SanDisk Q3 2007 Earnings Call Transcript

Oct.18.07 | About: Western Digital (WDC)

SanDisk Corporation (SNDK) Q3 2007 Earnings Call October 18, 2007 5:30 PM ET

Executives

Lori Barker - Senior Director of Investor Relations

Eli Harari - Chairman and Chief Executive Officer

Sanjay Mehrotra - President and Chief Operating Officer

Judy Bruner - Executive Vice President, Administration,Chief Financial Officer

Analysts

Craig Ellis - Citigroup

Jim Covello - Goldman Sachs

Ahmed Kapoor - Piper Jaffray

Harlan Sur - Morgan Stanley

Paul Koster - J.P. Morgan

Tristan Gerra - Robert W. Baird

Daniel Amir - Lazard Capital Markets

Vijay Rakesh - Oppenheimer

Gurinder Kalra - Bear Stearns

Edwin Mok - Needham& Co.

Daniel Gelbtuch - CIBC World Markets

Operator

Good day, everyone, and welcome to SanDisk Corporation’sthird quarter 2007 earnings conference call. Today’s conference is beingrecorded. At this time, I would like to turn the conference over to LoriBarker, Senior Director of Investor Relations. Please go ahead, Madam.

Lori Barker

Thank you. Good afternoon and welcome to the financialteleconference for SanDisk Corporation for the third quarter of 2007. I’m Lori Barker, SanDisk’s Senior Director ofInvestor Relations. Joining me is Dr. Eli Harari, Chairman and CEO of SanDisk,Sanjay Mehrotra, President and COO, and Judy Bruner, Executive Vice Presidentof Administration and CFO.

The agenda for today’s teleconference is as follows: Eliwill start with an update on the industry and SanDisk’s overall strategy, Sanjaywill follow with operational and business updates and Judy will end with ourthird quarter financial results and future guidance. We will conclude theteleconference with your questions for Eli, Judy and Sanjay.

Any non-GAAP financial measures discussed during this call,as defined by the SEC in Regulation G, will be reconciled to the most directlycomparable GAAP financial measure. That reconciliation is now available alongwith supplemental schedules on our web site at sandisk.com.

After the completion of this call, an audio replay of thisconference, a copy of today’s prepared comments and quarterly metrics will bemade available on SanDisk’s Investor Relations Web Site at sandisk.com.

During our call today we will be making forward-looking statements.Any statement that refers to expectations, projections or othercharacterizations of future events including financial projections and futuremarket conditions, is a forward-looking statement. Actual results may differ materially fromthose expressed in such forward-looking statements.

Certain factors that may cause actual results to differ aredetailed under the caption “Risk Factors” and elsewhere in the documents thatwe file from time to time with the SEC, including our Annual Report on Form10-K for fiscal 2006 and our quarterly reports on Form 10-Q. We undertake no obligation to update theseforward-looking statements, which speak only as of the date hereof.

Now I’d like to turn the call over to our CEO, Eli Harari.

Eli Harari

Thank you, Lori. Demand was remarkably strong in the thirdquarter, with high volumes straining our supply chain. We currently are sellingmore than one million cards per day, approximately half of which are for themobile card market, which barely existed three years ago and which we believeis only just beginning to take off.

The star product performers in Q3 were mobile cards and USBflashdrives. Also, our international sales are growing rapidly and reached 67%of total product sales in the third quarter.

The strong output from Fab 3 has allowed us to gain marketshare in key geographies where we were previously severely supply constrainedand our financial performance is becoming much less dependent on U.S. consumersentiment.

I want to share with you our current thinking on SanDisk’sdemand and supply requirements in 2008 and beyond. We expect the number onedemand generator for Flash memory in 2008 to be storage in mobile handsets andwe believe that this market is entering an explosive growth phase with abarrage of new multimedia handsets that will be voracious users of embeddedFlash and Flash cards.

We are very well positioned as a one-stop shop supplier ofboth the mobile OEM and the mobile retail fronts. In the third quarter, morethan 40% of our mobile revenues were generated through about 100,000specialized mobile retail outlets that now sell our mobile products.

In emerging markets, we see the solid state disk market as akey strategic long-term investment. Thisoverall market is projected to grow nicely in 2008, accelerating in 2009, andby 2010 or 2011, we project that Flash storage in solid state disk in computingapplications could become the second largest user of Flash memory after mobilehandsets.

We believe that our Flash systems expertise, and inparticular our MLC implementations as well as our extensive system IP, willbecome important differentiators in this market as it unfolds over the comingyears.

Adding to the Flash demand equation are existing marketssuch as imaging, USB flashdrives, audio, video, gaming, navigation, andemerging markets such as enterprise, home entertainment, automotive and contentdistribution. We believe that ourcombined projected demand from these markets will put us among the top threeconsumers of Flash memory. In 2008 and beyond, we believe our projected demandwill likely outstrip our total supply, even with some reliance on non-captivesources.

We plan to address our 2008 supply requirements in thefollowing ways. In Fab 3, we expect to maximize output through the followingsteps: first, complete the conversion to 56 nanometers in the first quarter of2008, second, convert a portion of the output of 56 nanometer to X3, that isthe three bits per cell, starting in March or April of 2008, and third, beginto convert to 43 nanometer in the second quarter of ‘08. In Fab 4, we plan a fast ramp on 56-nanometerand we expect to begin conversion to 43-nanometer as soon as 56-nanometeryields have stabilized. In parallel, we expect to re-enter the non-captivemarket as a more significant customer in 2008.

In 2009, we expect to continue ramping Fab 4 to its maximumcapacity. However, beyond 2009, we believe that we will need substantial newcaptive capacity if we are to retain our market leadership and competitivelyserve the very large markets that I just discussed.

Given that a new captive fab takes 18 to 24 months to plan,to build, equip, qualify, and begin to ramp, we have commenced discussions withToshiba for a potential joint Fab 5 for late 2009 or 2010 production starts.The timing for such a fab would be such that it would not require significantnew CapEx outlays before the second half of 2009 at the earliest.

Also, under a previously announced Memorandum ofUnderstanding, we are in discussions with Hynix for a potential minorityinvestment in one of their 300-millimeter Flash fabs. If that should transpire, the Hynixinvestment would be on a much more modest scale than a potential Fab 5 withToshiba.

As you can see the pace of business is picking up. We areaddressing opportunities in Flash markets of substantial scale, and theseentail substantial investments and risks. However, not all Flash competitorsare the same and I believe that SanDisk’s captive supply and retail presence,technology leadership and growing consumer brand position us very well inpursuing our vision for sustained growth and market leadership in the comingdecade.

I will now pass it on to Sanjay.

Sanjay Mehrotra

Thank you, Eli. Q3 was a very busy quarter for SanDisk, withcontinued new product introductions and the new manufacturing plant openings ofFab 4 in Yokkaichi,Japan, and our first captive assembly and test facility in Shanghai. We madeexcellent progress in achieving market share gains in Europe and Asia andfurther lowering our unit costs.

In the third quarter, overall demand for our products wasstrong with total worldwide unit sales in the retail channel doubling on ayear-over-year basis, driven by strong unit sales increase in USB drives andmicro-SD cards. Further, demand for our high-capacity 2-gigabyte and 4-gigabytemobile cards was strong and the supply of these cards was constrained duringthe quarter, as we could not ramp up back-end assembly and test capacity fastenough to meet the accelerated demand.

In the retail channel, during Q3 we shipped more mobile cardunits than we did in all of 2006. Infact, unit sales of the micro-SD card were at an all time record and it was thelargest single product in the SanDisk portfolio.

The mobile OEM channel grew nicely and continues tocontribute more than half of our mobile revenue. However, revenue growth in theretail mobile channel accelerated and grew at an even faster rate.

Going forward, we believe that video in mobile phones willbecome another strong driver for our high capacity products with shipments recentlystarted of multimedia 5-megapixel new phones like Nokia N95, Sony Walkman K850and others.

USB flashdrive revenues have resumed strong growth as a resultof combining, in the first quarter of 2007, our legacy SanDisk and msystems USBflashdrive teams under a single global organization. We realized solid sales of USB drives in theU.S. market during the back-to-school season and we also made excellentprogress in overseas markets by expanding our channel reach, offering segmentedproducts, and tailoring our products to each region.

According to GFK Europe, our overall retail market share incards and USB flashdrives grew by more than 350 basis points in the first twomonths of Q3 compared to the first two months of Q2, and now our market sharestands at about 28%; the highest share we have achieved in the Europe regionfor cards and USB flashdrives.

I am pleased to report that for the first time ever, weachieved number one European USB market share in August 2007. We also observed strong market share trendsin the APAC region. As a result of our global sales push, our retail revenue ineach of the regions of Europe, APAC, and Japan grew by more than 50%sequentially.

On the manufacturing front, Fab 3 continued to lead theindustry in cutting-edge manufacturing technology. Fab 3 has now achieved itstarget capacity of 150,000 wafers per month and we are achieving excellentyields on our 56-nanometer process technology on both 8-gigabit and 16-gigabitdevices.

We expect 56-nanometer technology to account for more thantwo-thirds of our fab bit production output by the end of 2007 and we are wellunderway to begin the transition to 43-nanometer technology in the Q2 2008timeframe. Further, work on 32-nanometer technology development is proceedingwell.

Industry wide assembly capacity for high capacitymicro-sized mobile cards with multiple Flash memory stacked die is notsufficient to keep up with the rapid growth in demand. In that regard, ourtiming for our captive assembly and test facility in Shanghai is proving highlybeneficial to us. The Shanghai facility is on schedule for a meaningfulproduction ramp in 2008.

As we look to the seasonally strong fourth quarter, webelieve demand will be strong for our products and the benefits of low-cost 56-nanometerproducts should enable us to position and price our products attractively forholiday shoppers.

We expect continued revenue growth in our Sansa line ofmedia players with the addition of new products such as the Sansa Clip, a verysmall audio player with superior value, and the Sansa View, our firstvideo-enabled media player. In addition, our high capacity and high performanceproducts in imaging, mobile and computing markets will also continue to play animportant role in our growth in Q4 and beyond.

With that, I will hand over the call to Judy.

Judy Bruner

Thank you, Sanjay and Eli, and good afternoon everyone. Ourstrong third quarter performance is highlighted by exceptional megabyte growthin both retail and OEM channels, and in particular for our mobile handset andUSB businesses.

Our 54% sequential megabyte increase in Q3 is an outstandinggrowth rate for the summer quarter. Thisgrowth reflects the continued development of the mobile handset mega-market forFlash memory and market share gains in Europe and Asia in both cards and USBdrives, the result of our strategic focus on growing share outside NorthAmerica.

The 16% sequential decline in our ASP per megabyte, asignificant improvement from the 26% decline in Q2, stemmed primarily from Q3price quotes provided to our OEM customers in Q2 and retail price reductionsimplemented in June, which had a full quarter impact on Q3. We took very littlepricing action during the third quarter.

Our retail revenue increased 25% sequentially, withmegabytes sold up 46% and ASP per megabyte down 14%. Retail revenue was 66% ofproduct revenue during Q3, a comparable mix to the second quarter.

On a year-over-year basis, our retail revenue grew a strong36% despite a 63% year-over-year decline in ASP per megabyte. Ouryear-over-year retail growth reflected an increase of nearly 100% in units soldand 267% in megabytes sold.

Our strongest retail growth was in the mobile handsetmarket, where retail unit sales grew more than 300% over the prior year. Theaverage capacity of a mobile card sold in retail in Q3 was over 1.2 gigabytes,up 114% on a year-over-year basis.

Our retail sales were also very strong in the USB marketwith both unit sales and average capacity up over 100% year-over-year. On anoverall basis, our average capacity in retail was 1.6 gigabytes, up 10%sequentially and 83% year-over-year, with the average growth rate influenced bythe increasing mix of mobile cards, which are at a lower average capacity thanUSB drives and camera cards, although growing at a very strong clip.

Our OEM revenue increased 32% sequentially, with megabytessold up 82% and ASP per megabyte down 26%. On a year-over-year basis, OEM revenue grew 37% with megabytes sold up206% and ASP per gigabyte down 57%. OEM growth was dominated by the mobilehandset market, although we also had nice growth from bundled camera cards,cards for GPS devices, and a small contribution from solid state drivesales.

License and royalty revenue for the third quarter of $119million increased 52% year-over-year and 11% sequentially. This growth wasslightly higher than we had forecasted due to higher MLC mix and better SLCpricing in our licensees’ sales.

Our Q3 non-GAAP product gross margin of 26.4% improved 7.4points from the second quarter. The decline in our cost per megabyte wassimilar to the decline in our ASP per megabyte, with memory cost declines reflectingincreased scale and the beginning of the transition to 56-nanometerproduct.

The primary contributor to the improvement in our grossmargin was a reduction in inventory charges. With inventory balances lower andprice movement less aggressive than in the first half, inventory charges weresignificantly down for both excess product issues and lower of cost or marketadjustments.

Another favorable factor in Q3 gross margin was the receiptof a one-time insurance payment for claims we had filed related to a fab poweroutage which occurred in the first quarter of 2006. Partially offsetting the favorable insurancepayment was Fab 4 start-up costs. Webegan production in Fab 4 inSeptember, ahead of schedule, resulting in start-up costs charged to cost ofsales rather than R&D in the month of September. The non-captive memory mix in our shipmentsremained below 5%.

Non-GAAP operating expenses were $199 million, up $29million from Q2. The growth in R&Dcame primarily from Fab 4 start-up costs in July and August and increasedengineering materials, masks and NRE.

In sales and marketing, the major contributors were variableco-operative selling costs and higher spending on branding, merchandising andcollateral materials. In addition, all expenseline items were impacted by the reinstatement of salary increases which hadbeen frozen from Q1, as well as higher spend on our IT infrastructure andincreased hiring.

We are carefully increasing our headcount and absoluteexpense investment, while still reducing our operating expenses as a percentageof revenue, targeting to be in our long-term model of 15% to 18% in 2008.

Other Income came down sequentially, in line with ourprevious forecast, due to one-time gains in Q2 and a higher mix of tax-exemptinvestment income. Our non-GAAP tax ratecame down to 35.1% on a year-to-date basis and to 32.3% for the quarter as ourprofits increased in low tax rate jurisdictions.

On the balance sheet, cash and investments, includinglong-term investments, remained unchanged at $3.2 billion. We generated $339 million in cash fromoperations and $43 million in cash from employee stock programs, and weinvested $324 million in Fabs 3 and 4 and $82 million in property andequipment. Our Flash joint ventures drew down $131 million of operating leases,bringing our net operating lease guarantees to slightly above $1 billion.

Our accounts receivable are up $126 million and ourinventory is down $56 million compared to the second quarter, both due tosignificantly higher shipments in the third quarter. You can also see theimpact of the higher shipment level in our deferred income in the liabilitysection of our balance sheet, which is up $61 million. Given the increased rate of sell-through,channel inventory is at a lean level of 7 weeks, and inventory on our balancesheet stands at 73 days, which is a lower level than we would prefer headinginto Q4.

Before turning to our outlook, I’d like to point out that weachieved a non-GAAP operating margin of 15.7% in the third quarter, moving intothe 15-20% operating margin range that we established as our 2008 target modelat our February 2007 Analyst Day. And on a year-to-date basis for 2007, we areat 10.7% non-GAAP operating margin, slightly above the 0% to 10% range that wepredicted for 2007 at the Analyst Day. We believe we have executedexceptionally well through the pricing volatility of recent quarters, and theinvestments we have made in capacity, technology and human resources are payingoff in market share gains and improving profitability.

I’ll now turn to our outlook. We expect strong demand forour product categories in the Q4 holiday season with growth primarily limitedby petabyte availability, given the completed expansion of Fab 3 and our lowinventory levels at the end of Q3.

We expect megabyte growth in the fourth quarter to be in therange of 45% to 60% sequentially, bringing our megabyte growth for 2007 toapproximately 200%.

We expect price decline in Q4 to be moderately more than the16% decline in Q3, driven primarily by Black Friday sales and other holidaypromotions. The annual 2007 decline inASP per megabyte is forecasted to be in the low 60% range.

We expect our Q4 product revenue to be in the range of $1.05billion to $1.2 billion, and we forecast Q4 license and royalty revenue to beabout the same as Q3.

We expect fourth quarter gross margins to benefit from ahigher mix of lower cost 56-nanometer memory, with this impact partially offsetby a full quarter of Fab 4 start-up costs and Q4 price declines.

We forecast non-GAAP Q4 product gross margin to be in therange of 27% to 30%.

We expect Q4 GAAP product gross margin to be lower thannon-GAAP by approximately two percentage points due to the inclusion of stockcompensation and acquisition-related purchase accounting charges.

We forecast Q4 non-GAAP operating expenses to be in therange of $240 million to $250 million with the growth from Q3 reflectingplanned spending on TV and other advertising, increased holiday merchandising,higher investment in certain R&D areas, partially offset by the eliminationof Fab 4 start-up costs from R&D, and increased spending on G&Ainfrastructure, including the start up of a new ERP project. Q4 GAAP operatingexpenses are expected to be higher than non-GAAP by an amount similar to the$35 million delta in Q3.

Other Income for Q4 is expected to be approximately $5million lower than Q3, due primarily to a continued shift to more tax-exemptsecurities which yield a better after-tax return. We expect the non-GAAP tax rate for thefourth quarter to be 34%-35%.

On the balance sheet, we forecast that Q4 inventory levelswill be approximately flat compared to the Q3 level as we ship all we that canfor the fourth quarter, but with work-in-progress increasing as we ramp Fab4. We expect to make Q4 investments inFlash joint ventures of approximately $200 million, and we expect to guaranteenew operating leases of approximately $130 million in Q4.

In summary, we are very pleased with the improved top lineand bottom line performance in Q3 and we look forward to a similarly strongQ4.

We will now open the call for your questions.

Question-and-AnswerSession

Operator

(Operator Instructions) We will take our first question from CraigEllis with Citigroup.

Craig Ellis -Citigroup

Thank you and congratulations on the quarter. Judy, can youclarify how much second sourcing you’re assuming in the bit growth guidance of45% to 60%?

Judy Bruner

At the moment, we are looking at the potential of gettingsome more non-captive supply in the fourth quarter. However, it is not clearthat we will be able to get it in time to influence the fourth quarter. Let meturn that over to Sanjay and he can elaborate.

Sanjay Mehrotra

Yes, our non-captive in Q4, as Judy said, if we are able torealize those, would very much depend on the timing of those purchases and ofcourse the competitive pricing of those purchases. In all, we would expect thenon-captive purchases in Q4 frankly to still remain below 5%.

Craig Ellis -Citigroup

Okay, and Judy, you’re saying that that isn’t included inthe guidance, or it is included in the guidance?

Judy Bruner

That level is included in the guidance.

Craig Ellis -Citigroup

Okay, and secondly, just given the pricing mechanics in thethird quarter, I would have expected royalty guidance to go up sequentially.Can you just elaborate on that?

Judy Bruner

For our primary licensee, they have not made any clearcomments that we are aware of as to what their pricing was in the thirdquarter. We have tried to make our best estimate based on their bit guidancefor the third quarter, their bit reports for the third quarter, as well asestimates of their pricing and that’s included in the total overall license androyalty.

Craig Ellis -Citigroup

So are you saying that you are assuming that pricing didn’tgo up for them in the third quarter?

Judy Bruner

We believe it may have gone up a little bit but we don’thave a specific number.

Craig Ellis -Citigroup

But you will have that when you close out the fourthquarter, obviously?

Judy Bruner

Obviously, yes,

Craig Ellis -Citigroup

Okay, and then a follow-up for Eli; Eli, can you justprovide some commentary about how we should think about the ramp-up of X3 andhow much of the mix could be X3 by the time we exit next year?

Eli Harari

For X3, it’s looking pretty good on 56-nanometer and wedon’t really see any issues with qualification and ramping it up. It isdesigned to be pretty much broadly based -- in other words, general purpose,not limited to just benign applications but I would say that by the end of2008, the majority of our products, the majority of our megabytes will still betwo bits per cell, partially because we will along with X3 on 56-nanometer alsobe aggressively transforming the 56 to 43-nanometer on two bits per cell and Ibelieve at the 43-nanometer, MLC is still more cost effective than the56-nanometer X3.

Craig Ellis -Citigroup

Okay, that’s helpful, and lastly for me, you sounded confidentthat the company would have to increase its second sourcing next year. Can youjust elaborate on what you are seeing that leaves with you that degree ofconfidence?

Sanjay Mehrotra

If you look at our Fab 3 production, which has now in termsof wafer output, maxed out at 150,000 or so wafers, and Fab 4 is just startingto ramp up and will contribute equally in 2008 timeframe. And you look at ourtotal demand requirements next year, we believe that we will not be able tofulfill all of that demand through just captive supply. We will be needing somenon-captive supply and the demand drivers that are really requiring that mix ofcaptive and non-captive we believe in 2008 are primarily driven by mobile, therecent applications of video, et cetera in mobile phones we believe will drivehigh capacity storage in mobile phones, as well as all of our other markets,particularly supplying to international growth, we believe will drive strongdemand in 2008.

Operator

We’ll take our next question from Jim Covello with GoldmanSachs.

Jim Covello - GoldmanSachs

Great. Good evening. Thanks so much. A couple of quickquestions; what are you guys estimating for a supply growth for the industryfor 2008 that leads you to believe that you will need to source captive supply,especially after what Samsung did with the CapEx increase last week?

Eli Harari

I think that we believe that we are entering a new baselinelevel, particularly with the handsets. I think that there’s not enoughrealization in the market of how strong and how fast this market is moving interms of requirements for storage. It may have been kicked off by the launch ofiPhone, but really until today, a very small number -- I’d say probably 30% ofthe phones that can use a card actually use it. We are seeing a very, verystrong move now to retail, to after market purchases of cards, one-, two-, andfour-gigabyte cards, and we think, as well as embedded. And the numbers thereare so large that if you just double the number of cards and then double themegabytes per card, you very easily I believe can outstrip whatever Samsung istalking about or the other players.

And then on top of that, of course, the 200-millimetersupply that is being retired next year that is very real. So I think that overall,2008 could be a year where there’s a good balance between the managed supply,even with aggressive ramping of new capacity.

Now, there could be first quarter seasonality, weakness thatwe’ve seen in the past, but for us at SanDisk as opposed to our competitors, wesee us being able to use everything that we can make and that’s not beingsufficient to meet our forecasted requirements for next year.

Jim Covello - GoldmanSachs

And then just a couple of other quick follow-ups; first, onthe solid state drive penetration for 2008, do you have any kind of percentagemaybe of the -- on the notebooks, what you think solid state drives couldrepresent of total notebook shipments in 2008? And could you offer someperspective on solid state drives in the data centers, when you think thatmight become a reality?

And then my final question is, any update on the Samsungroyalty negotiations? Thank you.

Eli Harari

Solid state disk, as I said, we believe is going to be avery, very substantial market and it definitely is very strategic. But until itmoves to the pricing of MLC, it’s not really in my opinion going to take off.And so far, everybody’s solid state disk, including our own, is based on SLC,and as you know, SLC component pricing has been very high up to this point andin that regard, it is definitely not helping this market in this stage to gobeyond the seeding stage.

I think in 2008, hopefully we will be able to move themarket to MLC and I think at that point, the pricing becomes much more realisticand much more attractive.

As far as the enterprise space, I think you asked, there isdefinitely market that eventually would be -- you know, a significant marketfor solid state disk. But in general, we still think that 2008, although itbecomes a real market for solid state disk, is still relatively small comparedto the growth in cell phones.

People are always looking, you know, where’s the catalystfor 2008, and I could tell you for SanDisk, the catalyst very simply is cellphones and international. All those other markets of course we are addressing,but in relative terms, the handset market is so immense. The growth there isstrong and again, international, because we started from a very low marketshare and very low presence, represents for us in 2008, a very major opportunity nomatter what happens.

I don’t mean no matter what happens, but under reasonableconditions and of course, we don’t know about the Beijing Olympics and the U.S.elections and so on.

Jim Covello - GoldmanSachs

Thank you.

Eli Harari

As far as Samsung, there is really nothing new to report.Everything that I said last time still applies. I think both companies wouldlike to come to some kind of resolution before the current process expires andthat still applies.

Operator

We’ll take our next question from [Ahmed Kapoor] from PiperJaffray.

Ahmed Kapoor - PiperJaffray

Thank you. Just turning again to the handset market, youmentioned that you sold about $42 million mobile units in Q3. I guess doing themath, that looks at about 15% penetration. How should we think of thatpenetration going forward and what are some of the key drivers you are lookingat?

Eli Harari

I would not say 15% penetration. I would say that if thetotal number of handsets sold this year, if 0.5 billion cell phones have cardslots, assuming let’s say 100 million handsets a quarter with a slot, 42million units is not 15%. It is much, much higher than that.

Ahmed Kapoor - PiperJaffray

Okay, so --

Eli Harari

Because not all cell phones have a card slot. We are -- youknow, we started a campaign that we call “wake up your phone” to educate themarket about what the card slot is all about, because we think that mostconsumers today still don’t really know that they can in fact put four, eight-gigabyteinto the cell phone and convert it into a very attractive music player. Sothere is education that has to happen but I think the heavy listing as far as [standardization]and slots and embedded is behind us. I think the iPhone is helping driving thatawareness amongst [consumers].

Ahmed Kapoor - PiperJaffray

That actually leads to my follow-up question in terms ofmost of the phones with memory card slots we see out there seem to be cappedoff at 2-gigabit densities. What do you think are some of the bottlenecks outthere and what do you think is necessary to get those densities up?

Eli Harari

We had a bottleneck last year that most of these phones weredesigned not to take the SDHC, the high capacity SD which caps at 32-gigabyte.I believe that the vast majority of cell phones are already designed to handlethe SDHC, which can go from 4 to 32-gigabyte.

Other than that, it’s the cost of the cards but that iscoming down, so I think that -- Apple in fact eliminating the 4-gigabyte versionof the iPhone and just going with 8-gigabyte is in fact helping us go in theright direction.

I think at 3GSM in February in Europe, you are going to seea huge number of phones that have a lot of gigabytes.

Ahmed Kapoor - PiperJaffray

Thank you.

Operator

We’ll take our next question from Harlan Sur with MorganStanley.

Harlan Sur - MorganStanley

Thank you and great job on the quarter, the execution. Yourguidance, megabyte shipments up 45% to 60% in Q4, given the constraints,obviously, but if you didn’t have these constraints, what do you think themegabyte growth would have been to support the true demand in the fourthquarter?

Judy Bruner

We’re not going to speculate on what the exact growth ratewould have been. However, I will say that we believe it could have beensomewhat higher if we had ample supply.

Harlan Sur - MorganStanley

Okay, and given the supply constraints, it sounds like youare pulling in the ramp of Fab 4. What is the barrier from motivating the teamto accelerate the ramp of 43-nanometer technology? Is it just too early days inthe technology development phase?

Sanjay Mehrotra

Actually, we are making very good progress on 43-nanometertechnology and as Eli mentioned, we will have 43-nanometer technology in Fab 3 startingto ramp up in the Q2 timeframe. So we are working as fast as we can in applying43-nanometer technology to the products, qualifying the products, and gettingthem ready for production ramp to begin in Q2.

Harlan Sur - MorganStanley

Okay, great, and then just one last question; the status ofyour MLC controller development for SSD laptop applications, is the team stillon track to bring that technology out in the first half of next year?

Sanjay Mehrotra

Yes, we are working aggressively on bringing -- applying MLCto SSD and we plan to have products ready by mid next year with MLC/SLC.

Harlan Sur - MorganStanley

Okay, great. Thank you.

Operator

We’ll take our next question from Paul Koster with J.P.Morgan.

Paul Koster - J.P.Morgan

Thank you. I have three related questions. The first one is,is the capacity constraint that you see uniform across the industry, both witha short-term perspective and a sort of ’08 perspective? In other words, are yougoing to lose market share to someone else during this period?

Sanjay Mehrotra

We do not believe that we will lose market share during thisperiod. The capacity constraint, despite our strong output from our fab, is onthe memory side as well as somewhat on the assembly and tests, and we areaggressively working on eliminating some of those bottlenecks and acceleratingthe output through our supply chain to really meet the strong demand that weare seeing for our products at this point.

Eli Harari

I think that there could be some temporary market sharelosses in some regions. We have the -- the U.S. usually around Black Friday,the demand really goes through the roof and we sometimes have to take care ofthat. But we ought to be able to recover that, if that happens.

Paul Koster - J.P. Morgan

I think a number of investors will probably be wonderingwhy, given the supply constraints, the gross margins aren’t shooting up higher.Can you just explain why they are lower than this time last year when thecircumstances were very different, perhaps over-supply was occurring last timearound?

Judy Bruner

Paul, I would say that the primary reason, if you comparegross margin expectations for Q407 to gross margins in Q406, which is I thinkwhat you are asking, is that pricing has come down 60% plus and costs have notcome down to that level in the last year.

Eli Harari

Year over year, I think we said pricing came down about 63%in retail and our costs, although came down very nicely, did not match thatlevel and that’s the real difference.

Judy Bruner

Now, the gross margins we expect will go up from Q3 to Q4,as I said, primarily because there will be a higher mix of 56-nanometer productin our Q4 cost of sales. But again, the cost reduction year over year is notenough to keep up with the price reduction in the low 60s range.

Paul Koster - J.P.Morgan

My last question is we would ordinarily expect a depletionof channel inventory in the fourth quarter, and it sounds like it could be evenmore the case this year, given the supply constraints. What does this imply forthe beginning of ’08 when I think people are concerned that over-supply rearsits head?

Eli Harari

Yes, I mean this -- we are just entering the real heavyselling season for the holiday sell season. I think the next two months willtell where things stand at the end of December, so I think it is premature tospeculate on what it is going to be, and certainly premature to speculate aboutQ1. We know typically, as you know, that seasonally it is weaker than thefourth quarter, but how much we don’t know, because overlying the seasonality,there is also the underlying very strong growth that I mentioned.

Paul Koster - J.P.Morgan

Thank you.

Operator

We’ll take our next question from Tristan Gerra with RobertW. Baird.

Tristan Gerra -Robert W. Baird

Good afternoon. We see a trend where there the central OEMsare increasing, embedded NAND Flash in some instances, de-emphasizing thebundling of the card. That’s the case for the Nokia 95, for example. The 88version doesn’t even have a card slot. Could you give us a sense of the margindifferential between your embedded business and your Flash card business?

And also, your view on the USS initiative and if that takesoff, what is the potential licensing indication for you?

Sanjay Mehrotra

With respect to the embedded business, we are definitelylooking forward to 2008 our embedded business in mobile phone increasing. Weare seeing strong design wins for our iNAND products, as well as we have saidbefore, in the beginning of 2008 we will start shipping multi-chip packagesthrough our Qimonda joint venture.

The N95, 8-gigabyte phone with embedded flash that youindicated only gives a halo effect to increase awareness and making theconsumers aware that high capacities are needed to fully utilize the featuresof these phones. That is by the way, one example of an N95 model; there areother N95 models with card slots as well.

So while embedded in mobile phones, we expect it to increasefor our business in 2008 the card slots as well as card bundling for OEM andthe retail aspect of our business will continue to be strong drivers of mobilegrowth in 2008.

Eli Harari

On the UFS initiative, the spec is not out. The publicity,the advertising is this is going to be the greatest thing since sliced bread.It will have phenomenal performance and it will do things that no other cardhas ever been able to come close. So we'd like to see what happens.

As far as licensing or IP, I believe that we'll have to ofcourse see what the UFS does, but if it's a device with flash trying to emulatea disk drive or a mass storage device, I think that it will more likely thannot be covered by our very extensive licensing patent.

Judy Bruner

Tristan, let me alsoaddress the question you asked about the gross margin of embedded card productsversus removable card products for the phones. The answer is that there is nota significant difference for us in gross margin whether we sell an embeddedproduct or whether we sell a card that's bundled with the phone.

Operator

Your next question comes from Daniel Amir – Lazard CapitalMarkets.

Daniel Amir - Lazard Capital Markets

Congratulations on a good quarter. First of all, on the newtesting and assembly operations in China,Sanjay, can you comment a bit about how it's going and also what the potentialmargin impact this could have on your business in 2008?

Sanjay Mehrotra

So the assembly andtest operation in Shanghai is goingvery well. We are very pleased with our ability to introduce new technologiesfor high capacity mobile cards in this factory.

Our goal is ultimately for this assembly and test factory tomeet 30% of our unit requirements; of course, that will ramp over a period oftime, over the next few quarters.

In terms of the factory's ability to meet costs, it is verycost competitive but in addition to costs, this factory gives us the benefit ofagain being able to introduce fast to market, new advanced technology productsas well as gives us the flexibility to meet the increases in demand that takesplace in our business in times such as Q4.

But overall, we are pleased with the cost competitiveness aswell as the production ramp of this facility.

Daniel Amir - Lazard Capital Markets

The margin impact?

Judy Bruner

The way that I would think about this is that producing aportion of our cards at this captive factory with very competitive costs isjust one of the ways that enables us to reduce the non-memory portion of ourproducts and try to keep the non-memory cost reduction in line with the memorycost reduction, which is achieved through the technology transition. So this isjust one of the many ways, but as Sanjay said, the cost is very competitive.

Daniel Amir - Lazard Capital Markets

It seems like now that you are starting production here inX3 next quarter, can you comment on where X4 stands in terms of potentialproduction and how should we look at the future of both technologies as a majorsource of your future production?

Sanjay Mehrotra

So regarding X4, as we have said before, we are applying X4,we are implementing the designs of X4 on 43 nanometer technology. We will havesamples of X4 in 43 nanometer technology toward the end of the 2008 timeframe,and any production starts will really take place in the 2009 timeframe.

X3, Eli already mentioned that we will be ramping X3 in 56nanometer production in 2008. It will primarily be 56 nanometer; in 2009 itwill be 43 nanometer, and X3 will become an increasing portion of ourproduction output next year. The majority next year will still remain 2 bitmemory, even by the end of next year, and as we ramp up in 43 nanometer X3 in2009, its percentage as part of our total production will increase.

X3 has been designed with a total forecast on reliabilityand performance and we plan to apply X3 over time across all of our productlines. X4 technology will likely be applied first in certain products where itsperformance and specifications can be best utilized, such as possiblyaudio/video players.

Operator

Your next question comes from Vijay Rakesh - Oppenheimer.

Vijay Rakesh -Oppenheimer

As you look at the non-captive mix for next year do youthink it grows? It looks like it's 11.5% here in Q3? Do you think '08 we goback to the 10% or 15% range?

Eli Harari

Yes, somewhere in that range in '08 timeframe. We are notprepared to put a stake in the ground yet for this, but we do believe that weneed non-captive, something around that range in the 2008 timeframe.

Vijay Rakesh -Oppenheimer

As you look at X3 and43 nanometer here, will X3 get to 5% of output by 3Q08? Do you think you canget it to that level by 3Q08 or you still think it's going to be a majority is2 bit?

Eli Harari

As we have said, byend of next year a majority of the output will be 2 bit, but X3 will continueto ramp during the course of the year.

Vijay Rakesh -Oppenheimer

Is 5%, 10% areasonable assumption for Q3?

Eli Harari

I think in the Q3 timeframe we will likely have somewhatmore than 10% in X3.

Operator

We will take our next question from Gurinder Kalra - BearStearns.

Gurinder Kalra - Bear Stearns

As far as your X3 and X4 is concerned, how do you thinkabout the licensing of the technology? Is there a part process which mightsuggest that let's keep it to ourselves and Hynix and not license it out toanybody else?

Eli Harari

X3 IP is somewhat different than X4 IP. X3 IP is verysimilar to MLC, 2 bits per cell. X4 is quite substantially more complextechnology and has its own relevant IP. So I think I would look at X3 and X4 somewhatdifferently. But at this stage I'd rather not comment on that.

Gurinder Kalra - Bear Stearns

My second question, I know you can't comment about Q1 and Ihear you on the demand you are seeing, but we are looking at a lot ofincremental supply coming on sequentially as we go into Q4 and then Q1, andclearly spot pricing has been declining so the chip level pricing doesn't lookthat great. Obviously Q1 last year was pretty painful. What makes you soconfident that Q1 '08 will not have a similar level of pain?

Eli Harari

I've said it many times; let me say it again. We believethat our markets are very young and have really tremendous growth opportunitiesfor us over the next three to five years. We are really planning our future andour entire strategy is based on a fervent assumption that these markets aregoing to grow at a very fast pace and that we need to plan our destiny based ona very fast growth trajectory; vector ramping up, a pretty steep vector. Wecannot slow down in any one quarter, make quarterly course corrections that maylook good for our quarterly results in any particular quarter if that meansthat we sacrifice the big opportunity that we see that we think is very, veryunique.

We are very unique as a company in that we manufacture allour own flash. We're in a pretty good position, I believe, to use 100% of ouroutput throughout the next several years and we have the ability to use otherpeople's flash but we are not a component supplier of service at all. We areessentially building new markets.

I just talked about the need eventually to ramp fab 5.Thereis no way that we can be a significant player in the solid state disk businessin 2010 and 2011 based on the output of fab 3 plus fab 4 plus anything that wecan get from the non-captive market. So these markets are huge, and it's just aparallel front of these markets growing at a very fast pace, and we just haveto plan for that based on our conviction in those markets.

So yes, we worry a great deal about what happens in Decemberor in January or by the first quarter and we manage the business as best we canthrough these difficult quarters, but in the long term, the strategy has provento be very successful for us, and we don't plan to change that model.

Operator

Your next question comes from Edwin Mok - Needham & Co.

Edwin Mok - Needham & Co.

First question is regarding fab 3. Since you guys reached150,000 wafer starts is there any possibility that you guys can squeeze moreefficiency out of that fab and actually increase your wafer starts more in thefourth quarter?

Sanjay Mehrotra

It may be possible to increase it a little bit, but reallynot by much.

Eli Harari

We've asked all operators to lose a few pounds so they cansqueeze by in the aisles. I've never seen a Japanese fab. It's so tight, it isjust unbelievable.

Edwin Mok - Needham & Co.

Just a follow-up question also on the supply constraint. AmI understanding correctly that you have supply constraint because we can go anda buy non-captive supply, they're not qualified within your product? Is thatwhy you guys can go and buy supply from other suppliers? Because it seems to methat there's additional supply coming online in the fourth quarter. Is thatcorrect?

Eli Harari

Until very recently, non-captive supply was extremelyexpensive and would be very difficult for us to conduct our business purchasingat the price that was out there.

Secondly, I have to tell you without naming any names, thequality of flash MLC is really not the same and we do believe that the ToshibaSanDisk MLC quality is significantly ahead of what we can find there, and wehave to be very careful with what we buy. There's a lot of inferior productthat is dumped on the market at any price, and of course, consumers are not awareof that. We need to make sure that if we are in this market and buy substantialoutput of non-captive, that our controllers are sufficiently powerful, potentin terms of error correction and so on to make the those up to our standard.It's not that simple.

Edwin Mok - Needham & Co.

Do you think thatgoing forward though, in 2008, you guys might want to increase non-captive, butyou might be limited by the same issue at all?

Eli Harari

First of all, yes. We've said that we are looking atincreasing our non-captive. We think the non-captive model is a very healthymodel. It's a good model. It probably will not be the 70/30 that we've had inthe past, because I think frankly the numbers are so high looking forward, that30% of our capacity being non-captive would be a huge amount of supply forsomebody else to supply us.

But yes, moving more towards the 15%, 10% to 15%non-captive, I think is something that will be very healthy for us.

Edwin Mok - Needham & Co.

In terms of the mobile phone market, looks like Viper ST wasvery strong. Can you put any color on the embedded side, any new designactivity that you thought was standing out or in terms of growth in that area,what are you guys expecting for the fourth quarter?

Sanjay Mehrotra

I cannot really specifically call out the design wins, but Ican tell you that for our product we do have design wins, and as I saidearlier, we plan to increase shipments of our embedded memory in the mobilephone in the 2008 timeframe.

Operator

Your final question comes from Daniel Gelbtuch - CIBC.

Daniel Gelbtuch - CIBC World Markets

Congratulations on a great quarter. I was wondering if couldyou give some color about or maybe hazard a guess as to where you see ASP permegabyte going down or declining in 2008? Do you think it's going to behopefully much better than this year in the 60s? Can we get back to anequilibrium level of 40 to 45 or 50?

Eli Harari

Honestly, I have no idea. If you had asked me at thebeginning of the year what would be the pricing for 2007, it went down reallylow in February/March. It went way up in the summer months. It's now headingback to where it was in February/March. I've never seen that before in the market, and I would not be able topredict it. I have no idea.

Daniel Gelbtuch - CIBC World Markets

I'd say on a grandscale and a bigger scheme over the course of a year do you think the demandvectors are so strong, coupled with the supply shortages that you envision, youthink that we could have a better, more stable year, I guess, in the biggerpicture?

Eli Harari

Let me say that based on the technology on the cost of the50 nanometer technology compared to 63 nanometer technology, clearly the coststructure of 50 nanometer on 300 millimeter in high volume will allow the kind of pricingthat you are seeing in the market, as we speak for those companies that havethat kind of technology and production.

I believe that this is a very exciting time for SanDisk.You've heard our thoughts of our growing markets, cards for mobile phones andindustrial markets, industrial sales. We're very happy with where we are ontechnology innovations.

I'd like to thank everybody for listening in today. Thankyou very much. Have a nice evening.

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: transcripts@seekingalpha.com. Thank you!