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M-Systems (FLSH)

Q4 2005 Earnings Conference Call

January 25th 2006, 12:00 PM.

Executives:

Lee Roth, KCSA Worldwide, Investor Relations

Dov Moran, Chairman, President and Chief Executive Officer

Noam Kedem, Vice President of Business Development and Marketing

Ronit Maor, Chief Financial Officer

Analysts:

Daniel Gelbtuch, CIBC

Sam Doctor, JP Morgan

Craig Ellis, Citigroup

Dan Harverd. Deutsche Bank

Eric Gomberg, Thomas Weisel Partners

Alex Gauna, UBS

Craig Ellis, Citigroup

Jonathan Half, UBS

Operator

Good day. My name is Jackie, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the M-Systems Fourth Quarter 2005 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. If you would like to ask a question during this time please press “*” then the “1” on your telephone keypad. If you would like to withdraw youe question press the “#”. Thank you. It is now my pleasure to turn the floor over to Lee Roth of KCSA. Sir, you may begin your conference.

Lee Roth, KCSA Worldwide, Investor Relations

Thank you Jackie, and good morning everyone. This is Lee Roth with KCSA Worldwide. With me on the call today are Dov Moran, President and Chief Executive Officer; Ronit Maor, Chief Financial Officer; and Noam Kedem, Vice President of Business Development in the US. You should have all received the copy of the press release, which was issued earlier this morning. If you have not received this release, please refer to M-Systems website at www.m-systems.com.

Now, before we begin, I would like to mention that the matters discussed on this conference call include forward-looking statements that may involve a number of risks and uncertainties. We caution you not to place undue reliance on these forward-looking statements, as they are subject to various risks, which may cause actual results to vary significantly. These risks include but are not limited to the risk factors detailed in the company’s most recent Form 20-F filed with the SEC and all of its other filings with the SEC. Also, M-Systems assumes no obligation to update such forward-looking statements and disclaims any obligation to publicly revise any such statements to reflect any change in expectations or in events, conditions or circumstances on which any such statements may be based.

With that said, I would like to turn the call over now to Dov, Ronit, and Noam who will provide you with an update on the business during the quarter including a review of the financials. After that Dov, Ronit, and Noam will be glad to answer any questions you may have. With that said, it is now my pleasure to turn the floor over to our President and CEO, Mr. Dov Moran. Dov, go ahead please.

Dov Moran, Chairman, President and Chief Executive Officer

Thank you. Good morning everyone. Thank you for joining us for our fourth quarter earnings conference call. Our fourth quarter was a record quarter at the end of a record year for M-Systems. 2005’s revenues grew by 55% compared to 2004 revenues with net profit more than doubling. We experienced tremendous demand for our products, particularly our DiskOnKey and our DiskOnChip for the mobile market.

I will begin going through our activity in all product lines and then Ronit who I am also delighted to report gave birth a month ago will provide some details about the numbers. I will conclude with a short review of Q1 and 2006 in general, the flash market, the challenges we face and outlook. I will begin with the products. Our DiskOnKey activity grew by almost 50% in 2005, exceeding the overall growth in the USB flash drive market. We also maintained our position as the number one choice for OEMs in these markets.

Our supply agreements with the leading flash vendors proved invaluable as flash supply became tight. Thanks to these agreements, which, as you know, grown peers capacity. We were able to grow our market share in the USB flash drive market at times of sharp growth in demand and tight supply. Looking to the future, we continue to expect great things from our DiskOnKey activity. U3 is gaining trust among customers as well as software developers. At the end of Q4, there were 10 OEM brands shipping U3 products compared with only one brand going into the quarter. U3’s Software Central has been doubling the number of new titles available online every month, currently displaying 75 software titles including programs from household names such as Skype, AOL and Yahoo!. We expect to see a U3 effect in 2006, particularly in terms of enjoying accelerated growth in the smart USB flash drive category as more and more software applications are launched for the U3 platform.

The U3 platform is increasingly providing the necessary differentiation and value proposition to enable our customers to reach new segments in a substantial way. We estimate that by the middle of 2006, close to half of USB flash drives sold in the US will be U3 smart drives. This is an amazing achievement and a great step forward in changing the IT world. I am very happy and very proud to be playing such instrumental role in the paradigm change.

Turning to our mobile activity, as expected, our mobile activity experienced the most significant growth, doubling from $67 million in 2004 to $135 million this year. Mobile revenues in the first quarter reached $65 million, 127% higher than Q3 and 165% higher than Q4, 2004. I repeat, 127% higher than Q3. These results could have been even stronger. Simply put, had we had greater quantities of Mobile DiskOnChips, our revenues would have been higher. These strong results, we believe, demonstrate not only the increase in NAND penetration into handsets and other mobile devices, but also that the benefit of an embedded flash drive architecture where the controller is tied to the NAND are being recognized. Within the EFD category, our DiskOnChip embedded flash drive is the leading EFD on the market designed into phones and other mobile devices from all the leading vendors in these markets.

In the past year, I have repeatedly mentioned the need to develop additional sources for our DiskOnChip. I’ve talked about the fact that being a single-sourced solution was to a certain degree an impediment in the adoption of DiskOnChip, particularly, in mass volume, high-end feature phones. A few weeks ago, we presented our long awaited multi-sourced DiskOnChip, the DOC H3. Because H3 is a multi-chip solution, it can utilize standard raw NAND, which we can source from our different flash partners. Subsequently, Toshiba and Hynix also announced that they will manufacture and sell DOC H3. In addition, DiskOnChip H3 allows us to utilize at any given time the most advanced and lowest cost flash technology available from our partners. I estimate that most H3 will be sold with MLC NAND providing a significant cost benefit to our customers compared with the other available solutions in this market. I will now turn the call to Noam to elaborate further on the new H3. Noam?

Noam Kedem, Vice President of Business Development and Marketing

Thank you Dov. DOC H3 brings a smarter approach to personal storage. It is a self-contained embedded flash drive, which transparently utilizes the latest cost-effective raw NAND flash materials for multiple fabs. Toshiba called it the efficient way for system designers to tap into our leading flash memory technology in an onboard storage form and Hynix spelled it out as an immediate path to the benefits of our most advanced technology and cost-competitive solution. By integrating our patented TrueFFS flash file system internally for the first time as firmware and by using a standard hardware interface just like hard drives, the virtually plug-and-play DOC H3 can practically immune handset and consumer electronics device designers to traditional design tradeoffs.

Our monolithic G series MDOCs were the right approach to promote embedded NAND in mobile devices in the last couple of years and continue to offer a good choice for densities below 256 megabytes, 2 gigabytes. However, they also take longer to develop and have only one fab source. In 2006, 2007 due to the growing density requirements in handsets and consumer electronics, as well as the rapid evolution of NAND technology in varying and sometimes incompatible directions, designers using monolithic single-die EFDs (Embedded Flash Drives) may get to market with stable products, but these stand to age faster offering a limited upgrade path to newer flash technologies as they become available.

In short, new flash may be more cost-effective, but it is also tough and sometimes impossible to handle in raw form long after it has been introduced. With DOC H3, designers can have the best of both worlds, the cost and other advantages of new flash with the stability associated with a mature solution and most important, a familiar standard interface regardless of which type of flash is inside the chip. To quote TI, “The new DiskOnChip H3 architecture enriches the ecosystem we are building, making integration and testing of the latest raw flash technologies with TI’s family of OMAP processors virtually effortless. It will help our customers focus their efforts on making superior products faster.” And if I may add, while keeping them within budget.

On the business side of things, DOC H3 is the first truly multi-sourced embedded flash drive, which will utilize generic raw NAND wafers from multiple partners. As a direct result, DOC H3 will also be offered through multiple vendors. Multiple sources can reduce supply chain risks as well as optimize costs.

Furthermore, the integration of our TrueFFS flash file system into DOC H3 helps fabs standardize around DiskOnChip architecture as it practically takes away the pains of maintaining specialized wafers or supporting software integration efforts on the system host, efforts which call for a well-trained work force. Another advantage of the multi-source strategy and the multi-chip architecture of DOC H3 lies in our ability as a fabless company to tap into multiple fabs’ flash roadmaps instead of tying ourselves to a single fab technology and allocation quotas. As we do so, we can work with several new sources of raw flash material, utilizing our most advanced controllers in real time. This spells freedom, freedom to choose the raw material most appropriate for the task, freedom to develop our products in short time-to-market cycle to complement today’s intensive end application design cycles, combine the business aspects with the technology and you have got a winning value proposition. DOC H3 is truly a remarkable product. Back to you, Dov.

Dov Moran, Chairman, President and Chief Executive Officer

Thank you, Noam. We believe DOC H3 will further enhance DiskOnChip’s adoption into mobile handsets and other mobile devices and solidify DiskOnChip’s position as the leading EFD on the market.

I am also pleased with the progress of our other mobile activity in the SIM card market. As you know, in the first quarter, we completed the acquisition of Microelectrónica. With this acquisition, we established a direct sales channel to mobile network operators, which we view as very important for our mobile activity, particularly in creating an independent sales channel for our MegaSIM and mobile memory cards. We expect our MegaSIM card product to be ready at Microelectrónica at the end of Q2 and moving to production in Q3. We expect our first sales in Q3 as well, although quantities will not be high. We expect ramp up to begin in 2007. In parallel, we are continuing successfully the cooperation with our other SIM vendors and partners.

With respect to the market in general, we have seen the market truly happening in the past several months with more mobile network operators expressing interest in conducting trials. Along with the increased operator activity, more handset manufacturers are developing handsets that are compatible with high-density SIM cards and the high-speed interfaces that they require. We are also working with several mobile software applications vendors that see the MegaSIM cards as a big opportunity for content and mobile software applications distribution.

At the upcoming 3GSM Congress in Barcelona, we will be demonstrating a number of these applications, which were developed with prominent applications developers. Our team devoted to the embedded systems market continues to take advantage of new opportunities created by the decline in flash prices. A particular effort is put into further extending our activities into additional consumer electronics applications based on our H series DiskOnChip product line. These opportunities are driven by digital content, which possess a clear trend for increasing embedded flash storage. As part of this activity, we recently announced reference designs with TI and PortalPlayer. I will now turn the call to Ronit to discuss our officials in more detail. Ronit?

Ronit Maor, Chief Financial Officer

Thank you Dov and good morning everyone. I will start with revenues. This quarter, we reported record revenues of $206 million. This represents 55% growth quarter-over-quarter and 80% growth over the fourth quarter of 2004. In terms of where our sales came from, we experienced revenue growth in all geographic markets. Revenue breakdown by geography for the fourth quarter follow the similar pattern to the previous quarter.

Sales in the US totaled 42% of revenues compared with 46% in Q3. Sales in the Fare East, excluding Japan, totaled 27% of revenues compared with 25% in Q3. Europe totaled 20% of revenues, up from 19% in the third quarter. And sales in Japan continued to strengthen and totaled 11% of revenues, up from 10% of revenue in the third quarter. With respect to our activity in Japan, we have recently successfully diversified our revenue base and expanded our mobile activity with two design wins, which are currently in mass production.

In summation, the breakdown of revenue by geography for the full year of 2005, sales in the US totaled 43% of revenues, sales in the Far East excluding Japan totaled 27%, Europe totaled 20%, sales in Japan totaled 10% of revenues.

Revenues breakdown by markets including the related license fees, royalties and income from a venture for the fourth quarter was as follows. Sales of DiskOnKey to the USB flash drive market totaled $119 million, which represents 58% of revenues in Q4. DiskOnKey revenues increased 38% compared with the third quarter and 58% compared with the fourth quarter of last year. As expected, sales of DiskOnChip to the mobile market, including handsets and other portable devices, grew the most totaling $64 million, which represents 31% of revenues. Mobile revenues grew 127% compared with the third quarter and 165% compared with the fourth quarter of last year.

Sales to the embedded systems markets totaled $17 million or 8% of revenues, reflecting a 6% decline compared with the previous quarter, but an increase of 17% compared to the fourth quarter of 2004. Sales of SIM cards to mobile network operators resulting from the acquisition of Microelectrónica, which closed in mid-November, totaled $5.5 million or 3% of revenues in fourth quarter. It is important to note that Microelectrónica’s activity consistent with the SIM business is very seasonal with a very strong fourth quarter. Its total 2005 revenues were approximately $26.5 million.

In summation, for the full-year of 2005, revenues by markets were as follows. DiskOnKey revenues totaled $340 million or 63% of revenue, reflecting a 49% increase compared with the revenues of 2004. Sales of DiskOnChip to the mobile markets totaled $135 million or 25% of revenues, an increase of 96% compared with mobile revenues in 2004. Sales to the embedded systems markets totaled $58 million, or 11% of revenues, an increase of 18% compared with 2004. And sales of SIM card and other products totaled $6.6 million or 1% of revenues.

Moving to gross margins, gross margins were 21.3% in the fourth quarter, down from an average of 24.7% in the first three quarters of 2005. The decline in gross margins was the result of similar trends we discussed in our last quarterly call, mainly supply mix and aggressive pricing in our mobile activity, coupled with relatively stable cost environment in this market.

To elaborate further, first the supply mix. As we’ve previously discussed, the higher our revenues especially when we grow faster than our suppliers, the more we purchase flash components from less favorable sources. Therefore, our incremental addition of revenues is by definition at lower margins.

Second, mobile pricing, a significant portion of our mobile revenues was generated by sales to Tier-1 handset vendors which designed our chips into mass markets’ high-end feature phones. As we indicated in our last earnings call, we quote aggressive prices to Tier-1 customers and this quarter due to the supply constraints, a larger percentage of our revenues came from Tier-1 customers. In addition, our costs were higher than we have anticipated for two principal reasons. First, our supplier was experiencing over-demand and a full utilization of its fab, and therefore did not lower the price as we expected. Second, a portion of our sales was of MCP products. We manufacture MCP products at a relatively expensive contract manufacturer. We are now in process of ramping up production at an additional manufacturer of MCPs that is expected to deliver at lower cost.

Operating expenses in the fourth quarter totaled $27 million, of which $2.5 million reflect a write-off of a certain in-process R&D in connection with the acquisition of Microelectrónica. The $27 million amount also includes Microelectrónica’s operating expenses for the second half of the quarter. Q4 operating expenses, excluding the one-time expense of in-process R&D, but including Microelectrónica’s operating expenses were up $2.9 million or 14% compared with the third quarter. As a percentage of sales, operating expenses excluding in-process R&D were down to 12% of sales compared with 16% of sales in the third quarter.

Financial income decreased from $2.3 million to $1.7 million due to a lower cash balance. The lower cash balance resulted from the purchase of fab equipment as per our agreement with Hynix in the amount $64 million with the remaining balance of $36 million to be paid in Q1 and the net purchase price of Microelectrónica’s acquisition in the amount of $40 million.

Other income includes one-time gain from the sale of investments totaling $6.3 million. All these resulted in net income of $25 million for the fourth quarter with earnings per share of $0.59. Net income for 2005 was $52.6 million with EPS of $1.30. Net income grew 80% compared to the third quarter and 179% compared to the fourth quarter of last year. EPS grew 75% compared to the third quarter and 146% compared with the fourth quarter of 2004.

Excluding the one-time items which are the in-process R&D write-off and the gains from the sale of investment detailed above, net income for the fourth quarter was $21.2 million and earnings per share of $0.50. Net income for 2005, excluding the one-time items, was $48.8 million or $1.20 per share. Full reconciliation of our as adjusted net income or net income calculated in accordance with GAAP is currently available for review on our website at www.m-systems.com. Excluding the one-time items, net income grew 52% compared with the third quarter and 136% compared with the fourth quarter of 2004. EPS grew 49% compared with the third quarter and 108% compared with the fourth quarter of last year. Again, I refer you to the reconciliation on our website.

As for inventory levels, the inventory balance at the end of the fourth quarter was $73 million compared with inventory levels of $51 million at the end of the third quarter. The inventory balance includes $23 million of shipments to customers of both DiskOnKey and DiskOnChip, which have not yet been recognized as revenues and, to a lesser extent, inventory on consignment. Excluding the above, the level of on-hand inventory at the end of the fourth quarter was $50 million, an increase of $16 million compared to such inventory at the end of the third quarter. The increase in on-hand inventory resulted from two main reasons. First, was the press for greater production levels at the beginning of January as our main DiskOnKey subcontractor is scheduled to close for the second half of January due to the Chinese New Year. And second, DiskOnChip inventory, which was scheduled to be delivered in early Q1. In any event, the majority of the on-hand inventory, which we had as of December 31st, is expected to be shipped by the end of January.

Our cash balance at the end of the fourth quarter was $183 million, down from $309 million at the end of the third quarter. The decrease in cash is mainly the result of both the purchase of equipment for Hynix in the amount of $64 million with, I’ve already mentioned, the remaining balance, sorry, with the remaining balance of $36 million due in Q1 and the acquisition of Microelectrónica.

I will now turn the call back to Dov.

Dov Moran, Chairman, President and Chief Executive Officer

Thank you, Ronit. I would like to conclude with comments on our expectations for Q1 and for the coming year. As our experience from past years has proven, usually once every number of quarters, the industry experiences a quarter of relatively sharp decrease in retail prices. We expect that to happen this quarter. We already began to see indications of sharp decreases in the selling prices by a number of players in the market. As expected, these price declines will have a clear and direct effect on our DiskOnKey activity as we work with our customers to maintain our market position. We expect prices of flash components will eventually catch up and will end up adopting at a similar magnitude as the product selling prices, but at a lower pace than the immediate price cuts at the retail levels. This, combined with the cyclical seasonality we traditionally experience in the third quarter, which will probably be strengthened by the sharp price drop could lead to lower revenues and gross margins.

It’s important to note that thanks to the tight inventory controls we have implemented in the past year, we carry relatively lean inexpensive inventory, and therefore we do not expect any significant write down of our inventory. Actually, no write downs at all. In fact, as Ronit indicated, most of the on-hand inventory, which we held at the end of December is expected to be sold by the end of this month before we see the effect of the price drop.

Therefore, with respect to our Q1 results, given the current pricing environment, we are currently projecting revenues between $140 million and $170 million with gross margins likely to be lower than fourth quarter levels. Despite the potentially difficult first quarter, we anticipate the effect of the tight pricing environment to be a short-term trend due to the elasticity of this market while average capacity per USB flash drive will grow. And therefore, we expect 2006 to be a very good year overall for M-Systems with sales and gross margins for both the DiskOnKey and the Mobile DiskOnChip and other products improving over the course of the year.

It is important to emphasize that our underlying focus continues to be improving our available capacity and cost of flash. A major step in this direction was the agreement with Hynix announced in August of 2005. We expect the full effect of this agreement to be felt when Hynix moves to better geometries and to MLC. This transition is expected to start in the second quarter of 2006. We view improving our flash cost and capacity over our competition as the most important objective for the company in 2006. Most of my efforts as well as the efforts of other members of our management team are dedicated to these tasks. Additionally, while we are exploring a number of interesting business opportunities, we believe that during 2006 we will be able to announce a technological breakthrough that will provide us the right long-term cost structure and a significant competitive advantage.

As for annual guidance, we are currently going through our annual planning process. We changed the timing of our annual planning process, which is a time consuming effort throughout the organization to the first quarter rather than the fourth quarter in which most of us are focused on execution. We expect to provide you with full-year guidance in our next earnings call. At that time, our annual planning will have been completed and the full effect of Q1 prices environment will be available. I believe that underlying fundamentals of our business are healthy and the demand for our products and for flash overall will continue to be strong throughout the year with new devices and applications, which will take the demand for flash to new heights.

I would like to conclude my prepared comments this morning by saying that I am confident in our long-term success. I am confident that we have the right ingredients with which we will build our future successes. We are in high growth markets. We continuously innovate to bring new technologies, new ideas, and new products to these markets. We created the right strategic partnerships across our industry. And most important, we have an excellent team to execute our long-term plans. As I mentioned earlier, we believe that 2006 is going to be a challenging, successful, and very, very interesting year. Thank you for being with us this morning. Ronit?

Ronit Maor, Chief Financial Officer

Thank you, Dov. Prior to the Q&A session, our attorneys have asked me to reiterate that the matters discussed in this conference call includes looking forward statements that may involve a number of risks and uncertainties. We caution you not to place undue reliance on these forward-looking statements, as they are subject to various risks, which may cause actual results to vary significantly. These risks include, but are not limited to, the risk factors detailed in the company’s most recent Form 20-F filed with the SEC and all of its other filings with the SEC. Also, M-Systems assumes no obligation to update such forward-looking statements and disclaims any obligation to publicly revise any such statements to reflect any change in expectations or in events, conditions or circumstances on which any such statements may be based. And now we will open the floor for questions.

Question-and-Answer Session

Operator

Thank you. At this time I would like to remind everyone, if you would like to ask a question press “*” then the “1” pn your telephone keypad. We do ask that you limit yourself to one questi9on and one follow up to allow the maximum amount of callers able to ask the question. We will pause for just a moment to compile the Q&A raster. Your first question is from Daniel Gelbtuch of CIBC.

Q - Daniel Gelbtuch

Hey, congratulations on a great quarter. You mentioned that you guys were able to grow market share in DiskOnKey, I was wondering what you guys were looking at as a full year number for USB drives for ‘05, where you are looking for it to be in ‘06? And where do you take your market share at?

A - Dov Moran

Okay. We believe that in 2005 the market for USB flash drives grew by roughly 40% to a number which is between $1 billion to 1.2, maybe more, we have a lot of uncertainty regarding the market in China. We do believe that in 2006, the markets for USB flash drive will grow by roughly 40%, 38%. They are different numbers that from a specific analyst that we are working with, and due to the fact that we are seeing more and more adoption of USB flash drives, surprisingly most of the users of the disk still don’t know what’s a USB flash drive as we saw in these several surveys. So, due to fact that it’s growing nicely, due to the fact that the capacities are going to grow, due to the fact that there have been new usages as are enabled by U3 standard, we believe that the market will grow and we see the demand as very, very nice demand, as well as reflected in the Q4 numbers, and as we are seeing even in the first quarter.

Q - Daniel Gelbtuch

Just switching gears, I saw that Imation bought Memorex this past week, any impact on the fact, on your relationship with Memorex as a result of Imation’s relationship with Trek?

A - Dov Moran

We have great relations with Memorex. We knew ahead of time about such a situation and we work closely with the managers of the joint company and we believe that we will be the supplier, of choice with the Imation and Memorex going forward, with the relation that we have built for many, many years, I do understand that Memorex’s management is going to be the one responsible for the retail markets of Imation, and I do believe that, although early, it is a good event for us.

Q - Daniel Gelbtuch

Excellent. Thank you very much.

A - Dov Moran

Thank you.

Operator

Thank you. Your next question is from Sam Doctor of JP Morgan.

Q - Sameer Doctor

Thank you and congratulations on a great quarter. Couple of questions. First, Dov, you had previously stated on the last call that you hope that 2006 growth with exceed 2005 growth. Without getting into specifics regarding the full year, do you still expect that to be true?

A - Dov Moran

Well, as I mentioned, we did not yet finalized our planning for 2006. Again, the way we are going to work, going from now on is from apple-to-apple internally, not for the market, clearly. But again, I am talking about feelings, which is not by planning, but more by reaction from customers, by our sales people, by feedback that we receive from the market, by expectations that exist regarding our product and generally, the flash market. I believe that the 2006 goals can be even larger than 2005 goals or similar to the goals of 2005. Again, I am putting restrictions over what I am saying due to the fact that it is not justified by internal planning as we do every year, bottom up and top down and all the rest. By feeling, generally regarding 2006 is very very good.

Q - Sameer Doctor

Great. Second question, as MDOC capacities grow, the total raw NAND content is going up as a percentage of your total COGS in the solution. What is the impact of this trend in gross margins? I mean, MDOC is above average gross margin, but at the margin, wouldn’t handset vendors be reluctant to pay the same premium on the incremental raw NAND?

A - Dov Moran

Well, the 2000 flash numbers, the gross margin on 2000 flash for MDOC were higher than the gross margin for the DiskOnKey. I believe that moving forward we do have the right solution there, especially while we are using MLC, multi-level cell, which has basically a lower cost structure compared to a regular raw NAND, and even if they are, even the new processors, some processors that are coming to the market will support to NAND, it is a very limited support and clearly it is not a support to MLC NAND, it is support to SLC NAND. Therefore, we can provide a very nice gross benefit to our customers. Clearly, moving to the H3, with the availability today of relatively very low cost controllers, geometries are moving forward and as MP3 technology is becoming more affordable and more cheaper in production will allow us to provide very, very good benefit, cost benefit to our customers as well as many other benefits, which are very, very critical to them and this relates a lot to the software and to integration, the integration of the product into their platforms, which is critical for developers while every month of delay in development can cause damage of many, many millions or tens of millions of dollar sometimes. We are, we have a very high confidence that we can get a nice gross margin from, for the DiskOnChip family going forward. As we said, we expect this margin to improve throughout the year 2006 due to improvements that we are going to do in the cost of the MPCs, due to the addition of the H3 some time in the second half of the year and other activities generally.

Q - Sameer Doctor

So, then we can sort of interpret that to me, the margin differential between DiskOnChip and DiskOnKey should remain where it is or perhaps expand?

A - Dov Moran

It is very, it’s truly very difficult for me to get into the, how the difference between the margins are going to progress.

Q - Sameer Doctor

Okay, alright. Thank you.

A - Dov Moran

Thank you.

Operator

Thank you. Your next question is from Craig Ellis of Citigroup.

Q - Craig Ellis

Thank you. Congratulations, Dov, on the revenue performance in the quarter and Ronit on childbirth.

A - Ronit Maor

Thank you.

Q - Craig Ellis

Just a clarification comment on gross margins, you said that they could increase from the first quarter’s level, would you expect gross margins on a full-year basis to be above that you were able to realize in 2005?

A - Dov Moran

Thanks for that Craig. Well, first, the gross margins for 2005 and 2004 were almost the same as you could see. We clearly are working very hard in order to create larger gross margins and this is a company mission. The way to do it, there are several ways of increasing the gross margin. One-way of growth is by creating extra value, which is what we are doing while developing the H3 with, by the way, very heavy investments in the R&D and in the marketing. This is clearly what we are doing while bringing the H3 to the market, which underlying what Noam said, there is a lot, there is a huge activity there that should bring the huge advantage to our customers basically by making the memory, memory of the cellular phones truly subsystem, a much more advanced and much more complicated in a sense that what exists before on the other side much more easier to integrate. So there is a lot of activity that is done in order to create value. That’s on one side of the equation. On the other side of the equation, we need or we have to create extra gross margin by lowering our costs and there is a lot of activity going on there. First in regarding the flash and we mentioned Hynix as one activity, there are others and other sort of activities that are not related to flash and this is of course working on lowering the cost of our contact manufacturers and overall other parts of the cost.

Q - Craig Ellis

Okay. And then…

A - Dov Moran

So, back to your question, we hope to finish 2006 with, again I can talk about hopes and there is no, we don’t have a plan yet, we don’t have detailed numbers for 2006. We are working very hard in order to increase the gross margins. It is very difficult for me at this stage to guarantee that we will finish 2006 with higher gross margins than 2005.

Q - Craig Ellis

Okay. Fair enough, but the clear message is that you expect margins to move up as you go through the year?

A - Dov Moran

That’s right, very, very clearly.

Q - Craig Ellis

Okay. And then to clarify the pricing commentary, it sounds like the aggressive pricing that you would expect in the first quarter is retail and would that be in the 20 to 30% price per megabit decline arena, Dov, or would it potentially be more aggressive than that?

A - Dov Moran

Well, we do have some I would say intelligence from competition and from activities in the market that give us the indication that the price might be at the level of 30%. Again, very roughly and it’s not, we don’t have accurate numbers. We believe that this is possible, yes.

Q - Craig Ellis

Okay. And then, is it that potential variance in the retail pricing that accounts for the wide variance in the revenue guidance, the 140 to 170 million?

A - Dov Moran

This is reflected in our number of the 140 to 170. Of course, there is a variance there due to the fact that a lot depends on the market’s reaction, customers’ reaction. We made the plan - we made our plan of, for flash supply to reflect the number of 140 to $170 million.

Q - Craig Ellis

Okay, thank you.

A - Dov Moran

Thank you.

Operator

Thank you. Your next question is from Dan Harverd of Deutsche Bank.

Q - Dan Harverd

Hi, and congratulations on the results. Dov, you mentioned some supply constraints meant that you weren’t able to supply DiskOnChip to all your mobile clients. What do your customers do in that case scenario in terms of their shipments? And do you anticipate that there is any lasting damage in terms of relationships with those customers?

A - Dov Moran

Well, it’s a good question, thank you, Dan. Basically, we work very, very close with our customers and what we actually did is that trying to shorten as much as we can the supply chain. So, we are shipping the products to our customers directly, almost directly from the fab, and even try to make it on the fastest way and actually directly to the contract manufacturer in few cases. Of course, being in a position that we cannot supply 100% of the supply is not easy for some of our customers and we had to do some sort of prioritization between customers. Clearly, strategic customers and first tier customers got more than others and I think that what the others are doing, some of them are delaying their production. It is possible that in some cases we lost customers due to the fact that we could not supply the customer demands and we tried to work closely with those customers and to help them or to make them move to the G4 solution that we are bringing onto the market in order to provide solutions and in order to ease the task of production to our customers. Clearly, not a simple issue. The demand that we saw was much higher than what we expect. Actually, what’s happened to us is that every product that was designed with DiskOnChip that went to the market did much better than expected by the manufacturer and in some small things like the formula of bringing a winning solutions to the market, is designing DiskOnChip into those cell phones. That’s the situation and luckily we were getting a good support from our partner Toshiba, but again, he did not expect those numbers as well. We didn’t expect those numbers as well. Our customers did not expect these numbers. So, we got a good support from our partner Toshiba and we hope to be in position that we will succeed to fulfill the demand for our customers in 2006.

Q - Dan Harverd

Okay. And then as a follow-up question, can you give us some kind of worst case scenarios of where gross margins can be in Q1 and also just discuss the kind of margin structure you would expect on the MegaSIM?

A - Dov Moran

That’s about expected, worst case scenario for gross margins in Q1 and how it relates to MegaSIM?

Q - Dan Harverd

And also just discuss how MegaSIM would then impact gross margins going forward?

A - Dov Moran

Okay. Q1, first of all, Q1 we are not going to see any MegaSIM. So, the MegaSIM is not going in 2006 overall to influence the gross margin. We are going to see deliveries of MegaSIM, but not in quantities or numbers that will truly change the gross margins as a whole. If you look at the magnitude of revenues today, whatever will be done in MegaSIM this year will not be significant to our business. Regarding first quarter gross margins, as we said, they might be lower than the gross margins of Q4. Again, we don’t have numbers; of course, the upside is possible as well, but you know that we are planning and we are estimating for the bad scenario, for the lowest case, we cannot provide a number for the projected lower case margins, it is not something that we are, there are many things that might happen in this market that can be a surprise and we prefer not to be, not to provide certain limits.

Q - Dan Harverd

Okay, thank you very much.

A - Dov Moran

Thank you.

Operator

Thank you. Your next question is from Eric Gomberg of Thomas Weisel Partners.

Q - Ami Joseph

Hi, Dov. Hi, Ronit, it is Ami calling in for Eric. Congratulations Ronit and congratulations Dov on the great quarter. In terms of the outlook for the first quarter, I understand you are not going to give us a number on the gross margin, but can you give us either some operating margin guidance or some guidance on operating expenditures?

A - Dov Moran

Ronit?

A - Ronit Maor

Yeah, as for operating expenses, we assume that it will be basically flattish with Q4, clearly excluding the one-time, I mean, take out the one-time of the IP R&D and the estimation that this will be about flattish. On one hand, we are continuing the investments in R&D, sales and marketing, etc., on the other hand, some sales-related expenses will be lower, the combination we believe will be about flattish.

Q - Ami Joseph

Okay, so am I right to assume that EPS will look like something in the, could look like something in the $0.20 range assuming kind of the midpoint of your guidance?

A - Ronit Maor

Again, since we didn’t guide for the gross margins, which I guess it is somewhere there in the calculation, it is important, we can’t relate to, I mean, we can’t answer your question.

Q - Ami Joseph

Okay, I know that you haven’t talked about your ‘06 expectations entirely, but do you expect 2006 revenue to accelerate versus 2005 or will it be a deceleration year? Kind of just directionally speaking.

A - Ronit Maor

Sorry?

Q - Ami Joseph

Will 2006 revenue be an acceleration year or a deceleration year in terms of growth?

A - Ronit Maor

I think that Dov related to that in a previous question; currently we don’t, we didn’t finalize the planning for ‘06, so we don’t have a clear answer for that. Clearly, we can say that we do expect sales to continue to grow, we see a lot of positive moves both on the DiskOnKey and on the mobile side. So, we do expect to see a nice growth, whether higher or lower, again, we didn’t finalize the planning, so we can’t give an accurate answer for that.

Q - Ami Joseph

Okay, and Dov, can you comment on your expectation for supply constraints or supply looseness in 2006, do you think that the first quarter will remain tight or this price got a sign of some loosening in the marketplace?

A - Dov Moran

Well, I cannot, the pricing environment, due to the pricing environment and what is in the market, first quarter might be also a bit loose or a bit over supply. I do believe that going forward, the second quarter, the third quarter, fourth quarter will see under-supply. I think that there are a lot of flash coming to the market and this is by the new fabs from Toshiba SanDisk and from Samsung and Hynix. On the other side, we do see many applications with huge requirement of flash coming as well, the PSP, the iPod nano.

Q - Ami Joseph

Okay, and just last question. Where do you think stand with your card strategy vis-à-vis the OEM customers and what kind of margin structure will you have on your cards, on your flash cards?

A - Dov Moran

Well, flash card is something that we are doing, I would say, only for specific market and this is the market that’s in mobile and in this market, actually most specifically, directing the mobile network operators, we will bring cards or we are bringing cards to the market with features and that are unique to this, the requirement of this market with the service and things required by customers in this market. We are encountering a situation that we are testing the water, we are touching the water, we are beginning some activity in order to learn the requirements, in order to become a provider to this market and clearly we do that in order to see margins, and to not sell on a, standard cards in a very low margins and be under the risks existing doing it of a inventories and the rest. So, basically, we are in a position that, we believe that we are going to see nice margins of this activity. Again, very early, not significant at 2006.

Q - Ami Joseph

Thanks. That is all for me.

A - Dov Moran

Thank you.

Operator

Thank you. Operator Instructions Your next question is from Alex Gauna of UBS.

Q - Alex Gauna

Yes. Thank you. I was wondering what the outlook might be. I know you discussed the volatility in DiskOnKey, what about in the MDOC product line looking into Q1, what kind of range of expectations are there there, what kind of visibility and pricing pressure?

A - Dov Moran

Okay. MDOC for the first quarter is supposed to continue the successes of the Q4. We don’t expect to see a higher number of revenues, but a similar one. Basically we already finished our third quarter, first quarter, maybe for the first, second, and third quarter, we said the design wins that we have for the, if I would have to guide for the first one, I would guide similar sort of revenues of, due to launch of some new models and of course due to the design wins and models that are already in the market. Basically, again, talking about the Q1, mobile should be similar, DiskOnKey revenues should be lower than the revenues of the fourth quarter, this is very, very clear. Overall, as I mentioned, margins might be lower than the fourth quarter, of course we are going to be profitable in the first quarter, I didn’t mention it because it seems to me very obvious, not required even to actually mention. And of course, but we cannot provide currently the level of profitability expected in the first quarter.

Q - Alex Gauna

And as a follow up to that, what is your accessibility to the now ramping MLC technologies out there? There are multiple producers out there ramping it. We’ve heard various comments about the difficulty of ramping. Is it widely available to you, yet? And as it becomes more available and if you can give us some color on the timing of that, will you be forced to pass much of that on to the OEMs in terms of price declines or how can you harvest some of that price decline as a benefit to yourself?

A - Dov Moran

Okay. Clearly, we are using MLC for a couple of years and generally MLC is something that we provided to our customers coming from Toshiba, of course, about two, from about two years ago already. What we buy today from Toshiba, what we purchase from Toshiba, with both DiskOnKey and Mobile DiskOnChip is all MLC. We have a technology that allows us to use MLC and provide to our customers many, many benefits and actually it will raise the level of the reliability and performance of MLC to the levels of SLC in a way that it is very difficult for the customers to distinguish between MLC and SLC. So, we gain, we are gaining or we are achieving the levels of reliability and performance that are the best in the markets, I believe, while enjoying the cost benefit of the MLC and this relates mainly for the part coming from Toshiba. Clearly, we work with Hynix, once Hynix will have MLC production, we will use MLC from Hynix, we do the same as we reproduce the MLC from Toshiba to enjoy the benefit of the MLC, the cost benefit, and bring it to the right level of the performance and reliability and, of course, we are still waiting for the MLC products from Samsung and once they will be available we will make usage from them as well.

Q - Alex Gauna

And any color on timing on when they will be available from Samsung or Hynix?

A - Dov Moran

Well, regarding Samsung you will have to ask them and get answer from them. I think that there were promises in the past and we are still a, we do have some samples of course. We play with the samples, we still assist them. But regarding to the timing, you really have to go and ask Samsung. Hynix made announcements which are more consistent and they said that they will have a part available in the second quarter. I would be cautious to believe that this will be probably at the end of the quarter. But again, we will work with all the three companies, Toshiba, Samsung, and Hynix.

Q - Alex Gauna

And does this play at all into the ramp of DOC H3 in terms of the real strength of it is having multiple source in place, right? So, what are your expectations from DOC H3 in terms of timing of that ramp?

A - Dov Moran

Absolutely. Noam, would you answer?

A - Noam Kedem

Actually the questions you asked are a perfect example, because there are multiple flavors or multiple types of NAND flash. We all talk about SLC NAND and MLC NAND. But it is really ‘NANDs’ with an ‘s’ in the end because not all these flavors are compatible, there are multiple directions in the way where fabs are heading, and these differences are only going to grow over time. So, one of the things that you can see as we move forward that these different flavors and different types of NAND are causing also not only incompatibilities, but the media actually degrades in performance and in reliability endurance over time. So, what we do with the H3 DiskOnChip is that we really mask all these differences behind a curtain just like you do with hard drives. I mean, if I were to you tell you that chipset vendors in the PC market are going to start tackling magnetic media technologies, or recording technologies in hard drives, you would laugh at me. And you’ll tell me, this is not their core competency, why would they be doing that? And it’s a similar case with NAND flash. We are going to be hiding everything behind the curtain of DOC H3 and the solution is going to deliver a homogeneous experience for the designs, no matter what the underlying technology is. So, a standard interface with a TrueFFS built into the device, it is truly a very, very unique value proposition.

Q - Alex Gauna

And as regard to timing?

A - Noam Kedem

With regards to timing obviously we have access to technologies even before they become market ready or mature in testing them and bringing them to market. So, whenever that technology is ready for, even before prime time, we will have that technology out there. We gave specific about the availability, specifics about the availability of DOC H3 in the three press releases we came out with on that subject. I can refer you to the press releases with Toshiba and with Hynix on December 12 and on January 4, and they have, I believe, the first samples are in the second quarter and then mass production in the third quarter for at least one of those flavors.

Q - Alex Gauna

Okay. Thank you and congratulations. Powerful quarter.

A - Dov Moran

Thank you.

Operator

Thank you. Your next question is from Craig Ellis of Citigroup.

Q - Craig Ellis

Thanks for the follow-up. Dov in 2005, I think there was a pricing reset on the MDOC side in the second quarter as customers, or your manufacturing supply transition over towards 90-nanometer, should we expect a pricing adjustment in that same timeframe as your MDOC goes more to 70?

A - Dov Moran

We expect the G3 solution to be the leading solution on the MDOC until the fourth quarter of 2006. So that’s why we don’t expect such a price change of the DiskOnChip family all over 2006, and this is not a suggestion on the second quarter of 2005 while we moved from the G2 into the G3. G4 is going to become a more prominent, more significant at the second half, but it is basically a component with 128 megabytes, 1 gigabit, and you see very few situations of double G3 that are going to be replaced by G4. What we saw in the second quarter of 2005 was many situations where we replaced double G2 by a G3 since the customers’ requirements were the 64 megabytes, which could be supported only by the double G2 moving to G3. Currently, we are, we will see a move from G3 to G4 that is going, that is in line with the customers’ requirements of getting higher capacity. But again, it’s not a massive replacement of double G3 by a single G4, and therefore, a price decline due to that.

Q - Craig Ellis

Okay. And I’m sorry if you mentioned this earlier on the call. But can you tell us what your average density is on MDOC and DOC? And where would you expect it to be as we exit 2006?

A - Dov Moran

We didn’t mention it, I think that the average MDOC capacity, I don’t have the exact number in front of me, but I believe it’s somewhere close to the 64 megabytes, a bit higher than 64 megabytes…

A - Ronit Maor

Yes, it is higher. It’s higher. It’s somewhere between the 64 and the 128 and growing.

A - Dov Moran

Yes. It’s between the 64 and 128, obviously, but it is closer to the 64. Most of our customers are using the single component of, you asked about DiskOnChip, not DiskOnKey right, Craig?

Q - Craig Ellis

Right. Just MDOC and DOC.

A - Dov Moran

MDOC. Most of our customers, most, I think it’s 90% of the applications are using a single component, single die solution and not double die solutions in their applications. Clearly, the number is going to grow as we are moving throughout the year by G4, which is going to be 128 megabytes, and later on, H3, which will provide 256 megabytes, H1 which will provide even a capacity that’s 1 gigabyte. I can estimate that if the most popular capacity today by far, with 90% of the application is 64 megabytes, a year from today, we will go and we will see in the market a capacity, average capacity of MDOC very close to 128 megabytes and overall capacity of the DiskOnChip family, both the Gs and Hs, which is at the ranges of over maybe a bit, in the range of 200 megabytes based on the conformation of the Hs and the Gs.

Q - Craig Ellis

Great, thanks for that.

A - Dov Moran

Thank you.

Operator

Thank you. Your next question is from Jonathan Half of UBS.

Q - Jonathan Half

Thank you. First of all, congratulations on a very strong Q4. Dov, can you give us the ASP for MDOC during the quarter and what you are expecting the price decline will be in percentages and what you are seeing right now in the marketplace on the MDOC in terms of the ASP? And also, if you can talk about, if there is, what is behind the decline in pricing, if it is competitive pressure?

A - Dov Moran

Hi, Jonathan, thanks. We are not providing ASP of any of our products and clearly we will not do that in the conference call or in other occasions. We are a, we believe that the ASP of MDOC will stay constant, they will, if it will go down, it will go down very lightly in 2006 due to the fact that the demands of the customers designs, the component into the cell phones, they have the requirements to get above the, they design all the, they estimated the cost, I mean, it’s part of their bill of materials and it was known to them that this was going to be price. Clearly, on the G4, the price of, G4 is double the capacity of G3, the price is not going to be double, but this is very obvious and it’s justified by the lower cost of manufacturing of the G4. But still the price is going to be a, it’s below double the price of G3, but of course, higher than the price of G3. That’s in regarding to the projected prices of the MDOC.

Q - Jonathan Half

Okay. As far as, what should we be expecting for the joint venture revenues in contribution in Q1 versus Q4?

A - Ronit Maor

Hi, Jonathan.

Q - Jonathan Half

Hi, Ronit.

A - Ronit Maor

Well, we don’t, as you know, we don’t disclose this number and again, it’s also irrelevant when modeling M-Systems because, as you know, part of the benefit appears on the revenues, part is deducted from costs. So, the standalone number is, it’s less relevant, it has no meaning as a standalone number.

Q - Jonathan Half

I was just referring to the number that you asterisk out at the bottom of your financials.

A - Ronit Maor

Yes, I know. But again, it is irrelevant for the modeling and clearly the gross margin guidance that Dov gave includes the JV side.

Q - Jonathan Half

Okay. Let me try to find a relevant question, Dov, can you talk about wireless USB, is that something that you guys see as an opportunity when you, if so when do you expect it to emerge and hopefully it’s relevant and you can discuss that a little bit?

A - Dov Moran

Sure. I think wireless USB is very interesting technology and it applies a lot to what we are doing. We are very interested in the focus that is happening in this market. And as you know, Jonathan, it’s an Israeli company that are dealing with it. And we clearly are going to be among the first companies in the market that are going to provide products that are supporting wireless USB. I should not say the trend in the market is very, very clear. The market focus, the market technology is going to make our life easier with more products, with more advance and progress towards such things like the wireless USB and others. And we are there at the front of technology in order to provide solution.

Q - Jonathan Half

Great, thank you. And good luck going forward.

A - Dov Moran

Thank you.

Operator

Thank you. This does conclude the question-and-answer session. I would like to hand the floor back to the speakers for any closing comments.

Dov Moran, Chairman, President and Chief Executive Officer

Okay. We would like to thank you very much. Thank you again for being with us this morning. And we would like to wish you a great day and a great 2006. Thank you very much. Bye-bye.

Operator

Thank you. This does conclude today’s teleconference. You may now disconnect your line and have a wonderful day.

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Source: M-Systems Q4 2005 Earnings Conference Call Transcript (FLSH)
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