SanDisk Corporation Q1 2009 Earnings Call Transcript

Apr.21.09 | About: Western Digital (WDC)

SanDisk Corporation (SNDK) Q1 2009 Earnings Call April 21, 2009 2:30 PM ET

Executives

Jay Iyer – Director of Investor Relations

Eli Harari – Chairman & Chief Executive Officer

Judy Bruner – Executive Vice President, Administration & Chief Financial Officer

Sanjay Mehrotra – President & Chief Operating Officer

Analysts

Daniel Berenbaum – Auriga USA

Gary Hsueh – Oppenheimer & Co.

Jim Covello – Goldman Sachs

Edwin Mok – Needham & Company

Daniel Amir – Lazard Capital Markets

Vijay Rakesh – Thinkequity Llc

Paul Coster – JP Morgan

Bob Gujavarty – Deutsche Bank

Kevin Vassily – Pacific Crest Securities

Hendi Susanto – Gabelli & Company

Stephen Chin – UBS

Operator

Good day and welcome to the SanDisk Corporation First Quarter 2009 Earnings Conference Call. Today’s conference is being recorded.

At this time, I would like to turn the conference over to Jay Iyer, Director of Investor Relations. Please go ahead, sir.

Jay Iyer

Thank you, Glenn, and good afternoon everyone. Joining us on the call today are Dr. 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/A for fiscal 2008 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. Our first quarter results represent a substantial improvement over the prior quarter. Demand for our products in the first quarter was stronger than expected and is holding up in April. NAND component pricing trends, which began a U-turn late in the fourth quarter of 2008, have continued to improve in the first quarter and into April.

Our production cut backs implemented in the first quarter and continuing in the current quarter combined with the successful completion of the restructuring of our manufacturing joint venture with Toshiba in the first quarter are positively impacting our inventory levels and provide us improved flexibility in managing our business back to profitability.

Our product gross margin in Q1 were substantially better than in Q4 and although we are still in negative territory, we believe gross margin is heading in the right direction in Q2. Our focus is on returning to profitability and to that end, we have raised prices for Q2 and of course our product cost should continue to decline throughout 2009, in particular due to aggressive ramping of our 3 bits per cell x3 NAND.

A key factor for improved industry fundamentals in Q1 was that substantial Q4 '08 losses reported by all NAND suppliers including ourselves brought about industry-wide NAND production cut backs in the first quarter. With supply coming into better balance with demand, NAND component pricing stabilized and began to rise, a phenomenon the NAND component market has not experienced in recent memory.

Although, this downturn is by no means over, things do look in field better now than at the beginning of the year. Third-party market research firms are forecasting that even if capacity utilization in the industry increases to 100% in the second half of 2009, industry-wide NAND bit output will grow by 50% to 60% in 2009 compared to 130% and higher in each of the previous five years. Sharp reductions in 2009 capital investments announced by the major NAND suppliers including ourselves reflect on healthy state of the NAND business during the last several quarters as cumulative price reductions, [positive] cost reductions in each of the past three years.

Additionally, the current scarcity of financing options due to the global credit crunch coupled with currently negative return on investment is likely to put a damper on the launch of new NAND wafer fabs until business conditions improve substantially. In the second half of this year, we expect demand for NAND to continue to grow particularly for mobile and portable computing platforms and this should hopefully absorb the industry supply growth projected for second half.

For our own restructured captive supply, we expect to return to full utilization rates in fab 3 and 4 in the second half. However, our decision on second half utilization rate will depend on actual market conditions this summer and we have some flexibility to dial it down if necessary.

We expect to start our 32-nanometer wafer production with 2-bits and 3-bits per cell NAND this summer and we believe that our memory cost structure should remain highly competitive in 2009 and 2010. As for demand creation, I believe that the handset business is being transformed on a scale similar to that which the web experienced in its early days and this has far-reaching implications for our mobile storage business.

In the U.S., you need to only pickup any major newspaper or turn on the TV to see compelling ads by Apple touting thousands of third-party applications for the iPhone. These evidenced the handsets transformation into a powerful mobile computer. And it is into only Apple, rooms newly launched up store, the rapid adoption of the Android platform that prompts three Nokia and Microsoft roadmaps all these show what handsets can become and in large measure have already become. These smart phones along with other mobile Internet devices so-called MIDs and netbook PCs are increasingly ubiquitous always connected and often subsidized by your local network operator. The opportunity for us is that these devices will have to be contented with wireless bandwidth and coverage limitations making off-line, local cashing of increased amount of data central to devices usability. Paradoxically, the promise of always-connected devices in cloud computing is resulting in ever greater need for local storage on the devices themselves.

Indeed, we are seeing increasing demand from major players in the mobile ecosystem for our comprehensive mobile storage solutions including Mobile Card, embedded iNAND and solid state drives for netbook PC's.

And speaking of SSD, we are shipping our second generation modular SSD known as SanDisk PSSD to netbook OEM's, and we continue to make good progress with our G3 SSD platform in our own costs for OEM customer sampling this summer. Regarding, our license renewal negotiation with Samsung, these are continuing and there is no further update for this time.

To summarize, I believe that we are executing well in the current environment, which remains challenging, although improving. Our decisive actions during the past two quarters have given us strong competitiveness and market focus, greater financial control and flexibility in our business. We believe that the mobile and computing storage markets are truly exciting and offer tremendous opportunities for our growth in the years ahead.

I will turn it over to Judy now.

Judy Bruner

Thank you, Eli. Our first quarter revenue was higher than we had forecasted, driven by stronger than expected demand primarily in our OEM channels, but also in retail. First quarter gigabyte sold, grew 9% sequentially with unit sales down 7% from the holiday fourth quarter and average capacity up 18%. On a year-over-year basis, our unit sales continued to grow increasing 11% and with average capacity up 140%, our gigabyte sold grew 166%.

Our first quarter ASP per gigabyte came down 27%, reflecting price declines that were put in place early in Q1 in both OEM and retail channels, as well as our focus on monetizing our inventory. With an improved supply demand balance, we began raising prices in the first quarter and we expect the positive impact to be primarily felt in the second quarter.

Our retail business made up 59% of first quarter product revenue. The sequential decline in retail unit sales from Q4 to Q1 was 30%, very similar to the last two years and contrary to our expectation that the seasonal unit decline would be more pronounced because of deteriorating economic conditions.

On a year-over-year basis, retail unit sales continued to grow and were up 14% with growth driven primarily by USB drives. Our OEM unit sales grew 18% sequentially and 9% year-over-year. Most of this growth came from microSD cards sold in the mobile market, in particular to mobile network operators.

License and royalty revenue for the first quarter was $71 million, down $50 million from the previous quarter with the decline due primarily to lower flash memory revenue reported by our licensees in the fourth quarter of 2008. In addition, our first quarter royalty revenue was negatively impacted by a reconciliation item from a licensee relating to new computations from them for years prior to 2008, which we are currently reviewing.

Non-GAAP product gross loss for Q1 improved considerably from the prior quarter, but it was still negative 67 million or minus 11% of product revenue. Cost of sales for Q1 included a charge for Q2 planned under-utilization of capacity of $63 million and benefited from a net reduction in inventory reserves of $34 million. Our improved pricing outlook resulted in new inventory reserves being less than the reserves released for product sold during Q1.

Non-GAAP operating expenses of a $150 million were less than we had forecasted reflecting successful restructuring and cost containment actions, as well as the postponement of certain expenses. Sales and marketing is the area where we took the strongest cost reduction actions. And in addition, Q1 included minimal investments in merchandising and branding.

Non-GAAP other income expense was an expense of $6 million in the range we forecasted, including costs related to the joint venture restructuring, as well as a final impairment for the disposition of FlashVision’s 200-millimeter equipment. Our GAAP other income expense was an expense of $19 million and includes a $13 million non-cash interest charge related to the new accounting requirements for cash settled convertible debt.

Our non-GAAP tax provision for Q1 is a tax benefit of 28%. On a GAAP basis, we are not benefitting our U.S. tax losses. So our GAAP tax provision primarily reflects taxes owed in profitable foreign jurisdictions. On the balance sheet, cash and short and long-term liquid investments decreased sequentially by a $154 million to $2.38 billion. Cash flow from operations was a negative $114 million including receipt of a tax refund of a $179 million received one quarter earlier than expected. We still expect to receive approximately another $60 million tax refund later in the year. The usage of cash by operating activities, which was $293 million before the tax refund was influenced by a pay down of accounts payable by $183 million as we reduced expenses, CapEx and wafer starts.

Cash flow used in CapEx related investing was a net of minus $52 million. Our investments in Flash Partners and Flash Alliance are very front-end loaded this year. And we invested $326 million in the joint ventures in Q1 leaving us with no more than a 100 million to be invested during the remainder of 2009.

We received $277 million from the joint venture restructuring and $13 million related to the closure of the 200-millimeter FlashVision joint venture. Non-fab related CapEx investments were $16 million. Our inventory balance declined by $46 million driven primarily by strong memory cost reduction. We are pleased that net inventory dollars came down even after a reduction in inventory reserves. A significant accomplishment in Q1 was the reduction of our off-balance sheet equipment lease obligations, which now stand at $1.2 billion, down from $2.1 billion at the end of Q4.

This reduction in off-balance sheet obligations reflects the transfer of leases to Toshiba, regular lease payments made by us, and the depreciation of the yen to the dollar. The dollar amount of long-term convertible debt on our balance sheet was reduced due to the restatement required for the new accounting pronouncement for cash settled convertibles. This new accounting required adjusting our income statement and balance sheet results from the initial issuance of the convertible debt in May 2006, through 2008. In addition, we have moved $75 million of convertible debt to current liabilities. This debt was assumed in the acquisition of Msystems and the debtholders have a call right in March 2010.

I will 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 forecasting stable to slightly higher pricing for Q2 relative to Q1. Higher pricing may reduce the typical growth we have seen in the second quarter in unit demand and average capacity. However, the restructuring of our captive supply allows us to more effectively balance profitability and volume. We are forecasting total revenue for Q2 between $650 and $725 million including license and royalty revenue between $85 million and $95 million.

Our Q2 non-GAAP product gross margin should continue to improve based on stable to slightly higher pricing and reduced product costs. Although this will be partially offset by more expensive yen based wafer purchases primarily from late Q4 and early Q1 that will be reflected in Q2 cost of sales. The Q2 product gross margin will also be influenced by the second half pricing outlook when we get to the end of Q2. If the second half pricing outlook at that time is for a continued benign pricing, then there should be little need for new inventory reserves and existing lower of cost or market inventory reserves will be released as the inventory is sold. In such a scenario, we would expect slightly positive product gross margin in the second quarter.

We forecast Q2 non-GAAP operating expenses between $170 and $180 million, including the delay of certain expenditures from Q1 to Q2, as well as higher retail mechanizing costs for Q2. For the full year, we are now expecting operating expenses to be between $700 and $725 million, down from our previous $750 million guidance.

We expect other income and expense for Q2 to be income between $5 and $15 million. Our total capital investment forecast remains at $500 million for 2009. Following the $326 million loan to the joint ventures in Q1, we expect approximately $75 million in Q2 and $25 million in the second half. Our non-fab CapEx is expected to be approximately $75 million for the year.

We expect a modest decline in our overall cash balance in Q2. Q2 will not benefit from the large cash inflows that we received in Q1 namely the JV restructuring and the tax refund. However, we expect the underlying cash usage from operations and capital investing to be less in Q2 than in Q1.

Maintaining balance sheet strength, while also improving the bottom line, remain key priorities.

We'll now open the call for your questions.

Eli Harari

Glenn, we are ready for Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). We will go first to Daniel Berenbaum with Auriga USA.

Daniel Berenbaum – Auriga USA

Yes, thanks for taking my call. Judy, when you are talking about pricing, obviously pricing has been firming. When you talk about pricing going up in Q2, are you talking, just to clarify, you’re talking essentially about product pricing and what’s happening to pricing on a per megabit basis?

Judy Bruner

I'm talking about SanDisk’s product, average ASP per gigabyte for our products that. We are expecting that average ASP per gigabyte to be stable to slightly up in Q2.

Daniel Berenbaum – Auriga USA

Okay. And, just out of curious, so that hasn't happened for quite a while back in my model.

Judy Bruner

It’s right.

Daniel Berenbaum – Auriga USA

What you call in the last and that happened on a per megabyte basis per gigabyte basis?

Judy Bruner

I don’t believe that it's happened while I have been here for five years.

Daniel Berenbaum – Auriga USA

Okay.

Eli Harari

I have been here 21, years I'm trying to remember.

Daniel Berenbaum – Auriga USA

So you would then characterize this as the best pricing you’ve seen in awhile. And then along those lines, can you talk about.

Eli Harari

But let’s say, the pricing is still not very good, quite honestly. I mean the pricing is, I mean we are still reporting negative margins.

Judy Bruner

We would like to see several quarters of benign pricing to get our P&L healthy again.

Daniel Berenbaum – Auriga USA

Right. So then along those lines, seems like cost reduction in the quarter was quite good again, by my calculations was the best you have seen in at least a couple of years. Can you give us guidance for a full year cost reduction, and then also since megabit shipments were up in Q1, which again I have to go back to ’06 to see an up Q1 megabit shipments I think, where do you think that your megabit shipments are going to be for the full year?

Judy Bruner

You are right, that our cost reduction in Q1 was very good. And it was largely the result of seeing the benefit of transition to 43-nanometer in 2008, which then begins to roll through our cost of sales in 2009. We still expect our overall cost reduction on a cost per bit basis to be in the range of 40% to 50% for 2009, that’s a range that we gave on our last conference call. And you are also right, that the 9% increase in bit sales in Q1 is very good, compared to...

Eli Harari

Particularly given outlook at the beginning of the year with the economic meltdown, this was quite surprising to us, really it is actually quite stunning.

Judy Bruner

But I would tell you, we are not prepared to give a full year bit gross guidance in terms of revenue. I will say that in 2008, our bit growth in sales was a 125%, in Q1 ‘09 it was a 166% on a year-over-year basis. And clearly we expect our bit growth in sales this year 2009 to be quite a bit ahead of our supply growth in bits. And that’s what's helping our business get healthier again.

Daniel Berenbaum – Auriga USA

And then you would expect, what was your bit growth in terms of supply. Could you give a projection for that.

Judy Bruner

It will be less than 50% this year.

Daniel Berenbaum – Auriga USA

Still less than 50%. Okay, thanks very much.

Eli Harari

That new supply, but we started the year with a high inventory.

Judy Bruner

Sure. We have inventory, we had started the year with high inventory. We still have more inventory than we would like and that’s what is enabling us to achieve much higher bit growth in revenue than the supply growth.

Daniel Berenbaum – Auriga USA

Okay great. Thanks very much.

Jay Iyer

Next question please.

Operator

We’ll go next to Gary Hsueh with Oppenheimer.

Gary Hsueh – Oppenheimer & Co.

Great. Thank you. With better visibility and as you said indications of a more benign pricing environment, I mean does it still make sense here to considered equity offering that’s still prudent to raise cash at the expense of 12% to 20% shareholder dilution with better expectation for cash flow and pricing and profitability here in Q2 in the second half?

Judy Bruner

We’ve not made any definitive plans in terms of a capital raise. As you know, we have our shelf in place and we can move quickly, if we believe there is an appropriate opportunity. But at this point, we’ve not made any definitive plans. We are watching the markets and we’re watching our own results very carefully.

Gary Hsueh – Oppenheimer & Co.

Okay.

Eli Harari

And we are very sensitized to the dilution issue.

Gary Hsueh – Oppenheimer & Co.

Okay. But it’s not fair to characterize the situation by saying the probability of this happening now is a little bit less given better results and more benign pricing

Judy Bruner

There is a lot of factors that will weigh into any decision that we should make and again, we are watching everything very carefully.

Gary Hsueh – Oppenheimer & Co.

Okay, understood. Second question here on products. Could you help me understand how the company is stepping through the product cycle, here and going from MLC to the x3 and eventually the x4 architecture? Could you talk about commercialization, can you update us on prospects for commercialization for the x3 in the second half. And is that expected to occur more on the OEM side or more on the retail side. And if you could explain like-for-like coming from MLC, what the impact could be on gross margin. I understand at least on the management side, x3, x4 requires a lot heavier hand in terms of management like ECC and block management. So, I am just wondering if increasing management in DSP needs is going to start to impact on the negative side gross margin on some of those products.

Sanjay Mehrotra

With respect to x3, we are actually very pleased with the progress that we are making on the ramp of x3 in production. If you recall, last quarter I reported that in Q4 we had about 15% of our bit production in x3 and that has continued to increase in the first quarter. About 25% of our bit production is in x3 in first quarter and our goal is to have about 50% of total bits produced in 3-bits and 4-bits in 2009 and we are on track for that. With respect to four-wafer cell, we have said that we will be introducing this in mid this year. We are on schedule for that. The production output of 4-bit per cell will likely be relatively small compared to 3-bit per cell. And as we get into 32-nanometer technology, it is likely that compared to 2 bit and 3 bit per cell it will become even smaller. The cost benefits of 3 bit per cell by product level is in the range of 15% to 20% over 2 bit per cell and for 4 bit per cell obviously, compared to 3 bit per cell, it will be a smaller percentage. Hence, overall basically for x3 doing well and we plan to apply it to all of our products, actually we have already been shipping it in our retail products, as well as our OEM products. x4 will be shipping in certain limited applications because x4 is a more challenging technology, and the suitability for applications tend to be more in somewhat lower performance products such as our blue label cards, and that’s where we plan to introduce that first.

Gary Hsueh – Oppenheimer & Co.

Okay. So let me get this straight. So, the transaction from MLC to x3 is pretty much transparent with the added benefit of 15% to 20% cost savings, but the transition from x3 to x4 is a little bit more niche oriented?

Sanjay Mehrotra

Yes, but in the products that we apply it x3 and x4, we make sure that those technologies are transparent to the user. So x4, the product that you will plan to apply to it. It will be transparent to the user in those products. And you would also add regarding controllers, certainly you’ll demand 3 bit per cell and 4 bit per cell technologies into products requiring significant level of controller sophistication. And 4 bit et cetera and SanDisk has expertise over last 20 years developing that. We have best position in terms of commercializing these technologies. And from a controller point of view, the cost is really not any significant in terms of 3 bit per cell or 4 bit per cell products.

Gary Hsueh – Oppenheimer & Co.

Okay, perfect.

Eli Harari

I just wanted to add one thing and that is that, as far as the cost reduction number that Judy gave you, the 40 to 50% for 2009. If you add that to what Sanjay just said, you could see that x3 is a very important component of our cost reduction effort for 2009 and for that reason, we believe very strongly that x3 technology is pretty fundamental, pretty crucial for the entire NAND flash industry to be able to continue aggressive cost reductions.

Gary Hsueh – Oppenheimer & Co.

Great. Great, thanks Eli.

Jay Iyer

Next question please?

Operator

We’ll go next to Jim Covello with Goldman Sachs.

Jim Covello – Goldman Sachs

Thanks, good evening. I appreciate the chance to ask a couple of questions. First, I guess on the comment, Judy about the recalculation from one of the licensees. Could you give us a little more detail about that and when that might get resolved?

Judy Bruner

I would tell you that our license agreements are fairly complex, they require some complex calculations and in this case, the licensee believes that they incorrectly computed, license payments for several years prior to 2008. We have not recognized revenue for this amount and it’s been reviewed, but I can’t give you anything really beyond that.

Jim Covello – Goldman Sachs

Is the number that you’ve recognized in Q1 reflective of some sort of catch-up or that’s what the lower rate would reflect?

Judy Bruner

What we recognized in Q1 is net of the total amount of the reconciliation item.

Jim Covello – Goldman Sachs

Okay, okay. If I can ask then maybe about the Japanese rating agency, what kind of dialog do you have with them? How much of an issue is this? With the business prospects looking much better, do you feel a lot more comfortable that there isn’t a ratings downgrade issue there or did you never feel that that was much of a threat or did they have more of a backward looking view as opposed to a forward-looking view?

Judy Bruner

We have a pretty regular dialog with the rating agency in Japan. We meet with them either in person or by phone typically quarterly and they look carefully at our results every quarter. I am sure they look carefully at the results we just announced today. I would tell you generally I believe our results are better than what third parties were expecting, but I can't speak for the rating agency.

Jim Covello – Goldman Sachs

Okay, great. If I could just ask one or two more, relative to the very low CapEx level in the back half of this year. I understand the comments about further cost reductions in the second half of 2009, that's really a reflection of what you’ve spent up until now, but will you be able to reduce cost significantly in 2010, if with the very low level of CapEx in the second half of 2009 or said another way when do you run out of the ability to reduce cost without starting to crank up the CapEx engine again?

Judy Bruner

Well. Let me just comment on one thing there, and then I will turn it over to Sanjay. Recognize that the cash that we spend on CapEx is actually lagged from when the investments are made. This is the way the joint ventures operate and so we will be investing in equipment. And the fact, in 2009 for the transition to 32-nanometer and much of that will end up getting paid for in 2010, just as what we just paid for in Q1 was largely for equipment that was installed in 2008.

Jim Covello – Goldman Sachs

Okay. So the lower CapEx isn't necessarily reflective of what you are ordering or what the technology transitions would be?

Judy Bruner

It is the 500 million a year, is an approximate run rate when we are not adding new wafer capacity. It’s just that the payment for the different technology transitions lags when the investment is really made.

Jim Covello – Goldman Sachs

Okay.

Sanjay Mehrotra

On the cost reduction, I’ll just add that for 2010 the main driver of cost reduction would be of course continuing to use the 3-bit-per-cell technology in production, but also transitioning to 32-nanometer technology. Just like in 2009, we are getting the full benefit of transitioning to 43-nanometer, as well as x3 2010. And the cost benefit will come from 32-nanometer transition which will begin mid next year in terms of wafer starts.

Jim Covello – Goldman Sachs

Okay.

Eli Harari

But Jim, let me also add to what Judy was saying. And I said that in the last quarterly earnings conference call, the 32-nanometer equipment set is not much more than the 43-nanometer equipment set, because they are so close together. The equipment set that we have in place for 43-nanometer can cover most of the process steps for 32-nanometer. And therefore the additional CapEx required is not like starting a clean wafer start, it’s actually just an enhancement. It’s a very cost effective, CapEx utilization going from 43-nanometer to 32-nanometer.

Jim Covello – Goldman Sachs

And that’s very helpful. Final question, then I will go away. In terms of restarting the fabs, I heard what you said, but it was, what would be the barrier to restarting the fabs in Q2, why, given that things are little bit better now, why wouldn’t you restart the fabs in Q2, given the delay between when you’re going to restart the fabs and when you’re actually going to get some product out? Thank you so much.

Sanjay Mehrotra

So, we indicated that our utilization rate in second quarter is somewhat higher than Q1. And we've also indicated that the second half of the year, we plan to be at 100% utilization of course. The wafer starts for the timeframe are not locked in yet, we can always adjust their timing back down. Also as Judy indicated that meeting our increases in demand projection through of course increases in our new supply, but also continuing to utilize our inventory to sell the products. So with all of that, we feel that the utilization rate in Q2, is at the right level for our business.

Eli Harari

I think also it’s important not to honestly jump too far ahead of ourselves, one quarter is just one quarter. And we really need to see a trend developing over the next several quarters. So, I think caution is important, conservatism is I think well placed.

Jim Covello – Goldman Sachs

Thank you so much.

Jay Iyer

Next question please.

Operator

We’ll go next to Edwin Mok with Needham & Company.

Edwin Mok – Needham & Company

Hi, thanks for taking my question and good quarter. Just first question is regarding yourguidance. If I use the midpoint of guidance it seems to imply not noted growth in second quarter. Is it because you guys expect lower bit growth because of higher prices or can you share some light on that? Are you just being conservative?

Judy Bruner

Sure Edwin, as I said in my prepared remarks, we don’t have much experience with this pricing environment, in terms of prices going up. And we do believe that could dampen somewhat the bit growth that we have seen typically, historically in second quarters. So that was taken into account.

Edwin Mok – Needham & Company

I see, great. And then my second question is regarding non-captive. Do you guys have any non-captive supply in the first quarter planned for second quarter or do you expect to have any this year?

Sanjay Mehrotra

We do not have any non-captive supply in the first quarter or second quarter. And at this point, we are not planning non-captive supply for second half. Although, there are demand scenarios that can be envisioned where a non-captive supply may be needed toward late in the year.

Edwin Mok – Needham & Company

Great. Thank you all. My third question is regarding, maybe your customer inventory. So, first quarter was quite strong, and you guys had positive bit growth in the first quarter. I guess a two-part question. First question, first part is, is it possible that because you have [covered] with a lower price in the first quarter, and you guys are raising price, your customer may be building inventory ahead of that. And then, the second part of the question is, have you seen increase bit per cart for your OEM customer, did that drive up demand for the OEM side. Thank you.

Judy Bruner

I would tell you that I don't think there is anything unusual in terms of the inventory held by our customers. Retail channel inventory is at a very normal level, it was about seven weeks at the end of our first quarter.

Sanjay Mehrotra

Regarding average capacities, which I believe you were asking for the OEM side. We definitely saw in the first quarter a nice increase in average capacities both in our OEM business, as well as retail business. And the OEM business, the average capacity on a per product basis increased well above 100% on a year-over-year basis.

Edwin Mok – Needham & Company

So is it fair to say that OEM costs out, because historical OEM cost tends to be a bit smaller than the retailer costs, and is it fair to say that is catching up right now, is that the trend that you’re looking?

Sanjay Mehrotra

So, our average capacity in retial are certainly higher than OEM, but yes I mean on the OEM side the rate of increase has been substantial, but the retail side the average capacities have continued to increase as well. Retial average capacities have also increased more than 100% on a year-over-year basis.

Edwin Mok – Needham & Company

Great. That’s all I have. Thank you.

Jay Iyer

All right. Next question please.

Operator

We’ll go next to Daniel Amir with Lazard.

Daniel Amir – Lazard Capital Markets

Thanks a lot and congratulations on a good quarter.

Eli Harari

Thank you.

Daniel Amir – Lazard Capital Markets

Couple of questions here, Eli maybe this is for you. We’ve seen in the past, these occasional price increases, obviously, it’s been the magnitude here it’s been probably a little sharper than previous times. What kind of gives you the confidence that this is different this time and that the memory market has kind of really learned this lesson. And we’re starting to see more of a longer period now maybe potential price stabilization compared to the ups and downs that we’ve seen maybe in ’06, ’07 and ’08?

Eli Harari

Good question Daniel, and thank you. I can’t speak for our – excuse me, of course I could say that we’ve learned a lesson off our over investment, over exuberance in 2006 and 2007, to a certain extent, off of 2008 and the restructuring that we have accomplished here is very, very good for us to basically, we balanced ourselves and resized ourselves. But I would say that the basic fundamentals that are very encouraging is that the industry as a whole has understood that, these thing is continues price reductions exceeding cost reductions eventually it makes the whole business such that there is no return on investment, which can justify new capacity increases.

The one big change that we’re seeing this year is the pretty dramatic reduction in CapEx almost across the Board taking us from I think what Judy said, 130% capacity increases last year and more or like 170% per year increase, in everyone over the prior years going onto 50% to 60% this year. That is immense; I mean remember when Samsung had a fire for like two days, about three years ago and that was a big blip on the pricing side, those costs have subsided. We are not taking about here two day production cuts. We are talking about six months production cuts with very, very substantial production in total capacity growth coming to the industry. In the meantime of course demand continues to grow. We do have markets, this is not the DRAM industry, there is nothing very dynamic about DRAM and there is plenty dynamic about NAND.

I mean NAND is a young industry and tremendous growth that I try to capture with the mobile, with the third-party applications and with solid state disk. So, now I do believe that this 60% or so annual price declines are really not sustainable, I've said that over the last three years and [inaudible] is definitely slowing down if you do the calculation for 32-nanometer compared to 42, 43 nanometer you see that it cannot support 60% cost reductions and therefore I think that the fundamentals dictate that if people want to run a profitable business, then this needs to be managed to justify a return of investment and today's return of investment is still negative based on today's pricing. So I think it’s very encouraging and I believe that really if somebody decided today, if the biggest supplier in this market decided today that they are going to pull all the stuff and really drive up, it’s still not going to make much of a difference in 2009. and I think it is really talking about, I think a period of return to much better health. But again demand is the key and without demand, demand is one part of the equation that we really don’t have any idea where it's going to go.

Daniel Amir – Lazard Capital Markets

Okay. Maybe I’ll follow through with that question. Related to the kind of demand and the pricing, how do we look at the SSD market, I mean obviously now pricing has gone up. So that some times it is countered to big argument of SSD versus hard disk drives. But what are you seeing on the cost front and on the MLC SSD now, when we should start seeing SSD becoming a bigger or an important portion of the NAND market?

Eli Harari

SSD eventually, of course, we always believed will be a very substantial part of the NAND market, NAND consumption market, but again it’s a question of, it’s going to be profitable in order to justify investments in major production capacity to meet the future demand. What is pretty obvious now is that the SSD market is going to be highly segmented. It’s going to have the enterprise space and which by itself a bit segmented, the mid range in notebook and desktop PCs and then netbook and niche. And I think each one of these markets are going to have strong dynamics including gross margins and target pricing that’s required to get those markets to really takeoff. I think the enterprise space we are already meeting the price requirements even with SLC NAND. We are not there yet with netbooks and notebook PCs. And we need to be careful that we don’t get too far ahead of ourselves in terms of this euphoria about such a huge market because it really needs to be thought of from the point of view of both meeting the requirements of the market price wide, but also the requirements for achieving profitability. And we are going to for ourselves, we are definitely going to prioritize profitability.

Daniel Amir – Lazard Capital Markets

Okay. Thanks a lot.

Jay Iyer

Next question please.

Operator

We‘ll go next to Vijay Rakesh with Thinkequity.

Vijay Rakesh – Thinkequity Llc

Thank you, guys. Just a couple of questions here, I was wondering, you said inventories are coming down in the second quarter, I was wondering what‘s a good number there, and also wondering what your depreciation for the year looks like for ‘09?

Judy Bruner

Vijay I don’t believe I gave any guidance on inventory for the second quarter. Really it’s hard to predict at this point, whether inventory dollars will go down or go up in the second quarter, a lot depends on demand, as well as on the level of inventory reserves released or taken during the second quarter. So, we don’t have a specific forecast on inventory dollars for the second quarter.

Vijay Rakesh – Thinkequity Llc

Okay.

Judy Bruner

And I am sorry. What was your second question?

Vijay Rakesh – Thinkequity Llc

And what’s your estimated depreciation for the year?

Judy Bruner

Well, you can see in our cash flow statement, the depreciation for the first quarter, which let me just get it for you. It was $39 million. So, I think that’s a reasonable run rate on a quarterly basis. We have split out this time. We split out depreciation and amortization. So, those are on two different lines.

Vijay Rakesh – Thinkequity Llc

Got it. My other question was, actually you ramped 32-nanometer here, what percentage do you think that will be your output and let’s say Q2 and going forward into Q3?

Sanjay Mehrotra

So, we have said that 32-nanometer will actually begin, ramp mid this year. We are in the stages of qualifying the technology in our product. So, it’s not part of any Q2 bit production. and in Q3 it will be a relatively small portion and towards Q4 and toward the end of the year, is when it’ll start ramping up to a meaningful volume.

Vijay Rakesh – Thinkequity Llc

Got it. Okay, thanks a lot guys. Good job.

Jay Iyer

Next question please.

Operator

We’ll go next to Paul Coster with JP Morgan.

Paul Coster JP Morgan

Hi, yes thank you. A few quick questions, the pricing power that you’ve seen very recently, is it extending across all geographies and all product categories uniformly?

Sanjay Mehrotra

Yes, the pricing that we are addressing, we are taking actions in OEM as well as retail and across geographies.

Paul Coster JP Morgan

Got it. The operating expense reduction was pretty amazing actually. I think it is a brilliant job. What though are the trade-offs, what is it the firm has had to sacrifice in cutting back so swiftly?

Eli Harari

I think that -- we fundamentally maintain all of our strategic initiatives intact. We are doing fewer things with less resources using them -- those resources perhaps more focused. We went from individual business unit structure to an OEM organization, and a retail organization in central operations and central engineering, which used to be our organization before the acquisition of Msystems. And that really does eliminate a lot of duplicative functions. It’s basically the trade of between being most effective and most efficient. And we are I believe, we are more efficient now. And we simplified our market focus. We have certainly not slowed down in any of our technology, our 3D Read/Write, our 32 and 24-nanometer NAND, 3 and 4 bits for cell and on innovation, product innovation applications of the technology to decommoditize more and more of our future business.

Paul Coster JP Morgan

Okay. Judy, you mentioned that there were some inventory reserves. I think they were released in this first quarter. Can you just go back across them and sort of clarify, what if any impacts you have in gross margins?

Judy Bruner

Sure. I said that there was a net release of inventory reserves of $34 million. So, there was a benefit to cost of sales and to gross margins of $34 million. At the same time, I also said there was a charge to cost of sales in the first quarter of $63 million, which is our estimated cost of the fab under utilization in the second quarter. So, those were the two large unusual items in gross margins in the first quarter.

Paul Coster JP Morgan

Okay, got it. And then finally, I know you stepped away from this, but do you care to predict, what your future, your target gross, products gross, and operating margins are, now, or is it too soon to do that?

Judy Bruner

I'll tell you, it's too soon. We are really taking our guidance one quarter at a time at this point.

Paul Coster JP Morgan

Okay got it. Thank you.

Jay Iyer

Next question please.

Operator

We will go next to Bob Gujavarty with Deutsche Bank.

Bob Gujavarty – Deutsche Bank

Hey, thanks for taking my question. Just a follow-up on the charges. If I look at last quarter, you had about $388 million of inventory and under utilization charges. If I do the math correct, if I take the 63 plus the 34 benefit, net, net has dropped to 30, am I doing the math correct?

Judy Bruner

Yes.

Bob Gujavarty – Deutsche Bank

Okay. And then the other question is, what are you anticipating under utilization charges, obviously they dropped pretty sharply from Q4 to Q1, and Q2 do you think they will drop further?

Judy Bruner

Our current expectation is that, we will most likely utilize the fabs at full capacity in Q3 and Q4. Although, we have not locked that in as Sanjay said. So, if that turns out to be the case, then we would not take an under utilization charge in Q2, because we are taking it one quarter ahead of the planned under utilization based on that being a firm plan.

Bob Gujavarty – Deutsche Bank

Okay, fair enough. And then just finally on charges, clearly if pricing is flat to up, since you value inventory on the LCM. I would guess the $34 million benefit, you could see a similar type of benefit in your Q2 gross margin, correct?

Judy Bruner

That could be the case. As I said, the gross margins in Q2 will be heavily influenced by the pricing outlook that we have for the second half of the year when we reached the end of Q2.

Bob Gujavarty – Deutsche Bank

Okay. Fair enough. And thanks, that’s it.

Jay Iyer

Next question please.

Operator

We will go next to Kevin Vassily with Pacific Crest Securities.

Kevin Vassily – Pacific Crest Securities

Yeah, hi. Most of my questions have been answered. Can you walk again through the tax benefit that showed up in the quarter? What was the dynamic behind that appearing this quarter?

Judy Bruner

The tax?

Kevin Vassily – Pacific Crest Securities

The taxes on the bit.

Judy Bruner

Yeah. I don’t think there is anything too unusual. On a GAAP basis, we have a valuation allowance and we are not recognizing a tax benefit on our U.S. tax losses. However, on a non-GAAP basis, we are continuing to benefit the loss and we took a benefit at a rate of 28%.

Kevin Vassily – Pacific Crest Securities

Something about this quarter that allows you to take the benefit relative to prior quarters where there were losses…

Judy Bruner

We took a benefit on a non-GAAP basis last year as well. What’s different is that on a GAAP basis, the size of our loss at the end of 2008 was such that we will require to take a valuation allowance and we are not recognizing a benefit on a GAAP basis, However, on a non-GAAP basis, we are still recognizing a benefit. There is essentially not a rule on this with respect to a non-GAAP financial statement.

Eli Harari

It's much easier dealing with electrons than with GAAP, non-GAAP.

Kevin Vassily – Pacific Crest Securities

I would agree with that. Thank you. That’s all the questions I have. Thanks.

Judy Bruner

Okay.

Jay Iyer

Next question please.

Operator

We'll go next to Hendi Susanto with Gabelli & Company.

Hendi Susanto – Gabelli & Company

Thank you for taking my questions. Could you give us more color on the transition process that is going into a mix production of captive versus non-captive? For example, what will be the ideal mix, what kind of timeline can we expect and in theory how long may that take, and lastly what kind of gross margin difference can one expect?

Sanjay Mehrotra

So, like you’ve said in the past, that our ultimate goal is to get to a captive, non-captive mix of 70% captive to 80% captive. And in terms of the timeframe to meet this kind of decisions, we are always evaluating based on our demand projections and our own captive available supply. Typically, it means a lead time of about three to four months to make decisions related to non captive purchases and the gross margin impact of non captive purchase on captive is really very much function of the non captive supply pricing. Obviously, the cost structure of a captive would be much lower than the cost of the non-captive that you will purchase. Again for 2009, we are not really projecting much use of non-captive.

Hendi Susanto – Gabelli & Company

Okay and second question. Could you give us a range of how much Japanese yen currency impact can be in the second quarter?

Judy Bruner

As I said, the cost of the wafers that I expect will be recognized through cost of sales in the second quarter will be more expensive than the cost that was recognized in the first quarter, and that's because the yen rates were less attractive for us late in Q4 and early in Q1, and that's my estimate of the timing in terms of the wafers when they were purchased and then ultimately flowing through cost of sales in the second quarter. And it could have several points of impact on gross margins.

Hendi Susanto – Gabelli & Company

Thank you.

Jay Iyer

Next question please.

Operator

We will go next to Uche Orji with UBS.

Stephen Chin – UBS

Hi, thank you. This is Stephen Chin calling on behalf of Uche. Just a follow-up to the prior question, regarding the balance between non-captive and captive supply, so assuming you guys are able to ramp production back to full capacity by Q3 and Q4. And I would assume there is some type of mix of non-captive purchases. However, in terms of any further upside to demand in that case. What would be the plan for building a capacity in the second phase of fab four, first of all? And I guess, secondly what would be the capital that’s available as a means for financing that type of expansion at this point?

Judy Bruner

I would tell you. At this point, we are not thinking about plans for adding wafer capacity. We really want to get our model back to a mixed model of captive and non-captive and in the range of 20% to 30% non-captive, before we really begin to think about too much about new wafer capacity. So, I would tell you that's really a question for another day as opposed to today.

Stephen Chin – UBS

Okay. The other question I have was on the flow-through cost of starting up the 32-nanometer production line. I would assume if that you ramp production by Q2 timeframe, is there going to be a typical impact on R&D first of all and then flowing on to COGS by Q4?

Judy Bruner

I don’t expect any significant impact on R&D and I would tell you in terms of cost benefit, given the lag in our business model, the second half of 2009 will be I believe more impacted by the increasing mix of x3 versus x2 and the transition to 32 nanometer, would probably start to see some impact very late in the year and then falling into 2010.

Stephen Chin – UBS

Okay. And lastly just on the potential price increases that was referred to earlier. Is there a limit on how much you can raise pricing both in the OEM and retail channel under your contracts?

Sanjay Mehrotra

So remember we are always trying to balance our profitability objectives as our total volume inventory et cetera. So this is a careful balance and we are reevaluating it on a regular basis and making adjustments as appropriate.

Stephen Chin – UBS

Okay. Thank you.

Eli Harari

Yes, that is from the model versus the Wal-Mart. I mean basically with higher pricings, you lose market share but you have more profitability and what you do so, but any way, I think we've been balancing this over the last 20 years and we are very, very focused on getting to profitability. I think we have to wrap it up, really I appreciate you joining us today and look forward to talking to you again during the quarter and next quarter. Thank you.

Operator

Thanks for everyone. And that does conclude today's conference. You may now disconnect.

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