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SanDisk (NASDAQ:SNDK)

Q1 2013 Earnings Call

April 17, 2013 5:00 pm ET

Executives

Jay Iyer

Sanjay Mehrotra - Co-Founder, Chief Executive Officer, President, Director and Member of Special Option Committee

Judy Bruner - Chief Financial Officer, Executive Vice President of Administration and Member of Secondary Executive Committee

Analysts

John W. Pitzer - Crédit Suisse AG, Research Division

Timothy M. Arcuri - Cowen and Company, LLC, Research Division

James Schneider - Goldman Sachs Group Inc., Research Division

Craig A. Ellis - B. Riley Caris, Research Division

Ambrish Srivastava - BMO Capital Markets U.S.

Hans C. Mosesmann - Raymond James & Associates, Inc., Research Division

Bobby Gujavarty - Deutsche Bank AG, Research Division

Monika Garg - Pacific Crest Securities, Inc., Research Division

Joseph Moore - Morgan Stanley, Research Division

Steven Bryant Fox - Cross Research LLC

Doug Freedman - RBC Capital Markets, LLC, Research Division

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

Operator

Good day, and welcome to SanDisk Corporation's First Quarter 2013 Financial Results Conference Call. Today's conference is being recorded. And at this time, I'd like to turn the conference over to Mr. Jay Iyer with Investor Relations. Please go ahead, sir.

Jay Iyer

Thank you, Aaron, and good afternoon, everyone. With me on the call today are Sanjay Mehrotra, President and CEO of SanDisk; 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 www.sandisk.com/ir. Please note that non-GAAP to GAAP reconciliation tables and all applicable guidance will be posted in our website. This guidance is exclusive of any one-time transactions and does not reflect the effect of any acquisitions, divestitures or similar transactions that may be completed after April 17, 2013.

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 2012 and our subsequent quarterly reports on Form 10-Q. SanDisk assumes no obligation to update these forward-looking statements which speak as of today. I'd like to take this opportunity to let you know that we plan to hold our annual Investor Day meeting on May 8, 2013, and our second quarter results conference call on Wednesday, July 17, 2013. With that, I will turn the call over to Sanjay.

Sanjay Mehrotra

Thank you, Jay, and good afternoon, everyone. We are pleased to report a record first quarter revenue for Q1 2013, with our performance driven by robust sales of SSD products, which drove 20% of our sales, and by strengthening our retail channel, which also set a revenue record for the first quarter. Our results demonstrate substantial progress and continued diversification of our portfolio driven by growth in SSDs and the broadening range of embedded solutions.

We believe our first quarter achievements have positioned the company well for continued gains on multiple fronts throughout 2013. Starting with the specifics of the first quarter, I'm happy to report that combined sales of Client and Enterprise solid state drives tripled year-over-year.

For the client market, we have begun revenue shipment of our new 19-nanometer SSDs to the retail and B2B channels. We are also in various stages of OEM customer qualifications with our 19-nanometer Client SSD, and we expect to begin revenue shipments late in the second quarter. The Client SSD market continues to grow, driven by improving attached rates to our [indiscernible] in PCs, and SanDisk continues to gain share and momentum in this market.

SanDisk is particularly well positioned to benefit from 5x5 caching and standalone SSDs, both of which we supply to the vast majority of leading PC OEMs. Our Enterprise SSDs also posted strong year-over-year and sequential growth, setting a second consecutive record for quarterly revenue. In the first quarter, for the first time, the majority of our Enterprise SSD revenue was derived using captive memory supply. These products are built with our 24-nanometer memory, and we expect to launch our next-generation SaaS and PCIe SSDs manufactured on our 19-nanometer technology in the second half of this year.

In the mobile market, we achieved strong year-over-year growth in our embedded sales as our portfolio offered a wide array of solutions to our customers. Design wins incorporating iNAND MCP, which is our iNAND embedded flash drive packaged with mobile DRAM, continue to increase to address the growing market for budget smartphones. We are also successfully extending our removable product segmentation strategy to embedded solutions as reflected in the most recent announcement of reference design win for the iNAND Extreme Embedded Flash Drive with NVIDIA's Tegra processor for tablets. In the first quarter, the combined sales of our iNAND discrete and iNAND MCP product lines increased substantially on a year-over-year basis.

Turning to mobile cards, we achieved significant progress in establishing the high-performance mobile card category in the retail channel with our branded Ultra microSD cards. In particular, due to the rapidly expanding base of Android devices, the majority of which also have card slots, we leveraged our broad market presence to drive strong growth in unit sales of our SanDisk Ultra mobile cards. This product line now represents an increasing mix of our mobile cards sold through retail. I would also like to point out that as the rate of card bundling with mobile devices and OEMs have declined, we have seen sustained increases in mobile card sales through the retail channel and at substantially higher average capacities.

Overall, in the retail channel, we achieved record first quarter revenue performance driven by market share gain and very strong year-over-year revenue growth from imaging and mobile cards, as well as from USB flash drives across all regions.

Additionally, the revenue mix of our high-performance products in retail increased by nearly 20 percentage points to over 40%. Our broad global footprint, diversified product portfolio and brand strength are key differentiators for our global retail offering and together represents a unique competitive advantage for the company.

Turning to manufacturing, our 19-nanometer technology remains the dominant production node in the first quarter and we anticipate continued high usage of 19-nanometer technology throughout 2013. We expect to begin initial production of 1Y nanometer technology late in the third quarter. We will review more details related to our 1Y and future technologies during our upcoming Investor Day on May 8.

Looking at supply bit growth estimates, we continue to believe that the 2013 industry supply bit growth rate will be in the range of 30% to 40% and that our captive supply bit growth will be meaningfully below that range. We expect a healthy demand-and-supply balance and a favorable pricing environment in 2013. We have decided not to add new wafer capacity in Phase I of Fab 5 during the remainder of 2013. Instead, concentrating our efforts on completing the remaining 19-nanometer transition, beginning the 1Y nanometer transition and making continued improvement in fab productivity.

Given the increased manufacturing equipment requirements of 1Y, we expect to utilize the remainder of the clean room space in Phase I of Fab 5 to continue the 1Y transition in the 3 Yokkaichi fabs. We expect that the Phase I Fab 5 clean room will be approximately 75% full by the end of this year and ultimately will be completely filled by the equipment required for the Yokkaichi 1Y transition.

We continue to make good progress in our 3-pronged memory technology strategy, which includes cleaner NAND scaling, 3D Bics NAND and 3D resistive RAM. As we consider future clean room space requirements, we will need additional space to complete the 1Y technology transition and to enable transitions to 1Z nanometer for Fab 3, Fab 4 and Phase I of Fab 5 and potentially for Bics NAND technology as well, once it is ready for manufacturing. While we have not made a final decision, we now expect to begin construction of the Fab 5 Phase II shell sometime in the second half of this year, with construction expected to take 7 quarters. Phase II of Fab 5 is not expected to contribute any meaningful incremental wafer capacity for SanDisk in 2014.

In closing, we ended the first quarter of 2013 in a position of increased competitive and financial strength. Our markets remain healthy, growth drivers are diverse and strong, and we remain focused on prudently managing our capacity, driving profitable growth and creating shareholder value. I look forward to meeting many of you at our Annual Investor Day on May 8. With that, I will turn the call over to Judy for her financial review and outlook.

Judy Bruner

Thank you, Sanjay. Our strong first quarter results reflect the benefit of our broadening product portfolio and our disciplined capacity management. The key highlights of the quarter included our SSD product revenue, which grew over 200% on a year-over-year basis, and the continued strengthening of our global retail channels which produced year-over-year revenue growth of 34%.

Our record first quarter revenue grew 11% year-over-year, with petabytes sold up 36% and ASP per gigabyte down 18% from Q1 last year. Sequentially, revenue was seasonally down 13% with petabytes sold down 16% and ASP per gigabyte up 2%, reflecting strong supply-demand balance and an improving product mix. This is the first time in our history that ASP per gigabyte has gone up sequentially for 2 quarters in a row.

Our Q1 blended price increase was driven by an increased sales mix of SSDs, as well as real price increases in several parts of our business, partially offset by a decline in the ASP of our retail sales due to mix. Our retail channel ASP declined sequentially due to a seasonally lower mix of imaging cards, a higher mix of USB sales and emerging markets business and also due to the strong growth in the average capacity of our retail products. While our overall blended retail ASP was down sequentially due to these mix factors, we did raise ASPs for many of the retail product lines, and retail delivered strong gross margin in Q1.

As I described last quarter, we are now reporting the channel mix of our revenue as retail and commercial. The commercial channel includes OEM customers, B2B customers, direct enterprise customers and licensees. Our total Q1 revenue was 62% commercial and 38% retail, reflecting a year-over-year mix shift toward retail of 6 percentage point driven by our strong growth in that channel.

Our first quarter commercial revenue grew year-over-year by 1% to $829 million with product revenue up $2 million and license and royalty revenue up $3 million. Within commercial product revenue, SSDs produced the strongest growth and embedded sales grew 30% year-over-year. The growth from SSDs and embedded products was largely offset by a continued decline in OEM bundled card revenue as well as a shift away from white label OEM cards and wafers in order to prioritize memory supply for SSDs and embedded.

Our license and royalty revenue was over $102 million, reflecting a seasonally strong Q4 for flash sales and also benefiting from higher one-time payments from system licensees, partially offset by a continuing decline in royalties related to the card market.

Our first quarter retail revenue grew 34% year-over-year to $512 million with the highest dollar growth coming from mobile cards. As Sanjay described, we believe that consumers are increasing their purchases of retail mobile cards due to the limited card bundling by OEMs, and our leading retail presence enables us to fulfill a large share of this demand, which tends to be higher-capacity and higher-performance cards than in the bundled market. The average capacity of our mobile retail cards in Q1 was over 11 gigabytes compared to less than 6 gigabytes for mobile cards in the commercial channel. Our year-over-year retail sales growth was also very strong for USB drives, client SSDs and imaging cards, and regionally, our retail revenue delivered substantial year-over-year growth in all major regions.

Our non-GAAP gross margin increased from 39.9% in Q4 to 40.5% in Q1. Our product gross margin remained approximately constant sequentially, with license and royalty revenue driving the sequential increase in total gross margin. Both our ASP per gigabyte and our cost per gigabyte increased 2% sequentially, with the increase in both metrics driven largely by product mix.

Looking at the components of our product costs, our flash memory cost per gigabyte improved modestly, with this sequential improvement more than offset by an increase in our non-flash cost per gigabyte. Our mix of 19-nanometer and X3 memory remained approximately constant on a sequential basis with the improvement in our flash memory costs driven by the usage of higher average capacity die and a slight improvement in our yen rate from 79 to 81. So far, almost all of our SSD products sold have been manufactured using 24-nanometer technology. As we begin to transition our OEM client SSDs to 19-nanometer late in Q2, as Sanjay described, we will have more opportunity to increase the 19-nanometer mix, which will contribute to cost reduction.

The increase in our non-flash cost per gigabyte came primarily from an increased sales mix of SSD and MCP products. In comparison to our traditional product mix, SSDs carry a higher cost on a cost [ph] per gigabyte basis for non-flash cost such as those related to transformation and test and the controller and PCB materials. And, of course, our MCP products carry a higher non-flash cost due to the non-captive mobile DRAM.

On a year-over-year basis, our non-GAAP gross margin increased by almost 500 basis points, with cost per gigabyte down 24% compared to the 18% decline in price per gigabyte. Our Q1 non-GAAP operating expenses were $255 million, equal to our previous forecast. The sequential increase in R&D expense came primarily from SSD development and memory technology and design. Sales and marketing expenses were sequentially down due to seasonally lower spending on branding and merchandising.

Our Q1 non-GAAP operating margin was a healthy 21.5% and the non-GAAP tax rate was 29%, including a one-time Q1 benefit from the retroactive passage of the 2012 R&D tax credit. Our diluted share count increased sequentially by 1.4 million shares as option exercises and employee stock purchases outweighed our increased share repurchases during Q1.

On the balance sheet, gross cash and marketable securities increased in Q1 by almost $500 million to nearly $6.2 billion, bringing net cash to over $4.2 billion. Our inventory balance decreased modestly in Q1, and we are supply-constrained in several areas. With solid profits and strong balance sheet management, cash flow from operations in Q1 was $474 million, our highest ever first quarter cash flow from operations. And we also received $54 million of repayments from the joint ventures. We spent $48 million of cash on property and equipment during Q1, primarily for test equipment and facilities outfitting, and our share of joint venture fab investments was approximately $50 million which was funded by the joint ventures.

The joint ventures did not take out any new leases during Q1, and our share of off-balance sheet lease obligations was reduced to $743 million. We spent $90 million on share repurchases during Q1 to repurchase 1.76 million shares at an average price of $50.97.

I'll now turn to forward-looking commentary. Based on our decision to add no new wafer capacity beyond productivity improvements in 2013, we expect to be supply-constrained for the remainder of the year. We anticipate a very modest level of price decline in 2013 due to our expectation of continuing favorable supply-demand balance coupled with an increased year-over-year mix of SSD and embedded product sales, as well as high-performance retail product sales. We expect our second quarter revenue to be between $1.35 billion and $1.4 billion. This is the narrow range reflecting supply constraints and also a sequentially lower level of SSD revenue in the second quarter due to lumpiness in the timing of sales to certain customers. For the full year, we are raising our estimated revenue range to $5.6 billion to $5.75 billion.

We expect our second quarter non-GAAP gross margin to be 41% to 43%, reflecting the positive impact from our hedged yen rate of approximately 86 compared to 81 in the first quarter, partially offset by a lower mix of license and royalty revenue as card market royalties continue to decline and without the benefit of certain one-time royalties in Q1. We expect gross margins to increase further in the second half of the year, and we are raising our estimate of full year 2013 non-GAAP gross margin to 42% to 44% with the midpoint 200 basis points higher than our previous estimate. The increase in our 2013 gross margin range is due primarily to our expectation of a continued strong pricing environment and a weaker yen in the second half, and also takes into account increases in demand mix and costs for certain embedded products such as MCPs, which we have developed for our strategic customers and that have a lower-than-average gross margin. With respect to the yen, we have locked in approximately half of the purchases that will impact our Q3 cost of sales at a yen rate of approximately 95. The second half of our Q3 and all of our Q4 yen-based cost of sales are unhedged and subject to market exchange rates.

I want to elaborate a bit further on the yen and describe 2 factors which are reducing the future impact of changes in the yen exchange rate on our gross margins. First, as the yen continues to weaken, the yen-based proportion of our cost of sales is naturally shrinking. Second, with our mix of sales evolving toward products that have a higher proportion of non-flash costs, this is also reducing the yen-based proportion in our cost of sales. Because of these 2 factors, the impact of a 10% movement in the yen to dollar exchange rate is currently about 300 basis points in our gross margins compared to our previous estimate of 400 basis points.

In summary, the midpoint of our 2013 non-GAAP gross margin of 42% to 44% has increased by approximately 900 basis points from 2012.

Turning to expenses, we continue to expect 2013 non-GAAP operating expenses of approximately $1.05 billion, with Q2 expenses forecasted at approximately $260 million. And we expect the non-GAAP tax rate for the remainder of the year to be approximately 32%, 1 point higher than our previous forecast due to stronger profitability.

Our stock price is now above the $52.37 conversion price of our 2017 convertible debt. While we hedge the conversion price to approximately $73, accounting rules require us to include potential dilution from the 2017 convertible debt in our diluted shares without an offset from the hedge. We expect to continue utilizing our share repurchase plan in Q2. However, we now expect our diluted share count to increase sequentially by approximately 2 million shares in Q2 due to the convertible debt accounting. We plan to spend quite a bit more on share repurchases in 2013 than we did in 2012, with the objective to at least offset dilution from employee incentive awards.

We expect 2013 capital investments to be similar to our previous estimates, and I will share more details on our capital investments at our May 8 Investor Day. One last comment related to the balance sheet and use of cash is the reminder that in Q2, the first of our convertible debt offerings will mature and we will utilize $928 million of cash to pay off the remaining principal. We do not expect to issue any shares in connection with the retirement of this convertible debt.

In closing, we are pleased with our strong first quarter results and expect to deliver further growth across the year in both revenue and profitability. We will now open the call for your questions.

Jay Iyer

Thank you, Judy. Thank you, Sanjay. Aaron, can you open the floor for questions, please?

Question-and-Answer Session

Operator

[Operator Instructions] We'll go first to John Pitzer with Crédit Suisse.

John W. Pitzer - Crédit Suisse AG, Research Division

Sanjay, I wondered if you could talk a little bit, now that you've made the decision not to move forward with additional wafer starts in 2013, what were the puts and takes behind that? Was that really a function of looking at shrinks that could get you the capacity you needed? Was it more of a view on the supply-demand environment for the overall industry? And just remind us the bit growth you're targeting this year and how we should think about 2014.

Sanjay Mehrotra

The bit growth that we are looking at this year, as we have said, for the industry is in the range of 30% to 40%, and the SanDisk bit growth is meaningfully less than the industry number that we have given you. Our decisions regarding growing our bits during 2013 are certainly, first, very much focused on technology transitions because technology transitions really give you the lowest cost and most efficient way of growing the bits and toward the maximum -- the investments made in technology transitions toward the maximum ROI on the longer term. So we prefer technology transitions to drive bit growth.

When we look at capacity additions, the decisions that we really need to consider there for new capacity are, of course, the demands, trends projected for the business and the industry environment, including the pricing environment that is expected in the future, the center of our technology transitions, the technology roadmap of the future, as well as the ROI on the new investments we made in new capacity. And regarding the ROI for new investments and new capacity, at this point, it is very important to assess that carefully because NAND's future technology roadmap beyond 1Z is certainly -- is not certain, and the 3D technologies of the future are in -- still in early stages of development. It's not clear that how much of the toolset of those 3D technologies will be usable. It will be common with the NAND memory production. Therefore -- and the 3D technology in there also, 2 to 3 years away from any meaningful production. That's why it's very important to assess the ROI on any new capacity at this point, and we continue to favor investments in new -- in technology transitions for growing our bits. We feel very comfortable with the plans that we have for capacity this year and our technology transition status for the future, together with our focus on continuing to strengthen the mix of our business in terms of driving toward higher value solutions such as solid state drives, embedded solutions, as well as our high-margin retail businesses.

John W. Pitzer - Crédit Suisse AG, Research Division

Helpful, Sanjay. And I guess as my follow-up for either you or for Judy, you guys talked a little bit about your pricing expectations for all of 2013. Just kind of curious, given that we've just gone through what's normally the seasonally weak period for pricing in the NAND market with much better results in the March quarter than normal, how do you think pricing trends from here on a sequential basis?

Judy Bruner

I don't want to give any specific projections of pricing on a quarterly basis, but I would say that our expectations are that the level of price decline this year in the industry will be lower than we've ever seen before in the history of this industry. And so we believe that, coupled even with much lower bit growth than we've also seen before is allowing us to strengthen our business in terms of growing the top line and growing the bottom line and delivering strong cash flow. So we really feel very good about the business model that we're able to drive even with much more modest bit growth given this pricing environment. And clearly, we think our disciplined approach to capacity management plays a key part in this.

Operator

We'll go next to Timothy Arcuri with Cowen & Company.

Timothy M. Arcuri - Cowen and Company, LLC, Research Division

Can you give us what the absolute wafer start capacity assumption is for the up [ph] 30% to 40% industry bit growth?

Judy Bruner

Well, I don't want to necessarily give a total industry wafer capacity. I think you can find some of those numbers out there. But I will tell you that our own wafer capacity today is a little below 2.5 million wafers per year. And through productivity improvements that we are working on this year, which includes installing some bottleneck tools, we expect to be able to exit this year at about 2.6 million wafers per year capacity.

Timothy M. Arcuri - Cowen and Company, LLC, Research Division

Great. And then just second question on quadbit, we've heard that you're shipping some of these into the market. Can you just talk a little bit about is that just another way for you to meet demand without adding wafers? And is that targeted at a particular market?

Sanjay Mehrotra

I'm not very sure what you mean by quadbit. In case you meant for 4-bit per cell, like X4 technology that we had in the past, I want to be clear that we are not shipping any quadbit products today. All of our memory production is 2-bit and 3-bit per cell technology, what is commonly referred to as X2 and X3. And we lead the industry in 3-bit per cell X3 production. And there is no quadbit, if that means 4-bit per cell technology, in the industry and production. The applications that the marketplace has today require very high performance, high reliability from memory technology and memory product solutions, and the technologies that are most suitable to address the industry applications, industry demand drivers today are X2-based and X3-based technologies and products.

Operator

We'll go next to James Schneider with Goldman Sachs.

James Schneider - Goldman Sachs Group Inc., Research Division

Thanks very much for the clarity on the Fab 5 plans. Related to that, though, could you help us understand by the end of this year, exiting the year, either on a bit shipments or on a wafer starts basis, what proportion of your capacity will have been shifted to 1Y technology?

Sanjay Mehrotra

1Y technology will start production in the third quarter. And even in the fourth quarter, the 1Y production level will be very small to really call out, so 1Y technology contribution for 2013 wafer output will be very small. And as a percentage of our total -- of our production exiting the year also, it will be small. 1Y will be ramping up primarily during the course of 2014 and perhaps some in 2015 timeframe as well.

James Schneider - Goldman Sachs Group Inc., Research Division

That's helpful. And then as a follow-up, obviously, there are a lot of moving parts, as you mentioned, in terms of your cost per bit reduction because of the mix of SSD changing up and down. Can you help us understand what the expectation should be for cost-per-bit declines for maybe this next quarter and for the broader year if we exclude Japanese yen effect?

Judy Bruner

Exclude the Japanese yen. So the cost per bit improvement this year, I believe, will be lower than we've ever seen before, similar to my comment that the decline in price per gigabyte, I believe, will also be lower than we've ever seen before.

And as you just saw in the first quarter that we reported, our cost per gigabyte actually went up 2%, driven largely by product mix. So the factors that are going to impact our cost-per-gigabyte improvement this year, and I do believe we will have improvement on a year-over-year basis, are that we will have some modest amount of technology transition primarily coming from continuing the remaining amount of 19-nanometer transition, very little, if any impact, in cost of sales from 1Y production this year. And that technology transition impact coming primarily from 19-nanometer will be offset somewhat by a decreasing X3 mix in terms of our output given the product requirements for the demand that we see this year, and it will be also offset somewhat by the increasing mix of products that we're selling that have increased non-flash contents, such as SSDs and MCPs. So those are some of the key factors and the -- and, of course, the yen is helping the cost improvement. But even with the inclusion of the benefit of the yen, I still expect that our improvement in overall cost per gigabyte will be very much below the levels we've seen in the past.

Operator

We'll take our next question from Craig Ellis with B. Riley.

Craig A. Ellis - B. Riley Caris, Research Division

Sanjay, oftentimes pricing this robust has encouraged manufacturers to add more capacity. Your outlook for industry bit growth this year is flat versus 3 months ago. What do you see out there that gives you confidence that competitors are going to stay fairly disciplined with capacity growth?

Sanjay Mehrotra

I think, certainly over the course of last several quarters, if you look at the industry trend, there has been disciplined exercise, I believe, in the industry for adding capacity. The demand drivers continue to grow very well in the industry. Looking at the future, the smartphones, tablets and SSDs, and Client computing as well as Enterprise continue to drive the demand side very well. And on the supply side, certainly, I can speak for our sales reps in attendance that the technology challenges are getting more and more complex. What you gain from technology transition in terms of gigabytes per wafer is reducing, as well as the capital intensity, for example, for 1Y node, is increasing. So then, one has to definitely be looking than making decisions on new capacity additions, as I mentioned before, has to be looking at ROI consideration. That's what we focus on. And that, in light of the increasing complexity of the technology and uncertainty of NAND scaling. And while before 3D in the industry becomes meaningful production, it really needs to be assessed very carefully and that's how we look at it. And I believe those are the kind of factors that are common to the rest of the industry as well.

Craig A. Ellis - B. Riley Caris, Research Division

That's very helpful. And then as a follow-up question for either you or Judy, the company had established a product mix target for the SSD business of 25% of sales for next year. You're already at 20%. Should we be revisiting that target and can you really get to a 25% level or even higher potentially this year with SSD?

Judy Bruner

So as I mentioned in my prepared remarks, we do expect that we will see some decline in our Client SSD revenue from Q1 to Q2 due to the lumpiness of sales to certain customers. So we continue to believe that we will be able to do more than 15% mix of SSDs this year in 2013. And at present, our objective for 2014 remains at 25% or more.

Operator

We'll take our next question from Ambrish Srivastava with BMO.

Ambrish Srivastava - BMO Capital Markets U.S.

I had a question on margins, Judy, and I just want to make sure I was clear on it. So the yen impact is reduced because of the non-flash component growing. I just want to understand, that's for this year that's based on the 50% SSD. Does that become a headwind next year as well, as SSD goes to 25%, and I mean headwind to margins?

Judy Bruner

So I want to be clear that the diminishing impact of a movement in the yen-to-dollar exchange rate is due to 2 factors. And one is the increasing non-flash memory content of our products, such as SSDs and MCPs. And the other is actually the weakening of the yen itself. As the yen becomes weaker and weaker, of course, then that lowers the proportion of our cost structure that comes from yen. And so both of those factors lead to a lower mix of our cost of sales being yen-based. And therefore, when the yen moves further, it has a dampening effect on the impact. But I wouldn't necessarily call it a headwind. I mean, we still are getting favorable benefit from the weakening yen. I just wanted to clarify that it's not quite as much of an impact as we had measured last quarter when we were measuring an impact of the yen going from a 2012 rate of 79 to a rate at the time which was in the sort of 85 to 90 kind of range. And then since then, the yen has continued to weaken further.

Ambrish Srivastava - BMO Capital Markets U.S.

Okay. And the follow-up is a quicker one. What's the mix between Client and Enterprise in your SSD business?

Judy Bruner

We haven't broken that down specifically, but we have said that the Client SSD revenue is a bigger portion of our SSD revenue today.

Operator

We'll take our next question from Hans Mosesmann with Raymond James.

Hans C. Mosesmann - Raymond James & Associates, Inc., Research Division

Just to go back to the 1Y dynamic in terms of increased capital intensity, how much more is it relative to, say, 19-nanometer previous nodes and how much more will it be when you go to 1Z, if you do go to 1Z?

Judy Bruner

So the increased capital requirements for a tech transition to go to 1Y as compared to 19 is actually significantly higher in terms of CapEx, and we would -- we're going to provide more granular detail on this at our Investor Day because it provides a -- it takes a little more time to explain the details of this and provide the context. I will tell you that when we go to 1Z, 1Z also will have a high capital requirement for a tech transition as compared to what we've seen in the past. However, we do believe that the 1Z capital requirement will be a little bit less than the 1Y capital requirement. But both will be high as compared to what we've seen as historical norms.

Hans C. Mosesmann - Raymond James & Associates, Inc., Research Division

Okay, and then as a quick follow-up. In terms of 3D technologies, I think Sanjay mentioned that it's 2 or 3 years out. Could it be more than that? Is that an industry kind of observation or is that specific to SanDisk?

Sanjay Mehrotra

I believe that meaningful production of 3D technology and here I'm, of course, referring to BiCS kind of 3D NAND technologies, meaningful production is 2 to 3 years out. Of course, some pilot line level of production can begin earlier because that what it would take to demonstrate the viability of the technology. But any meaningful production in 2 to 3 years away in the industry because meaningful production requires not just a technology. It requires all the application, all the system-level solution to be ready and for the technology to be adopted by the host of applications that exist out there. And if we speak about 3D resistive RAM technology, that is farther out. It is still in very early stages of development. And as we have said before, it requires EUV technology and EUV technology from becoming really cost-effective for byte adoption and production is also a few years away. So 3D NAND technologies in the industry, I believe, 2 to 3 years away before they become meaningful.

Operator

We'll take our next question from Bob Gujavarty with Deutsche Bank.

Bobby Gujavarty - Deutsche Bank AG, Research Division

I was just curious a little bit about the SSD business, really strong performance, above seasonal in 1Q. How do you characterize kind of the 2Q pause? Is it more attach rates are kind of plateauing before they start going up again? Is it a qualification issue where you're trying to qualify some more 1Y products? Just, if you could characterize a little bit of the speed bump in 2Q.

Judy Bruner

I would characterize it as really just a timing of the sales to a customer, and it's a large customer for us. It's not really a speed bump in terms of demand in the overall marketplace.

Sanjay Mehrotra

But actually it's for SSDs in laptops and PCs really continue to build up very nicely. New platforms are being designed with Haswell processors. You know this will come out later in the second half of the year, and SanDisk is well-positioned in SSD business and we continue to gain share in this market.

Bobby Gujavarty - Deutsche Bank AG, Research Division

Maybe a quick follow-up, then. Maybe what would you kind of estimate the kind of the attached rates are today and how does that look out over the course of the rest of the year from your perspective?

Sanjay Mehrotra

I think about, if you look at 2012 numbers and the third-party reports, about 10% of the total notebook had SSDs or flash in them. And that number is increasing dramatically. I think total Client SSD demand last year was like 50 million units, this year increasing to 80 million units. So this continue to increase rapidly in 3 to 4 year timeframe, I think by 2015, 2016 timeframe, third-party reports show that increasing to about 35% or so.

Operator

We'll go next to Monika Garg with Pacific Crest Securities.

Monika Garg - Pacific Crest Securities, Inc., Research Division

Just a clarification from the last question. When you talked about attach rate, was it pure SSDs or pure -- all, including pure and dual drive or hybrid, both [ph] ?

Sanjay Mehrotra

Anything that is using flash.

Monika Garg - Pacific Crest Securities, Inc., Research Division

Okay. Would you -- could you share like what do you think the transition of pure SSDs could do over the next 3 or 4 years?

Sanjay Mehrotra

Pure SSDs are definitely continuing to increase nicely, and that's where actually there's a very strong penetration ahead for pure SSDs. SanDisk is a supplier of a standalone SSDs, what you refer to as pure SSDs, as well as caching solutions. The bigger growth, the bigger attach rate is in the standalone SSD area. Caching solutions also continue to be a large part of the market, and in 2013 and 2014 timeframe certainly, they'll continue to be growing as well.

Monika Garg - Pacific Crest Securities, Inc., Research Division

Just a last question here. ESMO [ph] talked about that they expect NAND capacity orders in second half. They put some number to it, 100,000 as a start, which is about 10% of industry capacity. So are you taking this kind of number in your expectations when you guide to 30% to 40% bit supply growth for industry in 2013?

Sanjay Mehrotra

So for 2013, the 30% to 40% bit growth for the industry, our estimations do include certain level of capacity additions in the industry. And let me just point out that demand drivers for flash are very strong and are projected to be strong in the future years as well. And that, at some point, will certainly require new capacity addition in the industry. And, of course, those capacity additions have to be looked at from the point of view of ROI which, as I mentioned before, needs to be assessed very carefully. But when you look at demand trends and look at the capacity projections in the industry, I believe that there will be a continuing healthy demand-supply balance in the industry, not only in 2013 timeframe but also in 2014 timeframe.

Operator

We'll go next to Joseph Moore with Morgan Stanley.

Joseph Moore - Morgan Stanley, Research Division

I want to make sure I understand the SSD cost and margin issues. Can you talk about where SSD margins are relative to the corporate average? Are they a little higher, a lot higher? And then can you clarify the cost issue, what are the non-NAND cost that we should be focused on?

Judy Bruner

Sure. In the Enterprise SSD business, the gross margins that we're generating in that business now are definitely above our corporate average. In fact, they are the higher -- highest gross margins in terms of our different product categories, especially now that we've transitioned the majority of our Enterprise SSDs to our own captive flash. In terms of Client SSDs, those gross margins tend to be around the corporate average. So in terms of the higher cost that we mentioned a couple of times and I think you're questioning about, SSDs have a higher cost per gigabyte than our traditional products. They also have a higher price per gigabyte than our traditional products. So as the mix shifts to more SSDs in our business, it dampens the cost-per-gigabyte improvement metric. It also dampens the price-per-gigabyte improvement metric. So both of those metrics get influenced quite a bit now by the changing mix of our products business. But -- so don't be mistaken and think that SSDs are reducing gross margins. It's just that they change those 2 metrics quite a bit. And then they also tend to have higher non-flash memory cost, non-flash costs on a cost-per-gigabyte basis because they have higher cost for transformation, assembly and test. They have higher cost in terms of things like the controller cost and the PCB. So that's really another factor in the cost.

Joseph Moore - Morgan Stanley, Research Division

Okay, that's very helpful. And you said both cost and price per gigabit will be higher. Is the gross margin dollar-per-gigabit higher than corporate average?

Judy Bruner

Yes, they generate strong gross margin dollars, yes, on a per-gigabyte basis.

Operator

We'll take our next question from Steven Fox with Cross Research.

Steven Bryant Fox - Cross Research LLC

Two questions. First of all, I just wanted to clarify some of the comments about the yen for the second half of the year. You said that you're looking at it being unhedged later in Q3 and Q4. Is that sort of locked in that you're going to leave it that way or could you pursue some sort of hedging strategy that you just haven't come to a conclusion on? And then secondly, just looking -- just to round out the conversation on the mix. Given the weaker mix in this quarter and given some of the trends you talked about for the second half of the year, can you sort of walk through how the mix should improve second half of the year versus the first quarter? It seems like it can get better in the second half of the year versus what you just did. And what other the things you should look out as sort of caution against the mix improving from these levels?

Judy Bruner

Okay. So first, on the question about hedging of the yen, we are monitoring this on a really day-by-day basis as we go. We have been purchasing our yen more frequently than in the past in order to try to benefit from or to average the changes in the cost, and we have been purchasing a little bit ahead but not too far ahead. And so that's why as I've said, we have locked in half of the wafer purchases that we estimate will impact our Q3 cost of sales but not beyond that. We could decide, at some point, to change that approach and to hedge or lock in more. But so far, that has been what we've done. And generally, we have believed so far that there is not that much risk of a big appreciation in the yen, and therefore, we have not locked in too far into the future. But we could change that at any point in time, and we're always monitoring the situation. Your second question was about a weaker mix in the first quarter and might it improve in the second half. And I'm not...

Steven Bryant Fox - Cross Research LLC

Well, weaker mix in the second quarter from the first quarter. So I guess, my basic question is the mix in the first quarter, it seems like there's an opportunity for the mix to get even better or more favorable for gross margins in the second half of the year versus what you just posted in the first quarter, even that though there's a step back in Q2. And I was wondering if you could just sort of discuss that possibility.

Judy Bruner

Well, I wouldn't necessarily call the second quarter a weaker mix than the first quarter. What I said is that we expect Client SSD revenue to be somewhat less in the second quarter than in the first quarter, but I also said that Client SSDs tend to have a gross margin around the corporate average. So in that regard, I wouldn't necessarily call it a weaker mix one way or the other in terms of the impact on gross margin. Is that what you're asking or something else?

Steven Bryant Fox - Cross Research LLC

Well, actually what I'm getting at is just if I look at the second half of the year, kind of it seems like there's opportunities for the mix to improve further given how strong of a start SSD demand is and how you're improving on the Enterprise side with some of the new product introductions and also what you mentioned about retail.

Judy Bruner

We would expect to continue to be able to grow our Enterprise SSD business, and our retail business is generally stronger in the second half of the year than in the first half of the year. So in both of those areas, yes, that has been built-in to our expectation for both revenue and for gross margin for the year.

Operator

We'll go next to Doug Freedman with RBC Capital Markets.

Doug Freedman - RBC Capital Markets, LLC, Research Division

To better understand what's happening in the business, Judy, can you share with us what you're seeing in terms of the ASPs in terms of the profile? What is -- last year, we saw real divergence, I believe, in the market where high-quality bits were very expensive and retail low-quality bits were very inexpensive. Can you talk about what you've seen this quarter? Is that range tightening? Can you share with us maybe what the most expensive bit is selling for and what the lowest cost bit is selling for and how that's changed?

Judy Bruner

I would say our retail products actually command a very strong price per gigabyte. So I think when you are talking about these big divergences and you mention retail, I think you're talking more about what's being sold on the spot market in terms of components or cards sold to a white-label provider or wafer prices sold on the spot market. And actually, we, as I mentioned, have pulled away somewhat and we've reduced our supply allocation to those markets in order to prioritize our supply to market, such as embedded products and SSD products, as well as our branded retail where we command a strong price premium.

Doug Freedman - RBC Capital Markets, LLC, Research Division

So, I mean, is my takeaway that you've not seen a very big divergence or a big range in ASPs achieved in the different end markets?

Judy Bruner

There actually are relatively strong prices available today in the spot market because of the tight supply-demand balance in the industry. So in that regard, I would suggest maybe the difference that you're speaking of from past year that, that difference has been reduced because of the tight supply-demand environment.

Sanjay Mehrotra

And I would just say that the pricing environment is healthy in all segments, that flash memory as of today.

Doug Freedman - RBC Capital Markets, LLC, Research Division

All right, terrific. If I could move on to another point, can you discuss with us what your strategy is in terms of controllers in your SSDs? What percentage presently are shipping with controllers that you're building internally versus those that you're sourcing from the merchant market?

Sanjay Mehrotra

So our Enterprise SSDs are, as we have said before, designed and manufactured with all controller that are in-house controllers. Our Client SSDs use a mix of internal SanDisk-developed controllers, as well as third-party controller ESS. Even when we have third-party controllers ESS, we do have our own firmware. There's a lot of frequent source of managing the flash memory aspects using a firmware. So SanDisk in Client SSD has a mix of internally developed and third-party purchased controllers. I can't really break down the mix of internal versus external controllers for our Client SSDs, but our strategy is to continue to leverage in the Client SSDs space internal and external controllers because we made those efficient based on best time-to-market opportunities for our products.

Operator

We'll take our next question from Daniel Amir from Lazard Capital.

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

So a question here about your competitive position in the SSD market. More on the Enterprise side, given that this is an area that you've been focusing more in the past year. It looks like you're coming out with a PCIe at 19-nanometer. Can you expand a bit more there? And I have one follow-up.

Sanjay Mehrotra

So in the SaaS market, which is what Pliant originally had products in when we acquired them. We have continued to expand the fab customer base for our products, and the revenues today are derived almost all from SaaS-based solutions in enterprise-based. PCIe and Enterprise SATA, these are opportunities for us in the future. Today, our revenue from PCIe is negligibly small, but clearly it's a large market and we are excited about our next-generation products that we will be bringing to market in the second half of this year. And it will give us an opportunity to begin to gain share in this market and grow our revenues. Our focus very much is on leveraging our vertical integration, deep knowledge of flash memory applied to the controllers and systems, and including firmware for our Enterprise SSD products both in fab, PCIe solutions. And looking ahead, we should -- with high-performance solutions and high-capacity solutions, we should be able to -- and high-reliability solutions as well, we should be able to position ourselves well in this market space.

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

Great. And on the retail side, I mean how much is the strength here in the retail here for Q1 is a Q1 phenomenon, and how much of it is a trend you believe basically will continue throughout the year, and this could be a very strong year in retail overall?

Judy Bruner

I would say it's -- I wouldn't characterize it as a Q1 phenomenon. As you know, typically, Q1 has been our weakest quarter in terms of the retail business. And our retail business is down sequentially Q4 to Q1, but the year-over-year strength of 34% growth in our retail business is really just phenomenal. And I would say, we've been gaining share. And as Sanjay commented, we have really increased the mix within the retail business of high-performance products. So we've done very well in terms of segmenting the products that we sell in the retail, and we have increased our share and penetration of emerging market over the last couple of years. So really, I think we've been firing on all cylinders with respect to our retail performance.

Operator

Our final question today comes from Mehdi Hosseini with SIG.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

Given the tight supply-and-demand environment, Sanjay, do you see a situation where your -- some of your customers are willing to sign a longer-term contract and, unlike the past 2 decades, we'll see a different dynamics developing? And I have a follow-up for Judy.

Sanjay Mehrotra

We don't comment on specific customers' contracts or agreements. But what I'll tell you is that, of course, the NAND flash supply is tight, and customers are certainly focusing on making sure that for their going flash requirements, the supply can be sourced. And different customers have different approach in this regard. Certain customers manage it on a month-by-month basis in terms of their purchases, fulfilling their purchase requirements. Some manage on a quarterly basis. And it will not be inconceivable if certain customers do look at even certain longer-term horizon. And we are definitely focused on diversifying our customer base, as well as really deepening our relationships with our customers.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

But could we see an industry trend developing here where the customers are actually -- looking at the difficulties in the shrink and the difficulties -- or the suppliers have consolidated? Why shouldn't they start thinking more than just one month and sign contract for 6 to 9 months?

Sanjay Mehrotra

Well, as I said, different customers have their different approach in this regard, taking into consideration their own business dynamics. So -- I mean, that's all I can really say at this point.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

Okay. And then for Judy, even after paying off the convert, you're still going to be left with $20 cash per share. You're incubating smaller SSD-related companies. You have a VC fund. But if this double-digit free cash flow margin were to sustain, how should we think about the strategy here? Should we assume that you're actually looking for acquisitions or you would change your strategy with buyback? Would you become aggressive or would you just focus on saving the cash for a rainy day for acquisition targets? Any color would be great.

Judy Bruner

Sure. We do believe that when we transition in the future to 3D technologies, post-planar NAND technologies, that, at some point, we will need to add new capacity for those technologies and that the capital cost of adding that capacity will be high. So we do believe that we will need and utilize some of that cash at some point in time in the future when we are transitioning to 3-dimensional technology. Beyond that, we absolutely want to maintain flexibility for acquisitions. We believe that there could be opportunities out there that could be advantageous to our business and to adding shareholder value, and we want to maintain flexibility to be able to move quickly in those situations. And then on top of that, we are stepping up our share repurchases, as I mentioned. We purchased $90 million in Q1, which compares to $60 million in Q1 a year ago. And that was not enough to offset the employee equity dilution in the first quarter. So we are stepping it up again, and we do expect to spend quite a bit more this year than we did last year on share repurchase. So really, those are 3 areas of usage of the cash.

Jay Iyer

Thank you, Mehdi. Thank you, Judy. Thank you, Sanjay. And thank you, everyone, for joining the call. A webcast replay of today's call should be available on our Investor Relations website shortly. Thank you, and see you all on May 8. Have a good evening.

Operator

That does conclude today's call. We thank you for your participation.

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