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Executives

Jay Iyer - Director, IR

Eli Harari - Chairman and CEO

Sanjay Mehrotra - President and COO

Judy Bruner - EVP of Administration and Chief Financial Officer

Analysts

Gary Hsueh - Oppenheimer

Vijay Rakesh - Sterne Agee

Uche Orji - UBS

Daniel Amir - Lazard Capital Markets

Atif Malik - Morgan Stanley

Daniel Berenbaum - Auriga USA

Kate Kotlarsky - Goldman Sachs

Craig Ellis - Caris & Company

Bob Gujavarty - Deutsche Bank

SanDisk Corp. (SNDK) Q3 2010 Earnings Call October 21, 2010 5:00 PM ET

Operator

Welcome to the SanDisk Corporation’s Fiscal Third 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, sir.

Jay Iyer

Thank you, Elizabeth, and good afternoon. 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 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 materially differ 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 will turn the call over to Eli.

Eli Harari

This is the last quarterly call that I will address you as SanDisk Chairman and CEO. Therefore, rather than discussing our business in the third and fourth quarter, allow me to take this opportunity to review our most recent past and where I see our opportunities and challenges in the coming years. Sanjay and Judy will discuss our Q3 results and our expectations for Q4.

In the past three years, we experienced the industry’s most severe downturn followed by a strong recovery. We experienced six consecutive weak quarters generating a substantial operating loss, followed by six consecutive quarters of remarkable recovery. The current recovery continues even in the face of adverse macroeconomic in the US, much of Europe and Japan.

For SanDisk, our cumulative non-GAAP operating profit for the six quarters ending this year will be more than 2.5 times greater than the cumulative non-GAAP operating loss in the preceding six quarters.

We believe our industry is driven by several powerful secular trends that point to sustainable profitable growth for us in the coming years. First, in the more developed economies growth for us continues to be driven by the phenomenal rise of the mobile internet and social networks that fuel the surging demand for mobile devices such as Smartphones and tablets that in turn drive strong demand for flash memory.

The second major secular force is the surging consumer middle class in emerging countries such as China, India, Latin America, Middle East and Africa. We are directing substantial resources to expand our businesses in these emerging countries and in the coming years we are encouraged by our gains to-date.

The past downturn has taught the industry that even relatively small imbalances, either up or down, between demand and supply can disproportionately amplify market volatility. I have often said that the NAND industry is self-correcting and in the current recovery the industry did an excellent job of adjusting to compensate for the excessive CapEx investments that were made in the 2005 through 2008 timeframe.

Industry cycles are a fact of life in our business and even severe downturns are in fact quite manageable provided you have solid balance sheet competitive technology and manufacturing base and diversified sales channels so that you’re not overly reliant on any single channel or any single local economy.

New fab capacity decisions are made 18 months ahead of production and even under best laid plans it is now easy to achieve and maintain a healthy balance. Some products such as the iPhone, the iPad and the Kindle come out of nowhere and very quickly enter hockey stick growth trajectory that creates a whole new market category while other products such as solid state drives, SSD, can take much longer to develop. Our focus at SanDisk has been and will continue to be long-term value creation but we do our best to balance growth with profitability and cash flow.

Turning now to flash technology. NAND flash has confounded many skeptics as it marches with confidences to mass production at a 24 through 27-nanometer technology node, a fact that seemed iffy to manage just two years ago. An important element in the success of this rapid scaling has been the all but mandatory adoption of managed NAND requiring sophisticated controllers to compensate for deteriorating [raw] NAND reliability and performance.

This is amply demonstrated for 3-bits per cell X3 NAND where the market is witnessing a wide variability in performance and reliability between the X3 product from different NAND suppliers. I believe that SanDisk is uniquely well-positioned in this space because from day 1 we stayed true to delivering system flash and managed NAND solutions and this is our third generation X3 in production where we have optimized our chip designs and perfected our controllers to deliver a solid solution.

We now expect NAND to scale down to below 20 nanometers in the next few years. This will likely be achieved with existing lithography tools running in existing and new advanced NAND fab and this bodes well for our Yokkaichi fab as they become more fully depreciated in the coming years.

As we push the roadmap even further, extreme ultraviolet, EUV lithography tools will become indispensable and I expect the transition to EUV to be spread over a number of years and to be quite challenging for the industry.

With regard to post NAND technology alternatives, I remain optimistic about our three-dimensional 3D Read/Write directories currently under development with our partner, Toshiba. As I have said previously, I expect highly-scaled NAND and post-NAND technology to happily co-exist over the next decade.

Moving to IT, our flash memory and system portfolios and know-how are now dominated by many strong second-generation patents. These patents cover managed NAND, multi-bits NAND, advanced NAND device, process and memory chip design patents, solid-state disk, secure portable content, strong error-correcting algorithms, high-speed flash caching, wear-out optimization, application adaptive storage, 3D memories and so on. We believe this IT will provide us substantial leverage in the years ahead.

Turning now to our target markets, we have previously spoken about the legacy consumer markets, the mobile market and computing including SSD and cloud storage. Of these, we believe that mobile continues to present us the greatest opportunities in the coming years. The more than 1.2 billion handsets that will be sold this year dwarf any other consumer or computing market.

Increasingly, these are Smartphones and tablets which are morphing into sophisticated portable PCs that are always connected and that increasingly require more flash storage to support the explosion in third-party mobile apps and user content. Handsets are also rapidly assuming the role of the ultimate portable convergence device first with music and cameras, then with video games, video capture, GPS and Apps.

As for SSD, these are transforming enterprise storage as we speak and we are within one or two generations from the mass adoption in notebook PCs and other thin clients. To be a market leader in SSD, you need to have access to leading edge, high quality flash, shippable in high volumes at a competitive cost, applying sophisticated know-how for managing highly scaled NAND, having the requisite patents and building on strong OEM credentials. SanDisk has it all and we are working diligently to gain leadership position in this space.

As for our balance sheet, the numbers speaks for themselves, and I believe that Sandak is exceptionally well-equipped to execute our long term global growth strategy. Last but not the need least, our people. SanDisk people the can-do team driven by passion for innovation with a consistent track record of flawless execution through good and bad times. SanDisk’s technologies and engineers retained deep technology DNA from our early days.

Under Sanjay’s leadership, I believe SanDisk will continue to grow and prosper in the coming years. The management transition is going well and I expect 2011 will be another strong year for SanDisk.

I will now pass it on to Sanjay.

Sanjay Mehrotra

As expected the mobile market remained the key driver of the Company’s revenue in the third quarter and has represented half of our total product revenue mix.

Our top five customers in the third quarter were all in the mobile phone end market. We are particularly pleased with the strong growth of our embedded products business during the quarter. With an increasing number of handsets with our iNANDs for embedded storage going into production, iNAND units sold increased more than 100% from Q2 levels.

Our embedded products including iNANDs made up nearly 30% of our OEM revenues, up from just under 20% in Q2. Furthermore, strong focus on customer qualification and adoption of our X3 based iNAND products is starting to pay off as certain handsets with our X3 iNAND embedded are now starting production.

Our iNAND product line is also starting to generate design wins in numerous tablet SKUs and we are excited to be part of this rapidly evolving new product category. Additionally, in the third quarter, we had a successful launch of our embedded solid state drive, the iSSD with capacities ranging from 4 to 64 gigabytes and it has generated a high level of interest from both the PC and non-PC OEMs. We expect this product category to grow in 2011 and beyond.

Retail delivered a solid quarter as total unit sales grew at a healthy double digit rate on a year-over-year basis and sequential basis with the average capacity of retail units sold approaching 5 gigabytes. In North America, we saw the anticipated seasonal lift in USB flash drive sales primarily driven by back-to-school season.

We also saw a healthy double-digit revenue growth from BRIC regions, both on a sequential and year-over-year basis. In Europe, despite weak consumer sentiments our sales grew nicely and we believe increases in channel penetration and strong brand preference are leading to market share gains there.

From an operation standpoint, our fabs completed the transition to 32-nanometer technology is. A high mix of 32-nanometer X3 technology in the third quarter enabled us to deliver record product gross margins. We expect to begin volume production of both X2 and X3 memory architectures on our 24-nanometer technology in the fourth quarter.

I would like to make a few comments about the pricing environment. Industry pricing trends began to soften in the second half of Q3 in certain segments. We believe that this is primarily due to pockets of demand, supply, imbalances caused by low grade TLC, meaning competitors three-level cell NAND and early production of 2X nanometer products from other suppliers that are not qualified by large OEMs.

We believe that this low grade pricing impacted certain parts of our OEM business, specifically white label cards and wafers where we chose not to compete at some of these prices with our high quality X3.

A brief update on Fab capacity. The final phase of Fab 4 expansion is underway and we expect the facility to attain its full capacity in mid 2011. Regarding Fab 5, we continue to proceed with caution and have not made the final decision regarding ramp start date or the base of expansions.

To summarize, we are very pleased with our third quarter execution and performance. The fundamental growth drivers for NAND flash remained firmly in place and I look forward to providing you an update on our fourth quarter results and future outlook earlier next year.

I will now hand the call over to Judy.

Judy Bruner

With third quarter revenue growth of 32% year-over-year and operating margins of 35% on a GAAP basis and 37% non-GAAP, I believe our performance stands out even within a favorable NAND industry environment.

Our revenue of $1.234 billion was in the higher end of the range we predicted in July, with both product revenue and license and royalty revenue coming in as expected. Our product revenue for the third quarter shifted a bit toward retail, with a mix of 62% OEM and 38% retail. Our ASP per gigabyte declined a modest 5% with our prices mostly firm through August and some price reductions in September.

Our Q3 gigabytes sold grew 8% sequentially and 71% year-over-year and on a year-to-date basis, our gigabytes sold have grown 84%. In Q3, we experienced solid retail growth both sequentially and year-over-year in the Americas, Europe, and Asia with overall retail revenue of 13% sequentially and 20% year-over-year.

Our retail channels delivered sequential unit and revenue growth in all key end markets, including mobile, imaging, USB, audio/video, and gaming with the strongest retail growth coming from USB for back-to-school and from mobile products.

Our OEM revenue was flat sequentially and up 55% year-over-year. On a sequential basis, OEM revenue did grow from mobile products but was offset by a reduction in other product categories, primarily white label cards and wafers.

Across all channels, our third quarter revenue by end market came 50% from the mobile market, 22% from imaging, 10% from USBs, 10% from other product markets, and 8% from license and royalty revenue.

Our product gross margin increased 6 percentage points sequentially to 48%, our highest ever product gross margin with our products cost per gigabyte improving 13% sequentially compared to only a 5% price decline. Our cost decline was stronger than expected due primarily to higher 32-nanometer yields and rapid transition to 32-nanometer X3.

X3 memory continued to account to more than half of our shipments and non-captive memory was used for only 1% of our shipments. Non-GAAP operating expenses grew $13 million sequentially with the growth predominantly in R&D. Sales and marketing expenses were down slightly sequentially as certain we had anticipated in Q3 moved to Q4.

Our non-GAAP other income of $15 million included gains of $8 million related to foreign exchange and the sale of certain investments. Our expected non-GAAP tax rate for the year has come down to 35% and this reduced rate combined with certain one-time items resulted in a third quarter non-GAAP tax rate of approximately 34%.

On the balance sheet, cash and short and long-term marketable securities increased sequentially by $1.3 billion to over $5 billion. Deducting the maturity value of our convertible debt securities, our net cash is a record $2.9 billion. Cash increases during Q3 included $878 million from our convertible debt financing, $379 million of cash flow from operations, $60 million of excess cash returned from the Flash Partners joint venture and $23 million from employee options and the employee stock purchase plan.

We utilized $22 million of cash for non-fab capital purchases. Free cash flow for Q3 was $416 million, bringing the year-to-date free cash flow to over $1.1 billion. SanDisk’s portion of Fab 3 and Fab 4 investments on a year-to-date basis has been approximately $615 million with zero cash infusion to the joint ventures. Total capital investments both Fab and non-Fab are $675 million on a year-to-date basis.

Our off-balance sheet equipment lease guarantees stand at $891 million at the end of the third quarter, reflecting a reduction of $125 million from Q3 payments, partially offset by a $50 million increase due to the appreciation of the yen in the third quarter. Inventory on our balance sheet increased $33 million to $527 million primarily due to the appreciation of the yen.

Measured on a petabyte basis, our SanDisk-owned inventory remains lean at approximately eight weeks and retail-owned channel inventory is also on the low side ending the quarter at a global six weeks.

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

As we forecast Q4, we believe that demand for NAND is fundamentally strong with the strongest growth drivers being the secular trends in mobile phones and tablets, and growth from these end markets primarily shows up in our OEM business. We believe macroeconomic weakness, particularly in the US and Europe, continues to limit growth in our retail demand. However, consumers are still buying as seen in our Q3 retail results and we expect increased retail demand in Q4 for the holiday season.

In terms of unit and headed by demand, we expect good growth from both our OEM and retail channels in the fourth quarter. On the pricing front, we do expect higher price decline in our Q4 than in our Q3 and we have already made certain price adjustments.

Taking into account these factors, we expect fourth quarter total revenue to be between $1.25 billion and $1.325 billion, and within this total Q4 revenue, we forecast license and royalty revenue between $85 million and $90 million. This fourth quarter forecast was lead to full year revenue between $4.75 billion and $4.825 billion in the middle of our July forecast of $4.7 billion to $4.9 billion.

Turning to gross margin, there are three key factors that we expect will lead to lower gross margin in the fourth quarter as compared to the third quarter. First, we expect the higher rate of price decline. Second, the yen has appreciated relative to the dollar by approximately 7% since the beginning of our third quarter to present. This increases the dollar costs of the wafers we purchased in the last quarter and these wafers will be reflected in our fourth quarter sales.

Last, with the 32-nanometer transition completed and more non-captive purchases in Q4, we will see less cost reduction in Q4 as compared to Q3. Our forecasted non-GAAP product gross margin for Q4 is between 39% and 42%, yielding a total non-GAAP gross margin including licensee and royalty of 43% to 46%. To put this in perspective, our 32-nanometer transition was faster with higher yields than expected, which accelerated some of our planned second half cost reductions into Q3.

Our guidance for Q4 leads to a second half product gross margin above the estimate I provided in July. We expect fourth quarter non-GAAP operating expenses between $205 million and $210 million, with increases primarily in R&D and in sales and marketing for seasonal retail marketing programs.

Our Q4 forecast for non-GAAP other income is approximately $10 million and we estimate a non-GAAP tax rate of 34%, including some one-time benefits. On a GAAP basis, there is the possibility that we will release a substantial portion of our tax valuation allowances in the fourth quarter.

Our total capital investment forecast for Fab and non-Fab purchases remains at approximately $1.1 billion for 2010, meaning that the investment level in Q4 is estimated at approximately $425 million, reflecting investments for both the 24-nanometer transition and Fab 4 expansion.

The estimated fourth quarter cash equipment for these investments is expected to be approximately $75 million in loans to the Fab joint ventures and approximately $30 million for non-Fab purchases. Given this, the fourth quarter should be another good quarter for free cash flow.

In summary, our third quarter results were outstanding and our fourth quarter gross margins and operating margins are forecasted to be very attractive. We will now open the call for your questions.

Elizabeth, could you poll the callers for questions please?

Question-and-Answer Session

Operator

Our first question today will come from Gary Hsueh with Oppenheimer.

Gary Hsueh - Oppenheimer

Congratulations on the stunning results here on gross margin. Judy, just wanted to dig a little bit deeper here in terms of the gross margin. In terms of your guidance 39% to 42% for the product gross margin, exactly what does that correspond to in terms of cost per bit reduction because, I might have faulty math here but it looks like even at 42% gross margin, you are really not modeling or baking or taking in its account very much cost per bit reduction. It looks pretty flat even at the high end of the gross margin guidance. Could you kind of, walk me through what exactly your cost per bit reduction visibility is for Q4 and maybe where I have math wrong?

Judy Bruner

Let me help you a little bit. We do expect cost per bit reduction in the fourth quarter. I will tell you that it’s in a single digit percentage as compared to the 13% that we just experienced in the third quarter. That is factored into my 39% to 42%. Again, that single digit percentage is less than the third quarter because we completed the 32-nanometer transition in the third quarter and we’re now starting 24-nanometer transition, which will largely benefit our 2011 costs.

As I mentioned, we also have the impact of the yen and a bit more non-captive purchases that’s impacting the total cost per bit reduction in the fourth quarter. We do expect continued cost reduction per bit and we expect our full year cost reduction per bit to be well over 40%, full year over full year.

Gary Hsueh - Oppenheimer

I got a quick follow-up here for either Sanjay or Eli just about maturation of the X3 architecture here. Are you guys seeing any kind of incremental benefits now that you’re in your third generation for X3 in terms of basically reducing the bill of materials or COGS related to cards? Are you seeing an ability to extract a little bit more cost savings on the memory controller side as you shrink? Or are you otherwise able to come away and produce cards with a little bit less over-provisioning in terms of the content as you go from one generation to the next? Are there any other offsets on gross margin on the card perspective that’s helping you out here in Q4 and may be longer term in 2011?

Eli Harari

On the card basis, a very important element is, what is the maximum die size and capacity that you can fit into a microSD. microSD is the highest running volume cards for us and I believe for the industry. So, our X3, 32-nanometer X3, 32-gigabit die fits very nicely into a microSD and at 24-nanometer technology we expect a 64-gigabit to do the same with X3 but not with X2. X2 versus X3 allows you to shoehorn into a microSD which is I believe 11x15 millimeter and that ability to grow to higher capacities without double the number of half capacity chips translates into significant cost reductions.

Operator

We will take our next question from Vijay Rakesh with Sterne Agee.

Vijay Rakesh - Sterne Agee

I was just wondering looking out if you could walk us through what the cost reductions were in 4Q outside you said the 32-nanometer transition is over and so cost reductions in 4Q and what you see in the first half?

Judy Bruner

Vijay, even though we completed the 32-nanometer transition in the third quarter, we will still see benefit from that in our cost reductions in the fourth quarter that will spill over and benefit our fourth quarter. We’ll still have a higher percentage essentially all 32-nanometer in the fourth quarter. That will be the key driver of fourth quarter cost reduction. Then in the first half of 2011, we’ll begin to see cost reduction from 24-nanometer.

Sanjay Mehrotra

Just to be clear, we completed the 32-nanometer transition by end of the third quarter. There was still 43-nanometer product that was shaped in the third quarter. In fourth quarter, it will be a greater percentage of 32-nanometer products.

Vijay Rakesh - Sterne Agee

The Fab 4 expansion you said it will be completed by mid-2011. How much expansion will you be doing, let’s say, in terms of wafer starts, let’s say, in Q4 and let’ say, by mid-2011 in the first half?

Sanjay Mehrotra

We are not exactly providing the specifics laid down between Q4 and first half. As we have said, in the third quarter, we had started ramping our production of the available room space in Fab 4 and we need that capacity to meet our requirements in Q3 as well as in Q4 timeframe. This expansion will continue and we expect it to be completed by mid-2011.

Vijay Rakesh - Sterne Agee

When you look at 3Q, what is the wafer capacity in Fab 4 and when you look at mid-2011, what’s the wafer capacity in Fab 4 once it’s all completed?

Sanjay Mehrotra

With respect to exact numbers for wafer capacity, we are not providing that. What we have said before is that once Fab 4 completes expansion and the full capacity is up, our portion of Fab 4 will be at the rate of 2 million 12-inch NAND wafers per year. Let me be clear, this is Fab 3 and Fab 4 combined.

Operator

We will take our next question from Uche Orji from UBS.

Uche Orji - UBS

Eli, let me just start of with asking you about the impact you would expect your SSD products will have. I mean yesterday Apple talked about this is not the future of notebook market. I just kind of wanted to get a sense of what engagements you think you’re having right now and specifically, we can talk about tablet market as well, whether these NAND products you have is something that should lead to high engagements in those markets?

Eli Harari

The announcement this week MacBook Air having SSD as standard is I believe very, very important, not so much because of MacBook Air itself but because it’s really an industry signal I believe. Apple has done so in the past.

Apple was a first company to introduce PCs without a floppy disk at a time where everybody thought you’ve got to have floppies and I think that this going with a standard notebook PC that has nothing but flash memory, I think is going to force competitors to much more seriously go in that direction, but we all know that the real driver for mass adoption of flash memory, SSD in this type of notebook PCs is very much we need to get to a lower cost and that will happen I believe.

Tablets are, it’s really in different manner. This is really a product category that came out nowhere, it never was expected to be where it is today, even just six months ago and the nice thing about tablets almost by definition, 10-hour operations, very thin light weight, none of the tablets anymore actually none of the tablets are designed to use hard disk drive that was not the case for netbook PCs, where we all expected netbook PCs to be with primarily with flash memory SSD but pSSD but, in fact, turned out to be hard disk drive based.

Tablet PCs to the extend that they cannibalize notebook PCs, that’s good news for us and for the industry because notebook PCs really are not today using SSD to any large extent, whereas tablet PCs to the extent that they cannibalize notebook PCs, that’s good news for flash for all the industry and certainly for ourselves.

Uche Orji - UBS

Judy, let me ask you about pricing again, let me, I know something this gross margins. Let me just dig into the price elements of what’s going to drive gross margins. If ASPs were to hold where they are today, you’ve seen some decline already in October. What will ASP be by the end of the quarter? Also, the elements of non-captive, you ended up with just 1% of non-captive in Q3, what is the availability now from the non-captive markets? How much should we think about your demand for non-captive to meet your guidance need to be for the December quarter?

Judy Bruner

First on pricing. We’re not going to give any specific pricing guidance for the fourth quarter, but we do expect higher price decline in the fourth quarter relative to the third quarter. Keep in mind that our price decline this year has been quite benign and every quarter this year the year-over-year price decline has been 20% or less. So, the full year price decline even with higher price decline in the fourth quarter is going to be quite low in historical terms. In terms of our non-captive for the fourth quarter and assumed in our guidance is that we’ll utilize non-captive in the sort of the low to mid single digit range as a percentage of our total supply. So, up somewhat from the third quarter but not a very large percentage.

Uche Orji - UBS

Just one last question either for you Sanjay or for Eli, on that TLC, one of the criticisms with that of a TLC is it’s really not good enough for the embedded markets. I just want to ask you what your own thoughts are on that and whether you’ve had any embedded engagement for TLC. Then, also on the TLC price trends going forward, one of the things that was great for you in the June quarter, I remember you mentioned was you were able to get some premium on the TLC pricing. As you start to see other people introduce TLC no matter what kind of grade it is, should we expect that to now have more of the pull down on the pricing for you on TLC going forward?

Sanjay Mehrotra

We have said before that our 3-bit per cell memory, what we call X3, really leverages as many, many years of system level expertise that we have built to deliver and level products to the consumers that are high quality products, and actually those products were built with our X3 memory meet the specification of others compete quite well with this specifications that are delivered by others even with their X2 2-bit per cell as memory. This is what provides us with the pricing power with our X3 memory. We really continue to leverage that very well across our product lines and as I referred to in my prepared remarks we are looking at X3 memory, our 3-bit per cell memory, starting to look at that on the embedded application side as well.

Overall, over X3 strategy continues to work well. If to the extent that there is any low grade memory from others that, such as the TLC memory from some competitors or other low grade memory, which may be coming from early 2X nanometer production of others, that does impact some parts of our business but in the third quarter we chose not to compete with our high quality X3 memory with respect to the low pricing that was there from the TLC, the low grade memory of others.

Operator

We will take our next question from Daniel Amir with Lazard Capital Markets

Daniel Amir - Lazard Capital Markets

A couple of questions here. First of all, I mean, how do you see the tablet market impacting demand/supply environment next year, and could we potentially see a more benign pricing environment in Q1 because of this?

Eli Harari

We see a lot of design activity in tablets that clearly has been influenced to a large extent by the introduction of the iPad. You all heard Apple’s press conference and you know what Steve Jobs thinks about the people’s tablet. We think that the market does need competition and we will have competition to the iPad as good as the iPad, it is a great product and the industry would learn to use Android or other operating systems such as the RIM operating system to provide tablets with different functionality and we expect that to be a significant force in 2011 and we see great opportunity for us to participate in that.

Daniel Amir - Lazard Capital Markets

With regards to the iNAND, it seems like its 30% of the OEM business, it’s growing quite significantly. I mean, can you give us a little more clarity on what the momentum that you’re seeing there in terms of design activity and where do you really want this business to go? I mean, could this be potentially half of your OEM business, I mean is that the direction?

Judy Bruner

Well, not really prepared to provide any specific percentages here. All I can tell you is that we are actually doing very well with our iNAND design wins as well as iNAND shipping into volume productions with respect to Smartphones and the design wins in the tablet space. As Eli mentioned earlier, these are huge demand categories for our business and we are making very strong inroads here and we believe we are gaining share in this particular segment.

Operator

We will take our next question from Atif Malik with Morgan Stanley.

Atif Malik - Morgan Stanley

Congratulations on the great quarter. Eli, you once said that not all NAND is created equally. If I look at the pricing that you guys showed in 3Q, you guys have a lot of people fooled. Your price decline was quite modest relative to what some of the Tier 2 prices decline people saw. So, my question is, if I look at the MLC price decline, pretty wide spread, up 10% for high grade OEM made and then down 25% on the low end. So, what is the barrier to other guys, I mean how sustainable is this gap in your view moving forward?

Eli Harari

I think that NAND is getting more and more difficult to make and it is up. I firmly believe that the combination of Toshiba and SanDisk really have superior NAND technology and products. Of course, other people think the same of theirs and they are entitled to do that. Toshiba and SanDisk combined generate about 40% of world output and our own quality standards are pretty high. As we penetrate more and more OEM business, OEMs, major OEMs, have very high standards for quality and we have really to a large extent stayed away from playing in these low quality, low price markets.

Now, I’ve also said many times that I believe it’s very important for the industry to have continuous price reductions that are in line with cost reductions. The industry has had the benefit of really two generations of technology from the 43-nanometer to the 32 and next year 24, 27, with very, very substantial cost reductions that area leading to the very excellent gross margins which have been wonderful for stable pricing and so on. On the other hand, there is no question about it that some markets do require, like SSD, require some price reductions that take advantage of these cost reductions.

I used to accelerated these new markets as well as broaden our appeal to new strata of customers. So, I think price reductions, like we said, this year we think the industry, total price reduction year-to-year is about 20%, that’s very unusual. It has helped industry recover its health but the cost reductions really do allow us and the industry I believe in 2011 to get closer to what some of these markets need to have. So, in general I feel very good about our ability and I can’t speak for the industry, to continue cost reductions through technology through execution on our 24-nanometer with 3 bits per cell and we expect that this will allow us to be a very competitive player in these new markets in 2011.

Atif Malik - Morgan Stanley

The second one for Judy. I don’t want you to guide cost reduction into 1Q but I just want to understand the linearity of the 24-nanometer transition that you guys just started in 4Q. I mean, typically these transitions they happen over multiple quarters, is it fair to assume that the linearity of this transition is going to through the next two or three quarters into next year?

Judy Bruner

The transition will definitely take several quarters. As to exactly the linearity of that transition, it’s a little bit early to predict that at this point in time.

Operator

We will take our next question from Daniel Berenbaum with Auriga USA.

Daniel Berenbaum - Auriga USA

A couple of questions on 3-bit per cell actually, did you talk about what is it any 3-bit per cell being used in embedded right now? What percentage of your embedded business is 3-bit per cell?

Sanjay Mehrotra

No. We did not statistically breakdown what percentage of 3-bit per cell is in embedded. Overall, utilization of 3-bit per cell for all of our business, OEM and retail business combined for 2010 is greater than 50%. In terms of the embedded business, we have started shipping our 3-bit per cell for certain embedded application. Most of the embedded application that are shipping today is still 2-bit per cell and this is a progress that we look forward to making in the future with respect to our superior 3-bit per cell technology.

Daniel Berenbaum - Auriga USA

Well, can you sort of point us maybe across the next year how fast you expect 3-bit per cell to grow in embedded and what applications is suitable for an embedded?

Sanjay Mehrotra

I think regarding next year in terms of progress of 3-bit per cell, we’ll probably provide you some color on that in the January-February timeframe. In regard to the 3-bit per cell embedded applications, of course, we are continuing to work on that in the mobile handset the Smartphone space and particularly with respect to high capacity iNAND products.

Eli Harari

Let me give you a little bit of technology, just a little bit of technology. I will try to keep it a very simple. Our 3-bit-per-cell embedded iNAND, actually can write and very often relies on writing data into binary, SLC, not just 2 bits and certainly not 3 bits, but writing it to 1-bit-per-cell and then in background writing it into 3-bits-per-cell and that is what we call flash caching and adaptive flash memory, but we adapt the iNAND to that specific application.

That is where we have this benefit that our X3 can look in an application superior to somebody else’s X2 because actually we have this combination, which is very nicely covered by early patents between writing in binary and in background writing into X3. This is where you see tremendous advantage to experience and to the system know-how that we’ve been talking about.

Daniel Berenbaum - Auriga USA

Then maybe just a more near term question looking out to Q4. Judy, you mentioned the percentage of non-captive capacity growing, but it seems that bit shipments in this quarter were at least the bit shipping growth was relatively low. Again, just sort of doing some of the math, it seems like bit shipments next quarter would need to grow at 40% plus to hit that kind of 75% for the full year that you talked about having enough internal capacity for. Am I thinking about that the right way and I guess the question is, how certain are you that you’re going to need to go outside for non-captive capacity?

Judy Bruner

You’re right that in total our third quarter bit growth was a little bit less than we’ve typically seen in the third quarter. I’ll talk about the third quarter first and then the fourth quarter. In the third quarter, we actually were quite pleased with the bit growth in the retail part of our business. We saw a strong bit growth sequentially in the retail business.

In the OEM business, we saw more modest bit growth, but we had good bit growth overall in the mobile handset part of our OEM business and that was offset somewhat by the fact that we chose not to participate, as Sanjay described, in some of the low-priced business in the white label card and also in the wafer business. So, that impacted somewhat our bit growth there.

I’ve also mentioned that our bit growth in OEM in the third quarter was also impacted somewhat by the fact that there were some non-memory component shortages early in the third quarter that limited somewhat the shipment of certain handsets. When those handset shipments were limited that also then limited somewhat our sales of NAND into those handsets. We believe that that issue has been solved in the marketplace and that’s not an issue in the fourth quarter.

Turning to the fourth quarter, in the fourth quarter, we believe that we will strong bit growth both in the retail part of our business and in the OEM part of our business. So, we’re not giving any specific guidance but I think you are thinking about it correctly, as you try to model your bit growths for the year.

Daniel Berenbaum - Auriga USA

Where those bits that you didn’t ship in Q3, the inventory are didn’t go up that much, so I guess my questions is, where are those bits? Are they in inventory at handset manufacturers or are they in inventory someplace else?

Judy Bruner

Well, our inventory is lean. It would have been even leaner if we had shipped more in the third quarter and in fact, that is why we think we do need a little bit of non-captive in the fourth quarter and more non-captive in the fourth quarter than in the third quarter.

Daniel Berenbaum - Auriga USA

You would sort of implicitly expect inventory to go down in Q4?

Judy Bruner

I don’t know that it will actually go down. It’s possible it could go up some because remember, we are still ramping Fab 4, so we will have more bits coming in from Fab 4 even late in the quarter. Also, just in terms of the dollar value of the inventory, I can’t predict what will happen to the yen over the next three months, but the appreciation of the yen also puts pressure on the dollar value of the inventory.

Operator

We will take our next question from Kate Kotlarsky with Goldman Sachs.

Kate Kotlarsky - Goldman Sachs

A couple of questions if I may. The first question I have is around the Fab 5 and just wanted to ask you guys, you do seem to be pretty bullish on the outlook for NAND demand next year but you sound a little bit cautious on not the Fab 5 RAM, but at least the commitment to Fab 5 and how much you think you might ramp next year, so I was just hoping you can reconcile those two things for us kind of the cautious approach to Fab 5 yet being very bullish on NAND demand next year?

Sanjay Mehrotra

As we said, we definitely believe in the fundamentals being strong for our business in the Smartphone, the tablets and the rest of the business as well for next year. With respect to Fab 5, we are exercising the discipline and we want to make sure that we assess our demand projections before we really commit to the start of the fab 5 production. Keep in mind that fab 5 is currently under construction and we have lead time available for us to really make decisions regarding the start of fab 5.

Kate Kotlarsky - Goldman Sachs

Maybe one another question and this relates to the comment that Eli made earlier about having to have cost declines and ASP declines in order to drive some of the demand in applications like solid state drives and tablets et cetera. Was curious how you guys are thinking between the balance of having to take ASPs down maybe for you guys and for the industry as a whole in order to drive some of these applications. Maybe what kind of ASP declines do you think the industry needs to get to in order to have meaningful content growth in some of these applications like tablets and Smartphones next year?

Eli Harari

I think this is a very good question. Price declines, as we know, healthy for industry growth if they are in line with cost declines and if they are too slow with regards to cost declines they start slowing down growth if they are too fast, they create problems for the return on investment on our capacity. I would say in the fourth quarter this year SSD is not where it thought it would be a year ago because of the pricing during this year and SSD we all know needs to have a lower price point and what I said earlier is that the industry and certainly SanDisk has significantly lower cost structure as evidenced by our product gross margin in the third quarter.

What I’m saying is, it is very important if you’re looking long-term for sustainable growth with profitability and good return on investment, it is very important for us and I can’t talk for the industry but for ourselves to have a balanced not to be overly greedy frankly on the upside so that the downside as we know up cycles in this thing, are much more mild and acceptable. I know I’m not giving any number.

All I’m saying is that 20% price decline for 2010 has been very important to get the industry back into (inaudible) but the industry has also done very well in terms of cost reductions far exceeding 20% and I think it would be healthy for the industry and I am speaking really for SanDisk to have a balance between maximizing gross margins on one hand and growing our markets for the long term.

Kate Kotlarsky - Goldman Sachs

In your view, the 20% is the reduction that we saw this year is probably not enough to drive meaningful content growth next year and that we probably need to see something greater than that, maybe it’s not 50%, but it’s probably not 20%. Would that be a fair characterization?

Eli Harari

Yes.

Operator

We will take our next question from Craig Ellis with Caris & Company.

Craig Ellis - Caris & Company

Eli, you touched on PC adoption for SSDs, I was wondering if you might just look out into the future and give us some idea when you think PC SSD adoption might get to some benchmark level of say around 20%?

Eli Harari

It all clinches on really the 24-nanometer and let’s say, the 20-nanometer node. At 24-nanometer, the cost structure is very attractive, I believe, for SSD, particularly if one can deliver SSD with reasonable performance with 3 bits per cell, but even with 2 bits it gets a lot closer to where the mass market develops. At 20-nanometer, I think, the mass markets really begin to take off.

We didn’t want to two generations I believe of having the right cost structure for end performance, because performance is constantly improving actually at a very nice rate and reliability problems are being addressed very nicely throughout the industry, that I believe within the next one to two generations you’re going to a significant move on the upside for SSD and I don’t mean the enterprise SSD because as we know that’s already taking place because they can tolerate SLC pricing which is, of course, significantly higher per gigabyte.

Craig Ellis - Caris & Company

Judy, as I look at the cash CapEx this year, it strikes me that the mix of cash CapEx is far lower than anything I can remember seeing back to 2004, which is pretty remarkable and I’m wondering is the mix of CapEx funding with such a large portion of it coming from joint venture working capital, something that’s sustainable and if it is, then what does SanDisk plan to do with the excess cash that it looks like it will between piling up as we look out to 2011 and 2012.

Judy Bruner

I’d tell you that there has been growth, real growth in the cash generation power of the joint ventures, particularly as they have matured and become more depreciated. At the same time, some of the capital investment that we are making this year, such as the Fab 4 expansion in the second half of 2010, some of that will require some cash infusion in the early part of 2011.

There will be some more cash that needs to be put into the joint ventures in the 2011 timeframe. I think that it’s our business model is a little different obviously than the business model of a company that owns it fabs directly and it makes it a little bit hard to decipher, but you have to keep in mind that instead of seeing the depreciation in our results, you are seeing the operating cash flow of the joint venture themselves. Think that’s natural and we feel very good about the relatively minimal amount of cash that we’ve had to put in this year.

Craig Ellis - Caris & Company

Next year’s cash component will increase, but would it increase to levels that are below pass normative levels or would we move back more towards normative levels Judy?

Judy Bruner

It will still be better than it has been in the past, but exactly how much cash we have to put in next year is still not known at this point because we haven’t really formulated our capital investment plans for next year, including Sanjay described that we don’t have a ramp plan decided for Fab 5. We’ll have to really provide more details on that in our February Analyst Day.

Operator

We will take our next question from Bob Gujavarty with Deutsche Bank

Bob Gujavarty - Deutsche Bank

Judy, could you rank the relative weights on margin? What’s going to weigh our margins between the ASP declines offsetting COGS, yen appreciation and then finally non-captive? Can you rank them for us on which is most significant and least significant?

Judy Bruner

I’m not going to rank them from one to four for you, but I will say that the non-captive is probably the smallest factor in the fourth, and really the two primary factors are that we do expect increased price decline and we do expect a lower rate of cost decline. There is a couple of factors that lead to the lower rate of cost decline, including the timing of the technology transitions and the yen as I described.

Bob Gujavarty - Deutsche Bank

Then just a quick follow-up, I mean assuming normal seasonality, would it be fair to say that you’d have less need for non-captive capacity in the first half of the year compared to the second half of the year?

Judy Bruner

It’s really hard to predict our usage of non-captive at this point for next year. That might more likely be true for the first quarter in term of typical historical first quarter seasonality. Hard to say for the first half.

Bob Gujavarty - Deutsche Bank

Just final quick one, as the yen and dollar stabilize at these levels will the exchange rate be a further headwind in heading into 1Q or I’m just trying to figure out how long the tale is in terms of the exchange rate move?

Judy Bruner

If it’s stabilizes at these levels the yen has continued to appreciate, let’s say, over the last month. Yes, there would be a little bit more of a headwind relative to the average wafer cost purchased in Q3 and recognized in the fourth quarter cost of sales. I want to point out, however, though that really the yen has appreciated a fair amount not just in the last quarter but really in the last one to two years and that is all incorporated in our 48% product gross margins this quarter. That’s something to keep in mind in terms of how well we have performed.

Operator

Ladies and gentlemen that does conclude today’s question-and-answer session. I’d now like to turn the call back over to management for any closing comments.

I just want to say, this has been an incredible 22-year ride with all of you guys and Sanjay and SanDisk have a great absolutely great future. We go here with go SanDisk. Thank you.

Sanjay Mehrotra

Thank you all.

Operator

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

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