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SanDisk (NASDAQ:SNDK)

Q1 2012 Earnings Call

April 19, 2012 5:00 pm ET

Executives

Jay Iyer -

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

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

Analysts

James Schneider - Goldman Sachs Group Inc., Research Division

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

Daniel A. Berenbaum - MKM Partners LLC, Research Division

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

Sidney Ho - Nomura Securities Co. Ltd., Research Division

Jagadish K. Iyer - Piper Jaffray Companies, Research Division

Ryan Goodman - CLSA Asia-Pacific Markets, Research Division

Bobby Gujavarty - Deutsche Bank AG, Research Division

Betsy Van Hees - Wedbush Securities Inc., Research Division

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

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

Operator

Good day, everyone, and welcome to the SanDisk Corporation's First Quarter 2012 Financial Results Conference Call. Today's call is being recorded. At this time, I'd like to turn the conference over to Jay Iyer with Investor Relations. Please go ahead, sir.

Jay Iyer

Thank you, Jaimie, 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 Regulation G will be reconciled to the most directly comparable GAAP financial measure. That reconciliation is now available, along with supplemental schedules on our website at sandisk.com/ir. Please note that non-GAAP to GAAP reconciliation tables for all applicable guidance will be posted on our website. This guidance is exclusive of any onetime transactions and does not reflect the effect of any acquisitions, divestitures or similar transactions that may be completed after April 19, 2012.

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 discussed in the documents we file from time to time with the SEC, including our Annual Report on Form 10-K for fiscal 2011 and our subsequent quarterly reports on Form 10-Q. SanDisk assumes no obligation to update these forward-looking statements that speak as of their respective dates.

With that, I will turn the call over to Sanjay.

Sanjay Mehrotra

Thank you, Jay. Good afternoon, everyone. I will focus most of my remarks today on describing the key developments we are seeing in the industry and factors in our business that are causing our results to be less than we had anticipated, as well as how we are addressing these developments. We now believe the industry experienced an imbalance between supply and demand in the first quarter, and we believe this imbalance is likely to continue through the second quarter of 2012. Industry demand has been weaker than we had expected, and we believe supplies have increased more than we had estimated at the beginning of the year. This led to greater-than-expected price decline, particularly in the second half of the first quarter, impacting our revenue and gross margin. As we look into the second half of the year, we believe the ramp of new smartphones, tablets, ultrabooks and Enterprise solid state drives, along with stronger seasonality, should lead to an improved demand environment. With this demand, coupled with a modest wafer capacity growth expected within the industry for the remainder of the year, we expect a better supply-demand environment in the second half of 2012.

For SanDisk, our first quarter results were impacted by 2 key factors: greater-than-expected price decline; and slower-than-expected demand for mobile cards from certain OEM customers with whom we have high shares. If you recall, steeper industry price declines for certain products began to be reported in the late part of the fourth quarter of 2011, indicating the existence of some excess supply, which continued in the seasonally weak quarter. We had expected pricing trends to moderate later in the first quarter, but instead, the rate of price decline accelerated even more. Despite the weaker demand for OEM mobile cards, the diversity of our customer base enabled us to allocate more products towards the demand from our white label customers. As such, we met our first quarter petabyte and unit sales objective. However, the different mix of sales than we had originally planned contributed to our weak first quarter results.

I would like to comment on aspects of card demand as we have observed at some of our mobile OEM customers. As a part of offerings and the competitive environment for mobile phones continues to evolve at a rapid pace, some handset OEMs recently began to adjust their bill of materials, resulting in the lower rate of OEM card bundling, as well as a reduction in bundled card capacity. It is too soon to determine whether this is temporary or a longer-term trend, and we are monitoring it carefully. While we are maintaining our market share of bundled mobile OEM cards, we believe that the overall industry demand for OEM bundled cards has been somewhat below previous expectations and has contributed to the supply-demand imbalance in the first half of this year. However, we also believe that lower card bundling rates for slotted phones could translate into expanded opportunities for the retail channel at potentially higher unit capacities.

I will now comment on the second quarter. We expect the first quarter trends of industry supply-demand imbalance and weaker OEM card demand to continue in the second quarter as well. Further, we plan to reduce sales to the white label channels. An additional factor that is expected to impact our growth opportunity in the second quarter is our embedded business. Over the course of the last 2 to 3 years, this business has grown nicely for us, and our approach to drive it through our diversified customer base has worked well. We are a supplier to all the major mobile phone and tablet manufacturers. However, the mobile industry market share is becoming increasingly concentrated, and to fully address the mobile market opportunities now requires a more diversified portfolio of embedded offerings, which include not only iNANDs but also new embedded solutions, such as customer-specific multichip package and other unique and proprietary embedded products. We have been somewhat late in adapting our product roadmap to the broad set of requirements of the leading OEM customers, and this limits our embedded growth opportunity in the second quarter.

We are already in the process of developing and qualifying our new embedded products, including our next-generation, high-performance iNANDs for the leading mobile OEMs. We believe these new products will also expand our embedded market opportunity to a broader range of handsets, tablets and other devices for both the established and emerging markets compared to what we are able to address in the first half of this year. In fact, we have just completed qualification of our MCP embedded solution with a leading OEM and are in qualification at several other customers. With continued successful completion of product development and customer qualifications, we expect our new iNANDs, MCP and other embedded offerings to begin ramping production starting in the second half of 2012, enabling us to gain embedded share with leading mobile OEMs later this year.

In our other businesses, SSD sales posted solid sequential growth. In the Client segment, we launched our SanDisk Extreme Client SSD for both the retail and e-tail channels, and this has received excellent third-party reviews that show its industry-leading performance. Product revenue in these channels is gaining momentum, and we expect to launch additional products in the second quarter. For OEM customers, we successfully launched the X100 high-performance Client SSD and we have achieved stellar design wins already with many of these expected to begin high-volume production in the second quarter. Additional customer qualifications are in progress. Our partnership is conducive, formerly Diskeeper, enables us to offer a uniquely optimized software and SSD solution for SSD cache application, and this further strengthens our competitive position in this segment. Our embedded SSD offering, the SanDisk iSSD, has secured several new design wins in ultrabooks. Overall, for both standalone and caching SSD applications, ultrabooks are gaining momentum and increasing SSD attachments in mobile computing devices.

For the enterprise markets, we have begun qualification of our latest generation of 6-gigabit SAS SSDs at key OEMs. Our PCIe products are on track to begin shipments in the second quarter. Customer engagements continue to gain traction for our enterprise set of solutions. With the recent acquisition of FlashSoft, we added another dimension to our Enterprise solutions, and the initial customer response to our expanding portfolio has been positive. Our strategy to enable FlashSoft solutions to support a broad array of products, including competitive SSD and PCIe products, is important to our target customers. We believe the expanding portfolio and breadth of solutions with our SAS, PCIe, SATA, SSDs and software for our enterprise customers positions us well for continued SSD revenue growth in 2012 and beyond.

To conclude my comments on the SSD business, growth in our Client and Enterprise SSD revenues remains on track to account for more than a 10% mix of our total revenue for the year. In retail, our market share in the developed regions such as U.S., Europe and Japan remain strong. Units sold in the emerging markets more than doubled from last year, and these markets now account for approximately half of our total retail unit volume. Products sold to emerging markets tend to be at lower average capacities compared to products sold in the developed markets, but our average capacity for the total retail business grew on both a year-over-year and sequential basis.

From a manufacturing technology perspective, our 19 nanometer technology is ramping well, with use on both the X2 and X3 memory architectures ahead of expectations at this stage of the transition.

Turning to fab supply, based on the positive 19 nanometer yield trends and our latest estimates of demand assessment and supply requirements, we have decided to maintain the pause of Fab 5 capacity ramp through at least the end of 2012.

In summary, we are disappointed with our first quarter results and our near-term prospects, which we believe will lead to a sequential decline in revenue in the second quarter. We believe our business results for the first half of the year will reflect a temporary setback to our long-term vision and objectives, and we fully expect to reemerge stronger in the second half of this year. We remain highly focused on diversifying and strengthening the mix of our business portfolio. Our SSD business remains on a solid revenue ramp. Our retail business continues to see strong demand growth from emerging markets and we are gaining shares in most regions. Our cost leadership in the industry remains firm. In the second half, with a better supply-demand environment and successful execution with our next-generation embedded products, we expect to deliver strong quarterly sequential revenue growth. We are very confident about the long-term prospects for SanDisk in light of the secular growth drivers for our business from smartphones, tablets, ultrabooks and, in particular, Client and Enterprise SSDs.

With that, I will turn the call over to Judy for her financial overview and outlook.

Judy Bruner

Thank you, Sanjay. I'll cover the key aspects of our Q1 results and then turn to our future expectations. Starting with revenue, our first quarter product revenue was 65% OEM and 35% retail. Retail revenue was down 30% sequentially and down 6% year-over-year, and OEM revenue was down 22% sequentially and down 10% year-over-year. Both our retail and OEM businesses were impacted by a sequential decline in petabyte demand and a steep price decline. In total, our petabytes sold declined 4% sequentially and grew 65% year-over-year. And our ASP per gigabyte declined 22% sequentially and 45% year-over-year.

We had expected this sequential decline in petabytes sold, but as Sanjay described, the industry price decline was steeper than we had expected, particularly in the second half of the quarter. Within our retail business, we believe this sequential decline in petabytes sold reflected normal seasonality. In fact, it was less of a decline than we experienced in Q1 last year. Our retail petabytes sales grew sequentially in emerging markets, and we believe, overall, we gained retail card and USB share in emerging markets and in the U.S.

Our global retail unit sales were in line with our expectations, but the price decline was greater than we had estimated. Within the OEM channel, unit sales of mobile cards grew sequentially, but the unit demand was less than we had expected from certain mobile OEMs. And as we shifted our card mix more toward white label customers, this further increased the decline in our average selling price. Our Q1 mobile embedded product sales were down sequentially in units and dollars, but were in line with the forecast we had provided in January, which already reflected weakness from certain mobile OEMs as well as seasonality. Our SSD revenue, the majority of which is sold through the OEM channel, had strong sequential and year-over-year growth, and we are pleased with the progress we are making in the SSD markets. Our license and royalty revenue was up 18% year-over-year and down 4% sequentially due primarily to a favorable adjustment in Q4, which I commented on last quarter.

In summary, the miss in our Q1 revenue from our January forecast came predominantly from a higher rate of price decline than we had anticipated and from lower-than-expected card demand from certain mobile OEM customers. Our total non-GAAP gross margin was 36%, below our forecasted range of 39% to 42%. Our total cost per gigabyte improved 11% sequentially and 36% year-over-year, which was in line with our expectations even after taking approximately $24 million of unexpected lower of cost or market inventory reserves, resulting from the high price decline.

Non-captive memory represented approximately 8% of our Q1 revenue compared to approximately 11% in Q4. And the yen rate in our cost of sales was in line with our forecast at approximately 78, representing purchases that were locked in primarily during the fourth quarter of 2011.

The gap between our 22% price decline and the 11% cost decline drove the sequential decline in our total non-GAAP gross margin from 43% in the fourth quarter to 36% in the first quarter. Non-GAAP operating expenses of $205 million were down sequentially by $22 million, due primarily to reduced expense for incentive compensation tied to our financial results and a onetime insurance recovery of certain past legal expenses. Operating margin for the first quarter was 19% on a non-GAAP basis. Non-GAAP other income and expense was an expense of $3 million, which included a nonrecurring charge recorded at the joint ventures. Without this unexpected item, other income would have been similar to our previous forecast of approximately $5 million per quarter.

On the balance sheet, cash and short and long-term marketable securities decreased by $143 million and ended the quarter at $5.5 billion on a gross basis and $3.5 billion net of debt at the maturity value. Cash flow from operations in Q1 was $67 million. Our primary cash outflows included $144 million for CapEx, $55 million for the FlashSoft acquisition and $61 million for share repurchases. We had net zero capital investment in the joint ventures during Q1. We provided new joint venture equipment lease guarantees of $156 million, and our total off-balance sheet equipment lease guarantees stood at $737 million at the end of Q1. Inventory growth was in line with our expectations as we sold approximately the same number of petabytes as we had originally expected.

I'll now turn to forward-looking commentary. Our revenue expectations for 2012 have come down considerably due to the 3 key factors we have discussed today. First, while we expect the pricing environment to improve from Q1, particularly in the second half of the year, we expect the steeper price decline in the first half of 2012 to result in considerably lower price levels for the whole year, reflecting a weaker industry supply-demand balance than we had previously anticipated.

Second, market share among the mobile handset providers is consolidating, and we have been adapting our embedded product roadmaps to better address the evolving requirements of the leading mobile OEMs. We expect to complete product development and qualification of many new embedded solutions in Q2, with revenue benefiting the second half of 2012.

And the third factor is that we forecast mobile OEM card demand for the year to be less than our original expectations. We believe these factors, combined with reduced reliance on the white label channels, will result in a sequential decline in our Q2 revenue, with total Q2 revenue forecasted to be approximately $1 billion, plus or minus $50 million. We expect to deliver strong sequential revenue growth in both the third and fourth quarters, driven by sales of new embedded products and accelerating growth in our SSD sales combined with our expectation of an improved pricing environment. However, we expect the full year 2012 revenue will be down from our 2011 results.

Turning to gross margins, I'll provide some color on our assumptions as to cost and pricing. For the full year 2012, our anticipated cost improvement is in the upper half of the 25% to 35% range that we have previously shared. There are 4 key factors impacting our cost assumptions, all of which are included in our expected 2012 cost improvement. First, our 19 nanometer transition and yields are on track or ahead of original estimates. Remember that the 19 nanometer transition generates less cost reduction than did the 24 nanometer transition, and this will result in less cost reduction in Q2 cost of sales than we achieved in Q1, which still benefited from the 24 nanometer transition. Second, our expected usage of non-captive memory has come down from our original estimates for 2012, which has a positive impact. Third, our yen-based wafer purchases are approximately 70% hedged for 2012 at an average rate of approximately 78. While the yen has weakened somewhat, assuming it stays at its current level, our average yen rate in cost of sales for the remainder of the year will be approximately 79, which would result in a slight sequential improvement to our costs. And fourth, our costs include a higher level of expense related to inventory reserves than we had in our original estimates for 2012.

In terms of pricing, we expect some degree of supply-demand imbalance to continue in the second quarter and we expect an improved supply-demand balance in the second half. Factoring in these assumptions, as well as our forecasted product mix, we expect our total non-GAAP gross margin to decline in Q2 to approximately 28%, plus or minus 2 points. We currently expect the rate of price decline and cost decline to be similar in the second half, with product mix helping to improve this comparison. And we believe this will lead to gross margins at approximately the Q2 level and possibly improving modestly.

Non-GAAP operating expenses for Q2 are forecasted to be approximately $225 million, with the sequential growth primarily in R&D and also in G&A due to the legal credit reflected in Q1 results. Given our lower revenue and margin expectations for 2012, we are lowering our expense forecast to $920 million on a non-GAAP basis for the year, down from the $975 million we shared in January. This reflects reduced incentive compensation and a somewhat reduced rate of hiring, with year-over-year growth primarily focused in R&D. We expect non-GAAP other income to be approximately $5 million on a quarterly basis, and we forecast an effective tax rate of approximately 30%. With our decision to pause Fab 5 expansion for the remainder of the year, our 2012 capital investments are now forecasted to be at the lower end of the $1.1 billion to $1.6 billion range we provided in January. We now expect free cash flow, exclusive of M&A, to be negative in the first half of the year and positive for the second half of the year. We plan to continue utilization of our share repurchase plan, with an objective of holding our share count approximately constant from the end of 2011. We are disappointed with our results and near-term outlook, but continue to be confident in the medium- to long-term growth prospects of our industry and SanDisk. We expect an improved industry supply-demand environment in the second half, and we are adjusting our embedded product mix to leverage the growth opportunities in the mobile markets. We are pleased with our SSD progress and expect that the contribution of our SSD products to our growth will accelerate across 2012 and beyond.

In summary, we are managing our product and our capacity investments to return to growth and stronger profitability. We will now open the call for your questions.

Jay Iyer

Thank you, Judy. Jamie, could you poll the floor for questions, please? And if I can ask the callers to ask one question and a brief follow-up, that would be appreciated.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Jim Schneider with Goldman Sachs.

James Schneider - Goldman Sachs Group Inc., Research Division

I was wondering if you could maybe comment on the overall NAND bit growth supply outlook for 2012. What have you been hearing in terms of competitors? Do you have any adjustments to your overall industry bit growth expectations for 2012? And then where do you think SanDisk will come in relative to those?

Sanjay Mehrotra

So in terms of the industry bit growth, third party estimates, put it on an average around 71% over 2011. And I think their high end is around 75%. We think that the industry bit growth will be likely higher than the averages that are estimated by the third parties. Regarding SanDisk bit growth itself, we have said earlier that given it will be somewhat less than last year's bit growth, and last year's bit growth was 77% and given the improvements in our 19 nanometer ramp, as well as 19 nanometer yield, we would expect our bit growth to be somewhat higher than our prior expectation.

James Schneider - Goldman Sachs Group Inc., Research Division

And then, I guess, maybe you could give us a little bit of commentary on the Fab 5 restart. Clearly, things are weaker so you're pushing out the capacity additions, but what are the factors you look to determine when and whether you should restart that and when is the first opportunity that you could do that? Is that early in 2013 or potentially even later than that?

Sanjay Mehrotra

So the main factors that we look at is our demand assessment for the future, as well as our status of our technology and yields and production ramp. And based on that, we have decided that we will not restart the ramp anytime this year. So the earliest it could start is in 2013, some time. We have not made a determination of the timing. But again, the factors that we look at will be the future demand assessments and our overall supply requirements. And generally, in terms of equipment to add capacity, you need around 4 to 6 months. And if we continue to work closely with the equipment suppliers in terms of managing the timing of the deliveries to meet our future requirements in the fabs.

Operator

And we'll take our next question from Craig Ellis with Caris & Company.

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

Sanjay, as you think about the embedded products that you're repositioning for the changing smartphone OEM requirements that you talked about, what gives you confidence that with those coming to market or being developed in 2Q, you're going to get design-ins [ph] right away in the back half and what's the risk that those products really don't get designed in until 2013?

Sanjay Mehrotra

So some of those products actually are already in the design phase. As I said, they are already in qualification stage and those qualifications will complete in Q2 and ready for production ramp starting Q3 and continue to grow and increase our opportunity in shares in second half. And some of the products are in late stages of development, and we plan to enter qualifications in the second quarter. And they will continue to -- we'll continue to work with the customers and work on the qualifications. And I'm feeling confident that with the strong track record that SanDisk has on execution, I believe that our engineering execution will come through successfully with respect to the second half opportunities. And again, I would like to remind you that we work with all leading mobile OEMs and we continue to work closely with them, interact with them and work on understanding their business requirements and giving them visibility to our roadmap and the status of the products, and work very closely with them in terms of qualifications. So I have high confidence. And these new products basically leverage SanDisk's core strength in terms of our technology, in terms of our systems expertise and in terms of our manufacturing expertise. So really, they go to the heart of our core strengths and we have good confidence in terms of our ability to ramp them in the second half.

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

And can you state [ph] if those are 16- and 32-gig products or are those lower density 8-gig products?

Sanjay Mehrotra

Actually, they range in capacities, from low capacity to high capacity. As you know, their embedded requirements have a wide range of products across the host of -- across the slew of mobile devices. And these products will be in all those ranges, I mean full capacity range.

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

Okay. And then as a follow-up, but switching to the SSD side of the business, the company got into the year looking for SSDs to be about 10% of sales, and Kanau [ph] with a much slower revenue growth outlook. But with other companies like Intel saying a much bigger number of ultrabook designs for 2012 than they were looking for just 2 or 3 months ago, why wouldn't we expect to see your SSD business be a much greater percent of sales this year than 10%?

Sanjay Mehrotra

So as we had earlier said that we expect SSD business to be approximately 10% of our 2012 revenue, and we are saying now that we expect it to be more than 10% of our business. Keep in mind, we are absolutely expecting strong growth in our embedded business in the second half of the year as well. And certainly, as the price points become more attractive in the NAND industry, this will accelerate the adoption of SSD and the growth of SSD positively as well.

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

Can you quantify how much greater than 10% you'd expect, Sanjay?

Sanjay Mehrotra

Not really. I think we are very focused on continuing to drive and maximize our opportunities in widening the product portfolio. But at this point, I would say more than 10%.

Operator

And we'll take our next question from Daniel Berenbaum with MKM Partners.

Daniel A. Berenbaum - MKM Partners LLC, Research Division

Sanjay, you've alluded to potential changes in the card market. Can you elaborate on that a little bit? Are you talking about just the density of cards not increasing as you expected? Or are you talking about overall slower card unit sales? Can you help me understand what's going on there?

Sanjay Mehrotra

So as you know, the mobile phone market has been extremely dynamic and you know there are significant share shifts happening in that market. And several of the handset manufacturers have tremendous pressure to reduce their BOM costs. They have tremendous pressure from network operators as well to reduce the BOM costs. So each one is addressing these in somewhat different fashion. In some cases, they are not -- they have reduced their bundling of the cards with the slotted phones. In other cases, they have lowered the capacity of the card that they were previously bundling. Some are also -- have indicated to us that they are counting on more bundling happening in the region, with the network operators potentially bundling cards with the phones depending upon the demand considerations and the consumer profile for the regions. So there is a variety of steps that these mobile handset device makers have taken in terms of managing some of the cost pressures that they have. And of course, this is including -- these are phones with embedded flash, and in some cases, some of this is also going towards phones with embedded flash. And as I said in my prepared remarks, this could mean opportunity in the retail channel that the card for the aftermarket with the mobile phone demand picks up. It's just too early to tell that to what extent. To the extent that any of these card demands moves from bundling to the retail channel, as you know, we are very well positioned across the globe in terms of our retail brand and retail sales distribution channels. And we are leading global shares, so we will be able to benefit from that trend to the extent that it materializes.

Daniel A. Berenbaum - MKM Partners LLC, Research Division

And what percentage of your OEM business now is card versus embedded?

Sanjay Mehrotra

We have said that's about -- just keep in mind that our SSD business is increasing, right? So when we talk about OEM business, that now just not only includes cards and embedded and, of course, USB drives, but also now includes SSD. So our total card business, which includes selling to these OEMs, as well as selling to the white label channels, that total business, that's what we classify. That's where the cards are addressed. And we have said before that within OEM, our embedded business is approximately -- for first quarter, approximately 32% in the first quarter. About 1/3 of our OEM business is cards -- is embedded. So the rest is cards plus SSD. And SSD is included in that total number of OEMs. But let me just be clear again, the 33% is embedded.

Daniel A. Berenbaum - MKM Partners LLC, Research Division

Okay, great. Okay. And then sorry,. Judy, just one last question. You talked about $24 million in inventory charges this quarter, if I heard you right. Do you anticipate more inventory charges in Q2?

Judy Bruner

It is possible that we will take additional inventory charges in Q2. As I said, we do expect some level of supply-demand imbalance to continue into Q2. And that could result in us taking additional inventory charges depending on the forward-looking -- the pricing in Q2, as well as the forward-looking forecast of pricing and product mix, but we are adjusting our product mix in order to rely less on some of the low-priced channels.

Operator

And we'll take our next question from Vijay Rakesh with Sterne Agee.

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

I was just wondering, going back to the last question, how much of your exposure is bundled cards on the handset side specifically?

Sanjay Mehrotra

Bundled cards in the first quarter approximately contributed to -- I mean, contributed approximately 10% of our total revenue.

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

Again, that's the segment where you're seeing some dislocation, where OEMs might stop bundling cards or they're trying different strategies, right?

Sanjay Mehrotra

That's right.

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

Okay. And when you look at the inventory in the channel between -- on the handset side, especially with the market share shifts, you mentioned you work with your engineering expertise, you are trying to restrategize your approach to that market. The one guy that you're not having exposure, obviously the biggest, the #1 guy on the handset side, on the smartphone side. How do you see your prospects there given your expertise and your position in the handset market?

Sanjay Mehrotra

So as we have said before, we are a supplier to all leading mobile handset suppliers. So we really are a supplier to all leading handset manufacturers. So we are, and the opportunities that we have in the works will be addressing the entire set of mobile OEM handsets.

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

Do you expect in the second half to be able to supply to the #1 smartphone handset supplier in the market today?

Sanjay Mehrotra

Actually, we expect that to be increasing in the second half because we are already supplying to all of them today and we expect with our strong product roadmap to increase our share there.

Operator

And we'll take our next question from Sidney Ho with Nomura.

Sidney Ho - Nomura Securities Co. Ltd., Research Division

So if I do my math right, looking at the second half of the year just to get to revenue breakeven with the previous year, you kind of need 15% a quarter for each of the next 2 quarters, which is pretty big relative to the last 5 years. Should I think of demand in terms of unit as similar versus pricing, maybe a little better?

Judy Bruner

So Sidney, I said in my prepared remarks that we now expect the full year revenue for 2012 to be less than the revenue that we achieved in 2011. That said, we do expect strong sequential growth in the revenue in Q3 and in Q4.

Sidney Ho - Nomura Securities Co. Ltd., Research Division

Okay. And then my follow-up question is that follow-up to the last question. It seems to me that if you're not the top 2 OEM in the smartphones, you're kind of out of luck at least for the first half of this year. How are you confident that when you start seeing the build this year, that you're not really setting up another inventory corrections towards the end of the year?

Judy Bruner

Again, we said that we are supplying to all of the mobile handset providers, but we expect that we will be able to increase our share in many places, including with the leading mobile handset providers in the second half. And as Sanjay said, many of those new embedded products are already in qualification. So we're quite confident in our ability to increase our share and exposure with many of the leading mobile OEMs in the second half and to grow our revenue sequentially because of that, but also because of the accelerating growth of our SSD revenue and also because we believe there will be an improved supply-demand environment, which will mean a lower level of price decline in the second half. And clearly, we believe that our actions in terms of managing our capacity growth in Fab 5 will help us achieve the right level of supply-demand balance.

Sidney Ho - Nomura Securities Co. Ltd., Research Division

Just to clarify, so do you have visibility, pretty good visibility about the design wins, not the units through the end of the year by now?

Sanjay Mehrotra

As we said, we are in qualifications with several new platforms. And yes, we have visibility to the design win opportunities and we are engaged with them, and certain of the products are under qualification, under development and they will complete development and qualification in the second quarter for our second half growth opportunities.

Operator

And we'll take our next question from Jagadish Iyer with Piper Jaffray.

Jagadish K. Iyer - Piper Jaffray Companies, Research Division

Two questions. First, I just want to understand, Sanjay, what do you think your market share would be by the end of this year in terms of the overall embedded market, and where do you see that going forward by end of '13? And I have a follow-up.

Sanjay Mehrotra

In terms of the market shares, overall, I would say that in the first half for the total embedded market, our market share is somewhat challenged. But let me be very clear that for the iNAND market specifically, we will be maintaining our share in the first half, Q1 as well as Q2. As I mentioned, due to the fast-evolving requirements in the mobile market, particularly with the leading handset providers, some of their embedded solution requirements have moved towards certain customs and proprietary solutions, including MCP. And those are the ones that are in development. Obviously, we don't have share in that section today for those new products. But as we qualify them in the second half, we will be significantly increasing our share in the embedded market with complete set of product offerings to address most of the opportunities in this market segment, both mobile phone as well as the tablet segment.

Jagadish K. Iyer - Piper Jaffray Companies, Research Division

Okay. Just a follow up, Judy, and how should we think about -- I know you kind of gave some parameters on gross margins, but I just wanted to understand on how the pricing environment is for the SSD segment. Is it also weaker in the first half? Can you give some qualitative comments, please?

Judy Bruner

Sure. Actually, the pricing environment in the overall NAND industry has less of an impact on our SSD products than it does on most of the other products in our portfolio. And so our increasing SSD mix, we believe, is a positive for our product mix and for our margins. But keep in mind that our SSD mix is not going to be significant enough this year to materially impact our overall gross margin profile, but it is an improving factor in our gross margins.

Operator

And we'll take our next question from Ryan Goodman with CLSA.

Ryan Goodman - CLSA Asia-Pacific Markets, Research Division

First, I just wanted to know if you could comment on what you are seeing in SSD inventory in the channel at the OEMs. I know it did pretty well for you guys. I've been hearing from others that there is some build out there.

Judy Bruner

Actually from what we can see of the channel inventory, we believe it is at normal levels, both in our OEM channels as well as in our retail channels.

Ryan Goodman - CLSA Asia-Pacific Markets, Research Division

Okay, great. And then just one other question on SSDs. I know in the Analyst Day you had a slide showing maybe 25% or so of the notebook SSD, these are just Client SSDs, this year would be the dual-drive form factor where you have some cache with the HDD. First, just how is that looking at this point, we're a couple of months later and starting to see how the price points are coming out. And two, if that does end up shifting to more of the dual-drive solutions, how do you think about it? Is that a positive in terms of potential future gains just given your iSSD product offering or is that more of a negative just in terms of overall goods being shipped?

Sanjay Mehrotra

I didn't fully get the first part of your question and I would like to ask you to please repeat it, but let me first answer the second part of your question. With respect to the dual-drive opportunity, we actually look at it as a very strong opportunity for SSDs. Dual-drives will be bigger part of the market, we believe, in the ultrabook. And with our strong lineup of product offering, both from the cost sensitive part product offerings as well as high-performance product offerings, we are very well positioned. And then on top of that, the conducive formerly Diskeeper caching opportunities that really will enable to deliver strong performance with that software. All of that will really bode well. So I think, basically the dual-drive opportunity is a very strong opportunity. Of course, it comes at lower average capacity per unit compared to a standalone hard disk drive in a notebook device or in a ultrabook or mobile device. But units will be very large and this is a large opportunity for SSDs. And I would like to ask you to please repeat your first question.

Ryan Goodman - CLSA Asia-Pacific Markets, Research Division

Yes, I guess, just at the Analyst Day, I had seen a slide in your deck that showed that you got maybe 25% or so of the total notebook SSD opportunity in 2012, would be these dual-drive solutions. We're just a couple of months later, so I wanted to get an update on that on where you're seeing things play out in the pipeline.

Sanjay Mehrotra

I think that trend overall continues to look very positive in this regard. I mean, you'll hear announcements, as well as Intel continuing to really update the market in terms of by end of the year 40% to be ultrabooks. And it's a strong growth opportunity there for SSD. So I think all trends are looking good.

Operator

And we'll take our next question from Bob Gujavarty with Deutsche Bank.

Bobby Gujavarty - Deutsche Bank AG, Research Division

I mean, my question is a little bit more strategic, I guess, in that -- I mean, if I look at what you've done on a revenue basis, I mean, if I look at a 5-year CAGR from kind of '07 through '12 now based on the new guidance, your revenues actually have undergrown Intel by a significant amount. And I don't think most investors would consider Intel a growth company. So I was just curious if you have rethought your company as more of a traditional semi company that focuses on cash returns, dividends and stock buybacks because it doesn't appear you've been very successful in terms of growing the top line.

Judy Bruner

Bob, I view 2012 as a speed bump in terms of our growth trajectory. And we're disappointed with this result, but we believe we will get back into a growth environment again. And so I would just say that calculating through the 2012 number is somewhat putting the damper on that calculation. And we believe that we are in a favorable growth industry. We believe that over the next several quarters and couple of years that we will be gaining share in some of the faster growing segments of the industry, such as SSDs. And we believe that in the second half of this year, we'll have a very strong and diversified portfolio, particularly with these embedded products that we are adding to the mix.

Sanjay Mehrotra

And our leadership in technology and costs, which is key for our ability to drive the growth in these markets, is really continuing to be very strong as well. So I think the industry fundamental, the demand drivers are very strong, as well as all the fundamentals that are within SanDisk's control. We really are continuing to do a good job and that we are very excited about the opportunities ahead for us in embedded and SSD business, while continuing to have a solid position on the retail side of the business, retail and card and USB drive side of the business as well.

Bobby Gujavarty - Deutsche Bank AG, Research Division

Okay. Maybe a quick follow-up then. It seems like this downturn is a little bit different than previous downturns in that most of the industry and yourself have been very disciplined in terms of your investments and your CapEx. Would you agree with that assessment and that previous downturns are driven by some excess investment while this one is a little bit different?

Judy Bruner

I agree with that, Bob, that it is a little different in that regard. And in fact, that is what gives us optimism for coming out of this. You used the word downturn. I'm not sure I would use the word downturn as opposed to a speed bump. But coming out of this, I would say, easily than in the past in terms of cycles that we've encountered in the past. And as we think about 2013, we believe that the industry bit supply growth for 2013 is likely to be in the 50% to 60% range. We've shared that previously. And now, with these lower prices in 2012, which admittedly are weighing on our top line and our bottom line, but with these lower prices we believe we could see an acceleration of elasticity in some of the key markets, in particular the SSD markets, and also to some extent in tablets and smartphones also. So that gives us the optimism that we can come out of this cycle and return back to the strong profitability and growth that we have enjoyed for the last couple of years and do that more easily than in the last cycle.

Sanjay Mehrotra

And I would just also like to add that compared to the past, the markets that NAND flash is addressing today are diverse, very large. I mean we are looking at 1 billion smartphones in another 3-years-or-so timeframe. We are looking at tablets, 600-plus million units of tablets, in a similar timeframe on a per year basis. And so these are very, very large markets now compared to few years ago. And of course, as you pointed out, the supply restraint that is generally shown in the industry has been very different compared to the past as well.

Operator

And we'll take our next question from Betsy Van Hees with Wedbush Securities.

Betsy Van Hees - Wedbush Securities Inc., Research Division

I was wondering if you could help us understand a little bit in terms of what the design cycles are for your embedded products, what the design cycles are for SSDs given that the mobile business, you're talking about qualifications that are going to happen in Q2 that are currently in the works. And then you have other products that are in development. And so if you could help us understand how those design cycles will play out, it would be great, I'd really appreciate it.

Sanjay Mehrotra

So in terms of, let's say mobile OEM manufacturers, before we have a product qualified by customers, we, of course, qualify it internally and then we share that data qualifications with the customers, as well as work with them for them to qualify our products. And typically, their cycles, qualification cycles can take varying amount of time depending upon the timing of various model introductions. But generally, they could be anywhere from 1 month to 2 months or so before products get typically qualified by mobile OEMs. On the SSD side, qualifications tend to take a little longer. And of course, on the Enterprises SSD side, they take even longer.

Betsy Van Hees - Wedbush Securities Inc., Research Division

And then, Judy, you talked about the pricing environment in the first half of the year being, I think, I don't know if tough's the right word, and in the second half of the year, I think you said you still expected some pricing pressure. Is that how I heard that correctly?

Judy Bruner

Not exactly. What I said is that I do expect there to continue to be some supply-demand imbalance in the second quarter, and therefore, a gap between what we expect in terms of pricing and what we expect in terms of cost decline. By the second half, we believe we'll be in a much improved supply-demand environment given reduced capacity growth in the industry and/or continued essentially very low capacity growth and strong demand cycles and the seasonality of the second half.

Betsy Van Hees - Wedbush Securities Inc., Research Division

So are you expecting NAND prices to be flat or go up in the second half of the year? Is that what you're thinking is going to happen?

Judy Bruner

No, I didn't necessarily say that, but we're expecting a much improved pricing environment, meaning much lower level of price decline than what we see in the first half.

Betsy Van Hees - Wedbush Securities Inc., Research Division

And then one last question, in terms of your OEM business, how much of that OEM business was embedded?

Judy Bruner

Sanjay answered that question earlier, and what he said is that the embedded was about 1/3 of our OEM business, with the OEM business including our SSD businesses.

Operator

And we'll go next to Philip Lee with Lazard Capital Markets.

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

This is actually Daniel Amir. A couple of questions here. First of all, in terms of -- the other cycles were basically a lot more supply driven in terms of the decline in the market. And just a follow-up to a previous question, do you think that other players in the industry will follow kind of the more disciplined supply approach that you've taken here, in fairly quickly actually correcting kind of your behavior in order to address this market? And then I have one follow-up question.

Sanjay Mehrotra

I think if you look at last couple of years or so, even last 3 years, I think industry really has shown the strain in terms of growing capacity, adding capacity. And speaking for ourselves, we certainly are very committed to it and we continue to manage this very closely. And based on the reports that you hear in the media, I believe that rest of the industry is continuing to demonstrate supply growth constraints as well.

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

Okay. And with regards to the white label comment, can you better explain why, for instance, for Q1 you actually sold a lot into the white label card market, and in Q2, you're stepping away from that market? Can you just help explain kind of why you're doing that or why you're changing that?

Sanjay Mehrotra

So as some of the card bundling demand from our mobile OEMs reduced in the first quarter, particularly in the second half of the first quarter, we decided to make up for some of that lost revenue opportunity into the white label channel. And we sold more in that white label channel. And of course, as you know, the pricing environment in the industry in the second half declined considerably as well. So regarding the second quarter, when we look at white label channel, our considerations are that we want to make sure that it meets some of our profitability objectives. And this is why we believe that we will be reducing our sales into the channel in the second quarter.

Operator

And we'll take that final question from Mark Newman with Sanford Bernstein.

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

I had one quick question on your node transition. So normally, as new next advanced node of NAND flash is sold into the market and ramped up, we see some performance hit and lower level of endurance in the NAND components and often lower prices. I just wondered if you're seeing a lower level of performance or endurance in your 19 nanometer NAND flash and hence, any kind of lower pricing for that versus more mature nodes?

Sanjay Mehrotra

Let me be very clear that our 19 nanometer flash memory components are among the best quality components in the industry in terms of their specification. And of course, as you advance the technology generation, flash memory scaling becomes more challenging and the reliability considerations do become more difficult. And this is where you need the system expertise and the controllers and advanced algorithms that are implemented in those controllers to overcome the inherent weaknesses of some of the memory aspects. So in terms of memory component alone, we have high reliability components. But in terms of our system level solutions, they're our controllers, it manages the performance and the reliability and the operation of the flash memory, we have very high reliability products and no degradation in overall certifications going from one generation at the systems level to the next generation of system level products.

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

I see, fair enough. So you're not seeing a hit from the node transition then? It seems to be mostly pricing from the markets overall and maybe even a mix transition due to your move to more white label costs, perhaps. Going forward to second half, you mentioned the demand strengthening, fully understand that. Any comments on demand for 2013?

Sanjay Mehrotra

So as you look at the market demand drivers, the smartphones, the tablets, Client SSD growing, Enterprise SSD growing, so all of these really point to strong growth drivers. So we think demand will continue to build up in 2013 as well, and overall demand trends are continuing to be strong, even in 2012. It's really only the card bundling aspects that we refer to that really has impacted some of the demand trends. So I think the fundamentals of demand growth strength in our industries continue to be strong, and we definitely believe that they will be strong in 2013 as well. And to your earlier comment, yes, you're absolutely right that 19 nanometer has nothing to do with any aspect of supply or excess supply or price decline in the industry. It is really just only that in the industry, there is some excess supply, more supply than what was previously expected and a little bit of an impact in terms of demand side, particularly related to bundling, causing some exaggerated imbalance and steep price decline.

Jay Iyer

Unfortunately, that's all the time we have today. We would like to thank everyone for joining us, and a webcast replay of today's call should be available on our IR website at sandisk.com/ir. Thank you, and have a good evening.

Operator

That does conclude today's conference. We do thank you for your participation.

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