Here’s the entire text of the prepared remarks from SanDisk’s (ticker: SNDK) Q3 2005 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.
Lori Barker Padon, Director, IR
Eli Harari, President and CEO
Judy Bruner, EVP, Administration and CFO
Paul Coster, JPMorgan, Analyst
Eric Gomberg, Thomas Weisel Partners, Analyst
Satya Chillara, American Technology Research, Analyst
Gurinder Kalra, Bear, Stearns, Analyst
Katlin Wolford, Trellis Management, Analyst
Craig Ellis, Citigroup. Analyst
Sidney Ho, Merrill Lynch, Analyst
Steve Chin, UBS, Analyst
Ben Lynch, Deutsche Bank, Analyst
Hugh Cunningham, CIBC World Markets, Analyst
Daniel Amir, WR Hambrecht, Analyst
Good day, everyone, and welcome to the SanDisk Third Quarter 2005 Earnings Release Conference Call. Today's conference is being recorded.
At this time, I would like to turn the conference over to Ms. Lori Barker Padon, Director of Investor Relations. Please go ahead, ma'am.
Lori Barker Padon, Director, IR
Thank you. Good afternoon, and welcome to the financial teleconference for SanDisk Corporation for the third quarter of 2005. I'm Lori Barker Padon, SanDisk's Director of Investor Relations. Today with me is Eli Harari, President and Chief Executive Officer of SanDisk; and Judy Bruner, Executive Vice President of Administration and CFO.
The agenda for today's teleconference is as follows, Eli with start with remarks about SanDisk and trends in our markets, and Judy will follow up with our third quarter financial results and guidance. We will conclude the teleconference with your questions. An audio replay of this call, conference call, a copy of today's prepared comments, and quarterly metrics will be made available on SanDisk's Investor Relations' website. By now, all of you have seen the press releases for our acquisition of Matrix and our third quarter earnings with the associated Form 8-K this afternoon.
I'd like to remind everyone that today's comments, including our question-and-answer session will include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended, and 21E of the Securities and Exchange of 1934 as amended, based on current expectations. These forward-looking comments entail various significant risks and uncertainties that can cause our actual results to differ materially from those expressed in those forward-looking statements. The risks and uncertainties are detailed in our Form 10-K for fiscal 2004 and our Form 10-Q for the first and second quarters of 2005 and our press release and Form 8-K filed this afternoon.
Forward-looking statements in this teleconference are generally identified by words such as believes, anticipates, expects, intends, may, will, and other similar expressions. However, these words are not the only way we identify forward-looking statements. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements. Listeners are cautioned not to place undue reliance on those forward-looking statements, which speak only as of the date hereof. We do not intend to update information contained in this teleconference.
Now I'd like to turn the call over to our CEO, Eli Harari.
Eli Harari, President and CEO
Thank you, Lori. As you see from our press release, the third quarter results were outstanding. I will focus my remarks here primarily on the growing handset opportunity and the other markets that we address on our technology and manufacturing status, our patent litigation ITC case against ST Micro, and our joint announcement today with Matrix Semiconductor. Judy will then follow with, and cover the third quarter results and provide guidance for Q4.
We are experiencing exciting times for our industry. New consumer market for our products are growing at a fast clip. In 2006, MP3 players may consumer as much flash memory as digital cameras. In 2007, mobile phones may eclipse both digital cameras and MP3 players in their usage of flash storage. By the end of 2005, we believe there will be approximately 150 million handsets with slots for flash cards, almost twice as many as the number of digital cameras sold annually, and that number is projected to grow at a rapid pace over the next several years. On the horizon, we begin to see flash in video applications, and in a few years, we expect to see flash used extensively in hybrid combinations of flash memory and disk drives in notebook PCs.
In the third quarter Sony Ericsson launched a Walkman phone with a 512 Megabyte Memory Stick PRO Duo card supplied by us. Motorola introduced the iPod ROKR phone with a 512 Megabyte microSD bundle card supplied by us. Nokia announced their music-centric phone that will use, for the first time, a microSD card. And Samsung Mobile announced a support for our TrustedFlash cards in many of their content-centric handsets. Nine out of the top-10 handset OEMs have announced, or are expected to soon announce, models that support the microSD card, which is a TransFlash that we introduced and which is rapidly being adopted as the new de facto standard for removable cards in handsets.
Music is turning out to be the major trend in new mid- to high-end mobile phone, fueling the use of higher capacity cards. Most of these phones will also come standard with 2 megapixels or higher resolution camera, as well as video recording capability. In the third quarter we sold over 5 million cards into the handset market, up from approximately 3 million cards in the prior quarter. And, frankly, we were not meeting our customers' requirements, which stayed significantly underforecasted. Revenue from these cards accounted for more than 50% of our OEM revenues for the quarter. As you know, we have been developing and evangelizing this very complex market opportunity for the past three years.
In the U.S. market we have launched the retail sale of our mobile phone card through stores at the major network operators, including Cingular, with 54 million subscribers; Verizon, with 47 million subscribers; Sprint Nextel with 44 million subscribers; and Alltel, with 11 million subscribers. And in the third quarter we saw aftermarket sales of our mobile card begin to grow, both in the U.S. and in Europe. Combined OEM and retail sales of mobile cards exceeded 15% of the total product revenues, and were, in fact, higher for the first time than revenues from USB Flash Drives, however, I must say that this is partially due to our allocating flash memory preferentially into mobile cards. The 5 million mobile cards that we sold in the quarter compare to the 6.5 million iPods sold by Apple in the same quarter and point to the sizable opportunity we are creating for our mobile card in cell phones.
As for our other markets, we're doing really well with Ultra and Extreme cards in digital cameras, as well as in gaming applications with our MS PRO Duo card. Because of our current flash capacity constraints, we have been unable to allocate sufficient capacity to fully support our USB Flash Drives, as well as our MP3 players. Hopefully, that situation will improve significantly in 2006, as we bring on board substantial new NAND capacity at Fab 3. In the standalone, flash-based MP3 player market, we are focused on establishing a strong position in the $50 to $200 price range, where we believe we can provide a superior value proposition to consumers once we have the supply.
We tend to differentiate our audio players by including a secure system for music subscription downloads that is flexible and open to a wide spectrum of content service providers, including RealNetworks' Rhapsody, Yahoo! Music, Napster, and others and employing various DRM schemes, that's Digital Rights Management, from major providers. Down the road, we plan to introduce MP3 player models that will have slots for TrustedFlash cards that will also work in your cell phone or on your PC or in your car or at home. That said, we continue to firmly believe that, ultimately, the cell phone will become a primary personal music and video playing appliance, and this is driving our long-term strategy in the mobile audio market.
Let me switch gears and discuss the status of our NAND flash technology and supply. In the third quarter we completed our internal qualification, and FlashVision started full production of the 8 gigabit chip built on 200-millimeter wafers with 70-nanometer NAND/MLC. We began customer shipments of the 70-nanometer 8-gigabit product early this month and expect to see substantial benefit from this technology in the fourth quarter, where more than 25% of the captive disks shipped are expected to come from the 8-gigabit chip. 70-nanometer yield is slightly ahead of my expectations and is continuing to steadily improve as the volume picks up. And I'm glad to say we are already achieving lower cost per megabyte with our 8-gigabit 70-nanometer chip than with the mature 4-gigabit 90-nanometer chip.
We're making good progress on the 55-nanometer NAND technology, and expect it to be ready to start production by the end of the 2006. The Flash Partners' 300-millimeter fab, Fab 3, completed internal qualification on the 90-nanometer 4-gigabit NAND/MLC chip, and Fab 3 yields are tracking to plan and are steadily improving as the volume picks up. We are starting product shipments from Fab 3 early in Q4. And because of the fast ramp, we except output from Fab 3 to contribute approximately 30% of the Company's bits shipped in the quarter.
Together with Toshiba, we have been working hard to increase capacity at Fab 3 to catch up with the growing demand. The current accelerated plan that we are now executing to is expected to reach 30,000 wafers per month out, in total. That is for both the Toshiba and SanDisk by the end of March 2006, and then to proceed to 48,750 wafers per month out by the end of March 2007. And as I said, this is going to be split equally between Toshiba and SanDisk.
Flash Partners also plans to transition Fab 3 from 90-nanometer 4-gigabit chips to 70-nanometer 8-gigabit chip by mid-year 2006. The higher volume resulting from the accelerated production ramp at Fab 3 is expected to lower our overall cost per wafer out and give us much needed flash capacity at a highly-attractive cost structure in 2006. We are now projecting that the 300-millimeter 90-nanometer cost cross-over with the mature 90-nanometer on 200-millimeter wafers will occur in the first quarter 2006, which is one quarter ahead of our previous guidance.
In overall general terms, I would say that the most difficult and costly, and also the least predictable period of starting up Fab 3, as well as transitioning to 70-nanometer technology is now behind us, and this is very good news. In the fourth quarter, the focus at Yokkaichi is shifting to ramping up production shipment and further improving yield. While our Q4 rev revenues will still reflect the more expensive wafers from Q3, from the third quarter, by early next year we expect to begin to reap the full benefits of the flash technology and manufacturing investment that we have been making in 2005, which will hopefully help us build market share in international geographies and better supply our growing customer base in 2006.
We do still plan to leverage our non-captive supply agreements in the 30% range in 2006. And we expect to commence shipments of product employing Samsung's MLC NAND for the first time in this fourth quarter. While still in a fourth quarter supply situation, as you know, the consumer electronics subcontracting services are currently stretched to capacity, and this is straining the back-end assembly and test capacity at some of our major subcontractors. We are addressing these issues, in some cases by acquiring and installing dedicated equipment to relieve assembly and test capacity bottlenecks. However, this is an area of some concern to us, and we expect to be actively working these capacity issues throughout the quarter in order to maximize shipments to hit the shelves in the weeks before Christmas.
Commenting now on the NAND market conditions expected for 2006, as always, it will depend on the balance between demand and supply. Substantial new capacity is expected to come on the market in 2006 from ourselves, as well as from existing and new competitors. To correspondingly stimulate demand, we believe that price reductions in 2006 will likely be in the same 50%-plus range that our markets experienced in 2005. We believe that our dramatically lower cost structure, as we complete our conversion to 70-nanometer MLC and 300-millimeter wafers in the first half of 2006 will allow us to compete favorably and to lead the consumer market switch into the gigabyte era.
Moving now to our ITC case against ST Micro. The administrative law judge yesterday issued an initial determination upholding the validity and enforceability of the SanDisk '338 patent, but also found that ST's NAND Flash Memory chips do not infringe the three claims of the '338 patent cited in this case. We have multiple legal actions going on through several venues against ST Micro, as they have against us. In this particular action, we selected the ITC venue because of its fast track, and we restricted our infringement action to a single patent because a '338 patent had been successfully upheld in previous ITC proceeding involving NAND flash. The ITC's judge's full finding in the ST Micro case has not yet been made available to us, and, therefore, it is premature for us to comment.
We continue to believe that ST Micro infringes the '338 patent, and we plan to seek review by the Commission, and if necessary, we may appeal to the Court of Appeals for the Federal Circuit. This initial determination, whether upheld or not, will not impact any existing license agreements, nor will it adversely impact any of our existing royalty-bearing agreements. SanDisk will continue to vigorously pursue various legal actions against ST Micro and others based upon our deep product portfolio of over 300 flash storage patents.
Finally, I'm very pleased to announce today that we signed a definitive agreement to acquire Matrix Semiconductor. Matrix is a highly-innovative Silicon Valley privately-held company that has, for the past several years, focused on developing a three-dimensional, One-Time Programmable semiconductor memory technology, for which they have generated more than 100 issued U.S. patents and the relevant know-how. Although the 3-D semiconductor technology is unique and quite different from NAND flash, their technology is nonetheless attractive in a number of card storage applications where multiple read/writes are not required, but where low cost is paramount. Examples are video game cartridges, GPS street maps for car navigation systems, or shoot-and-store cards used in archiving applications.
We also plan to explore the feasibility of using the three-dimensional OTP technology in our new Gruvi cards for record labels to securely distribute their latest hits for playback in cell phones where CDs cannot serve as the distribution medium. Matrix is currently shipping factory pre-programmed video game chips using four physical levels of memory arrays built on a common silicon substrate. Technology aside, we view this as a strategic acquisition, and expect the near-term, relatively-modest dilutive effects that Judy will discuss to be well worth the long-term potential opportunity, as an effective content distribution media in mobile applications in future years. We intend to provide visibility of our vision for Matrix's future potential early next year.
So in summary, I'm very pleased with where we are today and optimistic about where we are going in the fourth quarter and in 2006. I especially want to thank the SanDisk team for their fantastic dedication, passion, and consistent execution. The flash market that we address appear poised for sustainable, strong, global growth in the next several years. And we believe that our strategic investment in fab capacity, technology, product, sales channels, and brand creations position us exceptionally well for the future.
Judy Bruner, EVP, Administration and CFO
Thank you, Eli. And good afternoon, everyone. We are very pleased to report third quarter revenue up 45% year-over-year and 15% sequentially. Our retail sales were higher than we had expected for the third quarter, reflecting a combination of strong unit sell-through, coupled with very modest price declines. And our OEM business benefited from growing demand by handset manufacturers to bundle flash cards with their feature phones.
Our operating margin of 27% demonstrates the robustness of our business model, combined with a well-executed initiation of production for both 300-millimeter wafers and 70-nanometer technology. This is our 12th quarter in a row with operating margins at 20% or above. Product revenue of 530 million was up 45% year-over-year and up 17% sequentially. Compared to the second quarter, our retail business grew 7% and our OEM business grew 66%, resulting in a third quarter channel mix of 76% retail and 24% OEM.
Within our retail business, sequential growth was strongest for USB Drives, Memory Stick PRO Duo gaming cards, and our Ultra and Extreme cards. Retail ASP per unit increased due to favorable product mix, combined with a very modest decline in ASP per megabyte. OEM sales growth was dominated by microSD and Memory Stick PRO Duo for the mobile phone market. The average capacity of our retail sales grew 4% in Q3, while average capacity of our OEM sales grew 46%, due to increasingly higher capacity cards bundled with mobile phone. Our overall ASP per megabyte fell only 5%, reflecting strong demand for NAND flash in a growing number of digital consumer applications.
On a geographic basis, our product revenue mix in Q3 was 48%, North America; 26%, Europe; and 26%, other international regions. Sequential revenue growth was strongest in Asia and Japan, with growth in Asia influenced primarily by our OEM sales, and growth in Japan coming from retail sales. License and royalty revenue was 60 million, in line with our expectation and approximately the same as in Q2.
Product gross margin of 37.2% was higher than we had anticipated, due to the following contributing factors.
First, the Flash Partners' 300-millimeter fab moved successfully into production status at the beginning of the third quarter, resulting in only 13 million of startup costs being recorded in the third quarter cost of sales, and the remainder of the Fab 3 costs, approximately 22 million, becoming wafer costs and included in the inventory at the end of the quarter.
Second, because we recognize retail revenue based on sell-through, the majority of our third quarter sales were generated by inventory built in the second quarter, with the very attractive cost structure of our mature 90-nanometer technology. While the very early production 300-millimeter and 70-nanometer wafers have higher costs, due to initially lower yields, the costs of these wafers will be recognized primarily in the fourth quarter, as products built with these wafers sell through the retail channel.
A third factor, pricing, was another favorable contributor, with ASP per megabyte declining only 5%, compared to our previously projected 15 to 20%. Our non-captive mix in the quarter was 39%, up from 33% last quarter. However, our cost from non-captive memory suppliers fell faster than did our retail and OEM pricing during the quarter, resulting in a net favorable impact to gross margin. And, lastly, our OEM mix also positively impacted gross margin, due to strong sales of higher margin mobile cards.
Operating expenses for Q3 of 98 million were down 9% from the second quarter, due to the elimination of Fab 3 R&D costs, as the 300-millimeter fab moved into production. Sales and marketing growth reflected increased spending on branding and merchandising, as well as employee hiring. And the increase in general and administrative spending is primarily attributable to legal expenses related to enforcing our IP rights. Other income of 12 million increased by 6 million from the prior quarter, due to no equity investment charges in the third quarter and growing interest income on our higher cash balances. Our effective tax rate remained at 37%, yielding Q3 net income of 107 million and EPS of $0.55, compared to 54 million and $0.29 in the third quarter of 2004, and 70 million and $0.37 in the second quarter of 2005.
Turning to the balance sheet, cash, cash equivalents, and short-term cash investments ended the quarter at 1.66 billion, up 204 million from the previous quarter. Cash flow from operations was 209 million. Accounts receivable ended the quarter at 211 million, or 36 days, down from 242 million and 49 days last quarter. The lower receivables balance reflects strong collections in Q3, combined with price protection reserves for known price adjustments in Q4. Inventory ended the quarter at 287 million, up 57 million from Q2 in preparation for the first half Q4 shipments ahead of holiday sale.
We provided 12 million to FlashVision during Q3 for 70-nanometer equipment payments, and this was recorded as a note receivable from FlashVision. Flash Partners was able to satisfy it's Q3 capital equipment payments through operating and lease drawdowns. SanDisk's portion of the guarantee on these lease drawdowns was 8.6 billion yen, or approximately $77 million for the quarter, bringing the total outstanding SanDisk guarantee for Flash Partners' leases at the end of the quarter to 15.4 billion yen, or approximately $140 million. Also during Q3 we purchased 5 million of fab equipment which is owned directly by SanDisk. This SanDisk fab equipment is included in our total capital equipment purchases of 24 million during Q3.
I'll now provide you with some key factors that we believe will have bearing on our future results. Let me remind you that the forward-looking comments I am about to make are subject to risks and uncertainties as described at the beginning of this call and in our periodic SEC filings. And we do not intend to update these comments or forecasts prior to our next quarterly conference call. I will first cover Q4 guidance, exclusive of the planned acquisition of Matrix. I will then provide a few comments on the anticipated impact of Matrix on our results for Q4 and for 2006.
We expect our Q4 ASP per megabyte to decline 15 to 20%, with the price decline dominated by holiday promotions, combined with certain price changes which we have already made, and a shift to higher capacity. We expect our megabytes sold to increase 40 to 50% sequentially. This is less than the sequential increase experienced last Q4, when we had a 14-week quarter and when price declines were 22% in Q3 and 34% in Q4, resulting in heightened elasticity. In addition, the availability of non-captive supply, which is coming later in Q4 than we would like, and the assembly and test capacity constraints that Eli referred to, are factored into our projected megabyte growth for the fourth quarter.
We expect Q4 license and royalty revenue between 64 million and 67 million given recent forecasts from our licensees. We expect Q4 product gross margin in the range of 33 to 35%, down from Q3 because of more aggressive price movement and because a sizable portion of Q4 revenue will be generated from early-production 300-millimeter wafers which carry a higher cost structure than the average wafers sold in Q3. We expect non-captive mix to be approximately 35% in Q4. We expect Q4 operating expenses of approximately 115 million, with the primary growth coming from increased spending on branding and merchandising in the holiday season. Expenses will also reflect continued increases in R&D investment and spending on G&A infrastructure to support Company growth.
We expect other income to be approximately 10 million, and the tax rate to remain at 37%. We expect inventory to be higher at the end of Q4 than Q3, due to the steep ramp of Fab 3 in support of our 2006 plans. With regard to the capital investments, we expect to invest approximately 25 million as an equity investment in Flash Partners in Q4, and we expect Flash Partners will make lease drawdowns requiring SanDisk to guarantee between 75 million and 100 million of incremental operating leases. Flash Partners is currently working with both SanDisk and Toshiba to expand it's existing operating lease facility.
We currently expect to close the acquisition of Matrix late in the fourth, after completion of regulatory approvals and other standard conditions. Given the timing of closing the transaction, we expect the operating results from the Matrix business to be immaterial to our fourth quarter. We do expect the purchase accounting to result in a fourth quarter one-time charge for in-process technology, however, we cannot yet provide an estimate on this charge, as it requires a valuation study, which will be completed after the close of the transaction.
For 2006 we expect the Matrix products to generate revenue in the range of 60 to 90 million and to add operating expenses in the range of 30 to 40 million. We estimate that these operating results, combined with the shares issued for the acquisition, will result in operating dilution of approximately $0.10 in 2006.
In addition to the operating results from the Matrix business, we will have amortization of intangible assets and stock compensation resulting from the purchase accounting. The amount of intangible amortization is difficult to estimate precisely until after we complete an appraisal of the asset. However, our preliminary estimate is that intangible amortization and stock compensation associated with the transaction will result in additional GAAP dilution of $0.10 to $0.20. Combining the operating dilution with the results of the purchase accounting, total GAAP dilution is expected to be between $0.20 and $0.30 in 2006. We will provide more information in our January conference call.
Given the intangible amortization and stock compensation from this acquisition, as well as the addition of ongoing stock compensation expense beginning in Q1 '06 with the adoption of FAS 123R, we plan to begin presenting non-GAAP operating results in addition to GAAP results and a reconciliation between the two in order to assist you in understanding our financial performance. The non-GAAP results will exclude non-cash stock compensation intangible amortization. We believe that this added disclosure will provide meaningful information about our operating performance and will assist you in comparing results over time, particularly since we will be adopting FAS 123R on a prospective basis only.
In summary, we're extremely pleased with our Q3 and year-to-date financial results, and we are focused on delivering a strong Q4 and on utilizing the significant captive memory output we will have in 2006 to expand our international presence, grow the mobile market, and address new applications for flash memory.
We will now open the call for your questions.
- The Q&A from this call is here.
- All Consumer Electronics Stock Blog articles on SanDisk.
- A list of full conference call transcripts available on the Seeking Alpha Network.
- The complete list of consumer electronics stocks (and links to articles about them) covered by The Consumer Electronics Stock Blog.
THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY’S CONFERENCE CALL AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE CONFERENCE CALLS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY’S CONFERENCE CALL ITSELF AND THE APPLICABLE COMPANY’S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.
Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.
THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.
If you have any additional questions about our online transcripts, please contact us at: email@example.com. Thank you!