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SanDisk, Inc. (SNDK)

Q2 2006 Earnings Conference Call

July 24, 2006 5:00 pm ET

Executives

Dr. Eli Harari – Founder, Chairman and Chief Executive Officer

Judy Bruner – Executive Vice President of Administration and Chief Financial Officer

Lori Barker Padon – Director of Investor Relations

Analysts

Paul Coster – JP Morgan

Daniel Amir – WR Hambrecht

Eric Gomberg - Thomas Weisel Partners

Amanda Hindlian - Goldman Sachs

Satya Chillara - American Technology

Gurinder Kalra - CIBC

Daniel Gelbtuch - CIBC

Craig Ellis - Citigroup

Pranay Laharia - Deutsche Bank

Jay Iyer - Morgan Stanley

Mark Fitzgerald - Banc of America

Operator

Good day and welcome to the SanDisk, Inc. Second Quarter 2006 Financial Earnings Conference Call. As a reminder this conference is being recorded for replay purposes. At this time I would now like to turn the call over to Miss Lori Barker Peyton, Director of Investor Relations. Please go ahead.

Presentation

Lori Barker Padon

Thank you. Good afternoon and welcome to the financial teleconference for SanDisk Corporation for the second quarter of 2006. I'm Lori Barker Padon, SanDisk's Director of Investor Relations. Today with me is Eli Harari, Chairman and Chief Executive Officer of SanDisk and Judy Bruner Executive Vice President of Administration and CFO. The agenda for today's teleconference is as follows. Eli will start with remarks about SanDisk and trends in our markets. July will follow up with our second quarter financial results and future guidance. We will conclude the teleconference with your questions.

Any non-GAAP financial measures discussed during this call as defined by the SEC in Reg-G will be reconciled to the most directly comparable GAAP financial measure. That reconciliation is available after the call and the completion of the call, an audio replay of this conference call, a copy of today's prepared comments and quarterly metrics will be made available on SanDisk's Investor Relations Website at www.sandisk.com. By now all of you have seen our press release and the associated Form 8-K filed this afternoon. I'd like to remind everyone that today's comments, including our question and answer session, will include forward-looking statements within the meaning of Section 27-A of the Securities Act of 1933 as amended in Section 21-E of the Securities Exchange Act of 1934 as amended that are based on our current expectations. Forward-looking statement in this teleconference are generally identified by words such believe, anticipate, expects, intends, may, will and other similar expressions. In addition, any statement that refers to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements. There are significant risks and uncertainties that can could cause our actual results to differ materially from those expressed in these forward-looking statements. These risks and uncertainties are detailed under the fashion risk factors and elsewhere in the documents we file from time to time with the SEC including our Form 10-K for fiscal 2005 and our Form 10-Q as well as our press release and Form 8-K. Listeners are cautioned not to place undo reliance on those forward-looking statements, which speak only as of the date hereof. We do not intend to update information contained in this teleconference. Now I'd like to turn the call over to our Chairman and CEO, Mr. Eli Harari.

Eli Harari

Thank you Laurie. I will direct my remarks first to our second quarter results and then focus mostly on our outlook for the second half. The second quarter was the best ever for OEM sales and the second best for retail, with record units and megabytes sold. The star of the quarter continued to be our growing mobile card business in handsets where we saw not only strong bundling activity with all the major handset OEMs but also continuing traction in the mobile retail after market. So we now sell our cards through approximately 64,000 storefronts. In the U.S., as well as in Europe, we have developed excellent partnerships with most of the large mobile network operators who sell our cards with their music and camera enable handsets. A number of handset models with card slots continues to grow steadily and reached 494 in the second quarter. We believe that this market is still in its early stages and are excited by its future growth potential for us in the coming years. According to NPD, Independent Market Data, our mobile cards commanded 96% of market share in U.S. retail in June.

Retail sales were also aided by solid sales of cards for digital cameras where out SanDisk Ultra and SanDisk Extreme product lines are gaining wide popularity with consumers and professional photographers. Last week we introduced our Extreme IV Cards, which add up to 40 megabytes per second y trade are by far are the world's fastest flash card. This announcement was made together with several of the leading professional digital camera makers including Hasselblad, Nikon and Life, which challenged us engineers to meet heretofore unheard of redirect performance flash storage. This is an important milestone for flash because at these performance levels flash begins to compete favorably on performance with competing disk drives.

Sales of our Sansa line of MP3 players grew nicely in the quarter coming from early from U.S. retail where our unit share for U.S. retail flash players grew to 15% in June according NPD data. We are very encouraged by the level of interest and support we are receiving from the major retailers in the U.S. and Canada who appreciate the exciting design of the Sansa E200 and the strong value proposition that our expending Sansa line up offers to consumers.

Microsoft's recent announcement of their intent to enter the audio player market is another indication of the growing importance of this consumer appliance. Based on what they have publicly said we believe that Microsoft will mimic Apple's proprietary closed system solution, which will provide us the opportunity to continue to clearly differentiate our Sansa platform as the open system alternative and deliver the best value proposition, particularly at the $50 to $150 segment of the audio player market.

The partnerships that we're developing with the various music services will become more visible in the coming quarters and will further enhance the Sansa user experience.

In the second half we expect to significantly expand our presence in audio players in Europe, the Middle East, and Asia.

On the operations side this was a very good quarter for continuing to run Prop3 with the stars who are currently executing the 300-mm. transitions to 70 mm. 8 gigabyte MLC. We expect the transition to 70-mm. on 300 mm. wafers to be essentially completed by the end of this quarter, which means that we will be out of the 90 meter on both 200 mm. and 300 mm. wafers. These developments should provide us with accompanying output that carries an attractive co-structure for the substantial Prop3 capacity coming out stream in the second half. This wrapping of captive capacity will likely reduce, at least temporarily, our reliance on non-captive supply although we expect our future sourcing to continue to have a non-captive portion within the flexible supply model that we have relied upon in the past.

Turning now to our outlook for the second half of the year. We expect the demand and supply should come into balance during the current quarter as we head into the fall. Our third quarter is typically back end loaded with back-to-school sales. In the fourth quarter we expect a traditionally strong holiday sales to drive demand, particularly from the two major growth engines, handset and Flash Audio Players. Flash is becoming ever more pervasive in new markets and even to more mature markets such as digital cameras. I expect it to show a robust demand during the holiday season.

Price elasticity following the dramatically lower pricing this year is expected to drive consumer preference to gigabyte capacities in the second half.

The Flash audio player market by itself is projected to consume perhaps as much as 25% of the total industry output of non-flash in the last four months of this calendar year. This represents a very large increase in Flash demand compared to the first half of the year and it is likely to have a strong positive impact on the demand side of the equation.

Demand for Flash in handsets, be it the flash side in cards will likewise continue to consume significant portions of the available Flash supply.

Industry wide supply will continue to ramp in the second half, including our own ramp. However, the cumulative steep price reductions for NAND over the first half are making allocation of whoever starts to NAND less attractive for the manufacturers. To be profitable in NAND you need to be in high volume production right at the leading edge. To date the new players in NAND have not caught up with the 70-mm. MLC technology note of the market leaders. Judy will provide guidance on our third quarter pricing. Our objective with these price moves is to continue to stimulate new demand, expand the total pie, and create new markets through continuously delivering greater value to our customers.

In summary, we are bullish about our business prospects and we'll continue to focus on innovation and growth in the years ahead. Thank you for continuing your support. Judy.

Judy Bruner

Thank you Eli and good afternoon everyone. Before discussing our results I'd like to point out that we have changed the presentation of our GAAP versus non-GAAP results in our press release financial statements to provide only GAAP results on the income statement followed by a separate page of reconciliations to certain non-GAAP measures. We believe that these non-GAAP measures are useful in accessing our performance, allocating resources, and planning for the future, as well as in providing consistency with prior financial reporting and comparing our results to those of other companies.

Our second quarter product revenue was up 40% year-over-year and up 18% sequentially. Megabytes sold increased 46% sequentially, slightly above the 35-45% range we predicted in April. An ASP per megabyte declined 19% in line with our previous guidance. We were pleased with retail sell through, particularly in the month of June. Retail revenue was 70% of product revenue for Q2 increasing 20% sequentially. Average capacity for retail products increased 15% sequentially to 758 megabytes with the fastest growing retail capacity coming in Micro SD Mobile Cards and Blue Label SD Camera Cards. Our OEM revenue increased a solid 15% sequentially to a record level of $191 million. OEM sales growth was dominated by micro SD cards for the mobile handset market followed by strong sales of the memory stick Pro Duro card, also for the mobile market. Average capacity of OEM cards increased 24% sequentially driven by increased capacity of bundled micro SD mobile cards. Our license and royalty revenue of $82.5 million was slightly above the range we had predicted in April.

On a geographic basis our product revenue mix in Q2 was 45% Americas, 34% Europe and 21% Asia and Japan. The sequential shift of two points towards the Americas was primarily due to strong Americas' retail business.

GAAP product gross margin in Q2 of 32.4% was higher than we had expected for several reasons. First, with retail sell through at the high-end of our expectations we recognized more low cost fab 3 production in cost of sales than we had forecasted. Second, in addition, strong fab 3 output led to Q2 non-captive purchases of less than 10% and products produced with non-captive memory represented less than 15% of our megabyte shipments during Q2 compared to 32% in Q1. And third, the cost of the plant shut down of fab 3 for a power upgrade in April was more than offset by strong yields and reduced cost per bit.

Non-GAAP product gross margin, excluding stock compensation, was 32.8% for Q2. Non-GAAP operating expenses, excluding stock compensation and acquisition related charges were $133 million, up $14 million from Q1 with the largest increase coming from investment in R and D. Excluding stock compensation and acquisition related charges our non-GAAP income of $159 million, or 22% of revenue, was up 50% in dollars on a year-over-year basis. Other income increased to $22 million due primarily to our higher cash balances and rising interest rates.

Our tax rate in Q2 remained consistent with Q1 on a non-GAAP basis at 35% while on a GAAP basis our tax rates decreased from 54% in Q1 to 36.5% in Q2 due to the nondeductible in process R and D charge in Q1 and variations caused by the impact of stock compensation expense.

Turning to the balance sheet, we ended the quarter with $2.7 billion in cash, short-term and long-term investments. You will note that $406 million of our cash investments have been reclassified to long-term based upon their purchase to maturity date.

Our Q2 cash flow from operations was $59 million. Cash flow from employee stock programs and related tax benefits was $42 million and net proceeds from our convertible offerings was $1.05 billion. Investing activities including a Flash Partners lull of $95 million and a Flash Partners investment of $84 million for a total Q2 cash contribution to Flash Partners of $180 million. We also guaranteed an incremental $140 million of operating leases for Flash Partners bringing our total stab related operating lease guarantees for Flash Partners and Flash Vision to approximately $540 million.

Accounts Receivable increased $66 million reflecting higher Q2 shipments and DSO stands at 45 days, a typical level for Q2. Inventory decreased $35 million to $378 million or 80 days of inventory down from 98 days at the end of last quarter. Channel inventory at the end of Q2 was approximately nine weeks down from approximately 10.5 weeks at the end of Q1. We believe both balance sheet inventory and channel inventory are at comfortable levels for our business model.

I'll now turn to our outlook for Q3 and the remainder of the year. Let me remind you that the forward-looking comments I am about to make are subject to risk and uncertainties as described at the beginning of this call and in our periodic SEC filings; and we do not intend to update these comments or forecast prior to our next quarterly conference call.

We have locked in lower pricing for our OEM customers for Q3 and we have already implemented certain retail price reductions in all regions in July. We will implement back-to-school promotions later in the quarter and selective additional retail price reductions are possible. Overall, we expect the Q3 sequential decline in ASP per megabyte to be similar to the decline in Q2. For the year, we now expect the 2006 average ASP per megabyte to decline approximately 55% from the average price per megabyte in 2005. Still in the range we gave at the start of the year but at the higher end. In Q3 we expect average capacities to continue to grow nicely based on the cumulative price reductions of this year while we expect unit growth to follow a seasonal pattern of slower growth in the third quarter than in the second quarter.

These two factors lead us to expect Q3 megabytes sold to increase sequentially by approximately 20 to 25%. For the full year of 2006 we continue to expect megabytes sold to increase between 180 and 190% over 2005. We expect Q3 license and royalty revenue to be in the range of $68 to $72 million based upon estimates that we have derived from recent Q2 reports of our licensees. We now expect total license and royalty revenue for 2006 to be closer to approximately $325 million rather than the $350 million we estimated at the beginning of the year.

In terms of gross margins for Q3 we expect cost reduction to be greater than we experienced in Q2 as we will have a higher proportion of our supply mix coming from 70-nanometer 300-mm wafers; and we expect our non-captive supply mix to remain at a level similar to, or lower than, Q2. Combining this with our forecasted price movement we expect non-GAAP product gross margin for Q3, excluding stock compensation, to be in the range of 33 to 35%, up from the comparable 32.8% in Q2. On a GAAP basis we expect product gross margin to be approximately one half point lower than on a non-GAAP basis.

We expect Q3 operating expenses to increase by approximately $10 million from Q2 based primarily on increased sales and marketing as well as R and D expenses; and we expect our tax rate to remain consistent.

Inventory levels are expected to increase during Q3 in preparation for the seasonally strong Q4. For Fab 3 expansion we expect to provide approximately $200 million either in the form of a cash loan to Flash Partners or in the form of an operating lease guarantee, or some combination of the two.

In summary, we are very pleased with Q2's year-over-year revenue growth of 40% as well as the GAAP operating margin of 18% and the non-GAAP operating margin of 22% and we are optimistic about results in the second half of the year. We will now open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) We'll pause for a moment to assemble our queue. We'll take our first question from Paul Coster with JP Morgan.

Paul Coster – JP Morgan

Yeah, I have a couple of quick questions. The first one is licensing, slightly short of your prior expectations and we're wondering where the weakness is coming. Is it by any chance in MLC at the sort of higher end of the food chain? The second question is are there any consequences to you reducing the non-captive consumption, particularly from Samsung?

Judy Bruner

Paul, I'll take that. You know, the primary reason for reducing our expectations for the year on license and royalty revenue was based on the results we heard from one of our key licensees for their second quarter, which translates into our third quarter and in that case the licensee experienced quite aggressive price decline in the second quarter without enough offsetting bit growth to offset and to the point you mentioned the percent of the MLC mix was down slightly from their Q1 to their Q2. We do expect the MLC mix to continue to grow but we've dialed back our estimates for Q3 based on what we heard about Q2 and then Q4 flowing from that.

Paul Coster – JP Morgan

Okay. Then on the…

Eli Harari

As far as the consequences Paul, no, there are no consequences for reducing, for the time being, our non-captive purchases model. That's precisely what the model is about. It gives us flexibility that we need to have and I don't see any consequences.

Paul Coster – JP Morgan

Okay. One final question Eli. You said that the Flash audio players would be a greater percentage of sales in the second half. Can you approximate what they may have been in the first half of this year?

Eli Harari

The first half -- I've heard a number that retail sales of audio players in the fourth quarter account for about 60% of the total annual unit and probably megabyte sales. So I'm basing it on -- really on that basic assumption. We certainly have seen in the last fourth quarter, you know, a huge spike and I would expect that. So I would not be surprised -- I don't have the actual numbers but I would not be surprised if the second half of the year represents, you know, at least 60% of the total output, compared to 40%; maybe 65/35. One third, two-thirds would be a reasonable number.

Paul Coster – JP Morgan

Okay, great. Thank you.

Eli Harari

I'm talking about -- this is for the industry as a whole. I'm not talking about ourselves.

Operator

(Operator Instructions) We'll move to Daniel Amir with WR Hambrecht.

Daniel Amir – WR Hambrecht

Thanks a lot and congratulations on a good quarter. I have a couple of questions. First can you comment a bit about your USB business as it goes to U-3 as well? It seems like in your press release or in your prepared comments you haven't commented much on that. Kind of how good was that segment in Q2 and kind of what are you looking at and for the second half of the year what can we expect?

Eli Harari

The USB market was relatively flat for us in the second quarter, a little bit down; and I would say we lost a little bit of market share. The USB in general has been very, very price competitive but we do expect that with introduction of more U3 platforms that this will reverse itself and also by the way USB Flashback, I believe, had the highest average capacity per unit, which is very good. So it's true that we, you know, we can do better in USB, particularly outside the United States and we will do better. This is -- we are certainly setting our sites on improving the market share and particularly outside of the United States.

Daniel Amir – WRI Hambrecht

As it relates to that, I mean continued having all this additional capacity from Fab 3. I mean are you just focused more on other markets? I mean is that the strategy specifically in the handset business or…

Eli Harari

No. No, absolutely not. USB and U3 in particular represents a very attractive market because we do believe that the capacity, capacity demands, from that application are somewhat open-ended, I mean insatiable drive to more and more capacity and eventually making significant in roads into the computing environment. So we remain very committed to this market and we are certainly not going to shy away from using -- applying our capacity as it comes on stream to gain market share and improve our sales.

Daniel Amir – WRI Hambrecht

Okay, and one final question. On your handset business, I mean last quarter you commented what percent of revenues it was. Can you tell us what it was here in Q2?

Eli Harari

I think we said about 30% of our revenues, product revenues…

Judy Bruner

Of our product revenues, yes.

Eli Harari

Last quarter I think it was slightly above that and you know the market has grown as a whole. So we think we're moving the right direction.

Daniel Amir – WRI Hambrecht

Okay, thank you.

Eli Harari

Not we think. We're pretty confident we are moving in the right direction.

Daniel Amir – WRI Hambrecht

Okay, thank you.

Operator

Our next question comes from Eric Gomberg - Thomas Weisel Partners.

Eric Gomberg - Thomas Weisel Partners

Hi, guys, nice quarter.

Judy Bruner

Thanks, Eric.

Eric Gomberg - Thomas Weisel Partners

I was hoping that you could give an update on what's going on in terms of your technology development and what you see competitively, specifically talking about, your -- the Matrix acquisition and the opportunities with that technology as well as what you see externally, including M systems, X4 technology.

Eli Harari

Yes. So technology is moving really along I would say three fronts. First of all, we are now solidly in 300 millimeter, 70 nanometer MLC 2 bit for sale. So we've crossed that bridge and I'm very pleased that we are where we are; very well positioned for the second half in terms of costs and capacity.

So the next major cost reduction hurdle, if you will, or challenge for us is to obsolete the 70 nanometer as quickly as we can with what we call a 56 nanometer and we expect that to start in the first quarter next year and we expect to be probably where we are today with 70 nanometer, in 56 nanometer by the same time next year. So it will start hopefully early in next year. In the second half next year that should become our next major production workhorse.

Matrix is doing very well with the integration and moving on to the next technology node, which is now under development. What we have done with Matrix is we've asked them to recruit additional engineering bandwidth as quickly as they can. And that's what they have been doing. The key is to move to a parallel development approach where they do not just focus on one generation at a time, we are moving to two of the next generation nodes.

So you will see the next generation technology coming into production in the second half of next year and then hopefully in 2008, the generation after that. By that time, they should be caught up with the technology lithography nodes and they will have all the benefits of the four levels.

This is still one-time programmable and we are definitely aggressively pursuing finding a way to drive to rewritable, but nothing new to report there.

On X4 I have said that we are developing X3, if you will -- what we call D3, three bits per cell -- and we are now getting more confident that this can be brought to bear in NAND MLC without sacrificing performance. Then X4 is an additional, kind of the last ratchet and we have been studying what M System has been saying on the X4 and we are taking this very seriously.

The biggest barrier in MLC was going from one bits to two bits, there's a lesser barrier going from two bits to three bits and lesser barrier going from three bits to four bits and each one of these significantly increases the complexity.

So certainly our engineers never a dull moment and it's actually very exciting. What you have seen is going from one bit to two bits per cell which is the easiest part; has been not at all easy for the rest of the industry. You should expect that going beyond two bits per cell will not be easy and I think it's definitely a system solution where we excel.

Eric Gomberg - Thomas Weisel Partners

Just a quick question for Judy. Just to coordinate my math to get the down 55% year-over-year suggests that pricing is a bit more stable in 4Q than in 3Q. Does that sound right?

Judy Bruner

I think you could get to 55% if pricing in the fourth quarter was in the mid-teens to slightly high teens; not that dissimilar from Q2 or Q3.

Eric Gomberg - Thomas Weisel Partners

Okay. All right. Thank you.

Operator

We'll take our next question from Jim Covello with Goldman Sachs.

Amanda Hindlian - Goldman Sachs

Good afternoon, this is Amanda Hindlian in for Jim Covello. My first question is can you update us on any progress you've made toward adding new licensees?

Eli Harari

Yes. We are in discussions with a number of companies that are interested in licensing our technology, but I can't comment at this stage.

Amanda Hindlian - Goldman Sachs

Any updates on the litigation front?

Eli Harari

Nothing more than what you know already. The ITC action against SD Micro is proceeding I think the trial is scheduled now for October.

Amanda Hindlian - Goldman Sachs

Then can you help me understand if the supply and demand dynamics are coming into balance in Q3, why the pricing is coming down so much?

Eli Harari

The pricing is not coming down any more really than what we had forecasted at the beginning of the year. I would say, in fact, our pricing has come down in a pretty systematic way rather than in leaps and starts so this is not -- last year we had a 52% price reduction for the year. This year we are saying it's going to be around 55%.

I think the key is to get this price elasticity; we are at about 750 or so megabytes per card in retail and we really need to move the market to about a gigabyte average capacity per card by the end of this year.

I think that the pricing that we are implementing achieves a predictable environment out there, we believe, and also I think are good for the market in terms of stimulating that transition to gigabyte capacity.

Amanda Hindlian - Goldman Sachs

Okay. That's helpful. Thank you very much.

Eli Harari

Thank you, Amanda.

Operator

We'll move to Satya Chillara with American Technology.

Satya Chillara - American Technology

With regard to Samsung, you talked about 55% to 59% pricing, based on that you guided right now to 55%. Do you think there is more pricing that you need to take if the demand is not that good going into Q4, or is that pretty much what you have in mind?

Eli Harari

I think with the pricing for the third quarter as well as the cumulative effect of the first two quarters, we think things are doing fine. My expectations and hope, if you will, is that by the end of this summer we will be in balance and that the cumulative effect will allow the market to move to higher densities and soak up additional demand.

I can't speak for Samsung, you really have to talk to them. But remember that Samsung sells components and we sell cards. We also sell MP3 players and we sell a lot of stuff that really is up the food chain and gives us the ability to maintain margins and not have to drive the pricing the way perhaps they've indicated for themselves.

Satya Chillara - American Technology

The reason I ask that question is I'm looking at the demand in Q4. It sounds like with all the macro climate and everything, the demand is not out there and that's why I think it's reducing the prices. You seem to be pretty confident going into Q4. The other question I have is Q4 looks like Q4 of 2004 with respect to the bit growth and so on. Is that what you have in mind at this point?

Eli Harari

Q4 of 2004 was very demanding. I think we reported 110% in megabyte shift. I doubt it. I think we've had very good growth this quarter. Judy has guided you to about 20%, 25% in megabytes in the third quarter. We are still confident about 180% to 190%, but I think 110% or so in the fourth quarter would blow away.

Judy Bruner

Yes. Let me just add, I'm not going to step you through the math here, but if you go do the math of various potential bit growths for Q4, clearly we would expect bit growth in Q4 to be quite a bit higher than in Q3, but not at the level of 2004, not at 110%. It doesn't need to be near that level to get you to 180% to 190% for the year.

Satya Chillara - American Technology

No, understood. One last question. Judy, this is for you. The non-captive mix for second half, can you walk us through what you're thinking, please? What it would be for Q3 and Q4?

Judy Bruner

As I said on the call, we expect in Q3 that the non-captive mix of our shipments will be similar or perhaps less than the non-captive mix in Q2. But we've not yet provided guidance for Q4. Clearly that's a decision we haven't made yet as to what the mix is we'll need in Q4.

Eli Harari

The real method Satya is that by withholding our guidance for the total of the unit shipments and reducing our requirements for non-captive, this is basically reflective of the progress we are making with captive output increasing quite substantially relative to what we saw at the beginning of the year, both year to yield and accelerated production ramp.

So there is nothing wrong with the non-captive supply. What it is is the captive supply is doing exceptionally well in these quarters and we are taking advantage of the flexibility of our model.

Satya Chillara - American Technology

Right. Okay. Good. Thank you very much.

Eli Harari

Thank you.

Operator

Our next question comes from Gurinder Kalra with CIBC.

Gurinder Kalra - CIBC

Thanks. I have two questions. The first question is to what do you attribute the recent price weakness? Is it just slow demand from handsets? Do you think a competitor failed to build out certain products in time? Conversely, why do you think we will see a supply/demand balance later in the third quarter?

Eli Harari

I think the price weakness may have something to do with the pricing late in the second quarter, which has carried over into the beginning of the third quarter. Basically with the exception of very good June sell through, we are now into the July, August months. Really there's no catalyst for a huge increase. We do believe that you are going to start seeing some substantial ordering towards the holidays; Black Friday and so on in the September/October timeframe.

So there's nothing surprising here. This is quite seasonal and quite normal. I think basically demand is going to catch up with supply even as supply is ramping up.

Gurinder Kalra - CIBC

All right. Thanks. The second question is you give a non-captive mix in shipments in the third quarter, how about in terms of costs?

Judy Bruner

We've never provided guidance as to the exact percentage of non-captive that is in the cost of sales. That's a little more difficult to arrive at based upon our retail sell-through revenue recognition. Clearly the amount of non-captive that is recognized in our cost of sales is lagged a bit from the percentage that is in the shipments.

Gurinder Kalra - CIBC

Okay. Thanks.

Eli Harari

In other words, the inventory that we have that is selling through represents the costs in the last two quarters, not in the current quarter.

Operator

Our next question comes from Daniel Gelbtuch with CIBC.

Daniel Gelbtuch - CIBC

Congratulations on a great quarter. A few questions. Number one, with regard to microSD, can you talk to the mix of bundled versus aftermarket? Obviously that seems to have grown, but what would you say the percentages are right now?

Judy Bruner

Well, for the current quarter, clearly the majority of the growth is still coming in the OEM bundled sales of microSD. The retail sales did grow as well from Q1 to Q2. I believe last quarter we indicated that there were about 2 million units of microSD that had sold through retail. We've not provided a specific number this quarter, but we did see some growth there and we believe we are continuing to see traction in the sale of microSD in retail.

Daniel Gelbtuch - CIBC

And as far as average densities in that segment of the market?

Judy Bruner

Yes. Actually, I mentioned in my comments that the growth in average capacity of microSD was the fastest growing capacity in our retail sales.

Daniel Gelbtuch - CIBC

What would you say is the most popular density right now? Do you see that growing at a very nice clip towards the end of the year?

Eli Harari

I think in retail microSD is at 512 megabyte and a great deal of 1 gigabyte now. In bundled, I have said we process by model. You've got 512 megabytes for music applications, and the lower capacity for basically just basic bundle.

Daniel Gelbtuch - CIBC

Just switching gears a second. With regard to U3, I've heard already that there are a number of competing controller manufacturers who have indicated to me at least that they are looking to support U3. What is the licensing front looking like to you?

Eli Harari

We have set up U3 LLC, a licensing entity that is chartered to license to all comers the U3 technology and the logo, and so on. I believe they are doing their job. Seeing a great deal of interest in controller manufacturers and other USB Flash manufacturers to get into this market. This is precisely what M Systems and SanDisk set out to do.

Daniel Gelbtuch - CIBC

The last question would be with regard to the void of Lexar being out of the market, what would you characterize what's happened in the market with regard to being rid of the crazy ede in the market? Is there a big void that you're filling, or are you seeing more stability in the market right now with Lexar gone?

Eli Harari

No. Lexar first of all is not gone. They are still there. Secondly, if anything, they probably will be reinvigorated through the support of Micron. But Lexar has been, as you know, waning in the last two years, getting weaker over the last six to eight quarters. So their going away, the way you describe it, is really a non-event. We don't see a big difference.

Operator

Craig Ellis with Citigroup has our next question.

Craig Ellis - Citigroup

Thank you. Congratulations on the quarter. A couple clarifications to begin. First, Judy, on the gross margin line, can you just identify the relative contribution of the three factors that contributed to the sequentially higher gross margin? Were there any negative offsets to those factors you identified?

Judy Bruner

Sure. Really in terms of relative contribution, I described them in that order. So the most important factor in the gross margin being better than we had forecasted was that our retail sell through was higher than we had expected and that enabled us to recognize sooner low-cost produced supply, primarily through fab 3.

The second largest impact was the less than 15% non-captive mix within the shipments and how that translates through to cost of sales. You may recall that last quarter I said that 19% of our purchases in Q1 were non-captive. We had estimated a higher percentage of the shipments and cost of sales being non-captive in Q2 than what it actually turned out to be so that reduction was significant.

I mentioned the power upgrade being sort of a non-factor because it was more than offset by cost reductions. That really was the third on the list.

Craig Ellis - Citigroup

So related to that, how should we think about the pace of cost reduction in the second half of the year versus what you achieved in the first half?

Judy Bruner

As I indicated in the guidance, we expect cost reduction to be greater in the third quarter than in the second quarter primarily because of the ramp in our 70 nanometer 300 millimeter output. What we're expecting is that price decline remains about the same, but that cost reduction accelerates.

Craig Ellis - Citigroup

Then you mentioned inventories up in the third quarter; can you quantify how much they would be up or where they would be, relative to the first quarter levels?

Judy Bruner

We're not going to give a specific amount of inventory, but we believe inventory will rise. We need it to rise in order to get a jump start on Q4 in terms of shipments for the holiday season. Also, we are making good progress on expanding output of Fab 3.

Craig Ellis - Citigroup

Lastly, and a broader question relative to two product areas. On MP3s, can you just update us on how well you think you're progressing with your US and your worldwide expansion there? Any year-end market share targets would be helpful.

Given that you're already shipping with ten handset OEMs on the handset card side, what are the growth opportunities there other than more slots in cards?

Eli Harari

Yes. In the MP3 market we think our storefront exposure today is still relatively small, mostly Best Buy and Circuit City. Up to this point I think you're going to see that expand a great deal in the U.S. in the second half. Also, we barely touched Europe and Asia up to this point and we plan to certainly increase our sales through these geographies in the next six months.

I can't tell you about market share. Microsoft is supposed to introduce their platform in November. It sounds a little bit late. Apple, I expect will introduce their next generation nano in September, maybe announce it in August. So it's very fluid. We are pretty comfortable with our positioning. We think that in the low price range where both of these guys are not really very strong, we are going to see very substantial opportunities.

In the area of handsets, we think if you look at 15 million cards sold in the quarter, where there could be, my guess would be over 100 million units shipped in the quarter that could have a card, you see that the attach rate is very small. I think in retail the attach rate for our cards in handsets is still something like 11%, 12%; still very, very low.

So the challenge for us is to work with the mobile network operators to increase their attach rate to the level that digital cameras have, which is 100% attach rate. That just takes time and training and support point of sale material. But it's happening every quarter, I expect we will see an improved attach rate.

Craig Ellis - Citigroup

Thanks, Eli. Lastly, and just going back to an earlier question. We've had significant pricing activity quarter to date, more is planned in the third quarter. You've got density shift working to your advantages, the MP3 business grows and yet as we look at bit growth implied in the fourth quarter, it is at the low end of what we would get if we just looked at the range between the fourth quarter of '05 and the fourth quarter of '04. So it would seem that the full year bit growth outlook is pretty conservative from here, unless there's something I am missing with that. Any color on that comment?

Eli Harari

180% to 190% is a tripling of the output. Throughout this, maintaining or improving gross margins in a very, very tough pricing environment really says a lot about our business model. I will be very pleased if it just continues to roll out the way we are guiding.

Judy Bruner

I mean we re-look at this every quarter and continue to believe our best guess is that we will fall in that range. As Eli just said, that's a pretty big increase over the last two years, in which each were closer to 165% than 180% to 190%.

Operator

And we'll move to Pranay Laharia with Deutsche Bank.

Pranay Laharia - Deutsche Bank

Can you talk about the revenue contribution from Matrix for the quarter? Are you still on track to get to $60 million to $90 million for contribution for the year?

Judy Bruner

We really are not breaking out the revenue contribution for the 3-D products, just as we aren't breaking out revenue from any other products. We are pleased with the progress that they have made and we expect, in particular, a fairly significant amount of growth from 3-D revenue in the second half of the year as compared to the first half of the year.

Eli Harari

But overall, yes, we expect to be in that range, $60 million to $90 million for the year. More of it concentrated in the second half of the year, from of course, gaming applications.

Pranay Laharia - Deutsche Bank

Understood. So no chance you're going to give the segment breakdown between cell phones, MP3 players, digital still camera for the quarter for 2Q?

Judy Bruner

Not for the quarter, but we will give it at the end of the year as we have now for the last two years. So we give that total breakdown annually.

Pranay Laharia - Deutsche Bank

Okay. Can you give wafer outs for 3Q and confirm your target for March next year? And talk about whether the ramp will be linear or more back-end loaded on that?

Eli Harari

We don't give wafer starts and we don't think it's appropriate to start that trend. There's a lot of information out there. But the ramp is progressing very nicely. I think we are now sometimes going from 70,000 wafers a month by the end of March next year to just over 90,000 wafers a month and we expect that now, that's split 50/50 between us.

Judy Bruner

Right. So what we have said is that the wafer starts for fab 3 in Q4 of '05 were about 10,000 per month, growing to about 30,000 per month in Q1 of '06 and that by the end of Q1 '07 we expect to be at about 90,000 wafers per month split 50/50 between the two partners. We continue to be on that ramp. We're doing well.

Pranay Laharia - Deutsche Bank

Fair enough. Just a last question. Remind me when you expect G bits per cell to be a commercial reality for you guys?

Eli Harari

We have not said when we're going to have that, but I would not say it's imminent.

Pranay Laharia - Deutsche Bank

Great. Thank you.

Lori Barker Padon

Okay. We'll have time for two more callers. Thank you.

Operator

We'll move to Mark Edelstone, Morgan Stanley.

Jay Iyer - Morgan Stanley

Hi, everyone, this Jay Iyer for Mark Edelstone and let me give my congratulations on a solid quarter as well.

Eli Harari

Thank you.

Jay Iyer - Morgan Stanley

Judy, if you could just break out the stock-based compensation expense between the SG&A and R&D lines, please?

Judy Bruner

The total stock compensation expense for the quarter is about $26 million. There is about $3 million in cost of sales, the rest of it in operating expenses. I don't have right in front of me the breakout between R&D and sales and marketing. I'll have to get that separately.

Jay Iyer - Morgan Stanley

Okay. You talked about your supply expectations for the second half. Would you care to guess where it might be in 2007?

Eli Harari

We have not changed our long-term model of 70% captive, 30% non-captive. Clearly, we are diverging quite a bit now as we are ramping. I can see a situation where we would get back to certainly above 20% non-captive next year.

Judy Bruner

I have the breakdown here. So R&D included a little over $10 million of stock compensation expense. Sales and marketing included a little over $5 million and G&A close to $8 million.

Jay Iyer - Morgan Stanley

Great. Thank you again.

Eli Harari

Thank you.

Operator

We'll move to go Mark Fitzgerald with Bank of America.

Mark Fitzgerald - Banc of America

Just curious given you're in the MP3 player marketplace with the emergence of combining the cell phone and the MP3 player, does the silicon content, particularly the Flash content go up, stay the same, or go down if you were to combine versus having the two stand-alone products?

Eli Harari

It definitely goes up. I don't think we would have seen the kind of demand for microSD and 512 megabytes and gigabyte if it were not for the music applications. The digital cameras and the cell phones are still relatively low resolution. It's definitely the MP3, the music functionality that's driving the demand for high capacity cards in cell phones.

Mark Fitzgerald - Banc of America

That takes into consideration that there's not an MP3 player that would be sold, or it would cannibalize an MP3 player?

Eli Harari

The MP3 market is a stand-alone market. The handset market we have always believed will ultimately be the MP3 biggest market opportunity and we have put lots of resources to make sure that when that happens and as it happens that we are a major player.

Mark Fitzgerald - Banc of America

Thank you.

Eli Harari

So if you look at Nokia, music players; Sony Ericsson, Walkman, music players, cell phones that is; Motorola’s MP3 players in the cell phones, they are customers of our high-capacity cards. Either microSD or Memory Stick Produo.

I'd really like to wrap up this conference call. I think it's been a great quarter. Thank you very much for joining us today. You can see we are pretty excited about the opportunities ahead of us and looking forward to seeing you all in the coming meetings and investor conferences. Thank you very much.

Operator

Thank you. This does conclude today's conference. We thank you for your participation and you may disconnect at any time.

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Source: SanDisk Q2 2006 Earnings Conference Call Transcript (SNDK)
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