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SanDisk Corporation (NASDAQ:SNDK)

Q2 2009 Earnings Call

July 22, 2009 5:00 pm ET

Executives

Jay Iyer - Director of Investor Relations

Eli Harari - Chairman and Chief Executive Officer

Sanjay Mehrotra - President and Chief Operating Officer

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

Analysts

Gary Hsueh - Oppenheimer

Paul Coster - J.P. Morgan

Daniel Berenbaum - Ariga U.S.A.

Uche Orji - UBS

James Covello - Goldman Sachs

Edwin Mok - Needham & Company

Craig Ellis - Caris & Company

Bob Gujavarty - Deutsche Bank

Operator

Good day, everyone and welcome to SanDisk Corporation’s second quarter 2009 earnings conference call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Mr. Jay Iyer, Director of Investor Relations. Please go ahead.

Jay Iyer

Thank you and good afternoon everyone. Joining us on the call today are Dr. Eli Harari, Chairman and CEO of SanDisk, and Judy Bruner, Executive Vice President of Administration and CFO. Sanjay Mehrotra, our President and COO, is away attending an off-site executive training program.

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 web site at sandisk.com/IR.

In addition, during our call today we will make forward-looking statements. Any statement that refers to expectations, projections or other characterizations of future events, including financial projections and future market conditions, is a forward-looking statement. Actual results may differ materially from those expressed in these forward-looking statements. For more information, please refer to the “Risk Factors” discussed in the documents we file from time to time with the SEC, including our Annual Report on Form 10-K/A for fiscal 2008 and our subsequent quarterly reports on Form 10-Q. SanDisk assumes no obligation to update these forward-looking statements, which speak as of the date hereof.

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

Eli Harari

Thank you, Jay. SanDisk delivered a profitable quarter in the second quarter for the first time in about five quarters. Resizing our organization in the fourth quarter of 2008 and restructuring our manufacturing joint ventures with Toshiba in the first quarter of 2009, coupled with strong execution in operations and technology are providing us new flexibility to achieve our financial objectives.

In the first half we have been able to weather the slow economy by leveraging our diversified channels and global brand, with approximately 60% of our second quarter product revenues coming from outside the US and 41% coming from OEM customers.

In the third quarter, we expect demand for our products to grow at a modest pace, with growth primarily from OEM mobile customers. Industry bit supply is expected to also grow at a modest pace in the third quarter, as idle wafer capacity has largely returned to production and technology conversions will continue as well. We expect approximately 50% of our captive bit output in the third quarter to be on three bits per cell architecture X3 on 43 nanometer technology. Our 32 nanometer transition has begun and we expect to ramp its production over the next several quarters.

Overall, we expect to sustain a highly competitive product cost in 2009 and 2010 in our captive supply base.

Since early July, we have been running our captive fab capacity at full utilization, however, our inventory is still on the high side and we may cut back the fab utilization rate late in the year or early next year, should the expected pickup in holiday sales fail to materialize.

The key to returning to sustained profitability is for the industry supply to closely track industry demand, as has been the case in the past six months, when industry-wide production cuts brought supply in line with demand. In the prior four years, the NAND industry had invested in substantial new wafer fab capacity to satisfy strong growth in demand from new markets. Some of these markets are maturing and growing at a slower rate, while new markets, such as solid-state drives, are still in their early days and their future bit growth trajectories will be closely tied to pricing that, except for enterprise SSD, may not deliver attractive margins, at least not initially.

Excluding the relatively modest investments in technology transitions, large scale investments in new NAND wafer capacity will require forward visibility of strong demand from new markets coupled with sustained profitability to provide attractive return on investment, and we believe that such conditions may be several quarters away from where existing NAND markets are today.

As for SanDisk, we are steadily increasing our participation in the very large flash OEM market. Our embedded flash business team, that pioneered the mDoc product line, is now fielding a strong lineup of bootable managed NAND components and these are being designed into top-tier handsets and smartphones, GPS, digital camcorders, MP3 players and numerous other portable devices.

In bundled cards, we are a significant supplier to all the top handset OEMs that support a card slot in their phones. Smartphones are, of course, bucking the declining trend of the rest of the handset market and are growing at a hefty pace, led by Apple, RIM and Nokia, but with other contenders in the wings, including Palm and a slew of Android-based phones. Recent iPhone announcements from Apple clearly show that highly capable smartphones need to have at least 8 gigabytes of storage capacity, even in $99 phones, with the high-end phones requiring as much as 32 gigabytes. In addition, third party applications ported on these devices are rapidly proliferating, and are expected to drive the demand for high capacity of mobile flash storage.

Mobile network operators are also becoming a fast growing part of our business. We recently announced our Service Delivery Card, SDC, which is targeted specifically at the network operators, and is designed to work symbiotically with their SIM cards. The SDC offers large incremental storage capacities, security and other features and applications aimed at increasing ARPU and reducing customer churn for the operators. We are pleased with the progress we are making on these initiatives and the early interest we are seeing from the operators.

In other areas, we launched our slotRadio player and cards in RadioShack late in the second quarter and expect to expand their availability for the holiday sales season.

I want to say a few words about our SSD business. Our development efforts are currently directed towards SSDs for notebooks and netbook PCs. These SSD target markets are highly price elastic, and the recent NAND component price increases have slowed down market adoption rates. To date our performance in the notebook PC market has been less than stellar, and we have some catching up to do. We are late to market with the G3 MLC SSD product that we showed at the January CES and we are evaluating our G3 product strategy.

On the other hand, our modular SSD, also known as SanDisk pSSD, has been well received by the leading players in the netbook PC space. Here our competition is entry level low-cost hard-disk drives. We expect to sell in the range of a million units this year, still a small part of our revenues, but an encouraging start nonetheless. Long term, our unique SSD IP, our managed NAND know-how, and our high quality captive NAND, provide us the opportunity to participate profitably in this emerging business.

Moving to IP matters, in the second quarter we announced with Samsung the renewal of our patent cross license and flash supply agreements. The satisfactory conclusion of these lengthy negotiations has provided market certainty about our IP monetization.

On June 30, the Wall Street Journal published the Patent Board Semiconductor Patent Scorecard showing SanDisk moving up to fourth position among the top 166 semiconductor companies, and also rating our innovations as number one in highest industry impact and number one in highest research intensity. This recognition reflects our investments in NAND scaling, including X3 and X4, 3D Read/Write technology, advanced controllers and embedded and card solutions.

One other point, relating to industry standard formats. After a decade of relentless evangelizing, we believe that the Secure Digital SD format has now become the de-facto standard for universal storage of consumer content, photos, video, music, maps and games. Apple’s latest MacBook PCs for the first time features an SD card slot. Fuji and Olympus appear to be transitioning their new camera models to the SD format from their proprietary xD-Picture Card and most digital SLR cameras now support high performance SD cards as well.

We believe that our microSD card has likewise become the de-facto format in mobile phones. We are proud of our leading role in creating, propagating and broadly licensing these open standards, which are very good for consumers worldwide, and it should have also positive implications for our future royalties.

Just a small footnote, if you would allow me, in the history of imaging, on June 22nd Kodak announced that it will retire its iconic KodaChrome film, bringing this exquisite innovation to the end of the road of chemical film after almost a century of unchallenged dominance.

In summary, our second quarter results demonstrate that we have executed well in a challenging economic environment. Of course, like everyone else, we are hopeful that market conditions will improve in the second half of the year. However, we are managing our business prudently and our focus remains on continued profitable growth.

I will turn it over now to Judy.

Judy Bruner

Thank you, Eli. Our strategy to reduce captive supply and prioritize profitability over volume worked very well in the second quarter. On last quarter’s call I indicated that increasing pricing would likely impact the growth we have historically seen in second quarter unit sales and average capacity, and that was indeed the case. In the second quarter, our unit sales decreased 6% sequentially as we chose not to pursue low price bids. And the average capacity of our units sold fell 2% sequentially, showing that elasticity works in both directions.

However with a 12% increase in ASP per gigabyte, our product revenue increased 4% sequentially, and the impact on gross margins was particularly positive, although margins are not yet where they need to be.

Retail sales made up 59% and OEM 41% of our Q2 product revenue, the same mix as in Q1. We increased prices in both channels, and unit sales were slightly down sequentially in both channels. On a year-over-year basis, our unit sales were up 3%, with unit sales of mobile handset memory products and USB products both growing faster than the average. Unit sales of imaging card products were up very slightly year over year, while gaming cards were down.

License and royalty revenue was $120 million compared to our estimate of $85 million to $95 million. The increase over our guidance came primarily from higher prices than we had estimated in our first quarter licensee sales.

Non-GAAP product gross profit for Q2 was $134 million or 22% of product revenue, up from minus 11% in Q1. Second quarter product gross profit included a net release of inventory reserves of $83 million, compared to a net release of $34 million in the first quarter. The inventory reserves released were largely LCM reserves, or lower of cost or market reserves taken in 2008 for product that has now been sold in the second quarter.

Q2 results also included a benefit of $4 million related to fab underutilization charges being less than previously recorded. There were no new charges for fab underutilization as we are now running our captive capacity at 100%.

Excluding the $87 million benefit from release of inventory reserves and reduced underutilization costs, our underlying non-GAAP product gross margin was a positive $47 million or 7.7% of product revenue, a significant improvement over the past several quarters.

Non-GAAP operating expenses of $160 million in Q2 were up $10 million from Q1 due primarily to increased retail merchandising costs, as we had forecasted. Expenses were less than forecasted in all areas due to strong expense management and the delay of certain expenditures.

Non-GAAP Other Income of $18 million was above our previous forecast due to several one-time gains. Excluding the one-time items, other income would have been approximately $10 million.

Our year-to-date non-GAAP tax rate is 35%, which results in a lower rate for Q2 since the first quarter loss was originally benefited at a rate of only 28%.

With this year-to-date tax catch-up, the Q2 non-GAAP tax rate is 26%, resulting in a one-time benefit to Q2 non-GAAP EPS of $0.05.

On the balance sheet, cash and short and long-term liquid investments decreased by $45 million to $2.34 billion, and working capital increased by $79 million. Cash flow used in operations in Q2 was $24 million, a result we are pleased with given that the majority of our license and royalty revenues are received in the first and the third quarters.

Cash used for capital and other non-cash investments in Q2 was a net of $22 million. We loaned $52 million to Flash Alliance for fab equipment and we invested $16 million in non-fab CapEx. Partially offsetting these investments, we received $53 million in loan repayment from Flash Partners as that joint venture generated more cash than was needed for equipment investments.

Our inventory balance declined by $25 million to $527 million, primarily driven by memory cost reduction, partially offset by the reduction in inventory reserves.

Our Yen-based off-balance sheet equipment lease obligations remained approximately constant in U.S. dollar value at $1.2 billion as principal payments made in the second quarter were offset by an appreciation of the yen to the dollar.

I’ll now turn to forward-looking commentary. Please note that non-GAAP to GAAP reconciliation tables are posted on our website for all applicable guidance.

We currently believe that industry pricing is likely to be stable to modestly down in the second half of the year, and within SanDisk, we will continue to emphasize profitable market share. We are forecasting total revenue for Q3 between $725 million and $775 million, including license and royalty revenue between $110 million and $115 million. Remember that our new Samsung license agreement goes into effect mid-August and it will start impacting our license and royalty revenue from the second half of Q4 2009.

We expect our Q3 non-GAAP product gross margin exclusive of inventory reserve fluctuations to be similar to slightly higher than the 7.7% underlying margin in Q2.

Based on our forecast of future pricing and cost reduction, we expect a net release of LCM reserves in the third quarter as we sell through previously reserved inventory. Including the impact of inventory reserve adjustments, we anticipate Q3 non-GAAP product gross margin to be between 15% and 20%.

In terms of underlying cost reduction for 2009, we are forecasting to be at the higher end of our previously forecasted range of 40% to 50%, with strong product cost reduction in the fourth quarter.

In terms of reserve adjustments, after Q3 we expect a reduced benefit from selling through previously reserved inventory.

We forecast Q3 non-GAAP operating expenses of $170 million to $180 million and for the full year, we now expect operating expenses to be between $660 million and $680 million, down from our previous estimates.

We expect non-GAAP other income for Q3 of approximately $10 million, and we forecast the non-GAAP tax rate to be 35%.

Our total capital investment forecast remains at $500 million for 2009, and approximately two-thirds of this capital investment is being funded by the return of cash in 2009 from previous investments, including $53 million of loan repayment from Flash Partners in Q2, $13 million from FlashVision wind-down in Q1 and the $277 million of cash received from the joint venture restructuring in the first quarter.

In summary, we are pleased with the improvement in our operating results in the second quarter. Our pricing actions in an improved industry environment together with our continued reduction of product costs and our control of operating expenses and capital investments have resulted in a cash and liquidity position significantly better than we anticipated at the beginning of this year. Moving forward, we are focused on sustainable profitability and returning to positive free cash flow.

We’ll now open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) And we’ll take our first question from Gary Hsueh with Oppenheimer.

Gary Hsueh - Oppenheimer

Thanks for taking my question. I just have a quick question here about your ability to be more disciplined in terms of pricing and walking way from lower gross margin business -- why is that trend in terms of your guidance really not continuing or extending into the September/December quarters? And what was particular in the June quarter that basically instigated this?

Judy Bruner

Well, I wouldn’t say that it’s not continuing. I’m not sure what you are pointing to in my remarks. We will continue to be targeting profitable market share. I did indicate that our expectation for the industry is that pricing will be stable to modestly down in the second half. We forecast this in part because in recent times, capacity has come back online for the industry and so we expect there is somewhat higher bp growth in the second half than in the first half of 2009 and that that may impact industry pricing in the second half.

I have not given a specific pricing forecast for SanDisk for the second half but we are very focused on targeting profitable market share.

Gary Hsueh - Oppenheimer

Okay, great and just one quick follow-up here if I may, just on the growth in the mobile business -- I was wondering if you guys could basically help explain your market share on bundled microSD or SD cards in general that come with mobile phones? And also your market share on the embedded flash applications, particularly smartphones and how you segue from basically a more bundled approach to now I think increasingly a more kind of embedded smartphone approach in terms of that business.

Eli Harari

Okay, so on the bundled cards, of course this is a very big part of our mobile business. Both the microSD as well as the M2, which is the equivalent of microSD for Sony Ericsson phones -- I believe that we are the largest supplier of bundled cards to the top 10 handset vendors. Of course, Apple doesn’t have a card slot so -- but other than that, I believe every other major handset vendor supports microSD and are a customer of ours.

I would say that with the -- the one impact of the higher prices that we have seen in the last four or five months, the impact in the OEM space has been that the bundled cards are trending to lower densities, lower capacities -- in other words, the OEMs have a certain budget for cards and if the price goes up, they just reduce the capacity. And in fact if you take a look at the market today, there’s tremendous shortages of 1-gigabyte microSD because business that used to be 2-gigabyte is going to one because of that pricing.

But we are very strong in this market and we see some of that market actually going to the mobile network operators who would like to see higher capacity cards and the question is do they buy the phone bundled with the card or do they buy it -- buy the card directly from us. And some of that is happening.

As far as the embedded space, as I’ve said in my prepared remarks, I am very, very pleased with the progress that we have been making in penetration with variants of our INAND. INAND is a managed NAND that is a bootable device that really eliminates the requirements for a NOR Flash to boot up and that standardization in the industry is moving in the direction of EMMC, which is EMC is 4.3 and 4.4 as well as ESV, and we are definitely the vanguard of that standardization and I think that many of the phones, we see 4-gigabyte, 8-gigabyte support these kind of products and we are in very, very good design position with some of the key players.

So I think that this is an area of good growth potential for us and we’ve been very good in moving the market from mDoc, which was more on the low density to the INAND, which is much more high density. We are not participating in the multi-chip package which requires mobile DRAM combination with sometimes NOR, sometimes NAND. We think that that market, although very, very large, is not where we play to our strengths.

Gary Hsueh - Oppenheimer

Great. Thanks for that detailed answer.

Operator

We’ll go next to Paul Coster with J.P. Morgan.

Paul Coster - J.P. Morgan

Eli, I wonder if you could just talk us through what your target gross margins are, and if you can’t do that, at least a road map that takes us forward from this sort of 7% to 8% level back to a level that is consistent with your objective of sustainable profitability -- what are the events that get us there?

Judy Bruner

Paul, let me start with that question -- as I said in my prepared remarks, we believe that in the third quarter, the underlying product gross margin is likely to be similar to somewhat better than the 7.7% that we experienced in the second quarter.

In the fourth quarter, we expect to experience very strong product cost reduction and that should be a significant help to the underlying product cost, or to the underlying product gross margin.

But as I’ve said for some time now, it takes several quarters of cost reduction exceeding price reduction for us to rebuild our product gross margins. But we think we are off to a good start and the 7.7% is quite a bit better than we experienced in the last several quarters and we were actually quite pleased with that outcome for Q2.

So we are taking our guidance one quarter at a time right now but we feel good about the path that we are on.

Eli Harari

Let me be a little bit more -- put our name on the line, if you will -- you know, this really needs to get back to the 20% to 30% product gross margin that we had in prior years and we are not there yet but we believe we know what needs to happen. Some of that is under our control and some is not under our control. What is, of course, not under our control is new capacity coming on-stream, you know, premature to the demand but we have no control of that.

Right now, things look certainly for the next several quarters, look like a good balance between demand and supply and I am hopeful that we can continue to improve our product gross margins and get them to where they need to be in order to make this a healthy business, where one can contemplate further investments.

Paul, did you have a follow-up?

Paul Coster - J.P. Morgan

I did, thank you. Are there specific technology sort of step function changes there, the 30X nanometer, four bit per cell, that you can sort of project out the timeframe for them having, sort of bringing about the relative cost advantage for you in the industry?

Eli Harari

Well, we’ve said last time that X3 gives you a 15% to 20% lower cost, basically a 15% to 20% gross margin advantage. Of course, if everybody had X3 for all their products and yielding and applied across their products, then that advantage goes away. But basically, and X4 goes further than of course the X3 and we are definitely driving in that direction.

But another area really is to drive the differentiation and to drive the brand and to gain an incremental product margins not just on costs and not just on commodity, you know, my price is 10% lower than yours and therefore I get the business.

And we are finding that we can in fact do some of that, that we can walk away from business and that our customers do value our brand and are prepared to pay us a premium for that.

Paul Coster - J.P. Morgan

Thank you.

Operator

We’ll go next to Daniel Berenbaum with Ariga U.S.A.

Daniel Berenbaum - Ariga U.S.A.

Thanks for taking my call. Can you talk a little bit about the royalty revenue and what drove the upside to your guidance there? And then maybe just help me put in perspective the changes that have gone on at your licensees with reducing capacity and is there a way that we can think about, if I look back, and I recognize you are not going to want to give guidance but if you think about looking back to where your peak license revenue was in Q3 of ’08, can we get back to that number in a reasonable time frame with all of the changes that have gone on with your licensees, or think about maybe what the maximum theoretical license revenue is or help me understand around that.

Judy Bruner

Let me address the upside to the guidance that I provided last quarter, as a starting point -- you might recall that last quarter, when we did our earnings release and I provided guidance, there had not been a release at that point in time from some of our major licensees. So clearly this is a number that we have estimate without much guidance and when we did hear results from major licensees, we heard that there had been quite a bit more price increase at the component level in the first quarter than we had anticipated or included in our forecast. And that really is the primary thing that drove the upside to our guidance.

And you might recall that our license and royalty revenue was fairly soft in the first quarter, so I would also add that we were probably conservative, perhaps a little gun-shy after the first quarter result.

In terms of your second question, you know, in terms of what is the maximum, keep in mind that the third quarter that we just gave guidance for is really the last quarter of what I might call status quo older license agreements and our new Samsung agreement will begin to impact our license and royalty revenue in the fourth quarter, impacting half of the fourth quarter and then all of 2010 and beyond.

And the best way for me to help you in terms of estimating is to say that historically over the last few years, the Samsung license and royalty revenue for us has ranged between about two-thirds and three-quarters of our total license and royalty revenue and we estimate that the all-in royalty rate of our new agreement will be effectively approximately half of the all-in rate of the older agreement.

Eli Harari

Yeah, but that assumes that that’s the end of it, that we will never have anymore royalties from any other source and I would not use that assumption. For one, I’ve just told you that SD and microSD are now I believe the global standards and I believe their volume in future years could go up quite substantially from where it is today and we area co-sharer of royalties collected on these cards.

And this is just one example and we also believe that we have a very valuable IP in the area of solid state disk, so I think that you are looking at a point in time and we -- of course, we have to deliver, I mean, we have to prove through actions greater royalties but overall, I think that the IP portfolio is very powerful as -- again, I’ve just pointed out that The Wall Street Journal considered us to be the most impactful IP portfolio, the most impactful in our industry.

Daniel Berenbaum - Ariga U.S.A.

Absolutely -- and then maybe I can just sneak in one more on a different topic, in terms of OpEx -- you guys have done a great job managing costs and I know that some of the cost reductions now that the Samsung negotiation is complete, but when you look at your traditional advertising spend as you get into the back-to-school and Christmas, are you giving up anything there and do you think that there’s -- you know, what’s the trade-off? Help me understand just how you thinking about that?

Judy Bruner

Well, I mean, you can see from the expense guidance that I provided today that there is a lift in the expenses in the third quarter and the fourth quarter, with the year still being quite a bit less than we had originally guided at the beginning of the year. So we are increasing our spending in the latter part of the year in merchandising and in some forms of advertising. I mean, clearly we are not spending on anywhere near what one might consider a full-blown advertising campaign but we do have some merchandising expenses built into that.

So we think we’ve found the right balance, at least for this year, in this demand environment.

Daniel Berenbaum - Ariga U.S.A.

Okay, great. Thanks very much.

Operator

We’ll go next to Uche Orji with UBS.

Uche Orji - UBS

Thank you very much. Eli, let me just ask you about how you plan to drive bit growth, just in case the recovery we’ve seen in the market continues -- you are not raising CapEx and you are running at 100% utilization rate, so obviously the only choice, way to drive bit growth is by shrink. So can you talk about where you are in terms of shrink, 32-nanometer transition, how much volume now, and what is the roadmap?

Eli Harari

We are well along, as I said, in the 32-nanometer transition and that will -- I think about early in the year in February, we announced our 32-nanometer, 32-gigabyte, three bits per cell X3 chip, I think 113-millimeter squared, which is smaller than any other chip out there in 32-nanometer or in any other technology. We expect that technology to be in production this year.

And we are bringing up on 43-nanometer both additional X3 capacity as well as X4 capacity, and we are -- so both the 43-nanometer and the 32-nanometer are transitioning as best we can, as much as we can, because our customers will still need the two bits per cell and some applications that needed two bits per cell. We are moving as much as we can to three bits and a little bit later in the year to four bits per cell.

Next year we will be mostly in 32-nanometer -- perhaps half of it in two bits and half in three bits per cell, and I expect that before the end of next year, we will be in what we call the 2X technology, and we are in development of the technology beyond that.

So as I’ve said in the past, we always kind of like three generations in development and the third generation always kind of looks like we are going to fall off the cliff from the point of your scaling but as we get closer to that edge of that cliff, we see actually there is a little bit more runway. So I’m a little bit more optimistic now on being able to scale NAND beyond 20-nanometer. That of course would be very good for extending the life of our existing capital investments and generating more bits.

But there’s a lot of work to be done and of course, every generation, as we scale down, we need more and more system support, more and more sophisticated algorithms and more powerful error correction and this is really the strength that we bring to the party.

So we have a very holistic approach to driving the technology and the technology goes with the algorithms of the controller that we are driving together with Toshiba -- very, very hard, the technology scaling.

There is, of course, beyond the 20-nanometer a very big, very, very big challenge which is the UV. That is a challenge for the entire industry or at least for those companies, very few companies that can afford to even think about it but that is certainly something that we are beginning to take very seriously.

In addition to that, of course, we have a full blown effort on the 3D read write because eventually NAND will come to the end of its economic scaling and at that point, we hope to have 3D read write.

So it’s a very, very substantial program, a tremendous amount of energy and passion and innovation and invention and it’s part of really what makes us feel that this technology has just so much potential ahead of it.

I think for SSD, for example, we are really within two generations from making this thing even on the cost side a different kind of value proposition. At the same time, you are seeing the tremendous improvements, very rapid improvements and benefits of SSD with Flash in terms of performance. So it’s not just meeting the required costs but it’s also demonstrating the performance advantages over hard disk drive and I think that that more than anything else will convince consumers that it’s time to switch.

Jay Iyer

Uche, do you have a follow-up?

Uche Orji - UBS

Yes, I do -- I mean, you talked about SSD in the last comment. When you talk about making a different kind of value proposition, I mean, right now at 120 gig SSD is too -- on retail is still priced around $300 against less than $50 for a hard disk drive. So from your surveys of customers, how do you think the value proposition is going to be compelling? Do you think if we get below $100 for 120 gig, it takes off regardless of the delta with hard disk drives? I mean, how should we think about -- what do you know in terms of how the customers think about this that will lead this to trigger an adoption?

Eli Harari

Well, it’s very important to meet consumer price points or perceived requirements of price points but it’s also important to make this a profitable business. And if the business is not profitable for the manufacturers because the cost just isn’t there to satisfy consumer price points, then nobody is going to build a factory to manufacture all of this Flash.

So the key is that the industry, the solid state drive industry really needs to emphasize the other attributes of Flash memory primarily speed, performance, responsiveness, ruggedness and so on, power [inaudible], low noise and so on, so that -- because I believe that once the industry achieves that, even at the price point that is higher than what consumers would like to have, I believe that consumers once they use a notebook computer with such a device will never want to go back to a hard disk drive, even if it’s given away for free.

Uche Orji - UBS

Thank you very much.

Eli Harari

Now, you know, I could be wrong but time will tell. I’m telling you that some of the projections that I’ve seen from independent market analysts that say that the Flash memory will reach ridiculously low price points by 2013 or so and that sort of takes for the SSD market to take off, there is no math in the world that I can think of that will have anybody build a wafer that generates those kind of prices in this timeframe.

So it may mean that the SSD market takes longer to develop, that it takes five years instead of three years. In some markets, in the enterprise, of course, it’s ready to go because pricing is not an issue and performance is absolutely there. All I’m saying is that this is -- really what I am saying is that the SSD is a tremendous opportunity. Eventually it will consumer a third to a half of the total bits of either NAND or another technology with 3D read write. Huge, huge volume but it will require that the manufacturers can achieve profitability, not just that the -- it should not be parity with hard disk drive.

Operator

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

James Covello - Goldman Sachs

Thank you so much for taking the question -- a lot of good questions asked already. I really want to focus a little bit more on the royalty, kind of looking forward. Eli, you talked about how this, we’re looking at a snapshot in time on the royalty and there’s incremental opportunity in SD and microSD and you think you have good solid state drive technology -- what about Micron? It would seem like all the other major OEMs now with Samsung and Hynix licensing and Toshiba and Intel obviously having cross-licensed, Micron is the one major producer OEM who is not -- who doesn’t either have a cross-license or is not paying you a royalty and that would seem like an increasingly significant opportunity for you.

Eli Harari

Yeah, it’s true, nothing has changed there. Micron is not licensed and I believe that’s a problem for them. And that’s all I can say.

James Covello - Goldman Sachs

And your strategy in the past has been kind of wait until someone who you think is in violation gets big enough and then pursue litigation to make the litigation costs worthwhile, like maybe you did with ST Micro years ago before they got out of the business. I mean, is that a similar kind of strategy here?

Eli Harari

Again, I am not going to tip our hand on what our strategy is with regard to Micron or anybody else.

James Covello - Goldman Sachs

Okay. I mean, I guess I’m just -- what’s preventing you from trying to get them to pay a license? It’s not -- I mean, they are not paying, they should be paying, so that’s not trade secrets.

Judy Bruner

Jim, we really can’t address legal strategy and IP strategy in our comments here.

James Covello - Goldman Sachs

Okay. All right, thanks very much. I appreciate it.

Operator

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

Edwin Mok - Needham & Company

Thanks for taking my question. My first question on the cost, just a clarification that Judy mentioned that you expect more substantial cost savings in the fourth quarter. Is it because you guys are ramping? I think you mentioned or Eli mentioned that you would expect X3 to be 60% of production. Is that why you expect the cost savings, because X3 is ramping this quarter? That will translate to the following quarter?

Judy Bruner

It is really the timing of the technology mix over the course of the year, and it’s a combination of the mix of X3, which has been ramping and it’s also starting late this year, starting to see a bit of benefit from 32-nanometer. But remember that there is a lag in our business model and that what you see hit our P&L in any given quarter is probably the result of production two quarters prior to that, given the supply chain lag, the inventory, and then our sell-through revenue recognition. And I’ve actually been saying for some time that the timing of that product cost reduction this year is such that it was very strong in the first quarter and would be reducing but not as strongly in the second and third quarter and then very strong again in the fourth quarter.

Edwin Mok - Needham & Company

Great, and then one question on your utilization charge -- I think in the first quarter, you guys had $63 million in the utilization, and I think you guys had mentioned that your fab utilization around 70% for the second quarter, that’s how you determined that charge.

I was wondering if demand has softened maybe towards December or towards first quarter of 2010, do you expect to dial back on your production and do you expect that kind of charge to potentially hit in your fourth quarter?

Judy Bruner

As Eli said, if demand is not as strong as we are expecting, particularly in the holiday period, then we could choose to run our captive capacity at less than full utilization and if we were to do that, you’re right, there would be a charge that we would take related to that under-utilization.

The charge, as I think you know that we took in the first quarter, which was as you said, the $63 million, was for our estimate of the cost of the under-utilization in the second quarter. And now in the second quarter, we are not including any -- we did not have any charge in the second quarter because we are running our fabs at 100% capacity in the third quarter.

Edwin Mok - Needham & Company

Great, that was very helpful, thanks for clarifying that. And finally, just one question on the SSD -- Eli, you mentioned that there seems to be some good demand on industrial SSD and I think historically, M-system was actually a strong play in that space and you mentioned that you guys have strengthened your embedded team and working with the mobile sector. Any thought about going after the current embedded SSD or I should say industrial or enterprise type SSD market, given that it’s a good market?

Eli Harari

We are currently not in that market and you cannot be in that market kind of like causally. You are either in it or not. So today we are not in this market, as I said. If we were to be in that market, it would be through partnership with other partners that are entrenched in the enterprise space, not so much in the industrial space. The industrial space, we have been in, M-system we have been in and it’s just too small a market.

Edwin Mok - Needham & Company

I see. Great, thanks for clarifying that.

Operator

We’ll go next to Craig Ellis with Caris & Company.

Craig Ellis - Caris & Company

Thanks for taking the questions. Eli, just the first question on the comments for potentially moderating utilization late this year if we get some sloppy supply in-demand dynamics, has SanDisk discussed with its manufacturing partner the possibility of doing so? And if your partner didn’t want to throttle back utilization, would SanDisk still be able to do that with --

Eli Harari

Well, of course, we can’t discuss what we are discussing with a partner but we do have the flexibility to ask unilaterally, of course, we would inform them of that and give them advanced notice and in fact, may offer them that capacity if they were interested in that.

There was a -- at the Apple announcement yesterday, Apple I believe said that they have prepaid Toshiba $500 million, and I’m just quoting public information, so clearly at least Apple thinks that they are going to be in need of guaranteed capacity, so -- and obviously Apple is a major consumer of Flash, so we’ll see.

Craig Ellis - Caris & Company

Okay, fair enough -- switching gears to inventory, Judy, can you provide some color on where you would like on-hand inventory to be, both exiting the third quarter and if you can provide any color on where you would be comfortable exiting the year, that would be helpful as well.

Judy Bruner

Sure. So as we’ve said, the inventory levels are still higher than we’d like them to be. Our inventory levels at present are slightly more than a quarter’s worth of inventory and given our vertically integrated supply chain, a good level is probably something in the neighborhood of nine to 10 weeks. We think that it’s possible we could be around that level around the end of this year and we anticipate year-end, it’s very possible we could need non-captive supply in 2010.

However, let me point out to you that in dollar terms, it’s very possible that the inventory dollars will increase on the balance sheet in the third quarter because one, we are running our capacity at full capacity and two, we expect that we will be releasing additional reserves as that inventory sells through.

Craig Ellis - Caris & Company

Okay, that’s helpful. And then I’m not sure if the last comment --

Eli Harari

Let me just clarify something, Craig -- when Judy talks about a total inventory, that is including what’s in the production line, in unfinished wafers.

Craig Ellis - Caris & Company

Okay, got it.

Judy Bruner

Yes, it includes raw materials, WIP, finished goods, and in fact it includes inventory in OEM hubs that we hold for some of our OEM customers and it includes some inventory in the retail channel, which was held on a consignment basis. So we have a fairly long supply chain, vertical supply chain.

Craig Ellis - Caris & Company

Yes, a lot there -- Judy, can you clarify the company wrote off, I believe, $370 million worth of product in 2008 and I think through the first quarter of 2009, how much of that has been reversed or sold back? I think about $100 million -- is that correct? And so is the balance left to go? How do we look at that opportunity to resell previously written down inventory?

Judy Bruner

Well, in the first half, we have released net reserves of $34 million in the first quarter and $83 million in the second quarter, so $117 million of net reserve. And so you’re right, there is still a sizable amount of reserve that is left on the balance sheet. We expect that we will release a fair amount of reserve in the third quarter but again, it will depend on how much sells through and the net impact to the P&L will depend on what the pricing outlook for the future is and what new reserves, if anything, are needed. And then we expect there will be some release in the fourth quarter as well, but probably at a declining amount.

Craig Ellis - Caris & Company

Thanks for taking all the questions.

Jay Iyer

Thanks, Craig. Jamie, we’ll take one more question.

Operator

That final question will come from Bob Gujavarty with Deutsche Bank.

Bob Gujavarty - Deutsche Bank

Thanks for squeezing me in and appreciate all the color around inventory reserves. That’s very helpful.

I’m just curious what you are seeing in the retail channel -- is it a little bit too early to look at back-to-school? Are you comfortable with your retail inventory? What are you seeing from that channel?

Judy Bruner

You know, I’ll say that we are quite comfortable with our retail channel inventory levels. We ended the second quarter with channel inventory between seven and eight weeks and that’s about the right level for us.

It’s really too early to comment on Q3 back-to-school sell-through trends. We just provided the revenue guidance for Q3 today.

Bob Gujavarty - Deutsche Bank

Okay, fair enough and just a quick follow-up -- I looked back on 3Q last year, OEM was about 37% compared to retail at 63 -- we’re already at 41, 59, and you suggested OEM would be growing as a percentage of mix in 3Q -- any range you could provide on what you think, how high that can get in 3Q?

Eli Harari

The OEM, we expect to be the star of the third quarter, the strong performer in the third quarter, so you’re right, it will -- it should increase in percentage.

Bob Gujavarty - Deutsche Bank

Okay. Fair enough. Thanks.

Jay Iyer

Thanks, Bob.

Operator

And that does conclude today’s’ question-and-answer session. At this time, I would like to turn the call back to you, Mr. Iyer, for any additional or closing remarks.

Jay Iyer

Great, thank you. Thank you all for joining us on the call today. A webcast replay of this call will be posted on SanDisk.com/ir shortly. Have a good evening.

Operator

That does conclude today’s conference. We do thank you for your participation.

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Source: SanDisk Q2 2009 Earnings Call Transcript
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