SanDisk Management Discusses Q3 2013 Results - Earnings Call Transcript

Oct.16.13 | About: Western Digital (WDC)

SanDisk (SNDK) Q3 2013 Earnings Call October 16, 2013 5:00 PM ET

Executives

Jay Iyer

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

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

Analysts

John W. Pitzer - Crédit Suisse AG, Research Division

Doug Freedman - RBC Capital Markets, LLC, Research Division

Ambrish Srivastava - BMO Capital Markets U.S.

James Schneider - Goldman Sachs Group Inc., Research Division

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

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

Mark C. Newman - Sanford C. Bernstein & Co., LLC., Research Division

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

Joseph Moore - Morgan Stanley, Research Division

Michael Bressler

Brian C. Peterson - Raymond James & Associates, Inc., Research Division

Operator

Good day, and welcome to SanDisk Corporation's Third Quarter 2013 Financial Results Conference Call. Today's conference is being recorded.

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

Jay Iyer

Thank you, Alise, and good afternoon, everyone. Before I start, I'd like to let you know we had a little bit of technical issue [ph] that we had to work through and that caused a slight delay in publishing today's earnings release and I apologize for that. With me on the call today are Sanjay Mehrotra, President and CEO of SanDisk; and Judy Bruner, Executive Vice President of Administration and CFO. In a moment, we will hear remarks from both of them and then we'll take your questions. Before we begin, please note that any non-GAAP financial measures discussed during this call, as defined by the SEC in Regulation G, will be reconciled to the most directly comparable GAAP financial measure. That reconciliation is now available, along with supplemental schedules on our website at sandisk.com/ir. Please note that non-GAAP to GAAP reconciliation tables for all applicable guidance will be posted on our website. This guidance is exclusive of any one-time transactions and does not reflect the effect of any acquisitions, divestitures or similar transactions that may be completed after October 16, 2013.

In addition, during our call today, we will make forward-looking statements. Any statement that refers to expectations, projections or other characterizations of future events, including financial projections and future market conditions is a forward-looking statement. Actual results may differ materially from those expressed in these forward-looking statements. For more information, please refer to the risk factors discussed in the documents we file from time to time with the SEC, including our annual report on Form 10-K for fiscal 2012 and our subsequent quarterly reports on Form 10-Q. SanDisk assumes no obligation to update these forward-looking statements, which speak as of today.

And finally, I'd like to inform you that we are planning for our Fourth Quarter 2013 Results Earnings Call on Wednesday, January 22, 2014.

With that, I'll turn the call over to Sanjay.

Sanjay Mehrotra

Thank you, Jay. Good afternoon, everyone. We are pleased to report outstanding third quarter results with record revenue and excellent growth in operating margins. We achieved these results through continued strong execution on our strategy of shifting the portfolio to a higher-value solution. We grew our Client and Enterprise SSD revenue, which, together, contributed 20% of quarterly revenue. We delivered strong performance in our embedded products and our retail channel grew in both emerging and developed markets. We closed the acquisition of SMART Storage Systems, which has significantly strengthened our Enterprise Storage Portfolio. Our excellent third quarter achievements keep us on track to deliver record 2013 results.

Turning to SSDs. Our client SSDs delivered record revenue for the fourth quarter in a row. The Client SSD market continues to grow, driven by growing customer preference for high-performance, instant-on capabilities of devices in thin and sleek form factors. SanDisk Client SSDs are now qualified at all the major PC OEMs. We also saw strong acceptance of our high-performance 19-nanometer client PCIe SSDs. We continue to invest in improving our product capabilities and customer engagements to further build upon our growing share in Client SSDs.

In Enterprise SSDs, we achieved sequential revenue growth to deliver yet another record quarter. Our growth has enabled us to establish SanDisk as a leader in the enterprise SAS market. We are pleased to have closed the SMART Storage Systems acquisition and we welcome the new employees to the SanDisk team. The acquisition brings us new enterprise customers and SanDisk Enterprise SSDs are now qualified at 6 of the top 7 storage OEMs.

In addition to expanding our SAS product offerings, the SMART Storage Systems acquisition also enables us to serve a 1.7 billion TAM for enterprise set of products. We are excited about the potential synergies that we can drive in our portfolio of Enterprise and Client SSDs by leveraging SMART Storage Systems Guardian Technology.

Following the close of the acquisition, we have been reviewing our overall Enterprise SSD roadmap. And I want to highlight some of our conclusions. We have determined that SMART Storage Systems' Enterprise SSD product architecture is more scalable than our existing platform with significant headroom to drive new features and higher levels of performance and endurance that our Enterprise customers require. Therefore, we plan to implement the Guardian Technology into more of the Enterprise products in our roadmap. Simultaneously, we are accelerating investments in UltraDIMM, a new product category aimed at the high-performance, low latency market, which, thus far, has been served mostly by PCIe-based products. Ultra-DIMM SSDs place NAND flash memory on DIMMs, very close to the processor, enabling lower latency and higher storage densities per server for high performance computing applications.

We believe the combined Enterprise product roadmap from SMART Storage and SanDisk significantly strengthens our portfolio and broadens the range of opportunities we can address, spanning Fortune 500 IP infrastructure to the hyper scale data centers.

As we review the progress on our next-generation 12-gigabit SAS platform, based on the client technology, we have concluded that the expected launch of our 12-gigabit SAS SSD product will be delayed. The related enterprise PCIe product will also be impacted. The 12-gigabit SAS SSD products are expected to be released around mid-2014 and we believe that our SAS product portfolio will continue to lead the industry. We expect to introduce a high-performance enterprise PCIe product in 2014. We also plan to address the high-performance, low latency market with our UltraDIMM product, which we are already sampling to OEMs to initiate their driver development and system integration activities.

Overall, with our broadening portfolio of products and customer engagement in the Client, as well as the Enterprise SSD market, we are on a trajectory to exceed our 2013 goal to deliver 15% of our revenue from SSDs and we remain on track to deliver 25% of our revenue from SSDs in 2014. SanDisk is also continuing to drive innovation in use cases for NAND flash to our ventured investments and we are pleased with the strategic benefits we have realized from the SanDisk ventured initiative, thus far.

We expect the Enterprise Storage Market will continue to see rapid innovation and growth and SanDisk with its strategic advantages, including deep enterprise storage expertise, software capabilities and vertical integration, is well positioned to provide leadership in this space. Our mobile product revenue represented 47% of quarterly revenue with the largest portion driven by our embedded solutions.

SanDisk has made significant inroads into the rapidly growing mid- and low-tier smartphone segments with our iNAND embedded flash and iNAND MCP offerings, further building upon our strong presence with global smartphone and tablet OEMs. Smartphone and tablet OEMs in China are eager to capture the growing mobile opportunity and their products are being launched with strong technical specifications and growing average storage capacities.

Additionally, industry trends in mobile are now showing new use cases that can increase local storage needs. For example, the introduction of 4K and 120 frames per second video capability, increasing adoption of burst mode in mobile devices and recent offerings from content providers that drive more usage of local storage are trends which bode well for the average capacity increases in smartphones.

Retail had an excellent quarter, driven by the back-to-school season and solid execution in all regions. Product innovation and leadership momentum remains high with the introduction of the world's fastest and highest capacity SanDisk Extreme Pro CompactFlash Card at 256 gigabytes and the SanDisk Extreme PRO CFast 2.0 product line, new products that are suitable for high-end broadcast, cinema and pro video market.

We also launched a new family of SanDisk Connect products that allow consumers to better manage mobile content and media, as well as to stream this content to multiple devices simultaneously. Our well-recognized and trusted brand, innovative and broad retail product offerings, global presence and strong supply chain execution position us well for continuing strength and further gains in the retail channel.

Turning to manufacturing. As of the third quarter, our 19-nanometer technology has fully ramped. We also commenced the ramp of our 1Y technology with X2, as well as X3 memory, and we have already shipped product to customers based on that technology. We expect 1Y to achieve cost crossover with 19-nanometer in the fourth quarter and we estimate approximately 15% of our production output to be on 1Y exiting the year.

In memory technology, we are making excellent progress in scaling to the 1Z node and expect to target production starts in late 2014. We continue to believe that our 1Y and 1Z 2D NAND nodes will position us well for accessing a broad range of applications and market opportunities in 2013 and 2015. From a future technology perspective, as we progress with our BiCS NAND development, our efforts are focused on modifying certain aspects of our memory architecture and related process technology to optimize for manufacturability, scalability, cost and product specifications targeting a broader range of applications. We continue to target pilot production of BiCS NAND in 2015 and volume ramp of product in 2016.

Switching to supply. We estimate that 2013 industry bit supply growth to be approximately 40%, with relatively similar expectations for 2014 as well. We continue to expect SanDisk 2013 bit supply growth will be approximately 20%. And that our 2014 bit supply growth will be between 25% and 35%. The industry bit growth estimates include assumptions of 2D NAND transitions, new wafer capacity additions, as well as conversions of from DRAM wafer capacity to NAND, and early production of 3D NAND. We believe that demand drivers for the industry will continue to be strong and that the fundamentals of the industry will remain healthy in 2014.

To summarize, we are very pleased to have reported outstanding third quarter results and we are looking forward to a strong finish to 2013. We are focused on executing to our technology strategy, driving our ongoing portfolio shift to higher-value solutions, prudently managing our capacity and creating shareholder value.

With that, I will turn the call over to Judy for her financial review and outlook.

Judy Bruner

Thank you, Sanjay. Q3 was an outstanding quarter with 28% year-over-year revenue growth, 50% non-GAAP gross margin and 33% non-GAAP operating margin. In addition, we retired 15.7 million shares and we made our first-ever dividend payment. And today, we announced our fourth quarter dividend. Our record revenue of $1.625 billion was comprised of year-over-year growth in gigabytes sold of 14% and a year-over-year increase in blended ASP per gigabyte of 12%. While our prudent capacity management has contributed to a strong supply-demand for our business, the biggest driver of our year-over-year price increase has been the mix shift in our sales towards embedded and SSD solution. In addition, we have increased the mix of our high-performance retail products and we have reduced the mix of non-branded sales.

On a sequential basis, our third quarter gigabytes sold grew 15% and our ASP per gigabyte decreased 3%. For the 9 months of 2013 compared to the same period of 2012, our blended ASP per gigabyte is unchanged, benefiting from the improving mix of our portfolio and careful attention to managing our capacity to meet demand.

Our third quarter revenue mix between commercial and retail customers remained constant, sequentially, at a mix of 65% commercial and 35% retail. Our retail revenue grew 11% sequentially and 18% year-over-year with sequential growth strongest in USB drives and year-over-year growth strongest in mobile cards. On a year-over-year basis, our retail revenue has grown nicely in all major regions and we believe that we have gained share globally. Our commercial revenue grew 10% sequentially and 33% year-over-year with the mix of our commercial sales shifting significantly towards embedded and SSD products. Within our Q3 total revenue, we achieved a record 50% mix from SSD and Embedded Solutions.

On a year-over-year basis, our blended cost-per-gigabyte declined 19% compared to our price increase of 12%, resulting in non-GAAP gross margin increasing from 31% in Q3 of last year to 50% this Q3. On a sequential basis, our non-GAAP gross margin increased 340 basis points with cost decline of 10% compared to price decline of 3%. The sequential cost improvement and related margin expansion came primarily from a more favorable yen rate in our cost of sales; an increased usage of 19-nanometer supply, driven by our portfolio mix; and lower period costs.

In Q3, the yen rate in our cost of sales was 93 compared to 85 in the second quarter. And the 19-nanometer mix in our sales increased to over 85% compared to less than 80% in Q2. Our Q3 non-GAAP operating expenses increased $22 million sequentially to $282 million with the increases coming from 3 primary areas: First, the addition of SMART Storage Systems from August 22 through the end of our quarter; second, an increased investment in memory technology and systems engineering; and third, an increased investment in sales and marketing for the commercial channel.

In our GAAP expenses, in addition to the usual stock compensation and amortization of acquisition-related intangibles, we have recorded an $83 million impairment of the intangible assets from our Pliant acquisition. This stems primarily from our decision to integrate more the SMART Storage Systems' architecture and technology into our future enterprise product roadmap, and to some extent, from the delay of our next-generation SSD platform built on the Pliant technology. There is $41 million of Pliant intangible assets remaining on the balance sheet, which will be amortized to expense between now and the end of 2014.

Our Q3 non-GAAP operating margin increased sequentially from 29% to 32.8%, resulting in record quarterly non-GAAP net income and we delivered a substantial increase in EPS on both a non-GAAP and GAAP basis.

I want to mention that in our non-GAAP share count, we are now including the expected impact of the bond hedge we carry on our convertible debt, which will provide an offset to the shares ultimately issued for the convertible notes at maturity in 2017. While the effect of the bond hedge cannot be included in GAAP diluted shares until it is exercised at maturity, we believe it makes sense to include this in non-GAAP diluted shares and we have reflected this in our Q3 non-GAAP results and retroactively adjusted our Q2 non-GAAP shares downward by 1.6 million.

A schedule available on the Investor Relations web page of our website outlines the share dilution expected from the convertible debt at various stock prices showing the difference between GAAP and non-GAAP share count. And this schedule has also been updated to account for the impact of the dividends paid to date.

Turning to cash flow, our cash flow from operations was $382 million and we spent $51 million on capital equipment, resulting in free cash flow of $331 million. We utilized a net $304 million of cash for the SMART Storage Systems acquisition; $1.07 billion for share repurchase, which includes an open ASR contract; and $51 million for our Q3 dividend. Our joint venture fab equipment investments in Q3 were $227 million with no cash contributions required. On a year-to-date basis, our joint venture fab equipment investments have been $407 million and all payments have been funded by the joint ventures with cash of $73 million received by us in repayment of our joint venture and notes receivable. The joint ventures have not utilized any equipment leases so far this year and our off balance sheet fab equipment lease guarantees have been reduced to $565 million.

I will now turn to forward-looking commentary.

We expect our fourth quarter revenue to be between $1.65 billion and $1.725 billion, reflecting continued healthy demand with blended price declines somewhat higher than in Q3 due in part to a higher mix of holiday retail sales. Our strong Q3 revenue, coupled with the Q4 revenue expectation brings our full year 2013 revenue forecast above the high end of our previous estimates.

We forecast our fourth quarter non-GAAP gross margin to be in the range of 48% to 50%. We expect fourth quarter sequential cost reduction to be less than we experienced in the third quarter, as our 19-nanometer sales mix is not expected to grow, the 1Y nanometer contribution to Q4 cost reduction will still be small and the sequential improvement from the yen will be less in Q4 than it was in Q3.

Our expected yen rate in Q4 cost of sales is slightly below 97. We expect expenses to increase in the fourth quarter due to a full quarter of expenses from the addition of SMART Storage Systems, seasonal marketing expenses, and increases in R&D expenses, some of which will be nonrecurring. Our Q4 non-GAAP expense forecast is $310 million to $320 million, including approximately $15 million of one-time and seasonal expenses. We expect our tax rate to remain about the same and we expect our diluted non-GAAP share count to decline by approximately 3 million shares as we benefit from a full weighting of our third quarter share repurchases. We expect an increase in capital investments in Q4 for 1Y transition equipment at the fab joint ventures and for manufacturing equipment within SanDisk, bringing gross capital investments to the year to between $1 billion and $1.1 billion

Q4 cash usage for these investments is expected to be in the range of $125 million to $150 million, bringing full year cash usage to $250 million or less. In summary, we believe our strong results reflect a broadened portfolio with increasing penetration into high-value solutions, strong execution on technology transitions and prudent management of capacity. We believe 2013 will set a record for us in terms of revenue, non-GAAP net income and cash flow from operations. And we are very pleased to have utilized a substantial portion of this cash flow to increase total shareholder return through our share repurchases and our dividend payments.

We will now open the call for your questions.

Jay Iyer

Thank you, Judy. Thank you, Sanjay. Alise, if you could poll the floor for questions. [Operator Instructions]

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from John Pitzer with Credit Suisse.

John W. Pitzer - Crédit Suisse AG, Research Division

Sanjay, you talked about in your prepared comments your expectation for SanDisk's supply growth next year of between 25% and 30%. I'm kind of curious what's the CapEx number we should think about that's embedded within that? And as we think about your ability to mix up, how should we think about the potential for mix up allowing revenue growth to accelerate above and beyond just bit growth?

Sanjay Mehrotra

So first of all, bit growth guidance that we provided for next year is 25% to 35%. Judy can comment on the CapEx aspect. And of course, our focus is to continue to strengthen the mix of our solutions offerings during the course of the year. SSD revenue approaching 25%, 25% is our target for next year, will certainly contribute toward our revenue shares outperforming our bit shares. And I will let Judy comment on the CapEx.

Judy Bruner

Sure. While it's too early to provide any specific CapEx guidance for next year, we do expect our CapEx investment to go up in 2014 relative to 2013 and the primary reason would be, that there will be more investment in technology transition in 2014 and, specifically, in the 1Y transition, which as we've described before, has a higher capital cost than the 19-nanometer transition did.

John W. Pitzer - Crédit Suisse AG, Research Division

Perfect, that's helpful. And then Sanjay, as my follow-up, you talked about, again, in the prepared comments, new applications in the mobile space like 4K and 120 frames per second. I'm kind of curious, when do you think those acquisitions will actually have a tangible impact in moving up sort of the densities in the smartphone market? And as we look out 12 months from now, where do you think the average density per smartphone will be versus where we are today?

Sanjay Mehrotra

In terms of -- some of the features that are -- have typically been only in the premium smartphones in the past, now some of those features are moving toward the mid-and the low-end range of the smartphones as well. And those are actually driving higher average capacities in the mid- to low-end range. I'm excited about some of the offerings related to 4K video capability, as well as some of the content offerings by content providers, such as YouTube and Amazon where you can download content to the device and watch it several hours later. These are all start of the trends. Of course, this is all very much in the beginning, it will take a while for all these trends to really proliferate across multiple product offering by multiple suppliers. But this is how this industry has really driven innovation and has flash -- and as time and again showed that's how it is really a strategic component in terms of enabling such features. In terms of the average capacities, average capacities from 2013 to 2016 time frame are expected to double in smartphone category. So I think, we have some exciting opportunities ahead for flash usage in smartphones.

Operator

Our next question comes from Doug Freedman with RBC Capital Markets.

Doug Freedman - RBC Capital Markets, LLC, Research Division

Having just guided to record numbers, is there any reason or anything that you would like us to think about that would keep you from reporting yet another record year next year?

Judy Bruner

I would say that as we said in our prepared remarks, we expect that the industry will have strong fundamentals in 2014. And we're very optimistic about our own business in terms of continued improvement of our portfolio mix and broadening of our portfolio. And we're working very hard to continue to optimize the combination of revenue growth, profits and cash flow. And so as we sit here today, we are optimistic about 2014.

Doug Freedman - RBC Capital Markets, LLC, Research Division

And as my follow-up, when I look at the overall industry and the profits that are generated by the manufacturers versus those of their customers, it would seem that the customers still have the upper hand and, yet, that balance of power is shifting. How do you deal with that? And how is your pricing power impacted? As well as when we look at the slowdown in your cost per bit declines, does it allow you to sit on inventory longer to maybe manage your output to use it when the market demand is there?

Sanjay Mehrotra

In terms of our engagement with the customers, certainly, as we continue to deliver leading-edge solutions and leveraging our system expertise to really bring value to our customers in terms of performance of the products, in terms of the reliability and the endurance aspect, these are the things we -- that make us a valued supplier to our customers. And of course, we work closely with our customers to also understand their future roadmap, to make sure that our products are well-aligned to their needs. And I think you are seeing the benefit of what SanDisk is able to bring to the customers. Our diversified growth portfolio of customers and our strengthening mix of solutions, I think you are seeing the benefits of all that translate into the results that we have produced this year and over last few quarters. And I really believe that SanDisk is in the best position in regard to really addressing the needs of the customers and really delivering value. The latest example, of course, is what we are doing on the Enterprise side, not only through high-performance, cost-optimized, as well as higher-reliability hardware solutions. But also bringing greater value opportunities to them through software capabilities. So these are all the things that we are focused on and ultimately, these are certainly leading to a consistent business model for us, as well as a strengthening of the business fundamentals for us. Regarding your question on inventory, maybe Judy can answer.

Judy Bruner

Yes. I just wanted to add on your question on inventory. We work very hard and I think we've done an excellent job this year to manage our capacity to the demand requirements that we see from our customers. And so I would not say that we would manage our inventory by sitting on inventory, but really rather by managing that supply-demand balance within our business. However, I will tell you that from time-to-time, yes, we do hold inventory for the most strategic needs for that inventory. And so we're very careful in terms of how we allocate that precious inventory to our customer base.

Operator

We'll go next to Ambrish Srivastava with BMO.

Ambrish Srivastava - BMO Capital Markets U.S.

First question on supply-demand. Last time, Judy and Sanjay, you guys laid out your assumptions now that there was a fire and -- at SK Hynix. They stopped some of the transition to NAND. What does that do to your supply-demand assumptions near term and as you head into next year, was my first question. Second, with the acquisition of SMART, you were sticking with the 25% target for next year. What are the puts and takes with Pliant being delayed a little bit and SMART should help you ramp to that? So if you could please throw some light on those 2?

Judy Bruner

So in terms of the impact of the fire, I would say that, of course, the main impact is on the DRAM market, not on the NAND market. And I would add that we have multiple sources of our mobile DRAM, and we feel that we have adequate supply of our mobile DRAM. Relative to the impact on the NAND industry, in the near term -- near to medium term, we do believe that this has some dampening effect on the growth of NAND bits in the industry as there will be, perhaps, somewhat less conversion of DRAM to NAND because of this. But in the longer term, and in particular for 2014 overall, we think it has relatively minimal affect on the NAND supply growth.

Sanjay Mehrotra

On the SSD question, Enterprise SSD question that you asked, so for next years, in terms of our target of 25% of revenue coming from SSDs, that's a sum of Client SSDs and Enterprise SSDs. We do expect Client SSDs to be larger next year also in terms of total revenue. Enterprise SSD will have the fastest growth, larger growth rate on a year-over-year basis in 2014 compared to the Client SSD. So we are very excited about our growth in Enterprise SSDs. With the acquisition of SMART Storage, of course, as I mentioned in my prepared remarks, we are now able to bring out Enterprise SATA SSDs to the customers. And we will certainly be expecting revenue increase in Enterprise SSD coming from SATA SSDs. We also have expanded our storage OEM customer base from 4 leading customers to 6 customers. That's exciting opportunity for us. And of course, broader portfolio of SAS offerings will also position us well for 2014. And I mentioned in my prepared remarks about a new, unique product category for SanDisk, which is UltraDIMM, they'll be engaging in -- with customers in terms of sampling and there's initial evaluation. And I would expect that to also start contributing to revenue some time towards the second half of next year. So I think on Enterprise, we are well prepared to drive our growth on SAS and Enterprise SATA SSDs and focused on also evolving our product roadmap for PCIe solutions.

Operator

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

James Schneider - Goldman Sachs Group Inc., Research Division

Judy, I was wondering if you could address the cost-improvement situation into Q4? Obviously, the yen is less of a benefit than it was in Q3. Would you expect the yen to still be a bigger portion of the cost improvement relative to the 1Y output transition going into Q4?

Judy Bruner

Yes. I think the impact of 1Y on cost improvement in Q4 will really be pretty negligible, because it will be primarily the 1Y that we produced in the third quarter that will impact cost of sales in the fourth quarter. So the fourth quarter cost-reduction capability will be less than it was in the third quarter definitely. And the primary impact or the primary factor in the fourth quarter will be the improvement in the yen rate in our fourth quarter cost of sales.

James Schneider - Goldman Sachs Group Inc., Research Division

That's helpful. And then maybe looking out into 2014, I guess you're running 19%, 20% cost reduction for 2013. Do you think that you can beat those numbers going into 2014, given that you're going to have pretty much the full runway of the 1Y transition in hand for next year?

Judy Bruner

No. I expect, in fact, that cost reduction will likely be slower in 2014 than it has been in 2013. And keep in mind that in our 2013 cost reduction, we have had a very significant boost from the weakening of the yen in 2013 relative to 2012. And we don't expect that to repeat in 2014. Of course, we expect that -- we're not necessarily expecting that the yen changes much from where it is, but we don't expect to get the kind of boost in 2014 that we did receive this year.

James Schneider - Goldman Sachs Group Inc., Research Division

I'm sorry, I meant to clarify, excluding the yen benefit, would you expect yen x cost improvement to be better or worse?

Judy Bruner

Excluding the yen benefit in terms -- you're saying 1Y relative to 19-nanometer?

James Schneider - Goldman Sachs Group Inc., Research Division

Right.

Judy Bruner

Right, so not necessarily a big difference there in terms of 1Y cost reduction versus 19-nanometer cost reduction. However, another factor in the overall cost reduction for 2014 is the mix of the products that we're selling. And as I said before, increasingly, the mix of the products we're selling are influencing the ASP per gigabyte statistics and the cost per gigabyte statistics. So as you think about 2014 and think about, for example, our SSD mix increasing, that SSD product has a higher cost per gigabyte. And so that will cause some dampening of the cost reduction statistic that you see. I wanted to also keep in mind, overall, that inherently, 1Y has less cost reduction than 19-nanometer. However, we did not ramp 19-nanometer as much in 2013 as we will ramp 1Y in 2014. So when you take those 2 effects into account, I think the transition cost improvement is relatively similar in the 2 years.

Operator

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

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

Can you talk a little bit about, Sanjay, about the bit impact from 3D next year? Some of your peers have been talking about something like a 20% to 30% incremental bit-per-wafer impact from their 3D on 24 layer. And then as they scale up, it'll be something in the range of like 60% incremental bits per wafer. Does that sound plausible to you?

Sanjay Mehrotra

I think 3D NAND in the industry next year will have a very small impact in terms of bit growth, because the total volume of wafers that will be produced in 3D NAND would be very small compared to the large installed base of the 2D NAND wafers. Of course, it is also already acknowledged by a competitor that some of the early 3D NAND generations that will be in production next year will not really be cost competitive with the 2D NAND. And their bit growth capability will also not be really that strong to provide meaningful benefit. So given all of that, I do not expect in 2014 3D will have any material impact in terms of the total bit production in the industry. By the way, that is already estimates of 3D wafer production in the industry by competitor are taken into account off our estimations of approximately 40% year-over-year supply bit growth in 2014.

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

And then as a follow-up, Judy, you talked about 15% to 20% -- or 15% to 25% cost reduction in the next few years. It sounds like next year might be a bit less than it was this year. Are you going to still be within that range next year?

Judy Bruner

I think it's too early to give a specific range for cost reduction next year. But I would expect to be in the lower end of what we've talked about for next year. And again, I want to remind you as I said a few minutes ago that the mix plays a big factor in what the cost reduction statistic actually turns out to be. SSD mix, MCP products, those type of products all carry a higher cost per gigabyte.

Operator

We'll go next to Craig Ellis with B. Riley.

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

Judy and Sanjay, you've both mentioned the positive impact of mix on the business and the potential for further benefit as you go through next year. Can you just rank the top 3 or 4 mix drivers that you have in the portfolio as you look out through the end of 2014?

Judy Bruner

Sure. Probably the growth of the Enterprise business is the biggest factor in terms of positively influencing the gross margin from a mix perspective. I would also mention that we are actually improving the gross margin even within each of our product lines. So it's not just a product line to product line mix effect. But we have improved the gross margin in our retail business. We have improved the gross margin in our embedded business. We've improved the gross margin in our Client SSD business. And so there are mix effects that we are managing even within each of those areas. It could be moving the consumer to higher-performance products. It can be introducing a new product that has a better gross margin and demonstrating the value to our customers.

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

So are you saying that, really, in every part of your portfolio, you feel like you've got positive mix dynamics going?

Judy Bruner

We certainly have had in 2013, yes. And I believe that a lot of those carry into 2014.

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

Okay. And then as the follow-up, congratulations on the accelerated stock repurchase program. How should we think about the company's intent to continue to utilize its free cash flow generation? At the Analyst Day, you put out a 70% repurchase target as a percent of free cash flow. How should we think about that target relative to what you've already done and could do?

Judy Bruner

Sure. I think, clearly, for this year when the year is over, it will show that we actually spent more than 70% of free cash flow on share repurchase, including the ASR that we put in place. Now that ASR will, perhaps, not completely close out until 2014. But we will have spent more money this year than 70% of free cash flow. Going forward in 2014, it is still our intent to spend approximately 70% of free cash flow on share repurchase. That may not be the exact number on a quarter-by-quarter basis. But that generally is still a guideline for us.

Operator

We'll go next to Mark Newman with Sanford.

Mark C. Newman - Sanford C. Bernstein & Co., LLC., Research Division

Talking about the technology migration, people have talked about how that's increasingly getting very, very difficult. I wondered if you could have a brief update on the schedule, how the technology migration is progressing for the 1Y. Is there anything that you expect to potentially further delay this? Or do you think there's some potential upside to the schedule there? If you could talk a little bit about that and the 1Z. And then also to 3D, is there any update to the 3D NAND schedule that you talked about before, which was, I believe, mass production by 2016? Is there any potential change to that schedule?

Sanjay Mehrotra

So regarding 1Y, we are actually very much on target with respect to our original plans for introducing the technology. As I mentioned in my prepared remarks, we already began production shipments of both X2- and X3-based products on 1Y technology, and we will be exiting the year with 15% of our production on 1Y technology. So 1Y technology, actually, is going very well. The yields on both X2 as well as at X3 are going well. And we expect to achieve cost crossover on a bit-cost basis in the fourth quarter. Regarding 1Z, I mentioned in my prepared remarks, that's also going very well, and we will be introducing that technology late in 2014 per our original plans. So we are very much on track with our schedules on both 1Y, as well as 1Z. Regarding the 3D NAND, the bit technology you asked for, as we said before, we are on track for production -- meaningful production in 2016 time frame, with sampling and product line production earlier, sometime in 2015.

Mark C. Newman - Sanford C. Bernstein & Co., LLC., Research Division

Great. And just a quick follow-up, on the -- considering your mix is continuing to improve and considering the dynamics of the industry continue to be much stronger than they were in 2012 for the overall constraint on the supply side and demand continue to be pretty strong, ASP dynamics seem to be looking continued -- continues to look pretty good for next year. Do you think we might see flattish ASPs continuing for another few quarters and possibly through 2014 with a combination of those 2 things, the positive the mix up to more Enterprise SSD and constraints of supply continuing?

Judy Bruner

We're not going to provide pricing guidance for 2014. But we do agree that the -- we believe the supply-demand balance in the industry will remain healthy, and we're working very hard to maintain a very strong supply-demand balance within our own business. And as we said, we have had 0 price decline for our business on a -- 3 quarters year-to-date versus the same 3 quarters last year. And I -- by the way, I believe that is stronger than has been experienced in the industry and stronger than experienced by our competitors, in large part, because of our portfolio mix shifts, as well as our strong balance, our prudent capacity management. So we are optimistic about continued good fundamentals in 2014 but too early to give any specific price estimates. And I will mention, as you did, that the mix shift will continue to influence that statistic. The mix shift influences price statistics and cost statistics in addition to, obviously, influencing gross margin.

Operator

We'll go next to the side of Mehdi Hosseini with SIG.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

It's actually Mehdi Hosseini, SIG. One question for you, Judy. What is the contribution of SMART into the Q4 guide?

Judy Bruner

Well, clearly, there is a nice increase in the revenue from the SMART business from Q3 to Q4, not only because Q3 included only a partial quarter of revenue and Q4 will be a full quarter of revenue, but also because that business is ramping and growing. So we're not going to break that down. But clearly, that is an increase in our Q4 revenue in terms of sequential quarter-on-quarter.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

Sure. And one question for Sanjay, more of a longer-term and more of a hypothetical question. As you ramp some of the recent acquisitions, especially on the software side, do you foresee a scenario where SanDisk would be able to sell Enterprise SSD-related software on a competitor raw NAND? In other words, your software solution becomes independent and therefore, helps the Enterprise customers with some standardization and help increase your mind share for SanDisk.

Sanjay Mehrotra

We have said before that software is certainly an opportunity for us to be selling it on a standalone basis as well. And in that scenario, of course, standalone can work with SanDisk hardware but we would definitely aim for having it work for other manufacturer -- other suppliers' storage -- flash storage product offerings as well. So certainly, that is important. And that's important, we know, to our customers as well because they want to be able to make sure that a software solution that they use is not just tying them up with only our hardware solutions. But keep in mind that software does give us tremendous capability right now to be engaging with our customers in terms of understanding what are the various usage models and what we can do in terms of really enhancing our value proposition of combination of hardware and software to them. As we have said before, software really is extending our vertical integration, going all the way from silicon, flash memory silicon, system expertise at the controller and the firmware level and now, even extending our vertical integration even deeper with software. And as we have said before, vertical integration is key to really winning in the marketplace, particularly in the Enterprise Storage area.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

So what would it take for SanDisk to help us in investment community to quantify these opportunities? Because right now, we're all focused on bits 3D, this 3D and that and pricing per bit. But at some point, as you scale -- as you execute and scale the software piece and vertical integration model plays out, wouldn't it be more helpful to actually break it out so that we could better quantify the opportunities?

Sanjay Mehrotra

So software right now is too small for us to really break it out. But the real opportunity that you see for us that leveraging our Enterprise hardware capabilities, as well as software capabilities, ultimately translate into our SSD revenue and you're seeing that, that mix of the revenue is growing. And we have also talked about our Enterprise Storage revenue within the SSD total revenue growing faster. So I think this is how you really see the benefits of all the assets that we have in the Enterprise Storage area in our financial results.

Operator

And we will go next to Joe Moore with Morgan Stanley.

Joseph Moore - Morgan Stanley, Research Division

I was surprised on what your cost per bit came down in the quarter. I think I had about 4 points of improvement from the yen, and it looks like you're down around 10. You had mentioned in the prepared remarks the sort of lower period cost and I'm wondering what's driving that? What's -- is there a lower fixed cost? And should we think about that having a forward effect?

Judy Bruner

There was, in the third quarter, some impact from utilizing some inventory that had been previously reserved. This was not a real big number. But that was one of the contributors to lower period costs. And so we really just had a very efficient quarter in terms of the period costs. I would not necessarily expect that, that would continue in the fourth quarter. As I said earlier, we expect lower cost reduction in the fourth quarter than we experienced in the third quarter and that will come from several areas. One, we'll have less positive contribution from the yen in the fourth quarter, although it still will be positive. Also less benefit from technology transitions since the 19-nanometer is essentially fully ramped and we won't get much impact from 1Y. And one other factor I also want to mention is that in the fourth quarter, as we will be ramping revenue from the SMART SSD business as we discussed earlier, those products, of course, are still selling on non-captive memory today until those products get qualified by our customers on our own captive memory. So that, of course, is another factor in terms of a somewhat shallower rate of cost decline in the fourth quarter. But all of that is factored into our gross margin guidance.

Joseph Moore - Morgan Stanley, Research Division

And then if you go back to the Q1 time frame, you had had an increase in cost sequentially as you had ramped up SSDs. And yet if I have the numbers right, you're running higher on SSDs now than you were then and you don't have to seem that same effect. Can you just kind of help us understand what the impact of the SSD number continuing to rise as in your cost per bit?

Judy Bruner

No. Actually, the quarter where we had a increase in cost, my recollection is that the biggest factor was an increasing mix of MCP products, multichip package products. But you're right, both SSDs, as well as MCPs, can't do carry a higher cost per NAND gigabyte and therefore, can sway those statistics somewhat. I think increasingly, it's less important to focus on the cost per gigabyte and ASP per gigabyte statistic in any given quarter and focus on the overall gross margin percentage and operating margin percentage. Because sometimes, in fact, even the cost statistic can be a bit at odds with what the gross margin result really is.

Operator

We'll go next to Michael Bressler with Kensico Capital.

Michael Bressler

My first question is on capital allocation. I followed the company for a long time and for a long period of time, there was a lot of cash in the balance sheet and there was a concern that they're -- it needed to be there for certain reasons. And then over the last year, there's been a change in how we allocate our free cash flow and then even we went on to the balance sheet to use some of our cash in a very aggressive ASR. Can you just walk me through why you're thinking changed and kind of what that means for the business going forward? And then I have a quick technical follow-up.

Judy Bruner

Sure. In terms of capital allocation, clearly, we have built our cash balances pretty significantly over the past 5 years. Our cash has grown through strong cash flow in the business. And at the same time, I believe we have improved the consistency of our business model, and we've grown in our confidence in our ability to deliver strong profits and cash flow going forward. And so, all of this, a stronger balance sheet, more consistency of our business model and our confidence in being able to deliver a strong business model going forward all played in to our belief that it made sense to utilize a significant portion of our cash to repurchase shares.

Michael Bressler

And then you said earlier that we would see 70% of free cash flow for buybacks. Did you mean that the dividend is incremental to that? Or was that meant to be total shareholder return?

Judy Bruner

Again, it will probably vary on a quarter-by-quarter basis. But generally, it is our objective to spend approximately 70% of free cash flow on the share repurchase and then there is the dividend as well.

Michael Bressler

Got it. And then on the technical side, can you elaborate a little bit on what X3 means in your product line? I think that as the business has changed, that technical aspect in the margin aspect has -- is sometimes glossed over. So can just maybe remind me what that really means and then -- and how it will impact the business going forward?

Sanjay Mehrotra

So X3 versus X2 means 3-bit-per-cell memory versus 2-bit-per-cell. So basically, it means that on a given wafer of flash memory, we are able to get more gigabytes with X3 memory compared to X2 or what others call MLC memory. So it gives you more gigabyte per wafer, which, with the same process technology, same wafer manufacturing cost, so essentially, it translates to lower costs on a per-gigabyte basis. With our system-level technologies, the controller and the firmware expertise that we applied to our products that use X3 memory, we are actually able to use the X3 memory to compete with competitors' X2 or MLC products. So hence, you can see the obvious benefits of X3 in terms of helping improve the margins because it's a lower-cost technology and we are able to build system-level products, which are able to sell at -- in the marketplace and compete with products that are based on -- MLC-based, the 2-bit-per-cell based solutions. So these are the benefits of X3 to us. It helps produce higher number of gigabytes from a given investment in wafer capacity. So it makes our investments more productive, provides higher ROI on the investments. It helps enable, obviously, higher level of bit growth with the same wafer level production. It gives lower costs per gigabyte, and when we are able to sell it at attractive prices, it helps us improve the margin profile as well.

Operator

Our final question comes from Hans Mosesmann with Raymond James.

Brian C. Peterson - Raymond James & Associates, Inc., Research Division

This is Brian Peterson with -- pitching in for Hans. Just a quick clarification on the yen-hedging strategy. Any intent to hedge beyond the fourth quarter to lock in the current rates? Or are we still just kind of playing that quarter-by-quarter?

Judy Bruner

Good question. We actually have begun to place some hedges across 2014. At this point, the percentage that we've hedged across 2014 is very small but it is likely that we will grow that somewhat as we -- during this quarter, as we approach 2014.

Jay Iyer

Thank you, Brian. That concludes the call today. Thank you, Sanjay. Thank you, Judy. We want to thank everyone for joining our call today. A webcast replay of today's call should be available on our IR website shortly. Thank you, and have a good evening.

Operator

This concludes today's program. We do appreciate your participation, and you may disconnect at any time. Have a great day.

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