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SanDisk (NASDAQ:SNDK)

Q3 2011 Earnings Call

October 20, 2011 5:00 pm ET

Executives

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

Jay Iyer - Director of Investor Relations

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

Analysts

Vijay R. Rakesh - Sterne Agee & Leach Inc., Research Division

Srinivasan Sundararajan - Oppenheimer & Co. Inc., Research Division

Alex Gauna - JMP Securities LLC, Research Division

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

Craig A. Ellis - Caris & Company, Inc., Research Division

Kevin Cassidy - Stifel, Nicolaus & Co., Inc., Research Division

Uche X. Orji - UBS Investment Bank, Research Division

James Schneider - Goldman Sachs Group Inc., Research Division

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

Ryan Goodman - CLSA Asia-Pacific Markets, Research Division

Bobby Gujavarty - Deutsche Bank AG, Research Division

Unknown Analyst -

Atif Malik - Morgan Stanley, Research Division

Operator

Good day, and welcome to SanDisk Corp.'s Fiscal Third Quarter 2011 Financial Results Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Jay Iyer, Director of Investor Relations. Please go ahead, sir.

Jay Iyer

Thank you, Jay, and good afternoon, everyone. Joining us on the call today are Sanjay Mehrotra, President and CEO of SanDisk; and Judy Bruner, Executive Vice President of Administration and CFO.

Before we begin, please note that any non-GAAP financial measures discussed during this call, as defined by the SEC in Reg G, will be reconciled to the most directly comparable GAAP financial measure. That reconciliation is now available along with supplemental schedules on our website at sandisk.com/ir. In addition, during our call today, we will make forward-looking statements. Any statement that refers to expectations, projections or other characterizations of future events, including financial projections and future market conditions, is a forward-looking statement. Actual results may differ materially from those expressed in these forward-looking statements. For more information, please refer to the Risk Factors section discussed in the documents we file from time to time with the SEC, including our annual report on Form 10-K for fiscal 2010 and our subsequent quarterly reports on Form 10-Q. SanDisk assumes no obligation to update these forward-looking statements, which speak as of their respective dates.

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

Sanjay Mehrotra

Thank you, Jay, and good afternoon, everyone. We delivered yet another record quarterly revenue driven by year-over-year growth in both our OEM and retail channels. Excellent improvements in memory cost helped deliver a very healthy gross margin. Despite the uncertainties surrounding the global macroeconomic environment, overall demand for our products continued to grow. This illustrates the secular growth trends in consumer and enterprise markets, which are driving ever-increasing demand for flash storage solutions and also highlights the benefits of our broad product portfolio and our diversified and global customers and channels.

Our mobile revenue grew nicely on a year-over-year basis from the increased sales of our embedded products, including iNAND, for mobile devices. The mobile market continues to experience robust growth in feature phones, smartphones, tablets and eReaders, and OEMs are increasingly competing by differentiating on product feature and performance attributes. Our broad array of high-performance embedded mobile products, including iNAND, iNAND Ultra, iNAND Extreme, iSSD and removable cards position us well for continued success in this evolving market. As for the tablet market, it underwent a significant shake out in the third quarter and yet, we delivered 25% year-over-year revenue growth from our retail and OEM mobile end markets combined, reflecting our strong gains in this ecosystem.

Turning to the solid-state drive business. I'm very pleased to report that our integration of Pliant Technology has gone exceedingly well. We are excited to see robust business momentum from our enterprise storage solutions group. SanDisk enterprise SSDs have been qualified at 3 out of 7 Tier 1 storage OEMs with multiple systems now shipping, contributing to strong revenue increase in the third quarter. We are deeply engaged at other OEMs and we expect to complete qualifications at several more customers in the next few months. Our differentiated products feature a proprietary, massively parallel architecture, utilizing our third-generation ASIC controller and advanced firmware. All of these features are designed to deliver very fast, predictable, data transfer and processing speeds with minimal power consumption. We expect to continue building on our early success in this business especially as we begin using our high-quality captive memory supply in our leadership products, and we believe that vertical integration will be key to long-term success in this market.

Within the PC ecosystem, innovation is unfolding in Ultrabooks driving demand for NAND flash. Specifically, from a system design perspective, NAND Flash can be designed into Ultrabooks either as high-capacity solid-state drives or as lower-capacity caches alongside high-capacity hard drives. Ultrabooks designs mandate a highly responsive user experience with features such as instant-on and longer battery life, packaged in an ultrathin form factor. We believe these innovations -- we believe these innovative developments bode well for significantly increased NAND flash consumption in the PC ecosystem in the years ahead. We have begun making inroads into this market with our SSDs and we have an early footing with the recent launch of one of the first SSD-only ASUS UX21 and UX31 Ultrabooks with another Tier 1 OEM design win achieved already. Design activity projects at several other OEMs are underway.

Our retail channel grew year-over-year, a trend that has continued since the first quarter of 2010. The emerging markets were the primary source of year-over-year growth in the third quarter. On a sequential basis, all regions posted healthy revenue growth with APAC the strongest. Third quarter retail revenue growth benefited from a successful back-to-school season in the U.S. with strong demand for our USB flash drives and mobile cards. In September, we unveiled a broad lineup of new retail products, mostly -- most notably the 64GB SanDisk Extreme Pro SD card and SanDisk Mobile Ultra microSD card, reflecting continued innovations in our removable products category. We also introduced the SanDisk Memory Vault, a new product designed to preserve images in their original quality for up to 100 years, creating a new preservation solution category. From a fourth quarter perspective, we believe we are well-positioned with our key accounts with programs and promotions in place for the holiday season.

In manufacturing, our 24-nanometer technology continues to ramp and accounted for slightly more than 60% of our bit production in Q3. We are on track to ramp production of our 19-nanometer technology this quarter using both 2-bit-per-cell MLC as well as 3-bit-per-cell X3 memory, which we expect will sustain our cost leadership in 2012. Fab 5 ramp is going very well with yields at world-class levels, a significant achievement in the short time since the Fab 5 began production in July 2011. We expect to deliver approximately 75% captive supply bit growth this year. If you recall, we originally provided a mid-80% bit growth estimate early in 2011, and this latest forecast takes into account the impacts related to the earthquake, the subsequent supply chain disruption as well as the power outage earlier this year.

Switching to our outlook. The secular demand drivers for our business remain strong and we believe there will be a healthy industry demand -- healthy industry environment in 2012. We expect the current capacity expansion commitment within Phase I of Fab 5 to be completed by the end of January 2012 and future Phase I expansion to begin approximately 3 months later. With this capacity plan, we expect our 2012 captive bit growth rate to be somewhat higher than in 2011, and the key drivers of the 2012 bit growth will be the 19-nanometer technology transition and the wafer capacity expansion in Fab 5. We believe that this plan achieves the best balance between prudent expansion and leveraging the growth opportunities ahead of us. We also plan to continue using some portion of noncaptive supply in 2012 to maintain flexibility in our supply mix.

From a demand driver standpoint, the outlook remains very favorable. NAND flash is a key enabler of smart mobile devices such as smartphones, tablets and Ultrabooks and it is increasingly used in high-performance enterprise storage and server systems. The broad and growing application opportunities for NAND flash bode well for the long-term outlook of our business.

In summary, Q3 was yet another solid quarter for SanDisk. The growth engines for NAND flash remain vibrant, and through our technology and systems expertise, we are delivering an ever-broader array of innovative storage solutions to our customers.

I will now turn over the call to Judy for her financial review.

Judy Bruner

Thank you, Sanjay. We are pleased to report another quarter of record revenues and robust profitability. This quarter marks the ninth quarter in a row of operating margins above 25% on both a GAAP and a non-GAAP basis. Year-over-year, our gigabytes sold grew 87% and our ASP per gigabyte declined 37%, contributing to a healthy 15% growth in revenues. Sequentially, our gigabytes sold increased 18% and our ASP per gigabyte declined 13%, yielding sequential revenue growth of 3%. Our sequential price decline was influenced by product mix, in particular a reduced mix of iNAND sales during the quarter due to the tablet market shakeout and an increased mix of OEM card sales. The timing of our sales during the quarter also contributed to the sequential price decline. We were relatively supply constrained during Q3 with our inventory balances benefiting late in the quarter from the Fab 5 ramp, allowing us to end Q3 with inventory better positioned, although still lean, for the fourth quarter.

The mix of our product revenue in the third quarter was 65% OEM and 35% retail. Q3 retail revenue grew 11% sequentially and 8% year-over-year. Our highest sequential retail growth was in Asia driven by increased penetration in China and India, and we were also very pleased with our sequential growth in North America retail, which was driven by strong back-to-school results.

Q3 OEM revenue was down 1% sequentially and up 21% year-over-year. Within our OEM business, we experienced rapid growth in enterprise SSD sales and some sequential contraction in the mobile sector influenced by our limited supply as well as realignment in the tablet market. On a year-over-year basis, the mobile segment of our OEM business grew at the same 21% rate as our overall OEM sales. Our license and royalty revenue was 7% of our total revenue in Q3, contributing 4 points to our overall gross margin.

We achieved the high end of our gross margin expectations with non-GAAP total gross margin of 44% and product gross margin of 40%. Our product gross margin declined one percentage point sequentially driven by the appreciation of the Japanese yen and increased noncaptive usage, which was 11% of memory supply in Q3. Fab 5 ramped very efficiently during Q3, resulting in startup costs below our forecast and actually down sequentially from Q2. On a year-over-year basis, the combined impact of the Japanese yen noncaptive usage and Fab 5 startup costs was approximately 8 points of gross margin. Our overall cost per gigabyte improved 11% sequentially.

Q3 non-GAAP operating expenses of $210 million were below our forecast due to a delay in the ramp of certain advanced technology expenses, lower-than-expected marketing and sales programs and a reduced rate of hiring, which we instituted during the quarter in light of macroeconomic uncertainty. On a sequential basis, our R&D expenses were down approximately $11 million as the elimination of Fab 5 startup costs from R&D was only partially offset by a full quarter of enterprise SSD expenses and increased advanced technology spending.

Our operating margins remained consistent sequentially at 29% on a non-GAAP basis and 27% on a GAAP basis. Non-GAAP other income and expense increased $10 million sequentially and included a $9.3 million gain on the repurchase of $222 million of our convertible debt. We were able to repurchase a portion of the debt maturing in May 2013 at slightly more than 95% of par, which made economic sense given the low rate of interest on cash and the 1% coupon. On a GAAP basis, this repurchase resulted in a $12 million other expense due to the acceleration of noneconomic interest expense.

On the balance sheet, gross cash and short- and long-term marketable securities decreased by $10 million to $5.27 billion with free cash flow largely offsetting the repurchase of convertible debt. Cash and marketable securities net of debt at maturity value increased by $212 million to $3.34 billion. Cash flow from operations in Q3 was $176 million inclusive of an increase in inventory and receivables. Inventory increased by $131 million as Fab 5 output ramped across the quarter, and inventory in petabytes grew from an extremely lean 6 forward weeks at the end of Q2 to 7 forward weeks at the end of Q3. This is 1 week less than we had at the end of Q3 last year, so it is still on the low side as we enter the seasonal Q4. Retail channel inventory also ended Q3 on the low side at 5 weeks compared to 6 weeks at the end of Q3 last year. Accounts receivable increased sequentially by $88 million as constrained inventory levels resulted in sales being more concentrated in September.

Q3 investing activities yielded a positive $13 million of cash with the fab joint ventures returning more cash to SanDisk than was needed for fab investments and capital equipment purchases. Year-to-date, our fab and nonfab capital investments have totaled $832 million and the associated cash outlay has been only $348 million with the difference funded by joint venture working capital. The dollar value of our yen-based off balance sheet lease guarantees for fab equipment decreased by almost $200 million to a balance of $545 million at the end of Q3.

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

We expect continued demand growth and supply/demand balance in the fourth quarter. Our revenue forecast for the fourth quarter is $1.5 billion to $1.6 billion, which would result in 2011 revenue in approximately the same range we indicated in July and at the high end of the range we provided at the beginning of the year.

Turning to gross margin. The yen exchange rate, which we experienced for Q3 wafer purchases, will put increased pressure on fourth quarter costs. We expect Q4 noncaptive usage and Fab 5 startup costs to be similar to Q3, and the 24-nanometer transition will continue to be the primary driver of cost reduction in Q4. We forecast Q4 non-GAAP product gross margin of 38% to 40% and total non-GAAP gross margin, including license and royalty of 42% to 44%.

Non-GAAP operating expenses for the fourth quarter are forecasted at $225 million to $235 million with the expected increase coming primarily from growth in our R&D investment level and the seasonal increase in sales and marketing spending. This fourth quarter forecast would bring full year non-GAAP operating expenses to approximately $850 million, equal to our beginning of the year forecast even after our acquisition of Pliant Technology, and at the low end of our long-term OpEx model of 15% to 17% of revenues. We expect Q4 non-GAAP other income of $5 million to $10 million and a non-GAAP tax rate of 33%.

Our estimate of 2011 capital investment in fab and nonfab equipment remains unchanged at $1.4 billion to $1.6 billion with significant investments in Q4 for both 24-nanometer and 19-nanometer technology transitions and Fab 5 capacity ramp. We expect to fund a portion of the Q4 capital investment with new operating leases and we now expect cash usage for 2011 capital investments to be significantly less than the $800 million to $900 million that we forecasted early this year.

In summary, our business model and our focus on execution continues to produce robust profits and free cash flow. Our 2011 forecast reflects all metrics in line with or better than the estimates we provided at the beginning of the year, including revenue growth, cost reduction, gross margin, operating margin, capital investment and cash generation. We will now open the call for your questions.

Jay Iyer

Thank you, Judy. Thank you, Sanjay. [Operator Instructions] Jay?

Question-and-Answer Session

Operator

[Operator Instructions] We will go first to James Schneider with Goldman Sachs.

James Schneider - Goldman Sachs Group Inc., Research Division

I guess, first off, on the supply side of things for a second, you talked about in 2012 U.S. mate that your captive bit supply is going to increase by more than it did in 2011. Any kind of a quantitative estimate on how much it would increase and how that compares to your expectations for the industry?

Sanjay Mehrotra

In terms of our captive bit supply growth, it will increase somewhat greater than 75% in 2012. And of course, that will depend on our 19-nanometer transition next year, the yields of 19-nanometer as well as the additional capacity from Fab 5. So I think at this point, that's the best estimate that we can provide. Of course, keep in mind that we will continue to utilize some level of noncaptive supply in 2012 as well similar to what we used in 2011.

James Schneider - Goldman Sachs Group Inc., Research Division

Understand. That's helpful. And then just as a follow-up, can you talk about where we are on the ramp of X3 or TLC sales at this point? Where do you think the ceiling on those sales might be as a percentage of your bit shipped and anything more you're seeing from competition in terms of their ability to ship it?

Judy Bruner

In terms of our X3 usage, it remains above 50% and it's actually been more than 50% of our revenue for more than 2 years now. So we've had a very consistent usage of X3 and we expect that to continue into next year. We continue to believe that we are far ahead of the competition in terms of usage of X3.

Operator

We'll go next to Daniel Amir with Lazard Capital Markets.

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

A couple of questions here. First of all, on the gross margins outlook here for Q4, can you give us a better idea? You said that your -- the Fab 5 output throughout the quarter, ending the quarter, is -- was quite good going into Q4 here. So can you help us a bit understand kind of the different moving factors of your gross margin guidance? And how should we look at that going into kind of the first quarter of the year? And then I have one follow up.

Judy Bruner

Okay. In terms of the gross margin, product gross margin guidance, for the fourth quarter of 38% to 40% relative to the 40% that we just achieved in Q3, the primary factor is that the yen has continued to appreciate and appreciated in the wafer purchases that we made in Q3, which will be a factor in our fourth quarter gross margin. At this point, the Fab 5 startup costs we expect will be at a similar level in Q4 relative to Q3, and we expect noncaptive usage to also be a similar mix in Q4 as in Q3. And so it's really primarily the yen and then, of course, whatever product mix we have during the quarter will also be a factor.

Daniel L. Amir - Lazard Capital Markets LLC, Research Division

Okay. And the other question is can you give us a bit more clarity on kind of your SSD business? It seems like it's doing well, maybe even better than expected here since you bought the Pliant business. I mean, how should we look at it going into next year in terms of impact on your sales, percentage of your business? I mean, do you expect the PC market to really take off next year? Or is that more the focus for 2013?

Sanjay Mehrotra

So first of all, on the enterprise side of the business, we're really very pleased with the progress we are making, the product roadmap as well as the customer traction and the rapid increases in the revenue that we are experiencing. So that part of the business is going very well and I think tremendous opportunity for us for the future. On the client SSD side, we are really seeing these Ultrabooks unfold and that definitely is driving increased adoption of SSD in the PC space. We only said that we have focused on the thin form factor of SSDs as the leading opportunity for our business. And I think Ultrabooks are certainly validating that as well. And in terms of our high-performance SSDs and we have project launched in retail well-received and also with the high-performance SSD with respect to the OEMs, we are engaged in continuing to drive that opportunity for our business. So certainly, next year, both from the enterprise side, as well as on the client side, we would be expecting a significant growth in our business coming from that category. And I can't really give you specifics in terms of the numbers, our percentages for next year, but what I would like to tell you is that over the course of the next few years, we would certainly expect our SSD business enterprise as well as the client SSD combined to really become something in the neighborhood of 25% of our revenue. So really, tremendous growth opportunity and we feel we are well-positioned here.

Operator

We'll go next to Uche Orji with UBS.

Uche X. Orji - UBS Investment Bank, Research Division

Sanjay, let me just start off by asking you about the tablet shakeouts you described at the beginning and what that means for the design win pipeline that you had referred to at the beginning of the year when you were talking about product design wins. So where does that put the pipeline of production to ramp? Where should we expect growth to come in terms of a future embedded2 growth?

Sanjay Mehrotra

So with respect to the tablet shakeout that we have said, we have been engaged with the entire ecosystem of tablet manufacturers. And we had always said that some of these devices may do well in the market and others may not. And I think you have better reports in the market. And certainly, the first generation of tablets, several of these tablets have not done as well in the marketplace. So that's what we meant by indicating the tablet shakeout. But in terms of our design wins, design wins actually continue to have strong momentum in tablets and, of course, in smartphones for our embedded products, so really, a continuing momentum on the design wins side in the tablet category. And of course, second-generation tablets are starting to come out and you're going to see more of them in the future. And really, this category continues to be a very large opportunity for us and we are well-positioned with our strong embedded products here.

Uche X. Orji - UBS Investment Bank, Research Division

But so between handsets and tablets, where should we expect most of the growth to come from? Because I think many people are still very skeptical about a tablet market outside of the iPad. So can you kind of quantify what the embedded handset outlook is?

Sanjay Mehrotra

We are really continuing to see strong growth opportunity for our business, both in mobile phones, including smartphones, as well as the tablet category. So not really breaking it out between tablets and smartphones, but both are strong growth drivers. I think you'll see that tablets are going to increase -- use large amount of flash in the future, and the numbers for tablets as a category are continuing to grow strongly and same thing for flash. So both of these will really continue to drive opportunities for us. Really, these devices now have become really an indispensable device for people. These have become a lifestyle opportunity as well as a productivity tool. And flash is really playing a key role in these devices. And these devices, I mean, there's a whole range of them available in the more affordable category such as the recent Kindle Fire as well as the high-end devices that you see out in the marketplace. What that means is really significant global expansion and significant increases in aggregate opportunity for flash in this category. And with our products, both on iNAND side as well as other components of flash, we are well-positioned in this entire ecosystem to drive the opportunity ahead.

Uche X. Orji - UBS Investment Bank, Research Division

Separately, Judy, you talked about inventory you characterized as being lean, I'm sure, looking at a number of days of inventory jump from 66 to 78. What is the comfortable level of inventory for you? I mean, because some people disagree with 78 days as being lean just given the recent trend. But anyway, we can understand what is the comfort level for you here.

Judy Bruner

Sure. I've long said that approximately 8 weeks of inventory on a forward-looking basis is around the right level for our vertically integrated supply chain model. So as I said at the beginning of the third quarter, we were 6 weeks forward-looking. That's very lean. We've entered the fourth quarter at about 7 weeks forward-looking, which is more comfortable. But generally, about 8 weeks is about the right level. You have to keep in mind that we own inventory in the fabs and then although in work-in-process and, of course, finished goods and, in some cases, in hubs for our OEMs as well as, in some cases, consignment with large retailers. So we have a very vertically integrated and long supply chain model, and that's where the approximately 8 weeks comes from.

Operator

We'll go next to Kevin Cassidy with Stifel, Nicolaus.

Kevin Cassidy - Stifel, Nicolaus & Co., Inc., Research Division

Of course, the disaster in Thailand is putting constraint on hard disk drives. Do you see this as -- are you getting calls already or -- for solid-state drives that help support some of the demand?

Sanjay Mehrotra

So in terms of the Thailand flood situation and its impact on the hard disk drive industry, really, it's really too soon to speculate on any impact on demand for SSDs. And let me just point out that our own supply chain for SanDisk products is not impacted by the Thailand floods at all.

Kevin Cassidy - Stifel, Nicolaus & Co., Inc., Research Division

And maybe talking about the 19-nanometer process node, do you expect that product to be able to go into SSDs also? Or is that going to be constrained to other applications?

Sanjay Mehrotra

Well, absolutely. I mean, as we ramp up 19-nanometer in the future, we will be applying that product to the SSD product line also.

Operator

We'll go next to Alex Gauna with JMP Securities.

Alex Gauna - JMP Securities LLC, Research Division

I'm wondering about the SATA DEVSLP initiative for you. Where are we in that process? And what sort of role is SanDisk playing in that? Is that a first mover advantage for you in that marketplace?

Sanjay Mehrotra

So this is a standard that is -- interface standard that's being driven by Samsung, Microsoft and Intel. And we are certainly engaged with the developments in this area and absolutely as we have always emphasized our engagement with the ecosystem to continue to drive opportunities on the OEM side of the business, and we definitely look forward to SSD fortunately unfolding in this regard in the future as well.

Alex Gauna - JMP Securities LLC, Research Division

I guess I'm kind of curious about the timing. And how different is that from what's underway today? And does that specifically -- I know it's an ultra-low power standard. Is that specifically involving some of your 3-bit-per-cell X3?

Sanjay Mehrotra

It basically is evolving right now, and we are definitely looking at this opportunity building with our products. And our products will support this standard.

Alex Gauna - JMP Securities LLC, Research Division

Is there any difference between the enterprise market and the portable market in terms of their willingness or ability to use X3? Or is it equal in both categories?

Sanjay Mehrotra

With respect to X3 utilization today, of course, SSDs are just MLC memory and, in the case of enterprise, some level of SLC as well. And therefore, we are focused on for near term as well. X3 memory in the clients' SSD side will certainly get utilized as well. And in fact, for our modular SSDs, we will continue to increase that as well. But on the enterprise, it will be primarily MLC and some level of SLC, non-X3 on the enterprise side.

Operator

We'll go next to Srini Sundararajan with Oppenheimer.

Srinivasan Sundararajan - Oppenheimer & Co. Inc., Research Division

My questions is do you think that this sort of problem in Thailand regarding the flood and the -- actually gives you an opportunity to perhaps reduce the prices a little bit more to increase the incorporation of SSDs into PCs?

Sanjay Mehrotra

As I mentioned earlier, it is really too soon to speculate on the impact of the Thailand situation on the SSD market.

Srinivasan Sundararajan - Oppenheimer & Co. Inc., Research Division

Okay. My question was, I think, could you probably maybe reduce prices on the SSD side so that you could gain a larger market share?

Judy Bruner

I don't think that we would engage in price reduction strategy in reaction to this environmental issue. We're very focused on continuing to deliver robust profitability and we feel that there's a good supply demand balance for our business in the current quarter.

Srinivasan Sundararajan - Oppenheimer & Co. Inc., Research Division

Okay. Next question is have you recognized these revenues from your client purchase so far?

Judy Bruner

Yes, we definitely have. We're very happy with how that business is proceeding. And as Sanjay described, we're shipping a number of different models to key Tier 1 OEMs and we're very pleased with the growth in that business, both in the near term and over the longer term.

Operator

We'll go to Atif Malik with Morgan Stanley.

Atif Malik - Morgan Stanley, Research Division

Congratulations, Sanjay and Judy, for exceeding the targets that you had set out at your Analyst Day at the start of the year. Now if I look at -- Judy, if I look at the underlying cost reduction, I mean, I get 47% kind of full year cost reductions, excluding the impact from the fab startup cost and noncaptive mix. So when we look into kind of cost reduction for next year, what arrangements are you guys making in terms of yen hedges that can kind of give us the confidence that you can kind of remain on this kind of trajectory for cost reductions next year?

Judy Bruner

Okay. So you're right, we're very pleased with the level of cost reduction we have achieved so far this year despite the fact that the yen has appreciated against us since the Analyst Day at the beginning of this year, and we are definitely still in the cost reduction range that I provided back at the Analyst Day even despite the appreciation of the yen. So very good performance. In terms of next year and how we're dealing with the yen, we are following a similar strategy to what we did in the latter part of 2010, which is to hedge a portion of next year in order to reduce variability. And we are working to hedge approximately 50%, at least 50%, of next year. We are not at that point yet. We have so far hedged approximately 30% of the yen purchases that we expect for 2012. Of course, we can't escape the market. And so the rates that we are locking in, we're at market rates. But we are trying to protect the downside in terms of any further appreciation of the yen.

Atif Malik - Morgan Stanley, Research Division

Okay. And then how many at 10% customers you had in the third quarter? I believe you reported one 10% customer in the second quarter, and was it the same customer in the third quarter?

Judy Bruner

We did not have any 10% customers in the third quarter. And that just demonstrates the very broad diversity of our customer and channel base.

Operator

We'll go to James Capello [ph] with Columbus Circle Investors.

Unknown Analyst -

I was just wondering, given the inventory build, the sequential growth rate I'm seeing for revenue for the fourth quarter, can you kind of give us a range or some detail into the ASP decline and the gigabyte growth sequentially for 4Q?

Judy Bruner

We haven't been giving guidance, specific guidance, on price decline or gigabyte growth. Of course, both are incorporated in the revenue range we provided. But I will tell you that we feel that our business is experiencing supply/demand balance in the fourth quarter. And we feel very good about the level of revenue growth, both on a sequential and a year-over-year basis. And we feel very good about the gross margins that we've guided to for the fourth quarter, which despite the appreciation of the yen are materially higher than what we had anticipated at the beginning of the year.

Operator

We'll go next to Ryan Goodman with CLSA.

Ryan Goodman - CLSA Asia-Pacific Markets, Research Division

I had a couple of questions on the SSD business. So first, you had mentioned that total SSDs are heading to somewhere in the 25% ballpark for total business. Any chance you could give us an idea of where the total business is today? And then also, specifically on the enterprise side of the business, I know you have launched several fast drives in the past quarter. Any thoughts on the long-term roadmap with PCI Express and SATA? Are these areas you need to, or plan to get into?

Sanjay Mehrotra

So first of all, on the SSD revenue, at this point it is small, and I was indicating earlier that in a few years' timeframe, we would expect it to become 25% or higher of our total revenue. So that's in a few years timeframe. And we are making, really, as I indicated, strong progress there. And on the enterprise side, the revenue today is all fast drive space and we do have a roadmap for PCI products and we will be introducing them in the first half of next year.

Ryan Goodman - CLSA Asia-Pacific Markets, Research Division

Okay. And then on -- just a side question, the cash is still relatively high and growing. You have about $15 net cash. Now it sounds like the cash requirement at least for this year with Fab 5 has gone down quite a bit. I'm still not sure, I guess, on next year, but we can see you started buying back some of the debt. And maybe just share the strategy you have with this going forward, if there's going to be buybacks, further debt reductions or more M&A.

Judy Bruner

Sure. Of course, the first priority for our cash is always the capital investment level for the business. We are a very capital intensive business, and we want to make sure that we always have ample cash on hand to fund those capacity investments. A key second priority is any strategic investments that we could choose to make from time to time, and the Pliant investment that we made in the second quarter is a key example of that. I expect that there is always a potential that we could repurchase more of the convertible debt, although getting it at the right price is what's most important. And so we'll be opportunistic if something comes along. In terms of share repurchase, we do not have a share repurchase program in place, but I don't rule out that that is something that we could look at from time to time in the future. The last time that we did repurchase stock was in 2007. In terms of an overall broad answer, I would give you that we think we have significant opportunity to invest within our business over time, and that's the primary reason that we want to hold a ample amount of cash on the balance sheet.

Ryan Goodman - CLSA Asia-Pacific Markets, Research Division

Okay. Is that cash mostly in the U.S. or is it overseas?

Judy Bruner

It is primarily in the U.S.

Operator

We'll go next to Craig Ellis with Caris & Company.

Craig A. Ellis - Caris & Company, Inc., Research Division

This year has been a really good year for the company to broaden out its embedded design wins. And given the progress that you've made, both in smartphones and tablets and in eReaders. I'm wondering, as you think about growth for 2012, is growth in the mobile business and embedded really a unit growth game? Or are you growing with the market? Or are you seeing new customer for new market segment opportunities? And relative to those, which would be the bigger growth opportunity for SanDisk next year?

Sanjay Mehrotra

So I think the mobile category, smartphones and tablets, will continue to be a very large growth category for us. And certainly, it is both unit growth opportunity as well as average capacities continuing to increase in categories such as smartphones and likely tablets as well. So it really is a combination of the 2. And as I pointed out earlier that all this profusion of mobile devices is really only continuing to increase the aggregate opportunity for NAND flash in the future. And also, of course, for next year, we are looking at revenue growth, strong contribution coming from SSD side of our business, the Ultrabooks, the client as well as the enterprise. So these, really, will start becoming strong growth drivers for our business, both mobile as well as the SSD, while the legacy markets of USB and imaging will continue to be strong markets as well.

Craig A. Ellis - Caris & Company, Inc., Research Division

Sanjay, and on the subject of solid-state drives and PCs, obviously, there's a lot of energy with some of the component players with the Ultrabook initiative. As you think about the average densities for SanDisk, what do you -- what's a reasonable way for us to think about average densities for SanDisk in 2012 in your consumer SSD business?

Sanjay Mehrotra

In the consumer SSD business, I mean, it will -- in the Ultrabook category, there are -- if you include, there are both SSD-based Ultrabooks as well as Ultrabooks that will be having hard drives as well as SSD on a file by file basis for caching purposes. So this average capacity in the consumer devices will really very much depend upon the mix of these devices as they unfold. So this is really all very evolving market. We are prepared to address it. There's a complete lineup of products, but this -- really, time will tell in terms of what exactly is the mix of the average capacity. And that will very much depend upon the mix of purely SSD-based Ultrabooks versus hard disk drive plus lower capacity flash that I had mentioned earlier. But the bottom line is that all of these units are continuing to implement and drive additional opportunity for flash, just increasing the time for flash.

Craig A. Ellis - Caris & Company, Inc., Research Division

Okay. If I could, Judy, the company's mentioned a bit growth range for next year. Since you're talking about next year's bit growth, is it possible to give us some parameters for CapEx?

Judy Bruner

It's too early to give a specific range for capital investment for next year. But I will tell you that at this point in time, we would expect to be ramping Fab 5 for 9 months out of the 12 months of next year and, of course, to have the investment that goes along with normal technology transition as well as nonfab capital investment. And as you look at this year, it just so happens that in 2011, we also had a ramp of fab capacity for 9 months out of the year because we were ramping Fab 4 in the first quarter of 2011 and then Fab 5 in the second half of 2011. And of course, we had tech transition in nonfab capital equipment. So those are the key factors, but we're not ready to give a specific range yet.

Operator

We'll go next to Bob Gujavarty with Deutsche Bank.

Bobby Gujavarty - Deutsche Bank AG, Research Division

Judy, I agree with you, the inventory doesn't look too bad at the moment. But I'm kind of concerned given that Fab 5 output is ramping, and we do have seasonality staring us in the face in 1Q. Is there some other puts and takes that I'm not aware of, perhaps, the noncaptive starts to roll off at some point that kind of balances out some of the potential for inventory to balloon here?

Judy Bruner

That is, one of the benefits of our strategy of using noncaptive is that we can always tailor back the noncaptive. And at present, we would expect noncaptive usage in the fourth quarter to be similar to the 11% that we used in Q3. So, yes, that is a factor. And at this point, I'm not concerned about the inventory levels as we enter 2012.

Bobby Gujavarty - Deutsche Bank AG, Research Division

Fair enough. The other thing I was curious about is are you guys seeing any kind of, perhaps, separation of competition, particularly at the high density parts of the NAND market given your TLC advantage, your node advantage, your manufacturing advantage? Do you notice that, perhaps, in the higher capacity, higher density configurations that it's become a little less competitive as some of the less technologically capable NAND vendors to just concentrate on the low density parts of the market?

Sanjay Mehrotra

Certainly, in the high-end capacity markets, our X3 certainly gives us an advantage and gives us a significant competitive advantage. And not only in terms of the capacity of the memory dye itself, but our X3 dye allows us to achieve to allow it to pack higher capacity of flash memory in packages such as microSD, where you can't really fit the highest capacity X2 memory whereas you can fit X3 memories in them. So it certainly gives us advantage in terms of offering high-capacity solutions. Keep in mind that our advantage is not only from X3. Our advantage, particularly in embedded, also comes from things like adaptive flash management that we have talked about. And nowadays, especially with all the tablets and smartphones really packing in more and more features and performance in them, it's really requiring flash solutions to deliver increasing capability in terms of performance. And that, again, really works well for us in terms of performance that we're able to achieve through our Adaptive Flash Management. All of these things position us well certainly for the high-capacity requirement of the market.

Judy Bruner

Bob, this is Judy. I just want to go back to the question you asked about inventory and point out that, as Sanjay described, we expect to complete the current phase of capacity expansion in Fab 5 at the end of January 2012 and then take a 3-month pause. And so the timing of that is actually good in terms of the seasonality factor of Q1 that you raised. So keep that in mind as well as you think about inventory. So there's really the flexibility that we get from noncaptive as well as, what I believe, is a very prudent ramp of Fab 5 as we go into 2012.

Operator

The next is Vijay Rakesh with Sterne Agee.

Vijay R. Rakesh - Sterne Agee & Leach Inc., Research Division

Just wondering what's the mix of TLC was in Q3 and what's it for Q4, and again, same thing on 19-nanometer and 24-nanometer?

Judy Bruner

Our 3-bit-per-cell mix continued to be above 50% in Q3 and we expect it to be above 50% in Q4. We're not being more specific than that for competitive reasons.

Sanjay Mehrotra

And we would expect similar trend to continue in 19-nanometer as well.

Judy Bruner

Yes.

Vijay R. Rakesh - Sterne Agee & Leach Inc., Research Division

Got it. Okay. And then second question, on Fab 5, by end of January, what will be utilized? How much will that be utilized?

Sanjay Mehrotra

So by end of January, with the current commitment of expansion completing in Phase I, Phase I would be about 20% utilized in terms of capacity.

Vijay R. Rakesh - Sterne Agee & Leach Inc., Research Division

Got it. And last question here. On the SSD side, I know you mentioned seeing nice pickup. What are your expectations for that growth next year versus this year?

Sanjay Mehrotra

Certainly, our SSD expectation is large. The SSD in 2011 has been -- is rather small, a revenue contribution for us, although, as we mentioned, the enterprise SSD revenue is on our fab samples as well as client SSD going well. 2012 is really when we expect SSD, both on the client side and the enterprise side, to become meaningfully a large opportunity. And we expect certainly strong growth rates for this part of our business in 2012.

Operator

And our last question is a follow-up from Uche Orji with UBS.

Uche X. Orji - UBS Investment Bank, Research Division

Sure. Sanjay, can I just ask you about your comments earlier at the beginning when you talked about clients -- the vertical integration model being a key differentiation for you in SSD? If you spoke to independent controller companies, they will talk about the flexibility they have.

Sanjay Mehrotra

Uche, you're breaking up quite badly.

[Technical Difficulty]

Uche X. Orji - UBS Investment Bank, Research Division

Now so when you were at the part of beginning, you talked about the vertical integration model as being a key differentiator for you when we're describing clients. I'm just trying to understand how you balance the advantage of being able to have a lower cost by being integrated vis-a-vis a flexibility that independent controller companies bring to the table. I'm just trying to understand if you can give us more color into that statement when you made it.

Sanjay Mehrotra

So really, there's tremendous benefit of vertical integration in enterprise. First of all, memory. Memory dominates the cost of enterprise SSD solutions. And our ability to manufacture the memory at the lowest possible cost is certainly a plus for leadership in that part of the business. However, even more importantly, the SSD's roadmap are working with our controller engineers, software engineers as well as memory technology engineers under the same roof to develop the roadmap for next few years is really a big plus because that's where we can optimize the memory as well as the system implementation to achieve the highest reliability and the highest performance and highest level of predictable performance, which is required in enterprise applications. So all of these things really, the memory cost and the ability to supply the enterprise customers' requirements in volume as well as the benefit of vertical integration on the technology and controller side, position us well there.

Uche X. Orji - UBS Investment Bank, Research Division

So I mean, if we look at a year like this, where you've been mostly supply constrained, won't an OEM look at that and think how that much for that would be flexible and use companies that can source NAND from everyone else as opposed to one that's lumped in. And I'm just trying to think how an OEM will make that decision when it looks at your model versus start acquiring newer company that can buy NAND from somebody else?

Sanjay Mehrotra

I can tell you that OEMs really are delighted to have SanDisk be a supplier of enterprise storage solutions, and they really value the supply base of flash memory as well as the vertical integration capability that, really, client brings us for this marketplace in terms of leading edge solutions, both flash drive and for the future roadmap of PCI as well. So they really look at, again, the benefit of technology, strong roadmap, capacity, reliability and all of these. They can trust that SanDisk will be a reliable partner for them in terms of delivering all their leading edge solutions. So really, big plus and customers are delighted at this.

Operator

We'll go next to Mark Newman with Sanford Bernstein.

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

Just a couple of questions. On the cost down for 2012, could you give me some guidance on how that may play out? And are you seeing the cost down actually declining from what we have seen historically? And following on from that, I'd like to get some kind of viewpoint from you either on the ASP trend which I know you don't like to talk about too much going forward, but perhaps, you could talk about supply/demand balance going into 2012. I think a lot of investors have raised concern about several suppliers increasing their supply at the end of this year and going into 2012 and concerned about what is it going to -- what's going to be the supply/demand balance going to 2012. So any kind of comments about that would be very helpful also.

Judy Bruner

Okay. Sure, Mark. So first, on the cost downs for 2012, it is clearly too early to give any specific guidance on the cost down for 2012. But our cost improvement next year will -- the primary influencers to that cost improvement will be both the 24-nanometer transition, which is continuing through the end of this year and into early next year and will be a driver of cost reduction; and then, of course, the 19-nanometer transition. So those are the 2 primary drivers. And it is true that as we move further and further along the scaling path of NAND that the cost reduction capability is reducing as we move through each node, and that is something that will influence us as well as everyone else in the industry. But we feel very good about our cost that we see for our 19-nanometer technology. Other factors in terms of cost down for next year is that the Fab 5 startup costs should be much less of a factor. We will have some in Q1 and then they should be done for next year. Noncaptive mix, I would expect, would be less of a headwind in 2012 than it was in 2011 because in 2011, we were moving from essentially a no noncaptive in 2010 to a higher usage in 2011. So that will be less of a year-on-year headwind. And then, of course, there's the yen, which will, at this point, does look like it will be a headwind and will be influencing the cost down for next year. But those are the key factors, and we'll provide more guidance on the cost downs in the early part of 2012. In terms of supply/demand balance, we, at this point, are optimistic about supply/demand balance for 2012. We see very strong secular demand drivers for our business, many of which we have talked about today. And at the same time, we think we are being very prudent in terms of our capacity expansion and we're really trying to balance prudent capacity expansion and also being able to meet the demand that we see for next year. So we feel good about the supply/demand balance and, therefore, the overall pricing environment that we expect to see in 2012.

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

Great. That's very helpful. And just one other quick follow-up question actually. Do you give any guidance or can you give any guidance on your product mix embedded versus removable probably?

Judy Bruner

Well, for the third quarter, the embedded was approximately 40% of our OEM business.

Jay Iyer

Thanks a lot. And unfortunately, that's all the time we have today. We want to thank everyone for joining us today, and a webcast replay of today's call will be available on our IR website shortly. Thank you, and have a good evening.

Operator

That does conclude today's conference. Thank you for your participation.

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