judy Bruner

We are planning to take restructuring actions in the company in the fourth quarter of this year so that we can enter 2009 at a lower expense level.

Edwin Mok - Needham & Company

Great, and then on your guidance, on your revenue guidance in terms of your ASP in terms of the guidance, do you expect it to decline in the level in the fourth quarter or better than the fourth quarter or worse [in the fourth quarter]? How do you [inaudible]?

Judy Bruner

We expect the pricing environment to continue to be aggressive in the fourth quarter. It’s possible that it could be at a similar rate to the third quarter.

Edwin Mok - Needham & Company

Great, and then I have one final question -- regarding the sales channel, you mentioned that part of your sales strategy is to provide price guarantees for your large I guess OEM or distributor. How do you view that strategy going forward, given how much pricing pressure there is in the market? Wouldn’t that inherently would have hurt either your gross margin or your [inaudible] because [inaudible] price guarantees [inaudible]?

Judy Bruner

Price protection does definitely impact our profitability and our gross margins. There has been no change really in our practices here over the years. It’s just that pricing, when pricing is very aggressive, you see the impact of that but it really is not so much of a difference whether the pricing happens at one point or another. You are just selling at the latest, lowest price. We don’t recognize our revenue until it sells through and so at the time that it sells through because we are giving price protection, we are recognizing that revenue at the latest, lowest price.

Eli Harari

Price protection applies of course to retail sales, not to OEM sales.

Edwin Mok - Needham & Company

I see. Great, thanks.

Lori Barker

Next question, please.

Operator

And we will go next to Daniel Berenbaum at Cowen & Company.

Daniel Berenbaum - Cowen & Company

Thanks for taking my call. I just wanted to get a little more clarity around the cost reductions and the restructuring. So you said, Judy, you mentioned that your OpEx for calendar ’09 all-in will be about $800 million. How do you think that evolves over the course of the year? And then a similar question on the gross margin -- you talked about product gross margin staying negative through Q109, if I caught that correctly. Can you tell me what you think your cost reductions are going to be? I mean, there’s some things you can control and some things you can’t. Of the things you can control, how do you think about your products, gross margin, and cost reductions over the next few quarters?

Judy Bruner

Okay, so I think there’s three questions there. On the expenses over the course of next year, again I said that we expect to enter 2009 at the lower expense run-rate. There will of course be seasonality in our expenses as there typically have been but we expect to enter at the lower rate.

In terms of gross margins for next year, I said that we currently expect gross margins may be negative into the first half of 2009. In terms of cost reductions, product cost reductions, I would expect that our cost reductions in Q4 will be somewhat better than they were in Q3 because we will have a higher mix of 43-nanometer products in the products that we are selling. But of course, the pricing is clearly a big factor in terms of what gross margins turn out to be, as are the level of inventory reserves that we may have to take. And the inventory reserves at the end of any given quarter are really primarily driven by our outlook for pricing in the coming quarters when we expect to sell that inventory on hand.

But specifically to cost reductions on the product, I would expect that our cost per bit will improve somewhat better in the fourth quarter than the third quarter because of the higher mix of 43-nanometer.

Daniel Berenbaum - Cowen & Company

And then could you just maybe expand that out -- what do you think your cost reduction roadmap looks like in the first half of ’09, the product cost reduction roadmap? And then also just on Q4 OpEx, I was a little bit unclear how much restructuring you expect in there in that guide that you gave.

Sanjay Mehrotra

With respect to cost reductions in 2009, earlier at the analyst day in 2008 we had indicated that our cost reductions on a per gigabyte basis would be in the range of 40% to 50%. At this point we expect our cost reduction capability in 2009 to be towards the high-end of that range and of course, that’s enabled by our, the large economies of scale, our technology transitions, our transition to 43-nanometer as well as 3 bit per cell transition that will be occurring during the course of next year.

Judy Bruner

In terms of your question on the Q408 expenses, I did not quantify the amount of the restructuring. We have not finalized yet our restructuring actions and so I don’t want to put a range on that number but we expect it will be covered by the $250 million to $260 million OpEx number that I gave for Q4.

Daniel Berenbaum - Cowen & Company

Okay, thanks very much.

Lori Barker

Thanks. Next caller, please.

Operator

And we will go next to Jim Covello at Goldman Sachs.

Analyst for Jim Covello - Goldman Sachs

This is Kate [Kudlarsky] for Jim Covello. My question is on supply/demand as you look into 2009. It seems like even given the significant capacity reductions, the industry players, including yourselves, supply/demand may not actually come into balance next year, absent any new killer app. And obviously solid state drives have been the one killer app that people have been talking about and obviously we won’t see significant adoption next year but I was just curious to get your views on what you think the hurdles are, aside from just price, to really get your customers to start adopting solid state drives in a more meaningful way. Thank you.

Sanjay Mehrotra

With respect to the solid state disk drives in a more meaningful way, the most important thing is to have a product that has the right specifications and the right price points to drive wider adoption of solid state disk drives. As you know, we are on our first generation of MLC products that we plan to bring out in the 2009 timeframe. And in 2010/2011 timeframe is when we will have 32-nanometer, the second generation MLC SLDs and that’s when we think that the price points for the SLD market get attractive enough to really drive a stronger growth in that segment.

In general with respect to the demand/supply balance that you earlier were also asking about, clearly the economic conditions are dictating and clouding somewhat the demand outlook. On the supply side, of course, as Eli referred to, there have been several actions taken by the competitors but of course very significantly by us as announced today in terms of managing the growth of supply, the incoming supply during next year. And we expect that by the second-half of next year, demand and supply should get better in balance.

Analyst for Jim Covello - Goldman Sachs

Thank you and just a quick question on your bit growth expectations for 2009 -- how has your outlook changed given the announcement today and do you have an updated number that maybe you can give us for next year?

Judy Bruner

We really think it’s too early to give an updated range for bit growth for 2009. We want to see how Q4 unfolds before we give that guidance but we do expect that within any reasonable range of bit growth for 2009, that we will be able to work down our inventory balances and that we will need that inventory in order to meet demand in 2009, and that will be a good thing in terms of our balance sheet.

Eli Harari

I would like to comment that I don’t think anybody from, not ourselves and I don’t believe our competitors, believe that 2009 capacity overhang or inventory overhang is going to be solved in 2009 through solid state disks. It’s still a very young market and really 2009 is not the year when it really takes off. However, on the positive side, there is definitely an expectation certainly by us that in 2009, the mobile environment handsets is going to be an engine of growth and a very large consumer of flash memory. This is what we have been saying for the last five years. The iPod 3G, a 16-gigabyte, is now really getting competition to come up with touch screen phones from Nokia, from Samsung Mobile, LG, and introducing third-party developer applications, introducing smartphone growth as well as social networking and of course, content downloading, as well as the slotMusic initiative that we are introducing.

So we think that mobile handsets, I think the number is something like 770 million handsets this year that will be sold with a slot for micro-SD or M2 card and we think that certainly what we are seeing is the capacity per micro-SD card going into that cell phone is increasing. It’s approaching 3-gigabytes in retail and also over a gigabyte in bundled cards. We expect that capacity to go up. The sheer volume of handsets is really what’s going to soak up a lot of the excess supply and in the second half of next year, I do believe that this is going to be the greatest factor for creating stability, supply/demand balance.

Of course, the biggest factor out there that none of us know is the global economy and it is like -- it’s almost as difficult as predicting what the price of a barrel of oil is going to be next year.

Analyst for Jim Covello - Goldman Sachs

Thank you very much and Judy, if I can maybe ask the bit growth question slightly differently and ask you if you didn’t grow wafer starts or your capacity at all next year, what kind of bit growth could you get from just shrinks and maybe moving to higher densities?

Sanjay Mehrotra

So with respect to the restructuring that we announced today, after the restructuring the bit growth in terms of the incoming supply would be significantly less than 100%. We believe that with our captive supply, with the technology transitions and the cost-effective captive supply, as well as inventory that will be going in from 2008 into 2009, we will be able to meet most of our demand requirements through captive supply. Maybe we will need some non-captive supply late in 2009 timeframe.

Analyst for Jim Covello - Goldman Sachs

Thank you very much.

Lori Barker

Next caller, please.

Operator

And we will go next to Daniel Amir at Lazard.

Daniel Amir - Lazard Capital Markets

A couple of questions here -- first of all, can you comment a bit about what the 43-nanometer mix is going to be first half of next year and kind of as we exit ’09? I guess the 34-nanometer mix and including the X3, X4 as well?

Sanjay Mehrotra

So with respect to 43-nanometer, we have said that by the end of this year, we expect two-thirds of our bit production to be in 43-nanometer, so this will of course continue to ramp during the course of next year. In the Q1 timeframe, we would be expecting significantly above that number of 43-nanometer. The 43-nanometer transition is going extremely well. Our [inaudible] are good as well as our conversion capability to 43-nanometer has been exceptionally strong. So in that regard, it will follow the transition trends similar to 56-nanometer and maybe better, well into 2009.

And with regard to 3 bit per cell, our target is to have 50% of our output with 3 bit per cell in 2009 timeframe. And with regard to the 32-nanometer, we will begin production -- we are targeting to begin production in the second half of 2009. In terms of exact mix of 32-nanometer versus 43-nanometer in 2009, we will update that later once the technology is ready for production.

Daniel Amir - Lazard Capital Markets

And the X4?

Sanjay Mehrotra

X4, we will begin shipments of X4 in first half of next year. At this point, we are encouraged by the early results that we are seeing with the X4 technology.

Daniel Amir - Lazard Capital Markets

Thanks, and Eli, maybe a follow-up question a bit on the industry side -- I mean, do you still see the industry going with more CapEx cuts here in the next couple of quarters? Or do you think that most of the industry has already cut the 200-millimeter and already delayed some of their fabs?

Eli Harari

You know, I can’t speak for Toshiba or Samsung. These are the main suppliers and I guess you have to ask them that question but clearly the 200-millimeter retirement is becoming less of a factor. Really these fabs are not cost-effective and frankly not generating a lot of supply. [Some have most of the 200-millimeter capacity left] and I would assume that they would want to retire those as soon as they possibly can.

Look, I’ve said for the last three years that 60% annual price declines are not sustainable. Unfortunately, I was proven right. There’s no question that 60% -- that this trend is not justifying return on investment, not delivering return on investment on new investments and the pricing really has to improve and the profitability has to return before anybody that wants to make money in this business can justify building new capacity that’s not on the drawing board.

On the other hand, this is a young industry that has tremendous growth ahead and there’s no question that new capacity will be built in the future that will return the kind of return on investment that it deserves. But I think first of all we have to work our way -- the industry really has got to work its way out of this downturn and into the next recovery.

Lori Barker

Thank you. Next caller, please.

Operator

And we will go next to Vijay Rakesh at Thinkpanmure.

Vijay Rakesh - Thinkpanmure

Just looking at the OpEx direction that you -- actually look at next -- [clearly I guess] you are running at 20%, 25% OpEx range. What do you think it could be for 2009, just ballpark?

Judy Bruner

We’re not very prepared to give that percentage because then clearly we’d be giving a revenue number for 2009 and we’re not ready to give a revenue range for 2009 at this point.

I will tell you that the OpEx percent in 2009 will still be higher than we believe it should be, in terms of our long-term model but we are taking actions that we believe are quite aggressive and will cause us to make some pretty tough choices in the business.

Vijay Rakesh - Thinkpanmure

Thanks. And also on the Toshiba announcement today, given the -- why is Toshiba buying that fab? And second, since you are transferring the ownership to them, will you still be sharing the out 50-50 from those fabs?

Eli Harari

You would have to ask Toshiba why they are buying the fab but this is a good deal for both companies. We are selling our 30% at book value. This is a good return for us and a good return for them because it’s established capacity that is in place. They have a different customer base, different usage profile than we do.

The important thing for us is to make sure that the 70% that remains in the joint venture, that 70% is split 50-50. The important thing for us is that costs to us of our captive supply is based on 100% of Fab 3 and Fab 4, not on 70% of the costs. So we get the full economies of scale of the entire 100% in Fab 3 and 4, even though our CapEx investments are 35% of the total capacity.

Vijay Rakesh - Thinkpanmure

Got it. And one last question, X3, what percentage of output does it get to let’s say by the middle of next year?

Sanjay Mehrotra

At this point I cannot break down the middle of next year timeframe but X3, as we have said before, for 2009 in total will be about 50%, targeting to be about 50%. And in the Q4 timeframe, X3 is about 15% of our total output, so we will of course continue to ramp this during the course of 2009.

Vijay Rakesh - Thinkpanmure

Got it. Thanks a lot, guys.

Lori Barker

Next caller, please.

Operator

And we will go next to Gary Hsueh at Oppenheimer & Company.

Gary Hsueh - Oppenheimer & Company

First question, just looking at the Toshiba balance sheet, not the prettiest balance sheet. Is the deal with Toshiba dependent on any external financing that you know of?

Judy Bruner

No, there are no contingencies in the MOU in terms of financing. Of course relative to the half of the value that relates to relief from operating leases, both parties, SanDisk and Toshiba, will need to work with the relevant banks to transfer those operating leases.

Gary Hsueh - Oppenheimer & Company

Okay, thanks. And assuming you do get those operating leases transferred over, to me by my math, half of that $1 billion savings, half of that would seem to translate to 19% or 20% cost reduction on the COGS line. If you look at the cost curve for 2009 and I know you guys have talked about 60% ASP declines year over year being a not sustainable sort of situation for the industry, assuming that happens again to the industry in 2009, when you look at things like this divestiture of your captive capacity to Toshiba, how much can you close that gap, assuming that there is another 60% decline in pricing next year?

Judy Bruner

Well let me try to clarify the way that the operating leases work, because I am not sure your calculation matches the way they work. The operating leases are really used to pay for the equipment over typically about a five-year schedule, so the operating leases that will be transferred, depending on what equipment they relate to, will likely have several years of life left on them and that amount is essentially amortized to COGS over the remaining life of the operating lease. There’s a quarterly pay-down schedule on the operating leases.

Gary Hsueh - Oppenheimer & Company

Okay, I think I was a little aggressive on the schedule there of that payment but just in terms of the cost curve in 2009, what are the major levers and what do you think are the respective contribution from those levers in qualitative or quantitative terms?

Eli Harari

So let me try -- first your earlier question about another year of 60% price decline, I think that we cannot really tell what the price decline is going to be but if there’s one thing that the announcement that we announced today, the MOU, does is that if it gets really that bad or really that ugly, we have the balance sheet to survive that kind of environment and that was really -- this is a very, very important factor. So we have really the ability and the staying power to continue despite the cuts with strategic development programs and I believe to make it through this current downturn, even if the economic conditions, global economic conditions continue beyond what everybody expects.

However, the second question, where are the levers, you know, the big levers are honestly on the technology side. We already have the manufacturing economies of scale. The inventory write-downs is really a very major factor in our gross margin and clearly if we can control our inventory and I believe that today’s announcement makes a big difference, that will allow us to return our gross margin, that together with the cost reductions.

Gary Hsueh - Oppenheimer & Company

Okay. I was just hoping to get a more quantitative number on what you expect cost per bit to come down in ’09 versus ’08 but if you can’t give that number out, I can certainly understand.

Judy Bruner

Well we previously said, and I think Sanjay said a few minutes ago, that we are expecting about 40% to 50% reduction in cost per bit over the 2009 and 2010 timeframe. Those are ranges we gave at our analyst day and that’s a factor in our business model that we are in pretty good control of.

Gary Hsueh - Oppenheimer & Company

Okay.

Sanjay Mehrotra

And I also said that in 2009, we will expect the cost reduction per bit to be more toward the high end of that range.

Gary Hsueh - Oppenheimer & Company

Okay, perfect. Thank you.

Lori Barker

Next caller, please.

Operator

And we will go next to Bob Gujavarty with Deutsche Bank.

Bob Gujavarty - Deutsche Bank

Thanks for taking my question. Just to hit the inventory a little bit, I mean, if you back out the inventory write-down, I mean organically inventories would have been up a little bit. When should we start to see organically the inventories start to come down? These announcements you’ve made about supply cuts, when does that start to kind of be shown on your inventory on-hand?

Judy Bruner

You know, it’s difficult to predict what the inventory dollar amount is going to be at the end of Q4 because the reserves are clearly difficult to predict. But I would expect clearly in Q1 after we close the restructuring transaction that we will start to see a fairly significant impact on inventory. Of course, Q1 often is a seasonal quarter but I think we will start to see impact in the first quarter.

Also I want to point out that not all of the inventory related charges relate to inventor on-hand. Some of them relate to inventory that’s in the channel as well.

Bob Gujavarty - Deutsche Bank

Okay, fair enough. And then the other, if you can give us any color, is there a big difference between inventory of let’s say finished products like Flash cards and inventory of NAND chips, is there some kind of dynamic going on there or is it a universal inventory problem?

Judy Bruner

Well, I would tell you that from Q2 to Q3, we saw a decrease in our finished goods and our work-in-process. Our raw material balance as the incoming raw components went up from Q2 to Q3.

Eli Harari

But at the fundamental manufacturing level, obviously you want to keep your inventory as much as possible at the die level so that you don’t invest in what we call transformation costs, particularly you don’t build products that may not be what the customer wants. So our Shanghai facility is very large scale and is geared more and more towards giving us the flexibility to build the right products with very fast cycle time so that we can postpone transforming die into finished products as late as possible, and that is something we are focused in 2009.

Bob Gujavarty - Deutsche Bank

Thanks, fair enough. And just a final question, and it may be too long to answer right now but there used to be a lot of talk about being able to differentiate your products. Now just from what I hear, it’s all the focus on costs. Is differentiation pretty much -- people don’t pay for differentiation, is that the fundamental view now of the NAND market?

Eli Harari

Not exactly -- we do think that we have a brand preference. However, the way it’s translated now is if we matched the price, we get the business more often than not because for the same price, people recognize that we have not just a better brand but also better quality through vertical integration. We also have the Ultra and Extreme products and we do have market segmentation, differentiation. However, the majority of the product, USB flash drives and our Blue label, are really driven very much by price and we have to meet the price in order to get the sale.

Bob Gujavarty - Deutsche Bank

Thanks, guys.

Lori Barker

I’m sorry but we’ll only have time for one more call -- the next caller, please.

Operator

And we will go next to Tristan Gerra at Robert Baird.

Analyst for Tristan Gerra - Robert W. Baird

This is Scott [Herleman] calling in for Tristan. I have a couple of quick questions on the CapEx, the $1.3 billion -- how should we think about that being split between wafer increases versus conversions and then also how is it split SanDisk internal versus fab CapEx?

Judy Bruner

The vast majority of it is related to technology transitions as opposed to wafer capacity expansion. And you know, I would tell you that this year, we are likely to see about $200 million, maybe a little bit higher than $200 million of non-fab related CapEx and so you can assume that that number is flattish or slightly down within the 1.3 next year.

Analyst for Tristan Gerra - Robert W. Baird

Okay, that makes sense. Thanks for that. And there was kind of an interesting comment that you guys had put in the press release about that you can pay up to 50% of the CapEx in the J.V. and I was kind of wondering what are your thoughts around that and what’s the reason for that? If you do pay 50% of new CapEx, then do you increase your percent stake or what would be the reasoning behind that?

Sanjay Mehrotra

So what we said is that for the future capacity expansions, total wafer capacity expansions in the joint ventures in the fabs, we have the option to expand that capacity on a 50-50 basis. So of course, as we make those decisions, and again those decisions are to be made only in the future when the timing comes up for those expansions, if we made those expansions on a 50-50 basis, yes, I mean, our total percentage output from the fabs will go from approximately 35% toward a higher percentage level.

Analyst for Tristan Gerra - Robert W. Baird

Okay, that makes sense.

Sanjay Mehrotra

At this point, we have adjusted total capacity to the levels that we believe are appropriate for meeting our demand requirements in the 2009 timeframe. The good thing is we have the option to continue to expand on a 50-50 basis for future capacity as well and we will of course decide that based on our assessment of the demand drivers.

Analyst for Tristan Gerra - Robert W. Baird

Okay, thanks for that. And on kind of 3D, I know we were looking at spending kind of into 2010, what’s the thought on spending for 3D on the CapEx for that? Is that pushed out further? When should we actually start to see that roll through?

Judy Bruner

You know, we really don’t have a specific plan as to significant CapEx for 3D. We expect that we will spend maybe something like $50 million within 2009 for some early 3D sort of development type of CapEx but in terms of 3D CapEx for production, it’s too early at this point to say.

Analyst for Tristan Gerra - Robert W. Baird

Okay, and one last quick question is -- I guess this is kind of contingent to maybe if the current agreement that you have gets moved on further with Samsung or not but when should we expect to see licensing revenues from X4 and kind of any idea about when that actually becomes a significant portion of your licensing revenues?

Eli Harari

The pacing item would be of course a cost license but actually the much bigger pacing item is the ability to do X4. In practical terms, we think that we are significantly ahead of the rest of the industry, we and Toshiba are significantly ahead of the rest of the industry. So I think certainly it would not be a 2009 event. I’d be shocked if somebody had an X4 product that was competitive in the market any time in 2009, other than what we are talking about.

Analyst for Tristan Gerra - Robert W. Baird

And do any of your current licensing agreements outside of your ones with Toshiba cover X4? Maybe the Hynix agreement that you announced or any of the other agreements that you have?

Eli Harari

I don’t remember what we said but these agreements are confidential and we normally do not disclose what each one of them cover the other side, unless the other side agrees, so I really cannot comment on that. Because as I said, in practical terms, we have been developing through end-systems initially the X4 technology for the last really five years and we are getting to the point now that we can actually -- we’re getting ready to implement it industry first next year and I think that our competitors are significantly behind.

Analyst for Tristan Gerra - Robert W. Baird

Okay. Well, thank you very much.

Eli Harari

So I think we need to conclude this session. Really I want to say that as you can see, we are building our business for the future, we are adapting to the near term realities, we are taking the appropriate steps and these are very strong steps proactively to sharpen our focus, definitely strengthen our balance sheet and I again very strongly believe that SanDisk will emerge stronger in the next recovery.

So thank you very much and we will see you I guess in January. There’s going to be a new President by that time. All right. Thank you. Goodbye.

Operator

And that does conclude today’s conference. We appreciate your participation. You may now disconnect.

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Source: SanDisk Q3 2008 Earnings Call Transcript
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