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SanDisk Corporation (NASDAQ:SNDK)

Q1 2010 Earnings Call Transcript

April 21, 2010 5:00 pm ET

Executives

Jay Iyer – IR

Eli Harari – Founder, Chairman and CEO

Judy Bruner – EVP, Administration and CFO

Analysts

Daniel Amir – Lazard

Kate Kotlarsky – Goldman Sachs

Paul Coster – JPMorgan

Bob Gujavarty – Deutsche Bank

Uche Orji – UBS

Craig Ellis – Caris & Company

Daniel Berenbaum – Auriga USA

Hendi Susanto – Gabelli

Caitlin Wolford [ph] – Ardent Capital Management

Betsy Van Hees – Wedbush

Tristan Gerra – Robert Baird

Atif Malik – Morgan Stanley

Operator

Good day and welcome to the SanDisk Corporation first quarter 2010 earnings conference call. Today's call is being recorded. And 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, Anthony, 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.

Before we begin, please note that any non-GAAP financial measures discussed during this call, as defined by the SEC in Regulation G, will be reconciled to the most directly comparable GAAP financial measure. That reconciliation is now available along with supplemental schedules on our website at sandisk.com/IR.

In addition, during our call today we will make forward-looking statements. Any statement that refers to expectations, projections or other characterizations of future events including financial projections and future market conditions, is a forward-looking statement. Actual results may differ materially from those expressed in these forward-looking statements. For more information, please refer to the “Risk Factors” discussed in the documents we file from time to time with the SEC, including our Annual Report on Form 10-K for fiscal 2009 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 turn the call over to Eli.

Eli Harari

Thank you, Jay, and good afternoon, everyone. First quarter results were considerably better than we had expected. Our OEM business was start at the quarter, driven by strong demand from our mobile customers as well as new channels and customers added in 2009.

The OEM business accounted for 63% of total product revenue in Q1, and has been a stabilizing factor compensating for the first quarter seasonality in our retail business, which has yet to recover from the economic downturn in the U.S. and Europe. Our focus in retail continuous to be to maximize profitability, while expanding into new geographies where we believe we are making steady inroads.

In the mobile end market we continue to see strong adopting of our iNAND embedded storage solutions as well as mobile card. Mobile has now grown to half of our product revenues, compares to virtually nothing five years ago.

MicroSD has become the de facto cards in mobile phones and the market place has bifurcated into low capacity one and two gigabyte MircoSD cards for low end phones and high capacity for 32 gigabyte MircoSD card for high end Smartphone and we believe we hold strong leadership positions in both segments.

The mobile market for FLASH is still in its early days. Just to remind you mobile Apps hardly existed and Smartphones were hardly household word just two years ago. The iPod along with other similar products is expected to drive demand for FLASH memory 64 gigabyte in higher capacities, where the DISK demand comes in the form of embedded storage or removable cards. We are now well positioned in both categories.

We continue to gain traction with leading OEMs for our modular SSD solutions, Solid State Disk in netbook and public computers. In the first quarter we also entered the retail Solid State drive market with our G3 products. At current NAND pricing levels, SSD solutions are still expensive. However, we believe this market too should drive very substantial consumption of high capacity flash as it becomes much more affordable. We expect this will occur with add vented of 20Xnanometer flash memory technology in mass production next year, and with 1 X NAND technology in 2012.

We're now executing to our aggressive solid disk road map that should take us to being top tier supplier as SSD adoption accelerates in net books, notebooks, and tablet PC platforms in the years ahead. On the operations and technology front we're very pleased with the ramp of our 32-nanometer technology as well as the continuing cost benefits that we see from broad implementation of our 3-bit-per-cell X3 technology into our products where we believe we are significantly ahead of competition. In the first, quarter our cost per gigabyte declined by 14% sequentially, continuing our highly competitive cost structure.

As for the industry environment, demand and supply appears to be in balance for 2010. For our sales we now expect our captive bit output to increase in 2010 over 2009 by approximately 75%, up from approximately 70% estimated previously with outside coming late in the year from better productivity and Fab 4 expansion.

Last month, Toshiba announced the intention to commence construction of the shell for a new clean image that will eventually be Fab 5. We're evaluating the timing of our participation in Fab 5, and we will provide further details as they become available later in the year.

In summery the first quarter was a very-very good start for 2010. With our leading technology, large scale manufacturing, diversified end markets, broad product portfolio, premium brand, and a strong balance sheet, we have powerful momentum to capitalize on future opportunities and we believe that in the coming decade flash will be bigger than you think. I will now turn it over to Jude.

Judy Bruner

Thank you, Eli. We delivered our best ever first quarter results driven by strong OEM demand, minimal price reduction and continued execution in product cost reduction and expense management. Our total product revenue was down sequentially by 13% which was less than we had expected given historical Q1 seasonality and a 14-week fourth quarter.

Our retail business reflected normal seasonality with revenue down 27% sequentially while our OEM revenue was down only 2% sequentially. As a result, the Q1 mix of our product revenue was 63% OEM and 37% retail. Our retail revenue grew 7% year-over-year, and our OEM revenue increased to 158% reflecting strong demand in the mobile market and the new channels we added in 2009. Looking at our revenue by end market, our first quarter product revenue came 49% from the mobile phone market, up from 38% in the first quarter of last year.

Retail demand continued to be soft in Europe and the U.S while Asia retail sales increased sequentially from Q4 to Q1. We believe we maintained share in U.S retail while we may have given up some share in low priced USB products in Europe retail. In Asia, we benefited from strong consumer demand as well as from our geographic expansion efforts.

Our first quarter OEM revenue benefited from strong demand in the mobile market and in general from new customers for mobile embedded solutions, cards, as well as wafers and components. Our overall ASP per gigabyte declined 7% in the first quarter much less than in the previous first quarter reflecting a healthy supply demand balance. And some of our 7% decline in ASP per gigabyte reflected the mix of product sold rather than price decreases.

Our units sold decreased 3% sequentially and grew 62% year-over-year. Average capacity remained fairly steady as the pricing environment has created strong demand for lower capacity units. Average capacity was down 4% sequentially and up 5% year-over-year our total gigabyte sold declined 7% sequentially and grew 71% year-over-year.

Our license and royalty revenue was slightly stronger than we had forecasted at $93 million and now fully reflects our new license agreement with Samsung. Our first quarter non-GAAP total gross margin of 46.5% and non-GAAP product gross margin of 41.5% benefited from a better than anticipated pricing environment and also from stronger than forecasted OEM sales that resulted in recognizing more of our 32-nanometer 3-bits-per-cell production in first quarter results.

Our product gross margin improved sequentially from an underlying product gross margin of 36% in Q4 '09 to 41.5% in Q1 driven by a 14% sequential cost reduction on a per gigabyte basis, compared to our 7% decline in price per gigabyte.

Non-GAAP operating expenses of 172 million were down 20 million from the fourth quarter reflecting a 13-week quarter compared to Q4's 14 weeks as well as seasonality in sales and marketing expenses.

Our first quarter non-GAAP operating profit was 334 million or 31% of revenue, and as with the last quarter, more than 70% of this operating profit came from our product business. Our non-GAAP other income of 23 million included gains of 15 million related to the sale of certain assets and investments.

On the balance sheet cash and short and long-term marketable securities increased sequentially by 279 million to nearly $3.3 billion. Our first quarter cash flow from operations was 328 million, and our cash flow from investing yielded a positive $1 million resulting in free cash flow of 329 million.

During Q1, we called our $75 million convertible paying it off with cash, and we reduced our off-balance sheet equipment lease guarantees ending Q1 with a balance of 931 million.

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

Given our strong results in the first quarter, we are raising our guidance for 2010. Our broad channels and growing demand from the mobile market give us confidence to increase our full year revenue range to 4.5 billion to $4.8 billion.

For the second quarter, we expect total revenue between 1.1 billion and 1.175 billion which reflects tightness in supply for certain low capacity products. Within this total Q2 revenue, we expect license and royalty revenue between 80 million and 90 million, slightly down sequentially since our second quarter royalty revenue reflects the seasonal first quarter revenue of our licensees. For the full year, we are also raising our expectations for license and royalty revenue to a range of 350 million to 375 million.

Turning to gross margin, we expect a sequential improvement in cost to be less in Q2 than in Q1 due to anticipated higher mix of demand for certain products in our portfolio.

We also expect our second quarter sales to reflect more promotional pricing in the retail channel associated with the moms, proms, dads and grad season. We expect non-GAAP total gross margin for Q2 between 42% and 45%, and non-GAAP product gross margin between 37% and 40%.

For the full year 2010 we now anticipate that our cost reduction will be at the high-end of the 30% to 40% range we provided in January and we expect price reduction to be less than our previous estimates. Partially offsetting these factors we may utilize some non-captive supply in the second half of the year.

We are raising our full year 2010 forecast for non-GAAP total gross margin to a range of 41 to 44%, and for non-GAAP product gross margin to a range of 36% to 39%. For the 2010 total gross margin this represents a more than 5 percentage point increase in the mid-point of the range from the previous guidance.

Given our increased top line expectations for the year, we now expect non-GAAP operating expenses to be at the higher end of the range previously provided or approximately 750 million. For Q2 we forecast non-GAAP operating expenses of 180 to 190 million.

We now expect non-GAAP other income to be approximately 60 million for the year and we forecast the non-GAAP tax rate to remain at approximately 37%. We expect our 2010 Capital Investments to be at the higher end of the 700 to $900 million range, we previously provided and the estimated cash requirement for 2010 Capital Investments remains in the range of 300 to 400 million concentrated later in the year.

In summary, we are pleased with our first quarter performance and it is looking like 2010 will be a year in which we exceed the operating margin in our long-term financial model.

We'll now open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) And, our first question will come from Daniel Amir from Lazard.

Daniel Amir – Lazard

Thanks a lot and congratulations on a great quarter.

Eli Harari

Thank you.

Daniel Amir – Lazard

A couple questions. First of all, can you highlight a bit what the drivers are incensing in your OEM business here going forward? And how should we look at kind of the OEM segment as a percentage of your overall sales here in the next two, three quarters?

Eli Harari

Hi. So, the OEM business is growing. I mean, we have said in the past that we believe we are now the third largest supplier now and certainly in the top three suppliers of OEM flash. And we believe that we have a tremendous room to grow, and talked about very large, very broad front of design-ins, particularly for embedded products, and we see that as really just starting.

At the Analyst Day, we talked about AFM, that’s the adopted flash management, which is part of our controller intelligence to allow us to optimized embedded flash to the specific application of the platform, and we're seeing very significant reception, productivity reception for that. So I would say that we probably have moved now quite solidly from a model where maybe a year ago or a little bit more than that we were maybe one third OEM and two-thirds retail to just opposite, one third retail and two-thirds OEM. And I don’t – I expect to this thing is going to be with us for the foreseeable future.

Daniel Amir – Lazard

Great. And the other question is in terms of kind of the e-book and tablet markets and with your commentary that you’re thinking of using some non-captive supply in the second half of the year. I mean how do you see those demand dynamics impacting the flash memory markets and then specifically your usage of potentially moving to a little more non-captive?

Eli Harari

So, the non-captive supply is very, very important in the long-term and we always said our model is to have 15 to 20% non-captive. However, it is also the case that with OEM becoming such a much stronger constituents portion of our output, I’ve said many times that OEM really cannot be satisfied through non-captive because you have to quote several quarters out and we really have to have control of our supply, so that really will very likely to the extent that we stay with this two-thirds OEM, one-third retail moving forward, or around that, our ability to employ non-captive will be reduced and we will have to use more captive supply.

Daniel Amir – Lazard

And the tablet e-book question?

Eli Harari

So, can you repeat the question on tablet?

Daniel Amir – Lazard

Yeah, so basically how do you see the tablet e-book market impacting NAND flash industry here in 2010?

Eli Harari

Tablets to the extent that you defined the iPod as a tablet and its competitors being more or less the same, we view that as a very, very important new platform that drives the demand for flash because it is really designed to be very thin, very long battery life and therefore really relies on attributes of flash for storage.

The iPod is driving 64 gigabyte. We fully expect that the competition will be really driving at the 64 gigabyte and opening up to 128 and 256 gigabyte. This is very, very positive development for the NAND industry no matter who serves it, and also very important because again the Analyst Day we talked about thin is in.

What thin means when you have very thin products and you can't have a fan to cool the environment, you basically are driven to use modular flash which modular SSD which is SSD functionality but not necessarily in the 1.8 inch or 2.5 inch form factors, and that clearly plays to our strength because we have the ability to customize solid state disk to be basically to fit into very, very thin and any kind of profile which of course no disk drive can do.

So in that kind of environment people are starting to look at SSD not just is it lower – does it match the cost of hard disk drive but more is it enabling technology that allows that kind of form factor.

Daniel Amir – Lazard

Thanks a lot.

Jay Iyer

Thank you, Daniel. Next question, please.

Operator

Our next question will come from Jim Covello with Goldman Sachs.

Kate Kotlarsky – Goldman Sachs

Hi. This is Kate Kotlarsky for Jim Covello. Eli, I had a quick question on the comments you made about supply being tight in general in 2010. I was just curious if you look at the second half versus the first half how much tighter at all do you think the second half of the year is going to be and kind of tying into that into your comments about evaluating Toshiba and what are the things that you're going to be looking at as you think about potentially making the investment in fab 5? Thank you.

Eli Harari

Okay, so there is a number of questions in that, so let me try and address those and I’m sure there would be maybe a few other questions on that. So, Judy has indicated we're raising our guidance for the year from 4 billion to 4.4 to 4.5, 4.8. That's $500 million additional revenues which of course would require very substantial additional gigabytes, petabytes and units that we are forecasting we will need flash for this year.

So of course the solution to getting that supply is from captive which is Fab 4, and then non-captive, and then anything we do with Fab 5 will definitely not have any impact.

It will not be available until really 2011 at the earliest.

So, this is what in my remarks I said we're striving to get our output this year to about 75% more bids this year, later in the year, and this comes from primarily greater efficiency in Fab 4, better yields than we had expected in Fab 4, as much utilization of X3 we can squeeze out of wafers and that's going very well and building some additional capacity in Fab 4 in the clean room space and there we're somewhat limited by equipment lead times and of course not much space left in there. So all of these in combination give you that 75% so increase and that may not be enough and in that case we will explore non-captive option.

Kate Kotlarsky – Goldman Sachs

Okay. So that's 75% implies that you're primarily using captive supply and not too much non-captive?

Eli Harari

That's correct, yes.

Judy Bruner

The 75% is the amount by which we believe we can grow our captive output.

Eli Harari

That's right.

Judy Bruner

In 2010.

Kate Kotlarsky – Goldman Sachs

Okay.

Judy Bruner

Revenue in bits could potentially be more if we purchased non-captive and or we're able to increase our inventory turns.

Kate Kotlarsky – Goldman Sachs

Okay. That's very helpful. Can I just ask one additional question? That 75%, how does that compare to what you would expect for the industry in general. That's it for me. Thank you.

Eli Harari

So we said in the past that we think from what we see from various independent marketing firms, they're projecting between 70 and 90% bit increase and we said beginning of the year we're going to be unable – that we'll be up to 70%. Now, we are more confident that we can be about at 75%, still at the low end of that industry range.

Kate Kotlarsky – Goldman Sachs

Okay. Thank you so much.

Jay Iyer

Thanks, Kate. Next question, please.

Operator

Our next question will come from Paul Coster with JPMorgan.

Paul Coster – JPMorgan

Yes, thank you. As you approach the CapEx decision along with your partner Toshiba, can you just talk to us a little bit about what's going into those discussions and also is there any chance that you may again revise the nature of the joint venture and the share of the JV that you own?

Eli Harari

Well. As you know, Paul, we announced more than two years ago in MOU with Toshiba and nonbinding memorandum of understanding with Toshiba for the creation of fab 5, and that of course ran into the recession that the whole industry and really was put on hold.

About a month ago, Toshiba announced that they will commence the construction of the shell in the KG. This is basically a decision to build just a building. And we certainly plan to continue the partnership that we have with Toshiba in fab 5. However, I also said in the past and we really feel very strongly that we need to play our part as best we can to maintain health in the industry by not bringing our new capacity – any new capacity that we have from any new sources too soon to the market that would be not good for us and of course, we can't control what our competitors are doing. But basically this for the last, I term last quarter is curbing our enthusiasm.

That said, we do need to – we do see demand for flash growing at a very strong pace both from the mobile and from other markets including SSD, and therefore we do – again, I have said on February 26, it’s not a question of if we’re going to participate in fab 5 but when, and to what extent and the timing and so on, and all of those have not yet been decided. And we will let you know when the decisions are being made.

Paul Coster – JPMorgan

Do you think that Toshiba shares your philosophy at the moment regarding being cautious about the introduction of new capacity?

Eli Harari

I think you have to ask Toshiba.

Paul Coster – JPMorgan

That’s right, thank you very much.

Jay Iyer

Thanks Paul.

Eli Harari

Thanks Paul.

Jay Iyer

Next question please.

Operator

Our next question will come from Bob Gujavarty with Deutsche Bank.

Bob Gujavarty – Deutsche Bank

Thanks, guys, and fantastic job on the margins. I’d just had a question given how the strong OEM sales have been. Do you get any sensor has this entered in to your discussion in terms of may be OEM pre-buying an anticipation of a shortage in the back half of the year? Have you kind of made some assumptions for that as you cleaned your backlog so to speak just the account for any possibility of pull-in of orders?

Eli Harari

Let me answer it without indirectly. We do feel that you heard me say as saying that in the next decade we think that flash already bigger than you think and that’s really based on the mobile in the way it's going as well as that’s obviously there is two major new markets that are very, very early, so the industry will need to build additional capacity that doesn’t exist. I think we all know that, and you know the key is really the timing of those because the return on investment by itself is tied to the timing.

Now, what that leads me to say is over the next several years there will be a period, I believe, of shortages of flash memory, and that will be times where people will understand, OEMs, particularly large OEMs, that flash is becoming very strategic to their business. You can view it as a commodity, but when you can't get it at any price because it is just not there because your demand far exceeds the available capacity of the industry, and the cumulative demand of all customers, then of course people will start wanting to secure for themselves some of that capacity, so I do expect some of that may happen.

Of course we don't know for a fact, but I would not be surprised if the strategic nature in the next few years is going to become effective. It's no secret flash is a very, very tough technology. There are very few companies that can really deliver leading-edge technology, very high volume, both from the technology and the manufacturing and the balance sheet. So the answer to your question is yes, I think there is going to be some of that but there are some OEMs will start taking steps to assure themselves of supply.

Bob Gujavarty – Deutsche Bank

Great. Thanks.

Judy Bruner

Bob, this is Judy. I will just add that at present time we worked very closely with our customers, and we monitor both the retail channel inventory and the OEM channel inventory and we believe that both are at normal levels today.

Bob Gujavarty – Deutsche Bank

Okay, great. And just a quick follow-up. I know we've had good positive retail sales data out of the U.S. Is there – are you at all more hopeful maybe now than three months ago or any color on the retail side of the business, not suggesting you give us the December prediction, but is there any inkling of hope there on that side?

Eli Harari

Yes, I think so. I mean, I think that the U.S. retail and Europe retail depends very much on the recovery in the economy and to the extent that people being a lot more optimistic about return of growth, even slow growth would be very helpful.

Bob Gujavarty – Deutsche Bank

Great, thanks a lot.

Jay Iyer

Thanks, Bob. Next question please.

Operator

Our next question will come from Uche Orji with UBS

Uche Orji – UBS

Eli, now first of all congratulations on the terrific set of results. Let me just ask you about your confidence getting access to non-captive supply. Right now demand supply is imbalance like you mentioned, but is there any anyway you feel for sure that being able to tap non-captive supply and has this already been negotiated prices or will you spending on what the spot market doing in terms of your future dependence on non-captive?

Eli Harari

We have legal agreements that afford us guaranteed access to capacity from several of our licensees. However, it is again, I’ve said in the past that you can't turn it off on a switch; you can’t just come and say okay, next week shipment. There is forecasting, there is lead time and it is not something you can jump it's not that easy.

Uche Orji – UBS

Okay.

Eli Harari

There is a lead time involved.

Uche Orji – UBS

Different question. I mean, you were talking about low capacity NAND that you sighting at being popular. Are these in retail or OEMs and if in OEMs what kind of product are using the lower capacity NAND?

Eli Harari

So I think the main driver for low capacity cards mostly MicroSD one or two be about amazingly there is a huge number of handsets in – in countries such as China, India, South America and so on, and Africa, where you can get a very good handset for $20 or $25 and those forms used to rely almost entirely on embedded flash, lower flash or non-capacity NAND flash and just in the last several quarters they seem to have switched in very large quantities to a card slot MicroSD in 1 or 2 gigabytes and play music and actually FM radio and they become now the music player and some of them for 25 bucks you have camera.

So traditionally, we expect that the 1 gigabyte and 2 gigabyte to even kind of disappear but it has come back because of these phenomena. We think it is here to stay, I mean for a long time.

Uche Orji – UBS

I see. And then just particularly the last one, how much of your bit production in Q1 was 24-nanometers and within the 24-nanometers, when will the X3 or X4 be qualified and in full production?

Eli Harari

We have said that 24-nanometer is in development right now.

Uche Orji – UBS

Okay.

Eli Harari

The advanced development and that we expect to start production by late this year.

Uche Orji – UBS

Okay. Is there any cost differential in terms of a CapEx cost to add capacity say 10,000 wafers demand incremental capacity at 24? How does that compare with the previous generation if at all just for us to have a sense of what this means for you from a CapEx cash flow standpoint? Thank you.

Eli Harari

Every generation of technology migration does acquire CapEx investments usually to far less degree than starting just wafers from scratch. And, it depends what kind of not that, different companies have different transitions between technologies. In our case, the technology – I am sorry – our 2-nanometer technology and our 24-nanometer technology require relatively small equipment changes, so that's actually very positive.

Uche Orji – UBS

Right. Well. Thank you very much.

Jay Iyer

Thanks, Uche. Next question, please.

Operator

Our next question comes from Craig Ellis with Caris & Company.

Craig Ellis – Caris & Company

Yeah. Thank you, Eli. Congratulations.

Eli Harari

Thank you.

Craig Ellis – Caris & Company

The first question is on just your cost reduction. Can you help us understand the linearity of the cost reduction that you hope to achieve this year, more front end loaded, relatively balanced, anything that would cause it to be lumpy through the year?

Judy Bruner

Craig, I would say that even how much of the cost reduction we were able to pull into the first quarter that in terms of sequential improvement in cost per bit, I expect that Q1 may be a quarter that is difficult to repeat, but relative to the other quarters, I don’t necessarily expect much difference between the Q2, Q3, Q4 in the approximate level of cost decline and as I said, we expect the full year to reach a cost improvement at the high-end of our range of 30 to 40%.

Craig Ellis – Caris & Company

Okay. That makes sense and then Judy, just on the outlook for the year, looks like there is unusual degree of stability and revenues from the first half to the back half. Does that reflect concern about the strength of the retail business in the back half of the year does that reflect concern about supply availability beyond your captive bit growth? How do we interpret the implication for the second half growth off of the full year guidance?

Judy Bruner

It does reflect some potential shortage of supply, particularly for the low capacity product that we just discussed a few minutes ago the 1 and 2 gigabyte memory, and at the moment, as we indicated, the retail business does remain somewhat soften the U.S. and Europe and we’re optimistic that we’ll begin to see some improvement later in the year, but we haven’t seen that yet.

Craig Ellis – Caris & Company

Okay. Congratulations again and thank you.

Eli Harari

Thank you.

Jay Iyer

Thanks, Craig. Next question, Anthony?

Operator

Next question comes from Kevin Cassidy with Thomas Weisel Partners.

Unidentified Analyst

Oh, hi, this is Neely [ph] for Kevin. I was just hoping you guys could may be tell me what the mix was between 3-bit and 2-bit for the quarter and what they might be looking like while going forward?

Judy Bruner

We are not going to give a specific mix but our 3-bit-per-cell was above 50% in the first quarter and we expect it to remain approximately 50% or bit more for the entire year.

Unidentified Analyst

Okay. And I also wanted to follow-up on a previous question regarding, I guess some of the cost benefits that you guys might have going from sort of the 34 nanometer 3-bit to sort of 20 nanometer 2-bit, if you could just maybe elaborate little bit on that?

Eli Harari

Actually we are 32 nanometer and some of our competitors [ph] are 34 nanometer. Actually it's only because people are talking about throwing numbers about what is 2X. Now we have 20 nanometer class which means whatever you want. It has a two in somewhere in the number. Anyway from 32 nanometer – first of all, 32 nanometer from 43 nanometer is very substantial cost reduction, and particularly if you stay 3 bits to 3 bits, 43 nanometer X3 to 32 nanometer X3.

As we get to lower geometries more scaled, I am sure again I said before we expect the difficulty of implementing X3 will increase but we feel they were playing to our strength. So we fully expect that when we go to 24-nanometer we will be able to take our X3 with us without in anyway comprising performance.

So from 32 to 24 again pretty substantial cost reduction and basically you're looking at – we have said NAND is going to start slowing down and we truly believe that, but at the same time the industry and we are moving still at a pretty rapid pace and I would say that the end of scaling of NAND has probably been greatly exaggerated, maybe by us as well. So, actually it's looking a little bit better all the time and that of course would be very good news for SSD particularly.

Unidentified Analyst

Thank you, guys.

Jay Iyer

Thank you. Next question, please?

Operator

Next question will come from Daniel Berenbaum with Auriga USA

Daniel Berenbaum – Auriga USA

Hi, afternoon. Thanks for taking my call. First question, what is the progress on getting 3-bits-per-cell into OEM? I know there had been some reliability concerns as you move to 3-bits-per-cell. How much are you selling into OEM currently and are you going to be able to expand that?

Eli Harari

Initially it has been an uphill battle but it is getting better now because we have been able to demonstrate to very exhaustive OEM qualifications that the product is very, very good and further more through this AFM adaptable flash memory we can actually get very good performance with X3 and everybody understands that the cost benefits of that. So, I would say the efforts of the last year are beginning to bear fruit right now, and I think once we're over the hump that people will hold still to adopt X3.

Daniel Berenbaum – Auriga USA

Okay. I am sorry, I should have said embedded actually.

Eli Harari

Yes, I am talking about embedded.

Daniel Berenbaum – Auriga USA

You're talking about embedded.

Eli Harari

It is removable cards we have been shipping. We are the ones that qualify X3 and clearly as that moves into production very early.

Daniel Berenbaum – Auriga USA

So that progress on X3, does that change your long-term view on what you can do for cost per bit reduction? Does that improve that longer term view? Related to that, Judy said that you expect operating margin to year to be above the long-term business model. You just have a very strong quarter. Why does that quarter not change your view of what the long-term business model should be? Can you just help me understand why – how you're thinking about that?

Eli Harari

Yeah. Let me start with the second part of your question. At our analyst day at the end of February when I laid out the long-term financial model, I described that model as a model that we believe is optional over the long-term in order to balance growth and profit and cash flow. I said that in some years we expect that we will beat the long-term financial model and in some years we will miss it, so it is not my expectation to continue to adjust that long-term financial model, but rather aim for that over time and what I am saying is it looks like this year is a year where we can beat the long-term financial model. And I am sorry. What was the first part of your question?

Daniel Berenbaum – Auriga USA

Just on the good progress on getting 3-bit-per-cell into embedded, does that change your view of the longer term cost reduction? I think you talked about longer term cost reduction as 20% to 30% per bit annually. Does that improved adoption of 3-bits-per-cell into embedded change the view of that?

Eli Harari

No, because we assumed it in the first place. We of course assumed success, not – so we are marching to our plan and we’re doing well against our plan.

Daniel Berenbaum – Auriga USA

Okay, great. Thanks very much.

Jay Iyer

Thanks, Daniel. Next question, please.

Operator

Next question will come from Hendi Susanto with Gabelli.

Hendi Susanto – Gabelli

Hi, all. Thank you for taking my questions. First, I would like to understand more about your plan with regard to the non-captive supply. Like, how much confidence do you have in securing 10% to 15% of the coming from the non-captive supply and how much is the maximum like non-captive supply can you get in the second half of 2010 meaning that whether you will be able to secure more than the 10% to 15% that you mentioned before. And could you help us understand and quantify what gross margin impact of using non-captive supply?

Judy Bruner

So, let me clarify. We’ve not given any percentage of non-captive for the second half of this year. And when Eli was describing a 10 or 15%, he was saying that that was sort of the range that we think we might be in – in some periods of time over time. I expect that if we use non-captive in the second half of this year it will probably be modest amounts of non-captive but it is one factor that we are taking into account in our expectations of gross margins for the second half.

Hendi Susanto – Gabelli

Okay.

Eli Harari

And the second margin implications.

Hendi Susanto – Gabelli

Yes. And, then –

Judy Bruner

Yes.

Eli Harari

The margin implications, as we said before of course, that this is a much lower-margin business.

Hendi Susanto – Gabelli

And then you mentioned that for OEM business there is a need of using more captive supply. And how about solid state describe will the choice of non-captive versus captive supply matter in SSD?

Eli Harari

Yes, very much so. Certainly a big part of the SSD market will be OEM, very much so in OEM. They will of course be the retail space in retail it can be non-captive, but I have to say that for SSD we have a very substantial engineering effort and I could tell you that it’s very, very focused on squeezing out the best performance from the flash that we know best which is on captive flash, so it’s very difficult to get the kind of performance that we feel we can deliver in an SSD environment at the low cost, very high performance, and great for liability we feel that the best approach is to use captive for that, even for retail.

Hendi Susanto – Gabelli

Okay. And one last quick question. For the low capacity memory product how is the margin compared to your corporate average margin? Is it lower or is it comparable or higher?

Eli Harari

The margin is very good. And just as an aside, we have said that the new channels that we have today that we didn't have a year ago really has given us the diversification to allow us to make decisions of how we allocate our supply, how between these markets based on maximizing profitability.

Hendi Susanto – Gabelli

Thank you.

Jay Iyer

Thanks, Hendi. Next question, please?

Operator

Nest question will come from Caitlin Wolford [ph] with Ardent Capital Management.

Caitlin Wolford – Ardent Capital Management

Good afternoon and, wow, great job. Just a quick question and you may have gone over this at the analyst meeting which I missed. Did you say on the call that you were slightly north of 50% on the 3 bit technology?

Judy Bruner

Yes.

Caitlin Wolford – Ardent Capital Management

Okay. And then that my question is assuming standard node for each 2 and 3 bit, is the number of die per 12-inch wafer similar?

Eli Harari

Yes. Yes, you just get – yes, very similar, you just get more bits per wafer.

Caitlin Wolford – Ardent Capital Management

Right. Okay. And then –

Eli Harari

Wafer die and (inaudible).

Caitlin Wolford – Ardent Capital Management

And then assuming a similar process node, is there a significant difference in terms of how the line is configured or the equipment between the two different technologies?

Eli Harari

No. Essentially identical.

Caitlin Wolford – Ardent Capital Management

So to move, you can move rapidly say within a quarter by moving 2 bit equipment to 3 bit line?

Eli Harari

Within a day maybe.

Caitlin Wolford – Ardent Capital Management

Within a day? Great, okay. That answered my question. Thanks so much, and great to have you guys doing so well.

Judy Bruner

Thank you.

Jay Iyer

Thanks, Caitlin. Next question, please?

Operator

Next question will come from Betsy Van Hees with Wedbush.

Betsy Van Hees – Wedbush

Thanks for taking my call and congratulations on a fantastic quarter. I was wondering if you could help us understand in regards to the new channels of that 626 million in revenue that you did in the OEM, how much of that came from the new channel.

Judy Bruner

Betsy, we're not going to break out the specific mix of old channels versus new channels, but I will say that our business from new channels and new customers that we added in 2009 did grow sequentially from Q4 to Q1.

Eli Harari

And it is quite substantial.

Betsy Van Hees – Wedbush

And it is quite substantial in terms of the growth or the percent of the overall?

Eli Harari

Both.

Betsy Van Hees – Wedbush

Okay

Eli Harari

Well, the percentage for sure.

Judy Bruner

Percentage, yes, but it did grow. As I said, our OEM revenue in total was down sequentially 2%, although keep in mind that was going from a 14 week quarter to a 13 week quarter. But regardless the new channels and new customers grew sequentially from Q4 to Q1.

Betsy Van Hees – Wedbush

Thanks, that's very helpful. So, as we look at the back half of the year and the concerns that you seem to be highlighting about capacity constraints and supply, what's that going to do to your new channels and your new relationships as you're looking at trying to allocate the supply that you're going to have to your various new businesses?

Eli Harari

Well, we are looking at all of these channels as strategic and long-term, and we understand that to do so, if we have to get into allocation we have to do so in a very sensible way and to spread the pain if you will. But our number one priority frankly is to see what we can do in the supply side so that we don't constrain our customers.

Betsy Van Hees – Wedbush

Thanks so much and once again congratulations on a fantastic quarter.

Eli Harari

Thank you

Jay Iyer

Thank you, Betsy. Next question, please.

Operator

Question will come from Tristan Gerra with Robert Baird.

Tristan Gerra – Robert Baird

Hi, what were your channel inventories at the end of Q1 for flash cards? I think you were at around five weeks last quarter?

Judy Bruner

Our retail channel inventory on a worldwide basis is at about 7.5 weeks on a backward looking basis at the end of Q1 and that's very similar to what it was at the end of Q1 last year. It is a very normal range. It tends to be lower at the end of Q4 on a backward looking basis because of the very strong sell through in the December timeframe.

Tristan Gerra – Robert Baird

Great. Thank you.

Jay Iyer

Thanks, Tristan. Anthony, we have time for one more question.

Operator

Our last question will come from Atif Malik with Morgan Stanley.

Atif Malik – Morgan Stanley

Hi, thanks for taking my questions, nice quarter, quick clarification, Judy. The full year gross margin guidance assumes non-captive supply buying in second half this year?

Judy Bruner

It assumes some potentially modest amount in the second half.

Atif Malik – Morgan Stanley

Okay. And then, Eli, the question supply, if you look at equipment makers in a backlog of very little NAND equipment in the backlogs like photography there is something different about this time, this year, on NAND spending, you guys and others like Samsung have been very disciplined in placing even on shrink any increment spending.

So my question is there anything fundamentally different in terms of technology, EUV, not ready, and two year's time that's giving NAND makers a pause or discipline that we will be in this kind of spending behavior longer and if we do as supply, it will be added in very small increments like you have announced 10% kind of incremental capacity? Is there anything fundamentally different about this time?

Eli Harari

No. And with regards to EUV, EUV still is quite away – away from a mass production and certainly for very high volume production. So I think the assumption is that the demand growth will overwhelm existing capacity and that new fabs that use existing, the photography and existing NANDs scaled to as far as it will go will have to be built to meet the demand in the next – I would say really two to five years.

Atif Malik – Morgan Stanley

Okay, thanks.

Jay Iyer

Thanks, Atif.

Eli Harari

Okay. Well, thank you very much. This is great. And as we said, we are looking forward to – this is a very good start and a good 2010. Thank you very much. We'll see you in a quarter.

Jay Iyer

Thank you.

Judy Bruner

Thank you.

Operator

Again, ladies and gentlemen, this does conclude today's conference call. We thank you for your participation.

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