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SanDisk Corporation (NASDAQ:SNDK)

Q4 2006 Earnings Call

January 30, 2007 5:00 pm ET

Executives

Lori Barker Padon - Director of IR

Sanjay Mehrotra - President and COO

Judy Bruner - EVP of Administration and CFO

Analysts

Jim Covello - Goldman Sachs

Craig Ellis - Citigroup

Satya Chillara - Pacific Growth Equities

Paul Coster - J.P. Morgan

Mark Edelstone - Morgan Stanley

Gurinder Kalra - Bear Stearns

Eric Gomberg - Thomas Weisel Partners

Daniel Gelbtuch - CIBC

Krishna Shankar - JMP Securities

Pranay Laharia - Deutsche Bank

Presentation

Operator

Good day everyone, and welcome to the SanDisk Fourth Quarter 2006 Earnings Release Conference. Today's call is being recorded. At this time I'd like to turn the call over to Ms. Lori Barker Padon, Director of Investor Relations. Please go ahead.

Lori Barker Padon

Thank you. Good afternoon and welcome to the financial teleconference for SanDisk Corporation for the fourth quarter of 2006. I am Lori Barker Padon, SanDisk's Director of Investor Relations. Joining me is Sanjay Mehrotra, President and Chief Operating Officer of SanDisk and Judy Bruner, Executive Vice President of Administration and CFO.

The agenda for today's teleconference is as follows: Sanjay will start his remarks about SanDisk and trends in our markets. Judy will follow-up with our fourth quarter financial results and future guidance. We will then conclude the teleconference with your questions. 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 supplementary schedules on our website at SanDisk.com. After the completion of this call, an audio replay of this conference, a copy of today's prepared comments, and quarterly metrics will be made available on SanDisk's Investor Relations website at SanDisk.com.

During our call today we will be making forward-looking statements. Any statements that refers to expectations, projections or other characterizations of future events or circumstances is a forward-looking statements including those related to revenue, pricing and expenses gross margin, tax rate, inventory, production capacity and technology transmission and future products. Actual results may differ materially from those expressed in these forward-looking statements. Factors that may cause actual results to differ are detailed under the caption risk factors and elsewhere in documents we file from time-to-time with the SEC including our quarterly report of Form 10-Q for the third quarter ended of October 1st, 2006. We undertake no obligation to update these forward looking statements which speak only as of the date hereof. We do not intend to update information contained in this teleconference.

Now, I would like to turn the call over to our President and COO, Sanjay Mehrotra.

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Sanjay Mehrotra

Good afternoon everyone. As most of you may know, I am co-hosting the call today, as Eli is away on a well deserved vacation. The fourth quarter was a record quarter for SanDisk. Total revenue of $1.2 billion marked the first ever billion dollar quarter for SanDisk, thanks to strong demand globally for our products, market share gains and our solid execution across all fronts. In addition, our fourth quarter non-GAAP standalone gross margin increased sequentially despite an aggressive pricing environment.

Total revenue for 2006 reached approximately $3.3 billion, also a record for SanDisk. We scaled the business at a rapid pace of 2005 and this required tremendous efforts from our employees, our manufacturing and supply base and our distribution channels. I am proud of the entire SanDisk team and the results we achieved.

In 2006, the OEM business contributed more than half of our annual revenue increase due to the strength in our mobile business. I would also like to point out that the regions outside of North America grew more than 70% of the increase in 2006 product revenue on a standalone SanDisk basis. We believe our strategy of building and promoting SanDisk's global brand and increasing our focus on the Asian and European markets is working well.

We increased our revenue market share in the US from 46% to 48% and we increased our global footprint in every major region we serve. In particular, our overall market share in Europe and Asia increased by approximately two percentage points to about 20% and 24% respectively. Even with these share gains our market share outside the US still represents relatively low penetration and hence we believe that there is a significant growth opportunity ahead that we plan to adjust with greater focus in 2007.

Demand elasticity remained strong in all of our key markets. While pricing moved more aggressively than original expectations, fourth quarter average retail capacity as well as our total unit sales doubled from the previous year resulting in rapid growth of our business.

2006 was a year when our mobile business began to meaningfully ramp, achieving 25% of our total consolidated revenue for the year. The mobile business benefited from the continued adoption of the microSD card slot in mobile phones, and this drove unit shipments of our microSD cards to increase more than three fold on a year-over-year basis making it our top selling product in terms of units sold. We added nearly 37,000 mobile retail store fronts during 2006 bringing the total to about 67,000 and that has enabled our mobile retail revenue to nearly triple from the previous year.

Our MP3 business performed extremely well in the fourth quarter, the revenue growing 74% and unit sales doubling, both on a year-over-year basis. We maintained a clear number two shared market share in the US while growing both our 2006 unit and revenue market share by a couple of percentage points from 2005 according to NPD.

Moving on to technology and operations, SanDisk along with Toshiba executed exceptionally well and we exceeded our plant production ramp plans in Fab 3. The total capacity increasing to 90,000 wafers per month at the end of Q4, for approximately the same investment as previously forecasted. We now expect Fab 3 output to increase to approximately 135,000 wafer outs per month by the end of 2007. We are beginning the transition to 56-nanometer technology on 300-millimeter wafers with production shipments scheduled to begin later in this quarter.

In addition, we plan to launch our Monolithic 16-Gigabit MLC NAND chip into production on 56-nanometer technology by the end of Q2. The 56-nanometer conversion coupled with increased Fab 3 wafer output is expected to give us the ability to scale our business and to continue to aggressively reduce our product costs during 2007.

The construction schedule of Fab 4 remains on track and we expect first production output near the end of 2007.

Our captive backend test and assembly facility under construction in Shanghai, remains on track for production output in the fourth quarter of 2007, and that should provide us additional flexibility in accommodating new product and technology transitions and seasonal demand fluctuations. While also further, loading our captive manufacturing product costs.

I am pleased with the progress we are making in creating and driving new demand through innovation. At the 2007 Consumer Electronics Show, we introduced our first 32 Gigabyte solid state drive, three new media players and three new USB products, which we believe will fuel new demand later this year. These announcements along with several others we have in the pipeline reflect a greater diversification of our product portfolio and we expect this trend to continue to propel us on a path towards becoming a consumer electronics powerhouse.

On the Sansa line of products, the Express, the Connect and the View, broaden our product offerings in the audio/video segment. At the low-end, the Express at $59 has a USB connection eliminating the need for cable connection to the PC. The Connect, allows consumers to download, recommend and share music wirelessly. According to Gartner Dataquest, flash based portable video player unit (inaudible) is expected to increase more than five-folds between 2006 and 2010. We believe that the Sansa View, our first portable video player, which is a sleek 8 gigabyte, pocket-sized, portable media device, with remarkably rich video capabilities, is well positioned for this market.

USBTV is another exciting concept we announced at CES, targeted to drive demand for high capacity flash storage. This affordable device will allow consumers to take their selected video content from the PC and play it on their TV. We believe our products are positioned well to benefit from the ongoing shift from an era of user generated content to user acquired and shared content.

SanDisk also announced at CES, that we are a premier partner of Microsoft's worldwide Vista launch, with a specific focus on a new feature called ReadyBoost. Our ReadyBoost compliant high capacity USB drives and flashcards target to improve performance of the Vista based computers and we believe that these products are well positioned to benefit from the imminent trend of the Vista operating system.

We announced our first 32-Gigabyte 1.8 inch solid state drive, SSD, with shipments expected to begin in the first half of this year.

msystems we have acquired customer relationships and leading products to develop the SSD segment, which we believe will be a highly price elastic, high growth business for SanDisk. According to market research, SSDs will be integrated in over $31 million notebook PCs by 2010, representing a penetration rate of about 20%. We believe that the implementation of MLC NAND in SSDs, will only accelerate the adoption rate of SSDs, due to the associated cost benefits, and we believe our MLC and controller system product leadership, puts us in the driver seat to deliver high performance, cost effective and reliable SSDs for PCs.

These two new products announcements, the 32 Gigabyte solid state drive, and USBTV concept were enabled by msystems. Speaking of msystems Limited or msystems, the integration process is going well. We are excited about the new products, markets, customers, channels, innovation and the people that the acquisition brings to our combined company. We are seeing a higher level of customer interest in our product offerings, as a direct result of the expanded nature of our product portfolio, following the acquisition of msystems. We plan to also leverage the msystems team to accelerate our international growth by creating differentiated strategies in different geographies.

Looking at 2007 and beyond the projected demand drivers for NAND Flash continues to look very strong, and we remain bullish about our future. We have always operated in a price elastic environment and we believe that demand for our products will only accelerate as NAND becomes even more affordable. In mobile phones for example, we're beginning to see better screens and more powerful processors supporting the advent of video as illustrated by recent announcements of the Samsung Ultra Music phone and Nokia's N95 phone, with the Nokia phone offering 30 frames per second video capture capability. Apple with the announcement of iPhone has raised the bar for multimedia handsets to require four and eight gigabytes of flash memory.

All of these trends moving to steep increases in average capacity for both flash cards and embedded solutions in the mobile phone space. We believe multiple mega-markets such as music and video phones, Vista enabled PCs, SSDs, and video imaging and content applications will further accelerate the growth in the average capacity and product demand supported by attractive price points, lead by aggressive NAND technology and manufacturing roadmap.

On the supply side, there has been some build up of NAND component supply beginning in December, resulting in steep declines in market pricing in the last few weeks. The industry has been adding MLC NAND capacity faster than demand growth in the seasonally slower first quarter. While we're encouraged by the marks made by some of our competitors that they plan to reallocate NAND capacity to DRAM indicating that the self-corrective nature of this industry is already acclaimed, and we expect this will lead to better demand/supply balance for the NAND industry in 2007, the pricing environment remains difficult to predict.

Despite the challenging industry environment, our vertically integrated model and strong OEM and retail relationships put us in an advantageous position to sell all of our memory output in the consumer products that we design and sell.

Given all the demand drivers that I just described, we are bullish on the industry demand bit growth in 2007 and we expect our growth rate will likely exceed that of the market growth rate estimates made by third party industry analysts.

Following a record setting fourth quarter in 2006, we expect the first quarter of 2007 to show typical seasonality in the retail channel with a pronounced seasonal slowdown for MP3 players. In addition, given the current pricing environment, we have decided to deemphasize the former msystems private label business for now in order to focus our sales efforts on the more profitable SanDisk branded products. Let me add that the former msystems mobile business remains solid, and in fact, it is poised to leverage our captive supply base to serve the growing needs of existing and new customers.

To summarize, the fourth quarter and the full year 2006 were record periods. SanDisk is a unique company in the highly innovative consumer electronic space and our key strengths are in creating and growing new markets, designing leading edge technology and innovative products, a highly flexible cost supply chain, valuable IP and strong balance sheet. We continue to invest in driving our growth and we believe that we are well positioned to face the opportunities and challenges as we drive to make SanDisk a global consumer electronics powerhouse.

I will now turn the call to Judy.

Judy Bruner

Thank you, Sanjay, and good afternoon everyone. We had a very strong Q4 and 2006, and to provide you with better clarity on our results, I will organize my comments in three major buckets. First, I will discuss our SanDisk's standalone non-GAAP results for the quarter and the year. Second, I will describe the non-GAAP results for the former msystems business from our acquisition day of November 19th through the end of 2006. And finally, I will describe the GAAP adjustments for stock compensation and acquisition accounting.

In order to make it easier for you to follow my comments, we have posted to our SanDisk's website at SanDisk.com in the IR section two charts that show you these components of our GAAP results. The first chart is for Q4 and the second chart is for the full year 2006.

So let's start with SanDisk's standalone results. SanDisk's standalone fourth quarter product revenue of $964 million was up 43% sequentially and 41% year-over-year. Our SanDisk's standalone megabyte sold increased sequentially 73% compared to our previous forecast of 50% to 60%. And our ASP per megabyte fell 17% within our forecasted range of 15% to 20%. Our strongest sequential growth in both units and megabytes was in our Sansa MP3 products, which comprise 14% of our product revenue in the fourth quarter.

Looking at our revenue growth on a year-over-year basis for Q4, our strongest growth in revenue dollars was from the mobile market followed by the MP3 market. For the full year of 2006, our SanDisk's standalone product revenue grew 36% over 2005, an accelerated growth rate from the 29% we enjoyed in 2005. This demonstrates the power of elasticity in our markets resulting from a 58% price decline in ASP per megabyte for average 2006, compared to 2005.

Our standalone royalty revenue for the fourth quarter was $84 million, slightly below our previous forecast, due primarily to licensee pricing. For the full year, our royalty revenue was $330 million, grew by 38% over 2005.

Looking at the breakdown of our SanDisk standalone revenue for the full year, the most significant changes were that the mix of mobile handset related revenue, doubled from 13% to 26%, MP3 related revenue grew from 6% to 9%, and digital imaging related revenue went from 52% to 39%, again, of our standalone revenue. Its worth noting that our revenue from the relatively more mature digital imaging market still grew to 2% year-over-year during a year of steep price decline.

Our standalone non-GAAP product gross margin for Q4 was 34.7%. Towards the upper end of the range we had forecasted, and up 200 basis points from Q3, benefiting from strong 70-nanometer memory cost reduction in the 300-millimeter fab. Shipments made with non-captive memory were less than 5%, and consistent with our plan.

For the full year 2006, our standalone non-GAAP product gross margin was 32.6%, within the 32% to 35% range we forecasted at the start of the year.

SanDisk Q4 standalone non-GAAP operating expense grew $29 million sequentially with the highest growth due to holiday related sales and marketing expenses. Our non-GAAP standalone operating margin was 23.7% for Q4 and 21.8% for the year, in the middle of the 20% to 24% operating model we have previously provided.

The msystems business acquired on November 19th added $115 million of revenue to Q4, at a product gross margin of 13%. The six weeks of former msystems sales consisted of approximately 50% private label USB sales, approximately 25% embedded mobile and industrial applications; and approximately 25% from the consolidation of the Toshiba-msystems joint venture called [TWIMSYS].

During the six-week period, the former msystems business utilized almost entirely non-captive memory supply and generated a slight non-GAAP loss. With the addition of the legacy msystems from November 19, our total consolidated revenue was $1.16 billion for Q4 and $3.26 billion for the year. Our total non-GAAP product gross margin was 32.3% for Q4 and 31.8% for the full-year and total non-GAAP operating margin was 21.3% for Q4 and 21% for the year.

Our non-GAAP annual tax rate was reduced from 35% to 33.5% based on a favorable evolution in the distribution of processes around the world and the reinstatement of the US R&D tax credit.

Our fourth quarter non-GAAP diluted shares of approximately 220 million reflect the addition of approximately 16 million shares on a six-week weighted basis for the shares issued and stock incentives assumed for the msystems acquisition. Resulting non-GAAP earnings per share was $0.87 for the fourth quarter, up 28% from Q4 of last year and $2.51 for 2006 up 25% over 2005.

Now I will comment on the GAAP adjustments to our results. Stock compensation expense was 31 million for Q4, and 101 million for 2006. Purchase accounting adjustments included three different components: First, the amortization of acquisition related intangible assets. Second, the additional cost of sales created from the write-up of finished goods inventory to net realizable value. And third, the write-off of in-process technology, which is not benefited in the tax rate. You can see each of these GAAP adjustments for Q4 and for the year on our GAAP to non-GAAP reconciliations, including these adjustments and the related tax effects, our fourth quarter GAAP results, or a net loss of $35 million.

Turning to the balance sheet, we ended the year with $3.3 billion in cash, short-term and long-term investments, up $295 million from the third quarter, with approximately $143 million coming from the former msystems business as of the end of the year. Fourth quarter cash flow from operations was 184 million, up from 79 million in the fourth quarter of last year. Accounts receivable for the SanDisk standalone business remained at a fairly consistent level of 42 days sales outstanding and the msystems acquisition added 168 million to accounts receivable as of December 31. Inventory ended the year at $496 million, up $100 million from Q3, primarily due to the addition of the msystems' related inventory. Fab 3 equipment investments were funded by an operating lease drawdown of approximately $195 million in the fourth quarter and our total net operating lease guarantee now stands at approximately $654 million.

I will now turn to our future outlook. I will limit my specific guidance to the first quarter of 2007, although I will provide you some color on the year. Given the changing characteristics of our business, I will provide you with a specific revenue range for the first quarter and be less specific about the change in megabytes and the decline in blended ASP per megabyte.

Our product portfolio is becoming increasingly diverse with significant differences by a product in ASP per megabyte and average capacity. We are seeing this with the increase in mix of MP3 products and with the acquisition of msystems embedded products, and we will see this even more with the introduction and anticipated growth of some of our recently announced consumer products, such as USB TV, Sansa View and Solid State Drives to name a few. And we are now consolidating the results of the [TWIMSYS] joint venture with Toshiba, which we acquired with msystems. As a result, the blended average ASP per megabyte is becoming less meaningful and more difficult to predict, especially in Q1, which is apples-to-oranges with our reported Q4.

There are four key factors that we expect will influence our first quarter revenue. First, we expect retail unit demand to exhibit typical Q1 seasonality, which would be down from Q4 and becoming more pronounced as MP3s have become a larger portion of our product mix. Second, we expect our mobile OEM business to remain strong and grow in units from Q4 to Q1. The third factor is that while we will have a full quarter of msystems in Q1, we are expecting the former msystems' private label USB business to decline very significantly from Q4 to Q1, as typical seasonality is exacerbated by current aggressive industry pricing and our decision in this environment to focus on building our more profitable branded business relevant sale at lower margins to third party brands.

Finally, the fourth factor is pricing and megabytes sold. It has been evident in the first month of Q1 that the flash industry is experiencing oversupply and prices have been coming down rapidly. We expect Q1 to be a period of steep price decline with the ASP per megabyte for most of our products falling more than it did during Q4 and we expect total megabytes sold to decline from Q4 to Q1 given retail seasonality coupled with our shift away from the private label business.

The four factors I have just outlined lead us to forecast Q1 product revenue of $700 million to $800 million, which represents a sequential decline of approximately 25% to 35% from our consolidated Q4. Based on recent comments by our key licensees, we are forecasting our royalty revenue to be in the range of $85 million to $90 million for Q1. This reflects our estimate of a decline in our licensees Q4 licensable revenue, but with a shift in mix toward higher royalty bearing MLC memory.

Turning to gross margin, our pricing expectations lead us to forecast a Q1 non-GAAP product gross margin of 24% to 28% compared to our consolidated non-GAAP gross margin of 32.3% in Q4 '06. This forecast reflects a mix of approximately 10% non-captive memory in our Q1 revenue. We expect Q1 GAAP product gross margin to be lower by approximately four points, due primarily to the inclusion of stock compensation and acquisition related purchase accounting charges.

We forecast Q1 non-GAAP operating expenses to be in the range of $195 to $200 million reflecting the inclusion of a full quarter of the former msystems business with some offset from the seasonal decline of certain sales and marketing expenses. We forecast Q1 GAAP operating expenses to be higher by approximately $40 million due to stock compensation and amortization of acquisition related intangible assets.

Other forecasts for Q1 include other income between $30 and $32 million and an effective tax rate of approximately 34%. In addition, our net income will reflect a reduction for the after-tax minority interest in the [TWIMSYS] joint venture, which we forecasted approximately $5 million for the first quarter. We forecast Q1 diluted shares to be approximately $238 million, including a full quarter of the shares issued and stock incentive assumed for the msystems acquisition and our plan to begin repurchasing shares under our previously announced repurchased program.

Turning to the balance sheet, we expect inventory to increase in Q1 based on the seasonality of sales. Our strong sell-through in Q4 2006 benefited from the availability of inventory, early in the fourth quarter, and I am optimistic about achieving the same benefit in Q2 of 2007.

We do not expect to make any significant Fab venture investments or loans in Q1, but we do expect to execute a $215 million drawdown against the SanDisk portion of the Fab 3 operating lease facilities. Non-Fab capital expenditures are forecasted as approximately 70 million in Q1, including equipment and building expenditures for our captive backend factory. I will provide a more comprehensive update of Fab and other capital investments on our February Analysts' Day.

Now I will provide a few comments on 2007. As Sanjay described earlier, we see strong demand drivers in 2007, resulting from continued price decline. As we project the pricing environment for 2007, we believe that given the steep price decline in Q1, ASP per megabyte is likely to decline at least 50% in 2007. If the current level of supply-demand imbalance in the market persists, the price decline for 2007 will be more.

If prices decline approximately 50% for the year, we expect strong megabyte growth and an improvement in the gross margins we have guided to for Q1. If prices decline in the range of recent quarters, which has been 60% plus on a year-over-year basis then we would expect even stronger megabyte growth, but with continued margin pressure and potentially little growth in royalty revenue.

We do not believe that this industry will exhibit a prolonged period of 60% plus price decline, because its leaders, ourselves included, cannot consistently reduce costs at that rate. We believe the market will self correct and that we are already seeing signs of that self correction.

On the supply side, certain component suppliers are shifting capacity to DRAM and on the demand side the new lower price points are opening up very large new markets, which we are pursuing aggressively, such as solid state drives for example.

Our industry is characterized by short periods of supply-demand imbalance, which can result in challenging margins as we are expecting during Q1. However, we are managing SanDisk for the long-term, which we believe has significant growth opportunity. So while we are working to limit expense growth, we will continue to invest in innovation and in scaling the company. Our primary investments and focus over the next several months include introduction of recently announced products, integration of the former msystems business, execution of the 56-nanometer transition and completion of Fab 4. We expect to incur Fab 4 startup costs in 2007, similar in magnitude to the startup costs we incurred in 2005 for Fab 3. The Fab 4 startup costs in Q1 are at a fairly low level and have been included in the guidance I provided for expenses and gross margins. For Q2 through Q4, we forecast approximately $50 million of Fab 4 startup costs. We expect approximately $40 million to be recorded as R&D, spread over Q2 through Q4 and approximately $10 million to be recorded as cost of sales in the fourth quarter as the Fab goes into production.

In summary we are very pleased with our strong Q4 and 2006 performance and we firmly believe that we are uniquely positioned to build on our leading market share with continued investments and technology, and innovative consumer products. We will now open the call for your questions.

Question-and-Answer Session

Lori Barker Padon

Thank you. Could you limit your questions please to one or two questions.

Operator

(Operator Instructions). We go first to Jim Covello with Goldman Sachs.

Jim Covello - Goldman Sachs

Good evening. Thanks so much. First question is on the self-correcting aspect of the capacity situation or excess capacity situation that you talked about. We all know about Samsung may be doing something and Hynix may be doing a little something in terms of NAND to DRAM. How about yourselves? Are you going to be part of that self-correcting mechanism?

Sanjay Mehrotra

So in terms of our own capacity RAM, we believe we are able to sell all of the capacity that we can manufacture. And in fact, we are targeting to sell our output, as I said in my script, in global regions as well and we see strong growth drivers coming on. The growth drivers I talked about, increased average capacity in mobile phones, video, portable video players, etcetera. That we believe will allow us to continue to use our output and basically sell it. In fact in the second half of the year, we see ourselves purchasing some non-captive supply itself. So I don't think for our business it makes sense reduce our capacity production. Of course, we always have the flexibility of non-captive supply, just like over last couple of quarters we turned down the non-captive supply to significantly less than 10%. We have that option going forward as well and we plan to dial it back up in the second half of the year.

Jim Covello - Goldman Sachs

So, if I could ask a follow-up on that, in my view, it's not really a question of if you can sell it. I think we all agree that you could sell it. It's a question at what price you could sell it? And if you as the industry leader isn't going to cut back on the capacity ramp then what makes you feel comfortable that everybody else is going to. This is a game of chicken in some senses where if my competitor isn't going to back down then neither am I. So, how can you be supremely confident that your competitors are going to be as aggressive as they need to be on the capacity roll back if you're not going to be?

Judy Bruner

Jim, this is Judy. Let me add that our bit growth in 2007 will naturally be quiet a bit less than it was in 2006, given the aggressive ramp we had in our Fab 3 in 2006. Fab 3 in 2007 will be reaching full capacity by the end of the year and the ramp is not nearly as steep in 2007 as it was in 2006. And of course Fab 4 will not really result in salable output until 2008. So, we have no plans to slowdown our fab capacity ramp for Fab 3 or for Fab 4, but by its very nature, the growth in that bit output will be quiet a bit less in 2007 then in 2006. And that's why Sanjay said in fact to meet the demand that we would expect in 2007. We anticipate e that we would be dialing up non-captive in the second half of the year.

Sanjay Mehrotra

And also we have to look at this thing in the long-term picture. And in the long-term, we see the demand for flash continuing to grow. Industry projections as shown here are moving from 650 petabytes last year to something like 13,000 petabytes in 2010, and with that kind of a scenario we have to with our leadership with us being in the driver seat, we have to continue to grow the demand, create the markets, and fulfill that with the supply. So, we really cannot just have one quarter or two quarter excess that may be going on till December timeframe determine our decisions regarding capacity cutbacks. We really are looking at the long-term demand pictures and positioning ourselves to be in the driver seat in that market.

Jim Covello - Goldman Sachs

Final question from me, Fab 5 there has been some speculation that may be Fab 5 -- even though that was only in the planning stages that that could be the Fab that -- maybe you take a little bit more of a cautious view around or your joint venture partner takes cautious view around given the pricing environment, is that consistent with your thoughts on Fab 5?

Sanjay Mehrotra

So, as you know, that in NAND Flash Toshiba and SanDisk invested jointly. But I must tell you that there have not been any discussions of Fab 5. These are just somehow market rumors and both Toshiba and SanDisk do not have plans for Fab 5.

Jim Covello - Goldman Sachs

So there is no plan for a Fab 5 in the first place is what you are saying?

Sanjay Mehrotra

There is on plan for Fab 5 at this time, yes, in the first place.

Jim Covello - Goldman Sachs

Thank you.

Operator

We'll go next to Craig Ellis with Citigroup.

Craig Ellis - Citigroup

Thanks Judy. With the royalty commentary, I know you are not providing specific for your guidance there, but can you tell us if there is any meaningful prospect that you would have an additional source of royalty revenue this year?

Judy Bruner

Craig, we really can't comment on the potential outcome of litigation or other discussions. So, I really cannot provide a full year royalty revenue estimate at this point. Not so much because of whether or not we would get new licensees, but more that the pricing environment is uncertain for the remainder of the year.

Craig Ellis - Citigroup

Okay. And then switching gears, you mentioned a couple of times that new products that were announced at CES, how should we think about the gross margin percentage of those new products relative to the current portfolio, and how can we think about the growth parameters or the volume parameters of those products this year relative to the existing portfolio?

Sanjay Mehrotra

So, the new products that we announced, for example, USB flash drives, Vista ReadyBoost flash drives, the gross margins for those products will be similar to our USB line of products. The other products that announced USB TV and the Sansa products, on the low-end, of Sansa Express and the Sansa Connect products those will continue to carry in margins that are similar to our audio/video line of products. As you know, that we are very much focused on scaling our business in the audio video space and as we scale up that business, basically we expect improved gross margins going forward with our focus on intense cost reductions for that product line as well.

Craig Ellis - Citigroup

So to clarify, you expect improved gross margins on those products, but those products are noticeably below the corporate average, aren't they Sanjay?

Sanjay Mehrotra

The audio/video products tend to be below the corporate average, yes.

Craig Ellis - Citigroup

Okay.

Sanjay Mehrotra

And again, because they do not yet have the benefit of the scale, and as you see that in Q4 we were driving that and we will continue to drive those products in global regions. That continues to drive the unit demand as well as broaden the product portfolio and that we believe will give us cost benefits, cost synergies and possibilities of improvements in gross margin.

Craig Ellis - Citigroup

And you think you get there in 2007 or is there really something you are going to do in 2008? Or you meaningfully improve the gross margin structure in those businesses?

Sanjay Mehrotra

Yes, we will continue to work on in it in 2007. We are excited about the opportunities ahead of us in this audio/video space. If you look at just Europe, we made very good progress in Q4 in penetrating Europe and in 2007 for audio/video, we want to basically go global and I would absolutely expect [then] our focus to continue to gain share and improve solidly our business in audio/video in 2007.

Craig Ellis - Citigroup

Thanks Judy. Thanks Sanjay.

Operator

We go next to Satya Chillara with Pacific Growth Equities.

Satya Chillara - Pacific Growth Equities

Yeah hi guys. Starting with you, Sanjay, on cell phone, in terms of cell phone demand with iPhone getting into 4 and 8 gigabyte embedded. From your point of view, your customers or carriers, are they asking for 4 and 8 gigabyte microSD, and if so basically what do you see for the cell phone business in 2007?

Sanjay Mehrotra

Actually we are seeing the demand definitely in high capacity microSD, but in embedded solutions as well, and as you know, through msystems, we have further strengthened our product portfolio on the embedded side. So we are seeing demand for 4 gigabyte, 8 gigabyte capacities for embedded, as well as cards. And for sure, later this year, we'll have 4 gigabyte microSD product, and we have complete lineup of embedded solutions as well. So basically we're expecting that with the iPhone announcement, with what the handset manufacturers and the carriers are indicating to us in terms of their interest in pushing the phones to the video capabilities to the high quality music, as well as to high-end camera applications. We actually expect in the mobile space for the average capacity to perhaps move even faster than what it has done in the past, with all these applications coming in.

Satya Chillara - Pacific Growth Equities

Okay. So can you clarify what average capacities it would reach by the end of '07 for the mobile phone segment?

Sanjay Mehrotra

I would expect -- I can't nail it down, but I would expect the average capacity is really over next four to six quarters to start approaching 4 gigabyte plus on an average basis.

Satya Chillara - Pacific Growth Equities

Okay. Moving on -- one question for Judy. Judy can you -- given the guidance of $700 million to $800 million. I just wanted some clarification here in terms of the discontinuation of msystems, private label, USB drives. How much of that basically is falling off on an apples-to-apples basis. And the second question I just wanted make sure for the year, in terms of gross margins with all this NAND, non-NAND related, whether it's Wi-Fi based or a flash video iPod products. Where can we expect gross margins for the year to go below 30% margins, compared to historical 33% to 35%? Can you shed some light please?

Judy Bruner

Okay. So, let me comment on your two questions. First of all on the private label business, the private label business within msystems has generally been about half of their product revenue and as I said for the six-weeks that it was included in our consolidated Q4 results, it was also about half of the revenue. So we are not going to break it out in terms of the $700 million to $800 million, but you can get an idea of the size of it in the past, and it is coming down significantly based on our decision to focus on the more profitable SanDisk branded business.

In terms of gross margins, and you are asking non-NAND components and perhaps that putting pressure on margins -- let me address that and also comment back on Craig Ellis' question in this area, and that is that while going forward, some of these audio/video related products will typically have a gross margin, that is somewhat below the corporate average. The embedded products that we have just acquired from the msystems acquisition, both in the mobile space as well as other embedded applications, tend to have a higher than corporate average gross margin. So there is a mix of new product lines coming in to our gross margin and we really can not predict at this point in time, how that will sort out. But I think -- there is both lower and higher than average. In terms of gross margin for the year, we are not going to put a stake in the ground at this point in terms of a gross margin for 2007 for all of the reasons that I described. We have given the range for Q1. And beyond Q1, I have given some color on the pricing parameters, but at this point, we are uncertain as to pricing beyond Q1.

Satya Chillara - Pacific Growth Equities

Okay. Thank you, Judy.

Operator

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

Paul Coster - J.P. Morgan

Thank you. Hi, can you hear me?

Judy Bruner

Yes.

Paul Coster - J.P. Morgan

I have three quick questions. First of all, Judy, you mentioned that the licensing revenues came in slightly short of expectations and you attributed it to pricing. What did you mean by that?

Judy Bruner

What I mean by that is our royalty revenue is based on a rate that is applied against the licensees' licensable revenue. So, if they have steep price declines in a given period, then that is going to depress the licensable revenue.

Paul Coster - J.P. Morgan

And that's, therefore is factored in thinking about licensing through the remainder of the year?

Judy Bruner

Correct.

Paul Coster - J.P. Morgan

Okay. Second question, I know it's less meaningful and it used to be, but the total bit shipments including msystems and the total ASP per megabyte decline for the fourth quarter, are you in a position to share those numbers?

Judy Bruner

In the ASP, really it's not a sensible number because it is only included for the six-week period, and it's not necessarily comparable to what we will see in Q1. If you think about it in Q4, the msystems business was heavier towards the USB private label business in Q1, and in Q1, we would expect it to be heavier towards the embedded business.

Paul Coster - J.P. Morgan

Okay. And then, my last question, Sanjay, as you think about your cost curve and therefore probably the industry's price curve to some extent, how does it change? Does the price -- the cost decline accelerate round about the time of the 55-nanometer, 300-millimeter activation or is there some other event that we should be thinking about in the sort of '07-'08 timeframe that will take the cost curve down in the sort of step function fashion?

Sanjay Mehrotra

So, in terms of cost, we have said that in general, on an average, year-in-year-out, cost come down by about 40% to 50% per year basis. So, this year in 2007, the decline in the cost will primarily be determined by our ramp of 56-nanometer technology. As we said, 56-nanometer we are just starting that in Q1 timeframe. But in terms of the effect of this -- the full effect of the 56-nanometer, we have said before, we will really start experiencing the benefit of that in the Q3 timeframe, mainly because of, again, its application to the retail products and the amount of time it takes for retail products to sell through the channel.

So, the 56-nanometer, as it ramps up into production, we will basically linearly essentially drive the cost reductions and our ability to transition the wafers to 56-nanometer during the course of the year as well as continue to improve use of 56-nanometer is what will determine the ongoing cost improvement that we will realize on a per megabyte basis during the course of the year. So, in terms of step transitions with 56-nanometer, it's not a step transition because it is determined by wafer ramp and yield improvement. The step transitions really come about when you go to a new technology such as potentially the volume production of x4 or 3 bit-per-cell etcetera.

Paul Coster - J.P. Morgan

And when will we see x4?

Sanjay Mehrotra

x4 we're actually making some good progress in terms of the engineering development and applying that technology to system level, applying our systems level expertise to their technology. But really, we'll not have any meaningful shipments of that product in 2007. It's more -- you'll see some impact of it in 2008 timeframe.

Paul Coster - J.P. Morgan

Okay, got it. Thank you.

Operator

We'll go next to Mark Edelstone with Morgan Stanley.

Mark Edelstone - Morgan Stanley

Thanks a lot guys. Few questions, the first one for you Sanjay. When will we see the crossover in 56-nanometer here this year on a wafer start basis?

Sanjay Mehrotra

Do you mean crossover in terms of bit cost of 56-nanometer and 70-nanometer?

Mark Edelstone - Morgan Stanley

Yeah, I was just thinking not cost but just total wafers 56-nanometer starts crossing over 70?

Sanjay Mehrotra

We plan to ramp it up aggressively. At this point, we're really not disclosing the plan ramp for 56-nanometer. It is just at the very beginning at this point, Mark.

Mark Edelstone - Morgan Stanley

Okay. So it sounds like best case is really somewhere in the second-half of the year anyways?

Sanjay Mehrotra

Okay.

Mark Edelstone - Morgan Stanley

Question was on msystems then for you Judy, when you look at their absolute revenues for Q1, given the fact that you had ownership for just six weeks in the fourth quarter. Do you expect those revenues to be flat or actually decline in absolute dollars quarter-to-quarter?

Judy Bruner

So again I am not going to break out this specific amount of msystems revenue in Q1. But I think -- you can get approximately there based on the comment that we had six-weeks in Q4 and about half of that business was USB private label, which we are significantly deemphasizing, alright. So, one can sort of assume that if you go from six-weeks to 13 weeks, and then takeaway what was about half of -- most what was about half the revenue you can get there.

Mark Edelstone - Morgan Stanley

Okay. That's what I was trying to clear figure out. It's flattish --

Judy Bruner

Yeah.

Mark Edelstone - Morgan Stanley

Still declines in total dollars. And then if I heard you correctly, I think you said that the product gross margins for the company on a non-GAAP basis will be 24 to 28% in the quarter, if you did not have the msystems business, what would the non-GAAP product gross margins for SanDisk be in the first quarter?

Judy Bruner

I would tell you that we do not expect the msystems business to materially depress our gross margin, because of two reasons, one is that most of the business that will remain is the higher margin embedded business, and second we are moving pretty aggressively to utilization of captive supply for the msystems business.

Mark Edelstone - Morgan Stanley

Okay. Fair enough, thanks for that and then just two very brief ones. One, you gave the year-over-year growth rate in MP3 for Q4, what was it sequentially in both revenues and units, if you can share that?

Judy Bruner

The MP3 unit and revenue growth from Q3 to Q4 was approximately 150%.

Mark Edelstone - Morgan Stanley

Okay, great. Congratulations on that. Then just lastly, where are inventories in the channel now in terms of days or weeks?

Judy Bruner

So when we talk about channel inventory, we always give it on a backward looking basis to be consistent, and on a backward looking basis, channel inventory ended at about six-weeks at the end of Q4, and that compares to about seven-weeks at the end of Q4 of last year.

Mark Edelstone - Morgan Stanley

Thanks for the questions. I appreciate it.

Operator

We will go next to Gurinder Kalra with Bear Stearns.

Gurinder Kalra - Bear Stearns

Yeah, hi. I guess you can't provide the ASP guidance for the combined company, but can you provide, I guess on an apples-to-apples comparison, if you were to look at just ASPs for SanDisk on a standalone basis in Q1?

Judy Bruner

No, we are not going to break that out. But as I said, we expect the ASP per megabyte for most of our products, will fall more in Q1 than it did in Q4.

Gurinder Kalra - Bear Stearns

Right. Is that a bottom-end to that range?

Judy Bruner

We are not going to project the range at this point.

Gurinder Kalra - Bear Stearns

I guess my second question is, can you update us on the progress on 3 bits-per-cell sell in terms of when we might be able to see something on that end?

Sanjay Mehrotra

I think with respect to 3 bit-per-cell, probably in terms of any production, early part of next year.

Gurinder Kalra - Bear Stearns

And if you have production on 3 bits-per-cell in the early part of next year and how do you think that could affect your negotiating stance on people you want to get royalty from or renegotiate royalty agreements from?

Sanjay Mehrotra

We do believe that those that manufacture NAND Flash as well as (inaudible) that are involved in system level products, do need license to our IP. But the impact of 3D or MLC or some of our other system level or device level patents. I mean this is really all, part of overall IP licensing policy, I would not really provide any comment or detail on the specific impact of one particular innovation or one particular IP aspect on the overall impact -- overall IP license.

Gurinder Kalra - Bear Stearns

Okay. Thanks very much.

Operator

We will go next to Eric Gomberg with Thomas Weisel Partners

Eric Gomberg - Thomas Weisel Partners

Hi thanks very much. I was wondering, if you could expand on mobile. I think in the opening remarks, you said that you expect dividends to be up strongly in Q1 or continue to be up in Q1, could you talk about the type of ASP pressure you may be seeing in mobile and also you gave a lot of color on revenue and mobile year-over-year in '06, could you talk that may be the unit volumes '07 versus '06 from the design activity that you already have booked?

Judy Bruner

So, Eric, you're asking -- I did say that we expect unit growth to occur from Q4 to Q1 in the mobile business. And as I said, we really expect to see price decline in Q1 in all of our product lines including mobile, but we're not giving a specific range. The pricing environment is challenging really for all product lines today, retail and OEM, although retail is probably a bit more challenging. Your second question was with regard to 2007 growth?

Eric Gomberg - Thomas Weisel Partners

Yeah, just trying to get a sense of your -- when you look at say bundling activity, from where you see today what the unit volumes may grow year-over-year? It would seem that grew well over 100% last year?

Sanjay Mehrotra

We would definitely see a strong growth in bundling as well in 2007. If you look at last year, about 250 million card slotted phones shipped. And 2007 projection is -- there are multiple numbers out there, but anywhere 400 million plus for 2007. So clearly, the increase in units we believe will still continue to result in increase in bundling. There are a more and more phones that are getting designed in with card slots. Actually the last count is about 700 phones that have -- 700 different models that have card slots and more than half of them are microSD card slots. And so, we fully expect that bundling trend in 2007 will continue in the mobile space.

Eric Gomberg - Thomas Weisel Partners

Could you talk about 3D memory and where you stand in terms of bringing that up to leading edge geometries and chip capacities, and your thoughts right now -- or your thoughts on opportunity in preloaded content?

Sanjay Mehrotra

So, the 3D business in terms of the preloaded content is basically going well, going per our expectations. And we have said before, that we will have the 3D products convert from under 30-nanometer to 80-nanometer technology in the second half of this year and that is still proceeding per plan.

Eric Gomberg - Thomas Weisel Partners

Okay. And I guess just one last question, I've realized you don't have great pricing visibility beyond Q1 or even necessarily in Q1, wondering other than seeing some NAND capacity go back DRAM, are there any catalyst other than typical Mothers Day, Father Day, graduations in Q2 that you see coming in Q2 that should kind of suit the industry pain and stop the price declines?

Sanjay Mehrotra

You are right. Usually Q2 is strong. We call it like second Christmas, as the second strongest quarter of the year and it tends to drive lot of demand for our products. So, therefore, it will definitely be happening for our sales. We have several new products that we will be starting to ship in Q2. The Sansa -- I mean actually we will start shipping in late Q1 ready for volume production, volume shipments in Q2. These are the Sansa Connect as well as the Sansa Express. And in addition, the new handset models that keep coming out and the mobile growth will continue to drive I believe strong demand in second quarter as well.

Eric Gomberg - Thomas Weisel Partners

Okay. Thanks.

Operator

We'll go next to Daniel Gelbtuch with CIBC.

Daniel Gelbtuch - CIBC

Hey guys. Few questions, first of all, just a follow-up on Eric's question with metrics. I know that Eli has talked about in the past about making a breakthrough with regard to 3D read-write, any new visibility on that front?

Sanjay Mehrotra

We are working on that, but really too soon to say anything, and no breakthrough to report yet. Generally, we tend to make announcements once we really ready with the technology, and I think Eli have said that this is something that will take considerable amount of R&D, considerable amount of investments, and we are continuing to do that. It will take two to three years, before this technology really becomes a viable production worthy possibility.

Daniel Gelbtuch - CIBC

Along the floating gate breakthrough lines, Intel and IBM recently made announcement about using hafnium alloys, which helps their ability to extend Moore's Law, does that have any application to you guys?

Sanjay Mehrotra

That is done for military transistors. Of course, that has been in the literatures and at various conferences, high-k dielectric has been explored for application to flash memory as well, and there are actually at this point multiple technology approaches that are being looked at to work on scaling of flash. So, I really cannot comment anymore beyond that on this at this point.

Daniel Gelbtuch - CIBC

And as far as you stand right now, where do you guys or where does Toshiba believe that they can scale beyond 56-nanometer, [I assume] 45 and 32 are in the mix at this point still?

Sanjay Mehrotra

Yes, we are definitely working on those generations of technologies and we believe the 4X -- we call it 4X, means, 40 something technology node would be the one that will get introduced in 2008 timeframe.

Daniel Gelbtuch - CIBC

And finally just on the supply side, I have spoken to lot of a suppliers, who've indicated that supply growth this year on a bit basis will be in the 140% range. Is that something that you find to be consistent and I imagine that's well below the typical average over the last few years? Do you think if that is so, we could see some sort of back half firming of the supply-demand balance?

Sanjay Mehrotra

Yes, the industry estimates are about 140%to 150% in terms of the base growth. We believe that there are enough applications that could be driving the demand to higher requirements than that. We have already said, that for our own needs, we probably will be using non-captive supply in the second half.

Daniel Gelbtuch - CIBC

Thank you very much. Good luck.

Operator

We will go next to Krishna Shankar with JMP Securities.

Krishna Shankar - JMP Securities

Yes can you comment on the premium that you addressed for SanDisk branded cards and drives in the retail and OEM channel embedded. Can you (inaudible) versus some of your generic competitors?

Judy Bruner

I am not sure I completely heard the question, but if the question was about the premium that we see between our branded products and other non-branded products in the marketplace. Yes, we continue to be able to sustain a premium for our cards and USB products in that marketplace. And in fact that's part of the reason why it makes sense for us in this environment to focus on our branded products.

Krishna Shankar - JMP Securities

And that has held up despite the challenging environment towards the end of Q4, has that brand premium held up or is it narrowing?

Sanjay Mehrotra

Brand premium has certainly held up and it's not like there is a fix formula for brand premium, it is different in different regions based on our strategies for our growth in those regions.

Krishna Shankar - JMP Securities

And my second question is given the challenging environment in Q1, can you talk a little bit about your inventory reserves and how you account for any actions that you've to take in terms of either protecting your margin or what's your choice in terms of reserves for the channels?

Judy Bruner

Sure, good question. Clearly, we took a careful look at our inventory reserves as we always do. And we did factor into our analysis, the pricing that we anticipate, will occur over the next several months as we sell the inventory that we had on hand at the end of the year. And we did in fact take some increased inventory reserves that are reflected in our fourth quarter results, in order to be prudent about the pricing environment.

Krishna Shankar - JMP Securities

Great. And Sanjay, can you -- it sounds like you folks, longer-term want to become a more consumer systems company, as well as accelerating those efforts and it seems like you want to become a more branded consumer company versus drifting it out from the flash card and private label market. Can you comment strategically on where you are heading longer-term?

Sanjay Mehrotra

Definitely longer-term, we want to become global consumer powerhouse, and we want to achieve that by bringing new products, new ideas that leverage our technology manufacturing and the vertical integration business model including our worldwide retail sales footprint. So you are absolutely right, that we should not be looked at as a component supplier, because we are really end-to-end solutions provider and continually trying to bring products that are just more than simple storage, basically products that also give user experience. Things such as your Sansa Connect or USBTV etcetera. So yes we are definitely moving in that direction.

Krishna Shankar - JMP Securities

Would that mean that you would perhaps lower your capital spending plans going forward and depend more on foundry outsourcing for greater portion of your needs -- beyond this year?

Sanjay Mehrotra

No, because -- the very factor that gives us the ability to succeed this vertical integration model, is our very cost effective supply. That's what gives us a real differentiator in terms of cost and really ability to penetrate the various value added products into the marketplace. So no, we will absolutely continue to invest and build our asset base in terms of the flash capacity going forward, because that is a very fundamental part of our business model and that's what makes us unique, that we have that flash capacity supply together we have the ability to innovate products and create new markets and really become a consumer powerhouse.

Krishna Shankar - JMP Securities

Great. Thank you.

Judy Bruner

Thanks. We have time for one more caller.

Operator

We'll take our final call from Pranay Laharia with Deutsche Bank.

Pranay Laharia - Deutsche Bank

Hi guys. How big were Sony Ericsson and Samsung in the quarter?

Judy Bruner

Well, we don't normally break them out right on a quarterly basis. We had mentioned, I believe, it was in the third quarter that Sony Ericsson was at 10% customer for the quarter. This quarter, as you can imagine, retail was particularly strong in the fourth quarter. So I would say that we did not have a 10% OEM customer during the quarter, even though OEM was very strong and we had several OEM customers in the top ten customers. But in the fourth quarter, the sequential growth was more in the retail space.

Pranay Laharia - Deutsche Bank

Okay, fair enough. And just last question, can you give an update on the legal front, important base etcetera, to keep in mind particularly against ST Micro [that you lost] in the second half?

Sanjay Mehrotra

In terms of ST Micro, we completed the ITC trial in December and the initial determination will be made in June. The judge had some health problems recently, therefore it has been pushed out, and the final determination would be, I believe the date is for October timeframe. But anyway the initial judgment is in June timeframe, and with respect to the other cases related to ST Micro, they are basically proceeding on their own schedule and nothing specific to report there.

Pranay Laharia - Deutsche Bank

Okay, great. Thank you, guys.

Sanjay Mehrotra

Okay. Thank you very much. Again I must congratulate the team on a year of excellent revenue growth, innovation and expansion into new markets. On behalf of Eli and our Executive team, I look forward to speaking to you on our upcoming Analyst Day on February 26. Thank you very much.

Operator

Ladies and gentlemen, this concludes today's conference. You may disconnect your lines.

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