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Executives

Jay Iyer - IR

Eli Harari - Founder, Chairman, CEO

Sanjay Mehrotra - President, COO

Judy Bruner - EVP of Administration, CFO

Analysts

Daniel Amir - Lazard

Gary Hseuh - Oppenheimer

Atif Malik - Morgan Stanley

Uche Orji - UBS

Daniel Berenbaum - Auriga USA

Kate Kotlarsky - Goldman Sachs

Craig Ellis - Caris & Company

Bob Gujavarty - Duetsche Bank

SanDisk Corp (SNDK) Q2 2010 Earnings Conference Call July 22, 2010 5:00 PM ET

Operator

Good day, everyone, and welcome to the SanDisk Corporation's second fiscal quarter 2010 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, [Elizabeth], and good afternoon, everyone. Joining us on the call today are Dr. Eli Harari, Chairman and CEO of SanDisk, Sanjay Mehrotra, President and COO 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'll 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 refer 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 up to date hereof. With that, I will turn the call over to Eli.

Eli Harari

Thank you, Jay, and good afternoon, everyone. We are very pleased with our excellent second quarter results continuing the positive trend of the past several quarters and setting the stage for a strong finish to 2010.

I will lyric my remarks in the prevailing industrywide demand supply conditions and our Fab 5 announcement last week with our partner Toshiba. I will then comment on today's announcement regarding my decision to retire as Chairman and CEO of SanDisk at the end of this calendar year and our succession plan.

Sanjay and Judy will provide details on the second quarter and the outlook for the second half of this year. We believe the NAND Flash industry continues to experience a healthy demand supply balance as evidenced by modest price declines throughout the second quarter.

In the second half, our customer demand is expected to exceed our supply driven primarily by strong mobile OEM sales as well as seasonal improvement in retail demand. Our own supply situation is looking quite tight in the second half, the result of our OEM business doing much better than we had forecasted just six months ago and we continue to work closely with our customers in this environment.

We now have greater visibility and are more confident in the sustained demand from our diversified channels and market and, therefore, we have now approved the final phase of Fab 4 extension which will result in additional petabytes in the first half of 2011.

Last week in Yokkaichi, Japan we signed the Fab 5 agreement with our long-term strategic partner Toshiba. This represents a major strategic decision for us, one that will allow us to keep face with the projected strong growth in our Flash market in the coming decade.

Due to long construction and equipment lead times, this decision is now timely and necessary and the Fab 5 contribution to our existing supply base will become meaningful starting in late 2011.

The Fab 5 agreement provides us flexibility to participate in up to 50% of the investment and corresponding capacity allocation with our actual percentage participation being determined at our discretion.

Furthermore, beyond the initial startup ramp and within certain limits we have the flexibility to time our own production ramp rate to best meet our customers' demand profile.

Fab 5 will take several years to ramp to full capacity at which point it is expected to be one of the largest, most efficient and most advanced NAND Flash memory fab in the world. It will be capable of supporting extreme UV, that's UV lithography tools when they become available for production and we also see possibly our first trial for 3D redrive when this technology becomes ready for commercialization.

Fab 5 will require substantial capital investments. It will be spread primarily over 2011 through 2014 as well as startup costs in the second half of 2011. We have not finalized our Fab 5 production plans beyond the initial minimum commitment and we will provide Fab 5 CapEx projections in the first quarter of 2011 when we have better playing visibility.

We believe that the much-improved strength of our balance sheet and the growing scale and diversity of our business support this important investment in Fab 5.

Moving now to today's announcement of my retirement from SanDisk and our succession plan; I consider myself to have been the luckiest guy in our industry these past 22 years. Together with our team we built SanDisk from the proverbial idea sketch on a napkin into a great company in an industry that we pioneered.

This year I turn 65. Also, this year SanDisk is stronger than ever and poised to do even better in the years ahead. This is good timing to pass the baton to a new leader. We are very fortunate that my partner and co-founder, Sanjay Mohrotra, has accepted the CEO roll effective January 1, 2011.

Sanjay is 52 years old and over the last 22 years he has contributed in numerous, major rolls as SanDisk grew to its current size and stature. He has tremendous integrity and business acumen and, as a superb memory engineer, he is as knowledgeable about flash storage as any other person in our industry.

Sanjay has displayed strong leadership through the years and, in particular, during the recent difficult downturn when we restructured and strategically redirected SanDisk on its current course. He has mine and the Board's full confidence and support and is ready and able to lead SanDisk to the next level in the years ahead.

SanDisk's new non-executive Chairman of the Board effective January 1, 2011 will be Michael Marks, a long-term SanDisk Board director and former Flextronics CEO. At the Board's request, I have agreed to provide the company with advisory service, particularly technology related on a part-time basis in the two years subsequent to my retirement.

For myself I will continue driving SanDisk hard until midnight December 31, 2010. During the next five months I hope to also meet with many of our shareholders, customers and partners. Beyond that, I currently have no specific plans and am looking forward to new adventures with my wife, my life's partner. I will now pass it over to Sanjay.

Sanjay Mehrotra

Thank you, Eli. Good afternoon, everyone. First, I would like to thank Eli and the SanDisk Board of Directors for their confidence in asking me to take over the role of SanDisk president and CEO starting January 1, 2011.

Over the last 22 years I have benefited from the valuable mentoring and insight provided to me by Eli as SanDisk grew from a [starter] to one of the most recognized companies in the high tech industry. It is my honor to have the [fortune] to follow in Eli's footsteps and as successful as SanDisk is today I'm confident that our best days are still ahead.

I look forward to working with the SanDisk team to bring innovative products to market that anticipate our customers' requirements and drawing standards to new heights.

Now moving on to our second quarter review, our revenue reserves were strong, driven primarily by continued success in the OEM market. Our OEM business grew 181% from the year-ago quarter with unit volume more than doubling during the same period. Within our OEM business, our micro SD cards boasted strong unit and revenue growth.

In addition, our embedded storage products business grew substantially setting a record for both units and revenue with robust increases in [payments] of high capacity, eight gigabytes or greater [product].

In retail we maintained our focus on continued improvements in profitability and [ramp premium] in all regions. The ramp of our 32 nanometer technology has progressed will with high yield and productivity. The mix of 32 nanometer technology using X2 and our current generation X3 architecture was about two-thirds of our total production output.

We expect to complete the 32 nanometer transition in the third quarter. This progress, combined with continued usage of S3 is delivering better cost reductions than we expected for the year. Our [x phase 9]s are now fully mature and we believe that they deliver significantly superior performance and reliability compared to competitors' X3 products.

Just for year-to-date, the use of our X3 and our card and embedded products is essentially [subsequent] to the user from what we price at no differently from comparable X2 (inaudible) products from our sales or competitors.

Addressing our next generation technology we are on track to start transitioning to the 24 nanometer [node] later this year.

Our supply chain [really did] well, delivered record unit sales in the second quarter. We now expect to ship well over 500 million memory units during 2010 with approximately 50% of these units assembled, (inaudible) and shipped from our Shanghai manufacturing facility. The scaleup of this factory has improved our cycle time, inventory management, costs and customer responsiveness.

As we look into the second half of the year and beyond, new product cycles from Smart phones, tablets, e-books and other mobile internet devices should continue to drive the need for the (inaudible) NAND Flash based storage solution.

We see plenty of design activity among the [QC] and other technology leaders to develop iPad-like products. We believe that the runaway success of the iPad and its future composition should [eliminate] that option of flash storage in such ultra mobile platforms.

This new generation of tablets [appears] a fast-moving category which sports a 10 lightweight compactor four-day [web dream], is web connected, application driven, always on and rugged and highly reliable. These (inaudible) can best be enabled by NAND Flash [waves], high-capacity sorted solutions including SSD.

Customer engagement with our product roadmap that includes PC solid state drive designed for tablets, network PCs and also (inaudible) and [GCD]s, SSDs for mainstream notebook PCs continues to evolve well.

We are gaining traction with design wins that key OEMs and look forward to growth in this important business. The SanDisk team is excited about the prospects for our business ahead and we look forward to a successful 2010. With that, I will turn over the call to Judy.

Judy Bruner

Thank you, Sanjay. We delivered our highest-ever second quarter revenue, gross margin, operating margin and EPS and our cash on investments stand at the highest level in the company's history on both a gross and net basis.

Our product revenue was up 10% sequentially and 79% year-over-year with the growth generated primarily from mobile handset products, imaging products and wafers and components.

Our license and royalty revenue was in the range we forecasted with a 27% year-over-year decline reflecting the current Samsung license agreement. Our Q2 product revenue channel mix was 65% OEM and 35% retail. Our retail revenue grew 3% sequentially and 7% year-over-year with the strongest retail growth coming from the imaging market.

Looking at our retail revenue by geography, on a year-over-year basis we experienced strong growth in Asia, modest growth in the Americas and a decline in EMEA reflecting weak economic conditions in Europe.

Our OEM revenue grew 14% sequentially and 181% year-over-year with the strongest growth coming from the mobile market. Across all channels, the mobile market generated 48% of our Q2 revenue.

Turning to a few statistics on pricing and bids, our ASP per gigabyte declined a modest 8% sequentially and 18% year-over-year and our gigabytes sold grew 18% sequentially and 116% year-over-year.

The average capacity of our products sold grew 9% sequentially and 16% year-over-year. Our non-GAAP product gross margin improved sequentially by approximately one percentage point to 42.4% as our product costs per gigabyte improved 9% sequentially, slightly more than price decline.

Gross margin exceeded our previous forecast primarily because we were able to manage the quarter with less retail promotional spend and our usage of three bits per cell memory or X3 remains similar to the strong level in Q1 whereas we had previously anticipated a slightly lower mix of X3 in the second quarter.

Non-GAAP operating expenses grew only $2 million sequentially and at 14.7% of revenue expenses are slightly below our long-term financial model range of 15% to 17%. We continue to prioritize investment in technology and innovation and we are hiring in order to manage growth and invest for the future.

Our operating margin improved sequentially on a GAAP basis from 29% to 30% and on a non-GAAP basis from 31% to 32%, second only to the fourth quarter of 2009. Our non-GAAP other income of $14 million included gains of $7 million related to the sale of certain investments.

Our expected non-GAAP tax rate for the year has come down from 37% to 35.5% and, as a result, the non-GAAP tax rate in Q2 is approximately 34% in order to bring the year-to-date rate to 35.5%.

On the balance sheet, cash and short and long-term marketable securities increased sequentially by $422 million to $3.7 billion. Second quarter cash flow from operations was $385 million and our six-month year-to-date cash flow from operations is $713 million, higher than we have previously generated in any full year.

During Q2 we purchased $22 million in non-fab capital equipment resulting in free cash flow of $363 million. SanDisk Fab 3 and 4 joint venture capital investments have been approximately $265 million on a year-to-date basis, all for technology transitions and this has been funded entirely by joint venture working capital resulting in no payments to the joint ventures and no new leases so far this year.

Our off balance sheet equipment lease guarantees totaled $966 million at the end of Q2, slightly up sequentially due to the Yen to dollar exchange rate. Our inventory dollars ended Q2 below $500 million, the lowest dollar level wince the third quarter of 2006 when our business was substantially smaller.

Measured on a petabyte basis, our inventory is between eight and nine weeks of supply, which is lean for our vertically integrated supply chain model.

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

Demand indications from our customers are strong for the second half of the year and we expect to be supply constrained in the second half. Incremental supply from Fab 4 expansion will primarily be available in Q4 which will help with end-of-year seasonality and we have placed orders for some non-captive supply which will also primarily benefit Q4 but we do not expect our available supply to be adequate to meet demand.

We expect Q3 total revenue to be between $1.175 billion and $1.25 billion. Within this total Q3 revenue we forecast license and royalty revenue to be between $90 million and $100 million. Despite supply constraints we are raising our full-year revenue estimate.

Recall we started this year with an estimate of $4 billion to $4.4 billion in revenue and after Q1 we raised that range to $4.5 billion to $4.8 billion. We now expect total revenue to be between $4.7 billion and $4.9 billion for 2010 including license and royalty revenue between $360 million and $375 million.

Turning to gross margins, we now expect our full-year cost per gigabyte improvement to be better than 40% and we expect the pricing environment to remain favorable. In the second half we will have some unfavorable gross margin impact from non-captive supply and from the Yen to dollar exchange rate which has moved against us in recent weeks.

Based upon all of these factors, we now expect the product gross margin percentage in the second half to be roughly comparable to the first half of the year. For the full year, this would result in product gross margin more than four percentage points above the midpoint of our previous guidance.

Our forecast for non-GAAP operating expenses for the full year remains at approximately $750 million with Q3 at approximately $195 million. Our forecast for non-GAAP other income remains at approximately $60 million for the year and we forecast the non-GAAP tax rate to be 35.5%.

We are pulling in the timing of Fab 4 expansion plans with the completion of Fab 4 expansion still in the first half of 2011. With this pull-in, our forecasted capital investments for 2010 have increased to approximately $1.1 billion compared to our last estimate of approximately $900 million.

The $1.1 billion is comprised of an estimated $1 billion of joint venture fab equipment in Fabs 3 and 4 and $100 million of non-fab capital equipment. Roughly $300 million of these investments were made in the first half of 2010 and approximately $800 million remain in the second half. Recall that there are three sources of funding for our capital investments including joint venture working capital, equipment leases and SanDisk cash.

While our 2010 capital investments have increased due to the pull-in of Fab 4 expansion, the estimated cash requirement for 2010 remains at the low end of the range we provided early this year, approximately $300 million due to strong joint venture working capital and certain expansion payments occurring in 2011.

In closing, we are extremely pleased with our Q2 results and we are working very hard to optimize and maximize supply for our customer demand in the second half. At the same time, we are managing our business and strategic investments to drive future growth, profitability and cash generation.

We will now open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Daniel Amir - Lazard.

Daniel Amir - Lazard

So first of all, considering your non-captive supply here, I mean, what will be your non-captive percentage here in the second half of the year and what do you expect now SanDisk's bit growth to be for this year? I have one follow-up question.

Judy Bruner

Daniel, this is Judy. In terms of non-captive supply in the second half we expect it to be in the single digits in terms of percentage of our overall supply in the second half. I'm sorry, the second part of your question was …

Daniel Amir - Lazard

Bit growth for the year.

Judy Bruner

In terms of our captive supply, our captive supply is growing at approximately 75% in terms of year-over-year growth. We're not providing a bit growth estimate in terms of our overall revenue. We're giving a revenue range of $4.7 billion to $4.9 billion and that does include this modest usage of non-captive in the second half.

Daniel Amir - Lazard

Now, in terms of the decision on using the non-captive supply, I mean, is the fact that there's not enough supply available that you wouldn't want to increase it beyond the single digits or is it an issue of you don't want to sacrifice necessarily the margins because those are obviously lower margin components for you?

Sanjay Mehrotra

Daniel, as you know, our demand has grown rapidly during the course of the year. In fact, we have raised the revenue estimate a second time compared to the start of the year now. So we basically are running as fast as we can in terms of really fulfilling the demand and that includes maximizing our captive supply but yet also tapping into demand non-captive sources.

So we saw the demand increasing during the second quarter. We placed orders for the non-captive supply. We'll be receiving it in the third quarter. So in terms of shipments, the impact of non-captive in the third quarter will be small and in the fourth quarter it will be somewhat larger.

As Judy said, overall for the second half still it will be in single digit percentage. So there are several factors that we look at in managing our non-captive business. We want to make sure that we are managing it prudently. Some of the considerations include margin, the mix of the product as well as basically the timing of the supply that's available.

So looking at all of that, our picture ahead is a single-digit percentage in the second half of non-captive utilization.

Daniel Amir - Lazard

Eli, just one final question. What was the though process on Fab 5 considering the difference in the agreement compared to Fab 3 and 4 in terms of capacity, output and investment?

Eli Harari

Well, as you know, we went away from the non-binding MOU that we had signed with Toshiba two years ago -- it's likely more than two years ago -- that was structured somewhat differently. It was really a 25%, 75% type agreement with another 25% that we could purchase on a foundry basis.

Of course, things have changed dramatically since that time. With the visibility that we have into the future now with our new significantly more diversified channels we felt that we would need basically to structure agreement on a 50, 50 basis just as we had in the prior agreement.

However, the difference that we were able to achieve here is to give us flexibility since our ramp profile and customer requirements may be somewhat different than Toshiba's to give us the ability, except for the initial ramp up phase which is jointly undertaken and committed to give us flexibility to have a different ramp that Toshiba while still maintaining an equal cost structure and also be able to catch up on that capacity. Of course, if we did not want to use a full 50% we have that flexibility as well.

Operator

Your next question comes from the line of Gary Hseuh - Oppenheimer.

Gary Hseuh - Oppenheimer

Judy, I've got a quick question here for you. Just help me understand -- you've talked about inventory numbers coming down at very much higher revenue levels. I was wondering if you could talk about differed revenue and differed income, why that number might be higher than it's ever been before and particularly considering the fact that this is more of an OEM business model now rather than a retail model.

Help me understand the discrepancy between inventory and differed revenue and what might be happening here.

Judy Bruner

Actually, one thing that's important to understand is that the differed revenue you see on the balance sheet is actually differed income, meaning it's the differed gross margin. Since gross margins are extremely high that tends to push the number up. So that's really the key variable in terms of the amount of that differed income.

Our channel inventory, which is primarily retail and is reflected in that number, is at pretty standard levels at approximately eight weeks of channel inventory.

Gary Hseuh - Oppenheimer

So you said that your inventory levels were eight to nine weeks but despite the fact that the differed income number went up the channel inventory level is roughly in the same range.

Judy Bruner

Yes. So there's two buckets of inventory and the eight to nine weeks I referred to earlier in my prepared remarks is the inventory on our balance sheet that SanDisk owns and then I am saying that in addition there is inventory in the retail channel that we have sold to the retail channels but for which we have not yet recognized revenue and that that stands at about eight weeks which is a fairly typical level.

Operator

Your next question comes from the line of Atif Malik - Morgan Stanley.

Atif Malik - Morgan Stanley

A question on the tablets, you mentioned you have a diversified part base now. So if I look at the tablets that are out in the market, with exception of one, we haven't seen other tablets come out yet. So when you say second half demand I'm just trying to get a sense -- since you guys are exposed to pretty much all tablets, are we expecting a pick up in a broad-based tablet demand for NAND in 3Q or in 4Q?

Sanjay Mehrotra

For this year our revenue contribution from SSDs, the [PSSD] and our other products that go into the tablet market will be relatively small. The growth driver for this year is mobile phones but I can tell you that we are experiencing strong design wins in tablets and we are continuing to actually have strong customer engagement and continuing to really look at growth picking up in this category for us in 2011 and 2012 timeframe.

So for the year, relatively small revenue; the primary growth driver is mobile phones. But exciting and fortunately that is building up and we are well entrenched with customer engagements in this area and design wins as well.

Eli Harari

I think that the iPod and tablets like the iPod clearly represent a major new category. I think everybody is scrambling -- everybody that's either competing with Apple is scrambling to deliver tablet PCs that can match anywhere close to the iPod. But the main thing, if you've seen Apple announcing this week in the first three months of the iPod achieving 3.3 million units and it took them 30 years to get the Mac sales to reach 3.5 million in the last quarter, which is still a great product.

So the nature of these new platforms -- I mean, e-book, Amazon just mentioned this week that they've sold more e-books than hardcover books, which is astonishing how quickly -- this is just amazing. Of course, flash is the storage media for all of these e-books and we are being designed into quite a number of e-books out there. We never think about flash as replacing paper but that's basically what is happening.

Atif Malik - Morgan Stanley

I know you guys don't comment on the pricing sequentially but if demand is going to be more than supply in second half is it wrong to model pricing going higher in second half sequentially? I understand there could be mix issue where three bit per cell could be more but, I mean, is it wrong to model pricing going higher in the second half?

Judy Bruner

Let me point out that in terms of our pricing our ASP per gigabyte, the product mix and the average capacity play into that quite a bit. By product mix here I don't mean three bit versus two bit because, as Sanjay said, we price those at equivalent levels. I mean, for example, OEM versus retail. OEM products tend to carry a lower price per gigabyte and they also have a lower cost per gigabyte.

Also, as the average capacities move up, that also tends to lower the ASP per gigabyte. So those factors will play into our ASP per gigabyte and tend to bring it down somewhat always as we move forward. But, as I said, we do expect a good supply demand balance and a favorable pricing environment in the second half.

Operator

Your next question comes from the line of Uche Orji - UBS.

Uche Orji - UBS

Let me start off by asking you, as we look at the OEM business, one area that I'm not sure I understand how much of a success you're making is in the embedded (inaudible) iNAND business. So as we look at the OEM business between costs resulting to Smart phones and the embedded business, can you talk about what success you're seeing there for both Smart phones and also the emergent tablet category (inaudible)?

Sanjay Mehrotra

With effect to embedded business, actually it is growing very nicely for us and we are engaged with all handset manufacturers pretty much in terms of our embedded products and our embedded revenue in a quarter-over-quarter basis. That includes iNAND products as well as our other products grew pretty substantially.

In fact, embedded products at this time represent approximately 20% of our total OEM business, which has increased from the past levels and with all the design wins we are experiencing with our iNAND products we see continuing strong growth fortunately on the embedded side, in the Smart phone side.

Also, as I mentioned earlier, our design wins for embedded products in the tablet space and the mobile computing space are doing very well as well.

Uche Orji - UBS

Could you just -- this is taking so long in terms of finally getting traction for iNAND. Can you just explain a little bit as to what led to the current traction of finally getting with this? I thought there were some issues in the past as to why this really didn't gain traction. Was there anything specifically that kind of reached a tipping point for these to finally start to gain traction?

Really the reason I'm asking this is to also understand what the future progress will be for the embedded business.

Sanjay Mehrotra

We definitely expect strong future progress for the embedded business and there are really a lot of things that are going in our favor with effect to our iNAND design wins. As we have discussed on Analyst Day we have adapted flash management techniques and these techniques basically allow us to meet the requirement of a customer [during] the requirement for a customer with respect to a feature set that [enhanced].

Ultimately the customers in the [white] platform and through these adaptive flash management techniques we can really tailor our inventive flash solution for the end customer, for the end application. This really is working well for us and this is one of the things that is actually helping us with strong customer traction and design win which should bode well for the future as well.

Of course, as flash memory scales and technology gets more difficult, continuing to deliver performance gets more challenging but our system and [controlled] expertise working well with our memory technology really allows us to continue to deliver specifications at our chip level, which are superior to other embedded solutions for many applications. That, again, helps us.

Basically the system expertise, which also includes adaptive flash management is a pretty powerful asset for us and continuing to do well with iNAND design.

Eli Harari

I'd like to add that four years ago we acquired msystems and msystems, of course, was well known for their [in duct] solution which was basically embedded solutions and the team that's really driving the iNAND is basically the team that is based in Israel and has really driven that business and now with a combination of X2 and X3 and adaptive flash management this is really beginning to blossom.

Uche Orji - UBS

Let me ask you about the fly constraint. Obviously it sounds like through the rest of this year you have the supply constraint. Your inventory is probably one of the lowest I've seen in recent times and in Q2 period.

If you step away from your standards and look at the industry what is your sense as to supply coming in through this year and into next year? While you're answering that, also as you transition to 32 nanometers and then to 24, any sense as to what the mix for 24 will be for Q4 just for us to kind of try and calculate what we think should be a bit growth [yourself]?

Sanjay Mehrotra

So with effect to the mix for 24 nanometer, as I said in my prepared remarks, that 24 nanometers will begin as production ramps late in the year. So its contribution to our bits during 2010 and even Q4 will be fairly small. So your other question regarding the demand and supply picture, based on what we see out there, demand and supply is tight in the industry and certainly with all the growth of customers and channels that we have enjoyed with broad set of product offerings as well, it is pretty tight for our business.

For 2011 in terms of new capacity that can contribute to bid growth, that new capacity, new wafer (inaudible) capacity is coming late in the year. So before next year also in terms of third party projections it's about 75% to 80% bit growth for 2011 over 2010.

Uche Orji - UBS

But that's not [leaving] the second half weighted for 2011.

Sanjay Mehrotra

Sorry I didn't quite understand.

Uche Orji - UBS

Does that mean then that the growth will be more back-end loaded for 2011 because it looks like between now and the back half of 2011 we'll really -- you'll be in a tight situation in terms of supply.

Sanjay Mehrotra

Yes, I mean, the bit growth in the first half will be coming through technology transitions and, for example, in our case, too, continuing Fab 4 expansion we plan to complete our Fab 4 expansion in the first half of 2011 timeframe. So that will be providing bit growth. The new fabs will contribute to bit growth late in 2011.

In our case, as we have said, Fab 5, even in 2011, even with capacity coming late in the year, will be in terms of wafer [entries] less than 10% of our total 2011. So the primary driver for capacity bit growth next year will be 24 nanometer transition.

Eli Harari

But in general we do see the industry still acting with discipline as far as [netting] new capacity and, certainly, this is what is guiding our drive for 2011.

Uche Orji - UBS

Just one last question, in retail, any comments as to what you're seeing within some of the key drivers like digital cameras or the product areas? Also, you talked about Europe being a little weak. Have you seen any rebound since during the month of July within Europe? That's my last question.

Sanjay Mehrotra

So within the retail business, I mean, certainly video is the trend that is driving demand and imaging we see continuing strong growth in demand and high capacity. Video, HD video and your digital cameras as well as camcorders, more and more camcorder models coming out that are pretty much all flash based now, those are -- that's really the primary trend in the retail business in terms of the demand aspect.

In terms of the demand from Europe, as Judy said, Q2 was somewhat slow. I mean, the consumer sentiment in Europe or in America is not totally back. However, in Q3 we do expect seasonal uptick in demand particularly associated with back to school.

Eli Harari

But I'd like to add that really we are riding waves of new markets that are growing and frankly outstripping in the growth rate, really outstripping the economic conditions in retail in Europe or in the US. The OEM business mobile, really we're not seeing that influence of weak consumer sentiment, at least not in the second quarter. We believe that, in fact, the second half of the year should be [capped] in retail as well. Demand is not our issue. Really it's how to meet that demand.

Operator

Your next question comes from the line of Daniel Berenbaum - Auriga USA.

Daniel Berenbaum - Auriga USA

Sanjay, you talked about selling three bit per cell at the same price as two bit per cell. How long can that last or are you concerned about competitors coming in and cutting pricing on three bit per cell? Is that part of your expectation for pricing maybe being a little bit weak through the second half?

Sanjay Mehrotra

No, we do not think that pricing with three bit per cell will be weak. I mean, keep in mind that our three bit per cell is high quality, high reliability and high performance in terms of our end product applications and really designed very well to meet the needs of the customers in their applications essentially, as I said, making it totally transparent for the application as well as the two bit product or three bit product.

That, again, really requires strong system level expertise, the control and the memory to work together to really give our three bit per cell base product that attribute. So we expect that lead to continue in the foreseeable future.

Eli Harari

Fundamentally, anybody that sells X3 at, let's say, 20% or so below X2 loses the entire benefit of lower cost of X3. The whole concept here is that you provide the same performance transparently and gain the benefit of more bits per wafer or per [dye].

If you sacrifice that because your performance is inadequate then there's no point and that is why we're not seeing, at this stage at least, strong competition in the X3 arena.

Judy Bruner

As we've pointed out for several quarters now, our strong mix of X3 has definitely been very favorable for our gross margins.

Daniel Berenbaum - Auriga USA

Then maybe if we can take that focus sort of our to next year and tie it in also the 24 nanometer transition. I mean, you guys have talked about cost reduction slowing over the course of the next couple of years and obviously you'd think that your cost reduction this year is going to be better than the 40% and I assume that that 40% better on your captive capacity, so just want to clarify that.

But then as you shift your mix to X3 and as you start the transition to 24 nanometer, number one, are you concerned about the technology roadmap beyond 24 nanometer and then does this sort of faster transition also affect how you're thinking about cost reduction that you'd previously guided to for 2011 and 2012?

Eli Harari

I think these are very good questions and, frankly, quite fundamental. Also, it came into consideration in our decision to move with Fab 5. We have in the past been conservative about how scalable is 20 nanometer below. We feel that as we get closer to 20 nanometer we are gaining significantly more confidence that we can drive the technology below 20 nanometer and hopefully also maintain our ability to ship X3 with 20 nanometer and below in the next, let's say, couple of years.

It is very important for being able to maintain a more aggressive cost reduction than we have previously projected, at least let's say the 20 nanometer and slightly below 20 nanometer. Beyond that, of course, you start getting into extreme UV and UV and that does require new manufacturing technology.

But overall I would say that we're getting more and more confident that we can take together with Toshiba nan technology to 20 nanometer and at least, let's say, the next generation below that, hopefully with X3. That makes the [LOI] decision on Fab 5 a lot better, a lot more attractive.

Daniel Berenbaum - Auriga USA

Then just one last administration question; Judy, were there any inventory adjustments in the quarter?

Judy Bruner

No. Changes in inventory reserves, inventory charges are very, very immaterial at this point.

Operator

Your next question comes from the line of Kate Kotlarsky - Goldman Sachs.

Kate Kotlarsky - Goldman Sachs

A quick question for you on the captive versus non-captive supply; you've done a great job on the cost side and it's great to see that margins are actually going to be sort of flattish for the remainder of the year despite the fact that you're going to be sourcing some non-captive supply.

I was curious, what kind of good growth do you think you would have to see in Q3 for you to consider potentially sourcing more than what you're currently expecting because it certainly seems like the demand environment is very robust and the industry, as a whole, I think is facing some significant shortages in the second half.

Judy Bruner

So keep in mind there are fairly long lead times to get non-captive supply. At this point it really would be too late to order any additional non-captive supply for the third quarter. We are still working on obtaining the non-captive supply that we have built in our forecast for the fourth quarter.

Kate Kotlarsky - Goldman Sachs

I guess the question was more how significant would Q3 bit growth have to be for you to think about sourcing more for Q4.

Judy Bruner

Well, we're already trying to source more for Q4 based upon our forecast of bit growth and basically based upon the indications of demand from our customers. So we're working on that as we speak and, as Sanjay described, there are several different factors that play into ramping up and obtaining and using our non-captive supply and we're working on that now.

Kate Kotlarsky - Goldman Sachs

Just a quick question on the pricing environment; I know a question was asked earlier about what we can expect for the second half. I was curious, in your full-year guidance, what kind of ASP declines, Judy, are you assuming for the full year?

Judy Bruner

We're really not giving ASP ranges in terms of guidance. You might recall that at the beginning of the year I said that -- I'll give you a few statistics. At the beginning of the year I said that we expected our cost reductions to be 30% to 40% per gigabyte and that we expected ASP decline to be less than that.

Since that time we have increased our expectation on cost reduction. We now think it will be greater than 40% per gigabyte and I would tell you that our expectation on price decline has come down even further from where it was as we started the year. So there has become a bigger gap between cost decline and price decline and clearly that is what's causing our gross margin to improve so substantially.

You saw the numbers today for the second quarter. In terms of price decline it was 18% per gigabyte on a year-over-year basis and we continue to expect to see a favorable pricing environment in the second half.

Kate Kotlarsky - Goldman Sachs

One final question; I wanted to ask about the mobile part of the business. Obviously it's a big part of your business now. I was curious if you could give us some color as to do you think about the mobile business overall. How much of the business now is Smart phones versus feature phones and what the trends are that you're seeing in each of the different markets?

Sanjay Mehrotra

We are actually doing very well both on the side of the Smart phones as well as on the feature phones. Even in the APAC market there are lot of phones getting shipped, low-end phones that are bit card slots and there is a lot of bundling of low-capacity cards that (inaudible) in those markets and we are a strong player to that as well to media handset manufacturers as well as to other customers in the region, in the APAC region.

In terms of feature phones, as well as Smart phones, we are doing well with respect to our cards, as well as our embedded solutions. In fact, our average capacity in the mobile phone market grew very substantially, more than the average capacity for the entire business because of strong success for cards and embedded products of high capacity.

Jay Iyer

[Elizabeth], we'll take two more questions.

Operator

Your next question comes from the line of Craig Ellis - Caris & Company.

Craig Ellis - Caris & Company

The first question on the non-captive for the second half maybe looking out a little bit longer than that; is the move towards non-captive more of a temporary move in your mind or, Judy, are we moving towards just a larger percent of non-captive in the mixes you talked about at Analyst Day?

Judy Bruner

We do expect that we will continue to use non-captive and it is favorable for us. Keep in mind that our business mix has changed quite a bit and that it is not necessarily as useful in the OEM part of our business as in the retail part of our business but we do expect that we'll continue to make use of our non-captive supply agreements.

Craig Ellis - Caris & Company

Then on the cost reduction side, this is the second time the company's talked about a little bit better cost reduction than it expected. One, can you quantify how much greater than 40% you'd expect cost reduction to be and, two, can you provide some insight on what the factors are that are relating to the better cost reduction that you're achieving?

Judy Bruner

I'm not going to go any more granular than greater than 40% at this point in time. We're only halfway through the year. But I will say that in terms of factors that are influencing them, one key factor is our very successful transition to 32 nanometer in terms of the speed of that transition as well as the yields that we're obtaining. Then another key factor is continued, very strong usage of X3 across most of our product lines.

Eli Harari

In addition to that, we are really getting the benefit of the tremendous economies of scale of Fab 3 and Fab 4. These are very large fabs running at full capacity with exception of the last part of Fab 4, very high volumes, very highly productive, extremely efficient and that really is what gives us the third element of cost reduction.

Sanjay Mehrotra

I would just add the fourth element is on the back end supply chain. Our Shanghai factory is really contributing very well to our cost reduction capability and ability to shape and manage inventory and cost, etcetera, pretty well. So our debt and supply chain is doing very well as well. So it's all these factors combined that we are making strong progress on and getting strong cost reductions on.

Craig Ellis - Caris & Company

Clearly very good execution. Lastly, second quarter in a row where we've got a 65, 35 OEM retail mix; is that kind of the natural balance of the business now or would you expect that to change meaningfully over time?

Sanjay Mehrotra

I think this is natural balance at this point but, of course, we are continuing to drive to maximize other (inaudible) on the OEM side as well as on the retail side.

Operator

Your next question comes from the line of Bob Gujavarty - Deutsche Bank.

Bob Gujavarty - Deutsche Bank

I think the industry looks great from supply demand right now but I know LP has made some noise about getting into the NAND market using charge trap. Do you think they can be competitive using that technology and what you know of their plans?

Eli Harari

As best as we can understand, we believe that they are focused very much on low-density memory for multi-chip packages, which really is not a market we are competing in. So, no, we don't see this really making any substantial impact on our business.

Bob Gujavarty - Deutsche Bank

Just a quick follow-up; given how pricing has been relatively stable, do you believe there's kind of a pent up demand for NAND? So even if we see potentially some slight over supply and lower prices there's a lot of pent up elasticity to absorb that demand. Does that give you some comfort going forward?

Eli Harari

There are markets that have a great deal of elasticity, as we said before, like SSD, markets that are relatively mature and, therefore, elasticity really is not very strong. Pent up demand, I don't know. I think that some products are introduced today with lower bundled capacity or embedded capacity because the shortage of NAND, not so much the price of NAND, but the shortage, unavailability of NAND.

If it were available it could well be that these units would be shipped with high-capacity of customers that are prepared to. We have data that shows customers are prepared to pay more for more storage but suppliers are very concerned that they will not be able to meet the demand and, therefore, in some cases we think that there is some products that are coming up with lower than desired capacity because of supply constraint.

Operator

That does conclude our question-and-answer session for today. I would like to turn the call back over to management for any additional or closing comments.

Jay Iyer

Thanks, [Elizabeth]. Thank you all for joining today. As a reminder, a webcast replay of this conference call will be made available on our website as sandisk.com/ir. Have a good night.

Operator

Ladies and gentlemen, that does conclude today's conference call and we thank you for your participation.

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Source: SanDisk Corp Q2 2010 Earnings Conference Call Transcript
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