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SanDisk Corporation (NASDAQ:SNDK)

Q4 2008 Earnings Call

February 2, 2009 5:00 pm ET

Executives

Jay Iyer - 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

Uche Orji - UBS

Jim Covello - Goldman Sachs

Edwin Mok - Needham & Company

Gary Hsueh - Oppenheimer & Co.

Daniel Amir - Lazard Capital Markets

Bob Gujavarty - Deutsche Bank Securities

Atif Malik - Morgan Stanley\

[Hindi Visanto] - Gabelli & Company

Vijay Rakesh - Thinkpanmure

Daniel Berenbaum - [Arega USA]

Operator

Good day and welcome, everyone, to the SanDisk Corporation fourth quarter 2008 conference call. Today's call is being recorded.

At this time, for opening remarks and introductions, I'd like to turn the program over to Director of Investor Relations, Jay Iyer. Please go ahead, sir.

Jay Iyer

Thank you, [Millicent], and good afternoon, everyone. Joining us today are Eli Harari, Chairman and CEO of SanDisk, Sanjay Mehrotra, President and COO, and Judy Bruner, Executive Vice President of Administration and CFO.

Before we begin, please note that 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 website at SanDisk.com/IR.

In addition, during our call today we will make 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. For more information, please refer to the Risk Factors discussed in the documents we file from time to time with the SEC, including our annual report on Form 10-K for fiscal 2007 and our subsequent quarterly reports on Form 10-Q.

SanDisk assumes no obligation to update these forward-looking statements, which speak as of their respective dates.

With that, I would like to turn the call over to Eli.

Eli Harari

Thank you, Jay, and thank you all for joining us today.

Our fourth quarter revenue results came in at the high end of our previously forecasted range due to a better than expected retail sell through in North America and EMEA. Retail sales were up sequentially across the imaging, USB flash drive, mobile card, and mp3 player end markets. We sold a record 68% more megabytes in retail in the fourth quarter compared to the prior quarter and believe we grew our market share.

Our average capacity across all products that we sell in retail is now approach 4 gigabytes, more than double what it was a year ago, and playing to our strength in high density NAND chips, where our cost reductions are the greatest. OEM demand was substantially weaker then expected, with much of the shortfall coming from handset vendors. Our operating results were adversely impacted by two back-to-back quarters of sharp industrywide price reductions as well as substantial inventory reserves and write-offs of underutilized capacity.

Despite the difficult pricing environment, the macroeconomic turmoil and the resulting impact on consumer purchasing, we delivered sequential revenue growth in the fourth quarter, demonstrating the breadth, diversity and brand value of our products and channels.

First quarter in 2009 visibility continues to be poor as seasonally soft demand is being aggravated by the global recession.

With dismal Q4 and 2008 results reported by all flash competitors, the flash industry is at a crossroads. Three consecutive years of price reductions exceeding cost reductions have squeezed profitability out of this industry, even for the most competitive suppliers, and this has been exacerbated by the global economic recession.

Although 2009 is shaping up to be another tough year, we are very encouraged by the deep production cuts by the industry that we see as leading to the return of balanced demand and supply, an improved pricing environment, and much healthier growth for the survivors in 2010 and beyond.

I will focus my remarks today on the steps that we are taking to navigate 2009 and emerge a leaner and more focused competitor and market leader. Our top priorities are maintaining a strong balance sheet, right-sizing our operating expenses, retaining our technology and IP leadership, and more narrowly focusing on our core markets.

First, we and Toshiba announced the definitive agreement to restructure our manufacturing joint ventures by selling more than 20% of our captive capacity to Toshiba. This agreement strengthens our financial position by approximately $890 million in lease obligation relief and cash receipts. In these financially challenging times, this agreement represents a vote of confidence in our partnership.

In addition, SanDisk has implemented temporary production cuts at the Yokaichi 300 millimeter joint venture fabs which are now operating at 70% of capacity and will delay the final phase of the Fab 4 capacity expansion that was previously planned for late 2009.

Further, SanDisk is cutting its 2009 capital investment outlays to $500 million, most of which is for technology transitions, including the start of the 32 nanometer conversion which is scheduled to begin at mid-2009.

The combined effect of these very substantial actions is expected to reduce our captive bit growth to less than 50% in 2009 compared to growth of more than 180% in 2008, thus curtailing our inventory and accelerating our return to a more desirable captive-noncaptive supply model.

Second, in the fourth quarter of 2008 we restructured our organization to focus on our OEM customers and our retail channels while exiting non-core businesses. Among these actions, we are discontinuing development of MegaSIM cards and shutting down our Spain SIM manufacturing line and we will outsource future SIM production. We are rationalizing the number of SKUs in all our product lines and discontinuing development of software services in our Enterprise business and will focus on supplying highly secure hardware storage solutions to the Enterprise industry.

We expect to reduce 2009 operating expenses to $750 million - that is non-GAAP numbers - through a 12% employee headcount reduction implemented in the fourth quarter, a freeze on salary increases, elimination of bonus payments, curtailed benefits and selective shutdown periods until business conditions improve.

We believe it is imperative to maintain our technology and IP leadership. We are very pleased with our joint development corporation with Toshiba of advanced technology at 32 nanometer and 24 nanometer, with x3 - that is, 3 bits per cell - and x4 - 4 bits per cell NAND  and 3D read-write. We believe the enormous complexity IP and know-how that these technologies entail is creating a widening technology gap among non-suppliers that may become an important factor in any future industry consolidation.

Next week, at the International Solid State Circuits Conference in San Francisco, we and Toshiba will provide details of our 32 gigabytes NAND chip employing x3 running on 32 nanometer technology and our 64 gigabytes NAND chip employing x4 on the more mature 43 nanometer technology, both industry firsts. We expect to begin production of both these chips and their companion controllers over the next two quarters.

Our 32 nanometer manufacturing process employs essentially the same fab equipment set used for 43 nanometer technology and therefore the CapEx investment needed to convert the production lines to the smaller geometry is relatively modest. Additionally, the migration from 2 bits per cell MLC to x3 or x4 memory architectures is achieved through our patented highspeed, high-reliability circuit and system design innovations and requires no new CapEx.

Our 32 gigabyte x3, a 2 nanometer NAND chip, is 33% smaller than a competitor's 32 gigabyte MLC chip with their 34 nanometer technology. That means that the extra bit per cell is equivalent to a half-generation cost advantage, which ultimately would translate to significantly more favorable product margins.

Looking at the future opportunities, we continue to see immense potential for flash storage in new and existing growth markets, in particular portable computing and mobile handset storage. In 2008, most of the 750 million slotted mobile phones sold worldwide had less than 1 gigabyte of embedded flash memory. Handset vendors and network operations alike see higher capacity mobile cards as vital for enhanced multimedia and smart phone functionality, and consumers are beginning to use more of these high-capacity cards.

In 2008 we sold a total of 175 million mobile cards to OEM and retail customers or 1 in every 4 slotted handset sold worldwide. Our opportunity is to increase a cache rate for cards in slotted phones, to boost the storage capacity per card, and to open up new applications as we preloaded [handset] cards such as our Slot Music and Slot [inaudible] cards.

At the January 2009 Consumer Electronics show we introduced our new third generation G3 solid state drive. The G3 SSD was designed from the ground up, with a new architecture to achieve [inaudible] 43 nanometer NAND MLC, the kind of performance, reliability and endurance that has hitherto required much more costly SLC NAND. With read-write performance five times data for typical notebook [inaudible] drive, operating life extending beyond 10 years in most typical notebook storage applications, and pricing breaking $250 for 120 gigabytes, we believe that this new generation SSD will be attractive to IT managers.

Our strategy in 2009 is to seize the market and qualify with leading OEMs our modular SSD also known as PSSD for netbook PCs as well as our SSD G3 for corporate notebook PCs. In general, it is clear that from almost daily product announcements, SSD development is accelerating from all directions, and this represents [goodness] for all Flash supplier. SSD should represent a much more sizeable slice of the Flash demand pie in the 2010 - 2011 timeframe, and there will be plenty of opportunities for large and small suppliers and integrators to segment this market from the simplest netbooks to the most sophisticated enterprise server.

Just a few words on IP. Regarding the renewal of the patent cross license agreement with Samsung I can say that we have been meeting with them, but as of now we have not converged on mutually acceptable terms. With regards to the ITC action involving our system patents, we expect the commission to issue its initial determination later this quarter.

So in summary, we believe 2009 will be a difficult year and we are taking the actions necessary to manage our business without compromising our key strength. Most encouraging to us, the Flash industry has now embarked on taking the decisive steps that are necessary to return the industry to its former health and growth with profitability. As the technology continues to advance at a rapid pace, we believe we are outstripping the competition and we are confident of our prospects in the next recovery.

I'll turn it over now to Judy.

Judy Bruner

Thank you, Eli. As usual, I'll being with remarks on the quarter and year results, and then provide some forward-looking comments.

Our fourth quarter revenue reflected solid sequential growth in our retail business, but weak OEM sales, particularly from our mobile handset customers. Fourth quarter megabytes sold grew 49% sequentially, while the decline in ASP per megabyte continued to be steep at 28% quarter-over-quarter and 70% year-over-year.

Our retail business made up 73% of our fourth quarter product revenue, with sequential retail revenue growth of 25% reflecting unit growth of 28% from the third quarter and average capacity growth of 31% sequentially. Our retail revenue increased from Q3 in all end markets.

On a year-over-year basis, fourth quarter retail revenue was down 26%, reflecting unit growth of 13% from the year ago quarter which was more than offset by a steep price decline.

Our fourth quarter OEM revenue declined 21% sequentially and 48% year-over-year. Unit sales to mobile handset vendors were down both sequentially and year-over-year. We believe we maintained share in the mobile OEM market, but demand for mobile handset vendors reflected weak mobile phone sales and pricing was also aggressive.

Looking at product revenue for the full year 2008, unit demand for our products continued to grow despite worldwide recessionary conditions and we believe we maintained or grew our market share. Our 2008 sales reflected 15% growth in units and a strong 96% growth in average capacity, yielding megabyte growth of 125%. However, a price decline of 62% per megabyte more than offset unit and capacity growth, resulting in our 2008 product revenue declining 17% compared to 2007.

License and royalty revenue for the fourth quarter of $122 million was down 8% sequentially, primarily due to the impact of industrywide price decline on our licensees and down 5% year-over-year as revenue declined for our licensees more than offset the new licenses we added. For the full year 2008, our license and royalty revenue increased 13% to $508 million.

Non-GAAP product gross profit for Q4 was a negative $449 million, reflecting significant period costs as well as price decline continuing at a rate greater than cost decline. Fourth quarter cost of sales included three large period costs totaling $388 million.

First, inventory reserves and related charges totaled $184 million. These inventory charges primarily reflect the writedown of inventory to the lower of cost or market. The size of these reserves reflects the fact that we have too much inventory and that this is the third year in which price decline has exceeded cost decline.

Second, we recorded $121 million to cost of sales for the committed fixed costs associated with planned underutilization of capacity in the first quarter of 2009. We are running output at approximately 70% of capacity in Q1.

And third, we recorded an impairment of our investments in Flash Partners and Flash Alliance totaling $83 million. Our investments in the joint ventures are denominated in the Japanese yen, which appreciated approximately 15% from the end of our Q3 to the end of our Q4. This impairment partially offsets the foreign exchange write up of our investments in the joint ventures.

For the full year 2008, our non-GAAP product gross income was a loss of $380 million or minus 13% margin compared to non-GAAP product gross margin of plus 24% in 2007. Including all inventory related charges and impairments, our cost per megabyte declined 45% from 2007 to 2008. Excluding inventory reserves from both years and the charges for underutilized capacity and joint venture impairment, the underlying cost of product declined 53% per megabyte from 2007 to 2008.

While this is strong cost reduction, it is far below the 62% price decline for the year. Clearly, this rate of price decline is not sustainable and this leads to our actions to restructure the joint ventures and reduce capacity utilization, both actions geared to reducing the rate of growth of our supply and ultimately easing pressure on pricing.

Non-GAAP operating expenses of $240 million included $31 million of restructuring expense related to headcount reductions and other actions to reduce our expense structure going forward. Our GAAP expenses for the fourth quarter also included the non-cash impairment of goodwill and intangible assets from acquisitions totaling $1.02 billion. The goodwill impairment resulted from our market cap being below our net book value and the intangible asset impairment reflects that our discounted cash flow projections for certain acquired technology and customer-related assets were less than the value on our balance sheet.

Other income of $24 million for the fourth quarter included approximately $10 million of net benefit resulting from revaluation of certain assets primarily related to changes in foreign exchange rates.

Turning to taxes, on our GAAP P&L we have taken a valuation allowance against our deferred tax assets primarily due to the size of our 2008 GAAP loss. On a non-GAAP basis, we are continuing to reflect a full tax benefit from the non-GAAP loss.

On the balance sheet, cash and short-term and long-term liquid investments decreased sequentially by $108 million to $2.5 billion.

Despite very disappointing P&L results for the quarter and the year, cash flow from operations was a positive $65 million in Q4 and a positive $87 million for 2008.

Our investments during the fourth quarter included $32 million for non-fab capital equipment and a $157 million loan to Flash Alliance for Fab 4 capacity expansion and 43 nanometer conversion. The joint ventures did not take out any further operating leases in Q4 '08, however the dollar value of our operating lease guarantees did go up due to the appreciation of the yen and stand at approximately $2.1 billion prior to the joint venture restructuring, which is expected to reduce those obligations by approximately 28%.

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.

We are planning for 2009 to be another very challenging year. The macroeconomic environment, coupled with the current challenges of the NAND industry, make it very difficult to credibly predict future results. Despite limited visibility, I will provide some color on Q1 and 2009, with more information on those elements that we can control. What is most important at present is management of our balance sheet to minimize cash usage, so I will also comment on certain cash flow expectations for 2009.

While our retail demand was solid in the fourth quarter, we are expecting a subdued retail environment in Q1 and a continuation of weak OEM demand. Given recent increases in component pricing, we have delayed or reduced certain price declines for Q1; however, other prices for Q1 were locked during the fourth quarter and we still expect our APS per gigabyte to come down a considerable amount in the first quarter.

In each of the last two years our Q1 revenue declined sequentially by 32%. We expect that this year's Q1 revenue decrease will be deeper give the macroeconomic backdrop and including our expectation for a sizeable decrease in license and royalty revenue due to industry pricing and limited bit growth in the prior quarter. In total, we are forecasting Q1 '09 revenue of $475 to $575 million.

Q1 product gross income is expected to be a substantial loss, although we currently expect it to be less than the Q4 loss. This would include a charge for the fixed costs associated with the Q2 fab slowdown for SanDisk. We will likely run SanDisk output at approximately 70% of our restructured capacity in the second quarter.

For the full year 2009, we expect the underlying cost per megabyte of our products to come down 40% to 50% on an equivalent currency basis; however, there are a number of factors that will influence the actual cost per megabyte decline, including currency fluctuation, fab utilization rate, and change in inventory reserves.

For example, the yen has appreciated about 15% during the fourth quarter and if it remains at these levels it will reduce the amount of cost decline we can achieve. Going the other way, we expect inventory charges to be less in 2009 than in 2008, particularly in the second half, as we begin to benefit from the joint venture restructuring and the first half output slowdowns.

We currently forecast our 2009 non-GAAP operating expenses to be approximately $750 million. Q1 non-GAAP expenses are likely between $190 and $200 million, including some further restructuring charges.

Other income and expense in the first quarter will include certain charges associated with the joint venture restructuring. In addition, new accounting rules will go into affect for cash settled convertible debt securities which will result in us recording additional interest expense for our $1.15 billion convertible. We will exclude this additional interest expense from our non-GAAP results since it is a non-cash conceptual amount. We expect non-GAAP other income and expense in the first quarter to be in the range of minus $5 million to minus $10 million, including the cost of the JV restructure.

In terms of taxes on our P&L, as long as we are in a loss position our GAAP tax provision will be an expense equal to the taxes we must pay in foreign jurisdictions. We currently expect to continue to take a benefit on losses in our non-GAAP P&L.

As Eli described, we have continued to lower our 2009 capital investment plans and we forecast these investments to total approximately $500 million for 2009, down from $1.6 billion invested in 2008. We will not seek any new lease funding in 2009. Joint venture working capital plus the return of cash from the JV restructuring will help to fund these new investments, leaving approximately $150 million to be funded from our current cash. This compares to a net outflow of approximately $430 million of cash used for capital investments in 2008.

An important source of cash in 2009 will be to collect cash refunds from the carryback of our 2008 tax loss. We currently anticipate receiving approximately $150 million by the end of Q2 and another $50 million by the end of 2009. The cash from tax refunds is expected to more than offset the net cash outlay related to capital investments; however, we do expect significant use of cash from operations in 2009. At a high level and treating the tax refund separately, we would expect cash usage from operations to approximately equal our non-GAAP operating loss in 2009.

We have today filed a universal shelf registration statement as our existing shelf was due to expire in May 2009 and we believe that some form of equity financing may be a prudent insurance policy this year. Our focus is to ensure an adequate liquidity cushion for our business given industry and economic conditions.

In summary, our priority is balance sheet management and you will see us continue to take action to manage our cash through an extended down cycle.

One last item I'd like to mention is that we have decided to defer our annual analysts day from our typical February schedule to later in the year. We believe that an analyst day will be more productive when there is better future visibility, including for industry pricing and consumer demand.

We'll now open the call for your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Uche Orji - UBS.

Uche Orji - UBS

Let me just ask you, start off with the utilization rates of 70%. Is this number, is it because of the JV restructuring or is it based on the old level?

Sanjay Mehrotra

So regarding the 70% utilization of the current capacity that we have undertaken in Q1 and we plan to be doing that in Q2, that 70% utilization of the capacity of the joint ventures. And this is in addition to the [inaudible] 20% capacity that will be transferred during the course of first quarter to Toshiba as a part of our lease [inaudible] agreement.

Uche Orji - UBS

And let me just ask you a question regarding how you plan to manage this business. So with the supply growth you are targeting, is this aimed now at maintaining market share or based on what you know is happening in the industry do you think you'll be able to gain share running at this level?

Eli Harari

We still have excess inventory getting into the year and we believe that our inventory actually will continue to grow during the first half of the year, even with these cuts, because of profitability of the lines increasing our percentage of x3, 3 bits per cell. So in the first half of the year, market share certainly is not an issue. In the second half of the year hopefully, when demand continues to grow and all of these CapEx start to really get our inventory more in line, at that point we intend to be more selective in the businesses that we go after and maintain market share in the more profitable businesses while being less aggressive in the markets where the pricing really is not up to par.

Uche Orji - UBS

Speaking of the environment, some electronic retailers have had bankruptcies like Circuit City. So if I look at your accounts receivables, are there any potentially places where we could look at some risk to the accounts receivables you have right now? To what extent do you think we should anticipate the writedown, you know, [inaudible] accounts receivables that you have right now on the books?

Judy Bruner

We believe that we are adequately reserved for issues in our customer base and we're monitoring all of our customers very closely.

Operator

Your next question comes from Jim Covello - Goldman Sachs.

Jim Covello - Goldman Sachs

I guess the first is kind of a high level question relative to, Judy, your comment about potentially an equity offering making some sense from a cushion standpoint. Why are you willing to sell equity at this price when there was a potential deal on the table with Samsung and that was turned down because of valuation?

Judy Bruner

You know, look, I think that we can't look back in time at this point, and we have to look at managing our business in the most prudent way. And we believe that we don't need money in 2009. I believe that cash will go down in 2009, but I believe that our cash levels will be more than adequate in 2009. But it's given the uncertainty as to the duration of the down cycle that we are looking, as prudent managers, at the possibility of raising additional capital.

I'd also mention that conditions in the marketplace in general have deteriorated a fair amount since the August - September timeframe.

Jim Covello - Goldman Sachs

Does that mean that to the extent that consolidation became a potential again that you'd be more open minded this time even though the price is lower than you were last time?

Eli Harari

Our Board has always stated that we are open discussions, including with Samsung. I want to remind you that there were other conditions involving settlement of the IP and deal certainty that the Board felt at the time were not met. So price was just one of the issues.

Jim Covello - Goldman Sachs

In terms of positioning for a NAND world looking forward that is sold more direct to OEMs as opposed to the retail channel, obviously SanDisk has established outstanding retail channel relationships over the years. How easy is it going to be to maintain that same relative positioning in the world looking forward where more NAND is sold through the OEM channel where most of the folks you're competing with either have already established those deep channel relationships or are indeed the customers themselves?

Eli Harari

SanDisk started the company as an OEM supplier. It was only in the last 12 years when we developed the retail channels, and I think that I would not fight off the retail channel. I there's phenomenonal growth ahead in the retail channel. But in the OEM, what's critically important is to have captive supply because you need to be able to guarantee availability of delivery of product and, very importantly, is vertical integration, the ability to offer a complete solution and stand behind its quality and reliability and so on.

We think that the vertical integration model that we have in terms of developing, designing the Flash chips, manufacturing the Flash chips, developing and manufacturing the controller chips and assembling the whole system solution at our SDSS facility in China puts us in an extremely competitive position and we are held in very high regard by all the major handset manufacturers. I think that we have a very strong market share in that market and believe that we can grow that market.

The question really is, is there going to be some debundling, frankly, of that market moving as handsets are commoditized and handset manufacturers are looking to reduce the bill of materials, would they prefer to just put a slot, a card slot, and have the customer decide how much capacity he or she wants to pay for, and that plays to our retail strength. I would say the fact that we are straddling both the OEM and the retail markets really give us a very unique vantage point, and I think that we can take advantage of that both ways.

Operator

Your next question comes from Edwin Mok - Needham & Company.

Edwin Mok - Needham & Company

My first question is regarding the CapEx outlook for 2009. Does that include spending in the China packaging facility and, if so, how much?

Sanjay Mehrotra

Yes, it does include the numbers for the China facility, but I would tell you that the numbers for the China facility in that are fairly small.

Edwin Mok - Needham & Company

And then the second question more relates to supply-demand, so I guess a two-part question. So the first thing is does the fab joint venture agreement that you guys have with Toshiba, the new agreement, does that really help reduce worldwide capacity supply? And you guys mentioned that you think supply-demand can potentially improve [inaudible]. Does it really need SSD to start taking off this year or are you talking about just the production cut itself is enough to enable better supply-demand?

Eli Harari

Well, I think with respect to the demand-supply balance, the key thing to note here is that this year the projections for supply growth are, if you look at third-party estimates, they're in the range of 60% to 90%. And actually those estimates are a couple of months old, so [inaudible] simply announce cutbacks, it's likely that the supply growth would be even less than that. So certainly the actions that we are taking, as well as others are taking in terms of managing the supply, we believe will work through the system over the course of the next quarter or two and will result in improved demand-supply balance, which we believe we are optimistic about will ultimately also lead to an improved pricing environment in the second half.

Now SSD market itself, yes, I mean, during the course of the year will continue to increase. But for 2009 it will still be a relatively small part of the total Flash requirements, although this market will continue to grow nicely, we believe, and strongly, we believe, in 2010 and beyond timeframe.

Edwin Mok - Needham & Company

Would you care to venture, to guess how much the SSD will consume in terms of the market?

Eli Harari

I think at this point it's too early to say as the market is projected to grow, to see it in 2009 timeframe, but exactly what percentage in 2009, it's early to say.

Edwin Mok - Needham & Company

Regarding your idle capacity charge on the fourth quarter, the $121 million, are we expecting around 20% less in the coming quarter because of the restructuring or how do we look at that?

Judy Bruner

Yes, the charge in the first quarter, we would expect it to be less because it will be based on the second quarter capacity. Now that assumes that we had an equivalent slowdown of about 30%. So if we had a 30% slowdown on the restructured capacity, then the charge would be less than the $121 million, as you said, you know, approximately 20% less. But we have not yet finalized exactly what the slowdown will be in the second quarter.

Operator

Your next question comes from Gary Hsueh - Oppenheimer & Co.

Gary Hsueh - Oppenheimer & Co.

Again just, you know, asking another question about the equity financing. I think a lot of people might be freaking out about doing equity financing at this point, at this valuation. Is there any kind of comfort level you can give us in terms of the downside to dilution? Is there any kind of boundary conditions that you guys yourselves have thought of in terms of dilution to current equity holders?

Judy Bruner

Sure. You know, again, we haven't made a final decision on when or how much, but we are currently thinking that some type of financing is a prudent step. In terms of sizing it, I'd say that we're thinking in the range of $300 million to $500 million. And based on current stock price, today's stock price, that would be dilution in the neighborhood of 12% to 20%. But again, we haven't made any final decisions as to when or exactly what form.

Gary Hsueh - Oppenheimer & Co.

But that would be a worst-case scenario in your mind, that 12% to 20% dilution?

Judy Bruner

I currently would not anticipate us going above that $500 million number.

Gary Hsueh - Oppenheimer & Co.

And I'm just kind of trying to make sense of the restructured JV with Toshiba and, you know, the potential impact to margins. Is there a way you can simplify for us what the impact is for margins pre and post this restructuring with Toshiba in terms of, I guess, your margins ex idle capacity charges and how idle capacity charges might change at the current utilization run rates with this new deal with Toshiba?

Judy Bruner

You know, let me start by saying that even with the restructuring of the joint venture, we still get the benefit of the full economies of sale of both fabs. So our cost per bit really shouldn't change as a result of the restructuring of the joint ventures. The capacity under utilization, of course, is going to result in a charge in the first quarter like it did in the fourth quarter.

Does that answer your question?

Gary Hsueh - Oppenheimer & Co.

I'm just wondering, you know, I understand that there's a capacity under utilization charge in Q1, but, you know, how does the restructured JV impact the amount of this idle capacity charge? I'm assuming it goes down. Is that not right? For the same, you know, capacity output?

Eli Harari

Yes, this is the 20%. This was a previous question.

Judy Bruner

Right, right. Was that your question?

Gary Hsueh - Oppenheimer & Co.

Yes, I think in another way, yes.

Judy Bruner

Right. $121 million is our charge for a 30% slowdown in essentially the full capacity, but in the second quarter we'll have restructured capacity and if we have the same 30% slowdown then that'll be smaller than the $121 million.

Gary Hsueh - Oppenheimer & Co.

Okay, just how much smaller?

Judy Bruner

Well, we've said that the restructuring is a little bit more than 20%, so it would be slightly more than a 20% reduction.

Operator

Your next question comes from Daniel Amir - Lazard Capital Markets.

Daniel Amir - Lazard Capital Markets

Strategically, you've mentioned that in product roadmaps you're doing restructuring and therefore you're maybe eliminating product lines or you're refocusing on more profitable product lines. The question is one, are you done evaluating which product lines you're going to focus on and which are you de-focusing, and if not, can you give us a little more clarity which product areas you feel are more profitable that you're going to focus the company going forward compared to others?

Eli Harari

Yes, we are done with concluding what actions we are going to take and we have taken those actions and are in the process of actually implementing them in the field. In general we believe that our largest opportunities are, as we've said, in mobile handsets, both embedded and removable storage card, and in SSD and PSSD, basically in portable computing. And everything else is going to flow from that. We will address both of these major markets at the OEM level as well as the retail. Of course, the SSD opportunity is mostly an OEM opportunity. The mobile is both OEM and retail.

But we know pretty much what needs to be done in the next two to three years and we're pretty focused on that.

Daniel Amir - Lazard Capital Markets

And in terms of the captive/non-captive mix, I guess your strategy that you laid out last quarter was kind of 70/30. I mean, is that still kind of the long-term strategy that you've moving the company or could it potentially change here depending on kind of the supply-demand dynamics this year?

Eli Harari

This year we're going to be almost 100% captive still. Hopefully towards the end of this year we will start needing to get into non-captive supply. But in general, yes, we believe that 80/20 or 70/30 is the right model for us over the next two to three years. And it may be different  OEM will be almost 100% captive, whereas retail may be more than 50% non-captive.

Daniel Amir - Lazard Capital Markets

And the final question is on x3, x4, can you just comment on kind of what the mix is this quarter and what you expect the mix to be by the end of the year?

Eli Harari

In fourth quarter for the x3 we had about 15% of our [inaudible] production output in x3. And we have said that during the course of 2009 for x3 we plan to be having 50% of our [inaudible] output in that technology. So that is still looking pretty good and we think that we will be having that level in 2009. Of course, from the 15% level of Q4 this number will continue to increase during the course of the year.

With respect to x4 we are in the early stages of qualifying the technology into our products. We will bring that into production toward some time the middle of the year. And it's too soon to call out the exact [inaudible] for x4. It will be relatively small compared to x3.

Operator

Your next question comes from Bob Gujavarty - Deutsche Bank Securities.

Bob Gujavarty - Deutsche Bank Securities

Just like walk me through this. I mean, your revenue came in pretty nicely, but your inventories only declined by $100 million despite $184 million reserves and then, of course, bringing your utilization down to 70%. Can you just talk about maybe the timing, is that why we saw those things? I would have expected your inventory to come down more or perhaps less of a charge.

Judy Bruner

You know, we've had very high productivity in terms of the output in both of the fabs, Fab 3 and Fab 4, so our incoming supply was clearly growing at a higher rate than our sales, even though our sales were good.

The 70% reduction in terms of the slowdown is being implemented in the first quarter, so that did not impact the fourth quarter inventory receipts.

Bob Gujavarty - Deutsche Bank Securities

And Judy, where do you think inventory will go in 1Q?

Judy Bruner

I think it's possible, you know, very likely that inventory could still go up in the first quarter.

Bob Gujavarty - Deutsche Bank Securities

It seems like the Toshiba transaction is a done deal. Will it hit your balance sheet in 1Q '09?

Judy Bruner

Yes, we expect it to hit the balance sheet in the first quarter. The transfer of the leases, which of course are not on the balance sheet, are scheduled to be transferred in a series of closings over the first quarter. And we expect to get the cash payment around the end of the first quarter.

Operator

Your next question comes from Atif Malik - Morgan Stanley.

Atif Malik - Morgan Stanley

Judy, on the last call you said that you expect product gross margins to bottom in the first half of '09. How should we think about the product gross margins trajectory from here? So Q4 was the worst and it's getting better in Q1 and then Q2 is still negative and the new breakthrough in Q3? Is that the right way to think about it?

Judy Bruner

You know, I don't think we're prepared at this point to give any specific guidance on gross margins by quarter for next year, but we are optimistic that the supply reductions that we are implementing as well as the supply capacity reductions that the industry has announced will lead to an improved pricing environment in the second half and lead to, on our part, us having less inventory in the second half, and both of those should be favorable for gross margin. But, you know, the environment is very difficult to predict right now, and I would not be comfortable giving a prediction on what those gross margins might look like.

Atif Malik - Morgan Stanley

A question on the Samsung royalties. Is it fair to think that your 2 bit per cell royalty rate, let's say it's 6% - 7% right now, could come down from those levels, but 3 bit per cell royalty rate could be at similar levels, 6% - 7% post-August?

Judy Bruner

You know, we're not going to speculate on what type of royalty rate we might be able to negotiate. As Eli commented, the two sides are talking, but we've not yet reached mutually agreeable terms.

Eli Harari

And we're not confirming by our silence the royalty number that you quoted.

Atif Malik - Morgan Stanley

And the royalties also at Samsung for 3D and for [inaudible] from Toshiba, how should we think about that magnitude? Well, this year it's probably going to be minimum, but next year?

Eli Harari

You know, 3D read-write is still not in production anywhere, not by us or by any other company that I know of, so do not expect any royalty. There are provisions that we have, but we really cannot comment on that.

Operator

Your next question comes from [Hindi Visanto] - Gabelli & Company.

Hindi Visanto - Gabelli & Company

I have a question in terms of the cash position. As I know that convertible debt now is selling at the deep discount of 47%, may I know what [rush] you have to be [deciding] not buying it in the open market to improve your balance sheet. But at the same time I realize also that you are in cash preservation mode, so is it possible that you may consider that, when you raise equity financing, like part of it will go to buying your convertible debt to improve your balance sheet?

Judy Bruner

You know, we've been watching the price of the convertible debt, but I would tell you that, you know, our first priority is the strength of the balance sheet. But we do look at that and we will continue to look at it.

Hindi Visanto - Gabelli & Company

At what cash level will you be comfortable at?

Judy Bruner

Well, it sort of depends on the market conditions and it depends on the business as well, but as I said, I do expect that our cash flow from operations will come down a considerable amount in 2009 and that is why we are looking at the possibility of adding some liquidity cushion. I expect that throughout 2009 our cash would still be above the level at which I would become nervous. So, again, this is not about us getting nervous about 2009's level, but it's about not knowing the duration of the down cycle.

Hindi Visanto - Gabelli & Company

With regard to the currency impact, should we expect more currency hedge going forward?

Judy Bruner

Well, you know, we regularly hedge the non-dollar assets and liabilities on our balance sheet. And we have done some hedging, some forward purchases, of the yen for our wafer purchases in 2009. However, in recent times we have stopped doing that because to do that at present would be locking in purchases at 89 or 90 yen to the dollar. So I would tell you that we have purchased forward at favorable rates to current rates about 20% of our expected yen purchases for wafers in 2009.

Operator

Your next question comes from Vijay Rakesh - Thinkpanmure.

Vijay Rakesh - Thinkpanmure

I think on the commentary on inventory and gross margins, Q4 was bad, but here in Q1 we're seeing pricing start to stabilize. [inaudible] contract pricing. So what's happening there? Can you give us a little bit more color there?

Sanjay Mehrotra

So as we said earlier, for Q1 a lot of our pricing was locked during Q4 timeframe vertically related to the OEM business. However, with respect to the retail business, we have delayed some of our price declines, moderated some of the price declines, as Judy had indicated earlier. Overall, we still expect that the price declines during the first quarter will be significant; however, we are certainly looking at moderating the price decline and we believe that the supply cuts announced earlier, the supply-demand balance and an improved pricing environment will be achieved in the second half of the year.

Vijay Rakesh - Thinkpanmure

So that said, if supply is coming down quite a bit, do you expect the pricing - I know that you have some fixed in Q4, but the Q1 prices that you fixed should be a lot better than Q4 and so flow into Q2 as well, right?

Judy Bruner

I think to reiterate what I said and what Sanjay said, we still expect our ASP per gigabyte will come down a considerable amount in the first quarter given that many of the OEM prices were already locked in in the fourth quarter and given that there were price declines even late in the fourth quarter.

Eli Harari

Supply coming down is really happening in the first half of the year and this is a very, very substantial factor for the second half of the year. The real unknown is the demand scenario. And remember, our retail sales - actually OEM sales, too - are pretty much global, and the U.S. economy is reacting and consumers in the U.S. react differently than in EMEA, Europe, which have quite strong in demand in [inaudible]. Asia-Pacific also quite strong in demand.

So there are just too many factors involved in here in the demand-supply equation. All we're saying is that we are very encouraged by the supply side reflecting the angst, the pain that the manufacturers are suffering at current pricing that is due to excess supply - primarily excess supply  and that, you know, we are taking the right steps we believe. You know, going to 50% growth in bit output is not something I would - it's pretty dramatic. Pretty dramatic.

Jay Iyer

Millicent, I think we have time for one more question.

Operator

Your last question comes from Daniel Berenbaum - [Arega USA].

Daniel Berenbaum - Arega USA

I want to talk about the cost reduction. You talked about 40% to 50% cost reduction in '09. I think that previously you talked about the ability to potentially hit the high end of that. Can you just talk about what are the swing factors that would take you to the high end or the low end of that cost reduction and then how do you look at that cost reduction versus pricing, particularly heading into Q1, where you're saying that pricing is going to be down. Do you think that your cost reductions will keep pace with the ASP declines in Q1?

Sanjay Mehrotra

With respect to the cost reductions, when we said that we expected to be toward the high end of the range, that was actually related to the 2008 cost reductions and we did achieve performance that was toward the high end of the previously guided cost reduction target.

So for 2009, cost reduction, again, at the underlying memory technology level, without taking into consideration exchange rates or slowdown, we believe will be in the 40% to 50% range. And the key factor there would be the continuing transition to the x3 technology during 2009 as well as continuing to increase our 43 nanometer production and toward the end of the year the 32 nanometer will start playing a role as well.

Daniel Berenbaum - Arega USA

Does your mix have anything to do with cost reduction? I'm thinking, in other words, if you get more solid state drives out because of the nature of the product, that or that you're producing to go into the solid state drives, does that accelerate your cost reduction?

Sanjay Mehrotra

So the cost reductions very much are a factor of the mix of 2 bit per cell and 3 bit per cell technology during the year. And with respect to SSD, initially SSDs would be using 2 bit per cell technology. But as I said before, during 2009 SSD would still be a relatively small part of our output.

Operator

That will conclude our question-and-answer session. At this time, I'd like to turn the program back to our speakers for additional or closing comments.

Jay Iyer

I just wanted to say thank you all for joining us today on the call. A webcast replay of today's call will be made available shortly on SanDisk.com/IR. Have a good evening.

Operator

Thank you, everyone, for your participation in today's conference and you may disconnect at this time.

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Source: SanDisk Corporation Q4 2008 Earnings Call Transcript
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