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Executives

Lori Barker - Senior Director of Investor Relations

Eli Harari - Chairman and Chief Executive Officer

Sanjay Mehrotra - President and Chief Operating Officer

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

Analysts

Heidi Poon - Thomas Weisel Partners

Bob Gujavarty - Deutsche Bank

Kate Padlarski - Goldman Sachs

Edwin Mok - Needham & Company

Amit Kapur - Piper Jaffray

Craig Ellis - Citigroup

Paul Coster - J.P. Morgan

Daniel Amir - Lazard Capital Markets

Harlan Sur - Morgan Stanley

Sidney Ho - Merrill Lynch

Erik Solomon - Morningstar

SanDisk Corporation (SNDK) Q1 2008 Earnings Call April 17, 2008 5:00 PM ET

Operator

Good day and welcome to the SanDisk Corporation’s first quarter 2008 earnings conference call. At this time, I would like to turn the conference over to Lori Barker, Senior Director of Investor Relations. Please go ahead.

Lori Barker

Thank you. Good afternoon and welcome to SanDisk Corporation’s financial teleconference for the first quarter of 2008. I’m Lori Barker, SanDisk’s Senior Director of Investor Relations. Joining me is Dr. Eli Harari, Chairman and CEO of SanDisk, Sanjay Mehrotra, President and COO, and Judy Bruner, Executive Vice President of Administration and CFO.

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

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 web site at sandisk.com. After the completion of this call, an audio replay of this conference, a copy of today’s prepared comments and quarterly metrics will be made available on SanDisk’s investor relations web site at sandisk.com.

During our call today we will be making forward-looking statements. Any statement that refers to expectations, projections or 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.

Certain factors that may cause actual results to differ are detailed under the caption “Risk Factors” and elsewhere in the documents we file from time to time with the SEC, including our Annual Report on Form 10-K for fiscal 2007 and our quarterly reports on Form 10-Q. We undertake no obligation to update these forward-looking statements, which speak only as of the date hereof.

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

Eli Harari

Thank you, Lori and good afternoon. Market conditions throughout the first quarter were similar to last year’s first quarter, characterized by excess supply, seasonally soft demand and aggressive pricing. Demand for our products was good in all regions, particularly in international retail. However, the sharp decline in market pricing exceeded our cost reductions and resulted in unsatisfactory product gross margins.

We believe that some of the large NAND Flash suppliers liquidated substantial amounts of excess inventory in late fourth quarter and throughout the first quarter at prices that were at or below their cost, thus precipitating the depressed industry-wide margins.

We believe that conditions should improve gradually as the low-priced inventory is sold through the channels and as the U.S. government’s stimulus package gets consumers back into the stores in time for Mothers’ Day, Fathers’ Day and school graduations.

NAND Flash component pricing has been inching up in the most recent weeks, and the anticipated 3G Apple iPhone and competitors’ new models are expected to fuel renewed demand for NAND Flash in the second half of this year.

Additionally, we believe the NAND Flash industry is self-correcting: NAND Flash component pricing has outstripped the competitiveness of 200-millimeter NAND production lines and is accelerating their decommissioning in 2008 and several competitors have announced plans to delay new 300-millimeter fabs and these actions should help to establish better balance between demand and supply in the second half of 2008 and into 2009.

As for SanDisk, our current phase of the Fab 4 production ramp is slightly ahead of schedule and we believe that our technology lead with 43-nanometer and 3 bits per cell, coupled with the scale of our Toshiba ventures, gives us significant cost advantages.

At the February analyst conference we discussed the CapEx investments required over the next 3 years and we believe that we have a strong balance sheet to support the cash flow requirements for these projected investments.

At the same time, as much as possible we want to grow capacity in sync with growth in market demand and to that end, we periodically review with our manufacturing partner the appropriate timing for new capacity additions. The current phase of Fab 4 expansion is in place through the end of this year and we’ve not made a decision yet on the timing and the extent of the ramp of the next phase, which currently is not due to start until the first quarter of 2009 at the earliest.

In these difficult times for our industry, I believe that SanDisk’s unique vertical integration model offers us greater flexibility than is available to other NAND Flash suppliers, who generally depend on a small number of large OEM NAND Flash customers for the majority of their business. They lack our very strong global retail sales channel which enables us to be one of the largest consumers of NAND Flash as we generate our own demand.

We are also executing on a strategy to decommoditize as much of our business as quickly as possible. For example, our Ultra, Extreme and Ducati card lines carry premium margins and have been adopted by high-end consumers worldwide.

Our Sansa line of MP3 players is holding steady ASPs per megabyte despite the drop in NAND Flash pricing. And you may have noticed in the past few months a flurry of announcements from our enterprise business that specializes in selling highly secure storage products to large corporations, banks and government agencies at very respectable margins.

We see similar opportunities in the mobile space working closely with mobile network operators on developing MegaSIM and TrustedFlash supported services.

One new market that we believe will provide opportunities to differentiate ourselves is the emerging solid state drive, the SSD market, where we have deep expertise and strong IP. This market appears to be developing into two significant segments: a large commodity segment in the notebook space where price per megabyte will be key and the enterprise space where premiums could be significant.

Recently there has been growing interest in embracing solid state disks in the enterprise space to augment hard disk drive storage arrays with high I/O bandwidth and low power Flash memory.

Intel is strongly promoting solid state drive adoption in computing platforms, and Sun and others are reporting dramatic performance and power gains achieved through incorporating solid state disks in new enterprise server storage architectures.

These systems are sold on cost per I/O and cost of ownership rather than cost per megabyte. For this market segment, the higher price of Flash solid state disks is not an impediment, and we expect accelerated deployment of Flash solid state disks in enterprise storage in 2009 and beyond.

To summarize my comments, this downturn is unusual for us in that we see demand for our products continuing to grow at a good pace, yet we have little to show for it in the near-term because the depressed market pricing has outpaced our aggressive cost reductions.

However, like all downturns we believe this one too shall come to an end and the next upturn should bring substantial long-term benefits, principally in accelerating the creation of major new markets for Flash storage to bring demand and supply into balance.

Our markets are young and vibrant and we believe that few companies in our space have SanDisk’s proprietary technology, IP, vertical integration business model, balance sheet and management experience. We are optimistic we will improve our gross margins and operating margin as pricing conditions moderate, so that we can deliver strong results to our shareholders in the years ahead.

I will now turn it over to Sanjay.

Sanjay Mehrotra

Thank you, Eli. Good afternoon, everyone. The first quarter reflected solid demand with good sell-through in most of our served geographies. Unit sales were generally consistent with seasonal patterns and our global growth in the retail business was particularly strong in Japan, APAC, and Europe.

Our mobile business remained a key driver of our overall revenue growth. Unit sales and average capacities of our microSD cards more than doubled year-over-year, not only because this was a fast growing market but also due to the price decline for these cards that was more aggressive than the overall average during Q1.

We added more than 15,000 mobile store fronts world wide, and our global total increased to 107,000. Our focused marketing and sales strategy continued to succeed as our retail attach rate of mobile cards to phones increased further to a high-20% rate.

In addition, there is continuing momentum driven by the mobile network operators to make mobile cards a significant part of the handset sale. In many of the emerging markets such as India, Brazil, Mexico, Ukraine, Poland and others, mobile products represent more than 50% of our product sales.

Our audio-video business performed well as growing sales of our Sansa Clip, among other products, continued to gain traction within the high-growth sub-$100 segment of the MP3 market. Our unit share in the overall U.S. retail MP3 market has remained stable in the mid-teens, while our share within the sub-$100 market segment is more than two times higher and it is approximately 30%, according to NPD data.

Most importantly, the MP3 product line experienced the least year-over-year price decline among all of our product lines, and we view this as indicative of the growing success of our de-commoditization strategy.

On the operations side, Fab 4 continued to ramp slightly ahead of plans and we expect to achieve a capacity of 110,000 wafers per month in the back half of the year. The faster ramp of Fab 4 has contributed to higher inventory levels, but we are comfortable with the planned ramp as we believe that its output will be needed to meet our anticipated demand in the seasonally strong second half of the year.

During the quarter, we began ramping the industry’s first 3 bits per cell technology and we are on schedule to begin shipping end products that incorporate 3 bits per cell, starting with USB drives, later this month. Ramp of our 43-nanometer 2 bits per cell technology remains on track as well and we expect to begin product shipments during this quarter as previously planned.

In the near term, while our industry is traversing difficult times, we are utilizing this period as an opportunity to streamline our operations, reallocate internal resources to the most productive businesses, control our expenses, accelerate product cost reductions, and focus on improving our margins.

In summary, we were pleased with our Q1 demand trends and we remain optimistic about our business for 2008. With that, I will turn the call to Judy.

Judy Bruner

Thank you, Sanjay and Eli and good afternoon, everyone. Overall our first quarter revenue performance of $850 million was in line with our expectations, reflecting a seasonal decline of 32% from the Q4 holiday period, the same seasonal decline we experienced in Q1 2007.

Megabytes sold declined sequentially by 9%, much less than the 22% decline experienced in the first quarter of 2007; however, sequential price decline was steep at 29%. Even with this pricing, our product revenue grew by 5% on a year-over-year basis, and remember that Q1 of 2007 included $53 million of revenue from the consolidation of the Twinsys joint venture, which we have since exited. Excluding Twinsys, our product revenue grew by 14% year-over-year with megabyte growth of 189% and price decline of 61%.

Overall, our Q1 retail revenue was $418 million or 58% of our product revenue. Q1 retail revenue grew 22% on a year-over-year basis, with 12% growth in North America and 36% growth internationally.

Our Q1 OEM revenue of $306 million was down 14% year-over-year, but if you pull out the Twinsys joint venture from last year, then OEM revenue was flat year over year. OEM sales in megabytes grew a very strong 237% year over year; however, ASP per megabyte was down 70%. The price decline in the OEM business primarily reflects competitive pricing in the mobile OEM space, as well as a shift to higher capacity mobile cards. Our OEM average capacity grew 154% year-over-year.

License and royalty revenue for the first quarter of $126 million increased 30% year-over-year. This strong growth rate reflects the addition of new licenses that did not exist in the year-ago quarter as well as growth in variable NAND component based royalty and card royalties.

First quarter non-GAAP product gross margin of 20.9% was lower than we had forecasted in January as we made more price moves than originally planned for the quarter, reflecting the competitive industry environment. And we also recorded higher inventory reserves than originally forecasted related to the growth in our inventory balances.

Our first quarter cost of sales included zero Fab 4 start-up costs and very little non-captive memory.

Non-GAAP operating expenses of $230 million were down 3% sequentially and up 30% year-over-year. Our expenses came in above our previous Q1 forecast of $215 to $220 million primarily because of legal expenses and increases to our bad debt reserves.

Non-GAAP operating income for the first quarter was $47 million or 5.6% of revenue, essentially the same dollar level and same percent of sales as last Q1.

Other Income of $26 million is down year-over-year due to lower cash and interest rates and up sequentially because Q4 included a 200-millimeter Fab impairment charge.

Non-GAAP EPS for Q1 is $0.21 compared to $0.19 in Q1 of last year, with the increase primarily due to a reduction in our fully diluted shares and a reduction in the tax rate.

On the balance sheet, cash and short and long-term investments increased from Q4 by $128 million to $3 billion. Q1 cash flow from operations was a positive $219 million, primarily reflecting the impact of our bi-annual receipt of certain royalties.

Accounts receivable declined reflecting Q1 seasonality and the impact of price protection and promotions.

Inventory on our balance sheet grew to $695 million, more than 90 days’ worth, reflecting the ramp in Fab 4 and the seasonally lower Q1 sales.

Channel inventory ended Q1 at approximately 7 weeks, a healthy level.

Related to capital investments in the Flash Ventures, we invested $37 million of cash during Q1 and we guaranteed additional operating leases of $426 million.

Turning to our outlook, we currently expect a more moderate pricing environment in the second quarter and sequential growth in megabytes sold driven by seasonality and the continued expansion in average capacity.

We are forecasting second quarter total revenue, including both product revenue and license and royalty revenue, to be between $875 million and $950 million. Within this total revenue, we expect our Q2 license & royalty revenue to be between $115 million and $125 million.

We continue to forecast 2008 growth in megabytes sold of 150% to 170%, and while we believe that pricing will moderate over the course of the year, the aggressive start to pricing in Q1 could result in annual price decline being at the high end of our forecasted range of 50% to 55%.

We expect the second quarter to be the low point in our gross margin for the year as we have now recognized most of the benefit from the transition to 56-nanometer wafers, and the P&L benefit from 43-nanometer wafers will begin in the second-half of the year.

Compounding this, the dollar has recently depreciated significantly versus the YEN, making our YEN-based wafers more expensive. Based on these factors, we expect second quarter non-GAAP product gross margin to be between 14% and 18%.

While we expect an increase in gross margins in the second-half, the stronger YEN may result in us being unable to achieve our previous annual forecast of 24% to 28% non-GAAP product gross margin.

The dollar has depreciated about 6% relative to the YEN since the end of February and about 10% since the end of 2007. A 10% depreciation of the dollar relative to the YEN impacts our product gross margins by approximately 4 percentage points.

We have implemented significant expense controls across the company and are working to reduce investment in certain programs and projects and streamline business operations. We expect Q2 non-GAAP operating expenses to remain approximately flat to the Q1 level, with a decrease in G&A expenses, an increase in sales and marketing expenses related to the seasonal retail programs, certain one-time costs related to the expense reduction actions we are taking, and also an increase in expenses resulting from the weaker U.S. dollar.

In addition to the non-GAAP guidance I have provided, our Q2 GAAP results will include share-based compensation and amortization of intangibles. Forecasts for these expenses in COGS and operating expenses are included in the non-GAAP to GAAP reconciliation tables that are currently posted on our website. We expect Other Income for Q2 to be between $20 million and $22 million.

On the balance sheet, we expect inventory dollars to increase and we expect to make Q2 investments in the Flash Ventures of approximately $100 million. We also expect to guarantee additional operating leases of approximately $300 million for Fab equipment purchases by the Flash Ventures.

Looking beyond Q2, we are optimistic that margins will improve in the second-half due to favorable technology transitions and our continued expectation of more moderate price declines. As we make key business decisions such as pricing, product prioritization, and capacity growth, improving profitability is a top focus for our management team.

We will now open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) And we’ll take our first question from Heidi Poon with Thomas Weisel Partners.

Heidi Poon - Thomas Weisel Partners

Could you please comment on the recent contract -- price stabilization in the market driven by these capacity cut announcements versus what you know Intel said to be likely an oversupply situation for the whole year?

Eli Harari

The announcement so far we’ve heard from Intel indicating that they expect in future quarters this year to be flat, more or less flat in the growth of bits [out of] -- from their joint venture and announcements from Micron and Intel that IMFP will delay the ramping up of their Singapore Flash Fab. And we’ve also had announcements from Hynix regarding retirement of 200-millimeter Fab for NAND Flash and delaying of their 300-millimeter NAND production.

So basically we think that technology leadership is very, very important in this market to achieve low cost structure and having the scale that we have together with Toshiba gives us the combination of very advanced technology we believe leading the industry, and also having the scale. And we think that some of the players that I mentioned that entered this market more recently are probably -- you know, this pricing situation is not -- is particularly difficult for them given their cost structure.

Heidi Poon - Thomas Weisel Partners

I see. My second question is regarding SSD. Could you please give an update or more color on your earlier comments? In particular, could you give a sense of how quick it will ramp in ’09? You know, what percentage of the revenue SSD could be contributing in ’09 and the 2010 timeframe?

Eli Harari

SSD we’ve said many times in the past we expect to be a very substantial catalyst for Flash usage in future years but that until the industry sees the move to solid state disk -- I’m sorry, to MLC, multi-level cells, that the cost structure with SLC is rather prohibitive except for early adopters.

We see a lot of announcements and including our own effort to begin the shift to MLC and solid state disk products. That really will start accelerating as we get into the end of this year and early next year and at that point, we think that both the notebook market and the enterprise market will start accelerating the adoption of solid state disk.

The real significance of this market in this early phase is that what we are seeing now is a lot of design-ins and this is really still in the evangelizing phase and for architectures to be developed that could take advantage of Flash memory. A very, very good example of that is a joint application by Sun Microsystems and Intel, where they showed by combining hard disk drives, fast-spinning hard disk drives that are very power consuming but very fast, combining that with a solid state disk, you could achieve a much higher I/O performance, much lower power, and basically absorb the cost of the -- the higher cost of Flash memory because the pure I/O results are actually superior.

In notebook computers, of course, the best, the great advantage is not so much power as much as ruggedness and I think that there we just need to get the costs down and I think that is going to happen.

Once that happens and that’s behind us, then this is a huge, huge reservoir for Flash memory that will be very price elastic and will I believe be capable of creating a much bigger on the demand/supply balance let’s say 2010 than the iPod ever was. Because the iPod very much is a limited MP3 market whereas the computing space is the biggest consumer of memory.

Heidi Poon - Thomas Weisel Partners

Great. Thank you very much.

Lori Barker

Next question, please.

Operator

We’ll take our next question from Bob Gujavarty with Deutsche Bank.

Bob Gujavarty - Deutsche Bank

Are you -- is there something in inventory besides just Flash cards? Is it some -- because you are building more systems, more value-added products, that drives the inventory dollars up more than maybe the units are up? They just seem to be up an awful lot if it’s all just Flash cards.

Sanjay Mehrotra

So in the inventory is primarily memory -- memory in terms of Flash memory cards, you have Flash drives, et cetera. But also memory very much at the die level from the wafer perspective. So those are the key drivers of the inventory. As we indicated that during Q1, Fab 4 increased output contributed to the increase in the inventory beyond the normal levels.

Bob Gujavarty - Deutsche Bank

Okay, and any concern that the inventory overhang, I mean, on a days basis, could impact pricing or is that factored into your forecast for the product gross margin?

Judy Bruner

That is factored into our forecast and while the inventory on our balance sheet is higher than we would like, it is flowing through and will largely be sold. The inventory we have on hand at the end of March will largely be sold in the next 90-plus days. Of course, it will be replaced with more inventory that is coming from the fabs.

Eli Harari

But our forecast for the year indicates that we will -- that the seasonality of Flash is you have a relatively soft first quarter and a very strong fourth quarter, whereas the seasonality of a new Fab is it ramps up. It’s not seasonal. So you end up having excess supply in the first quarter typically, which we believe will be consumed in the fourth quarter.

Last year in the fourth quarter, we were short of supply. Our inventory was short of our requirement and we don’t want a repeat of that.

Bob Gujavarty - Deutsche Bank

Okay, fair enough. Just one final question -- does how well Fab 4 is ramping and given you do have some extra inventory, does that affect your captive/non-captive mix for the year? Do you think you’ll need less non-captive product?

Sanjay Mehrotra

Fab 4 is actually ramping well. We expect to reach 110,000 wafers per month in the second half of the year, so we are pleased with the wafer ramp as well as the [units] and the output of the Fab 4 will be utilized to meet the demand during the course of the year.

At this point, in terms of non-captive purchases, they will be fairly minimal during the course of the year.

Bob Gujavarty - Deutsche Bank

Okay, great. Thanks, guys.

Operator

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

Kate Padlarski - Goldman Sachs

Hi, this is Kate [Padlarski] on behalf of Jim Covello. A quick question about your CapEx plans -- you mentioned that for now you are keeping your plans unchanged but that some of your competitors have begun to push out their own CapEx plans, and particularly some of your competitors that have 200-millimeter capacity are clearly disadvantaged in the current environment, which gives you an opportunity to perhaps extend your own position in the market. I’m just curious how you are thinking about on one side trying to extend your technology position and your market share in the industry, and then trying to be disciplined on spending in case your competitors don’t cut back enough and pricing is down more than you expect. Thank you.

Eli Harari

Fab 4, the current ramp to 110,000 wafers a month in Fab 4 is already determined. There is not much we can do about that. The equipment is either already installed or being installed, but certainly capacity is there, the people are there, and you either run the wafers and take advantage of the very low cost structure or you don’t. And as I said, we expect our own demand to be such that we will need the output.

But it is -- but we have not at this stage, as we’ve said, made a decision about the next phase. Fab 4 is a very large structure that is modular and we can delay additional capacity in 2009 for equipment that has not yet been ordered.

We have not engaged in either the component business. We are not selling components as some of our competitors do, and we also are very reluctant to engage in quarter ending inventory dumping, which we think comes back to haunt us or the industry.

So quite honestly, we have been through these down cycles in the past, the downturns. We do believe that we are at the low point of the current down cycle and we want to be prepared and be in a very strong position as we emerge out of this thing and yes, we will be opportunistic in terms of using our advantage to gain market share.

Kate Padlarski - Goldman Sachs

That’s very helpful, and by when do you have to make the decision about the next phase of the capacity expansion?

Sanjay Mehrotra

The decision for next phase of capacity expansion is typically six to nine months in advance and as we’ve said, at this point we are committed to the fab expansion through the course of this year and we have not yet made the decision for the next phase.

Kate Padlarski - Goldman Sachs

Okay. Thank you.

Lori Barker

Next question, please.

Operator

We’ll take our next question from Edwin Mok with Needham & Company.

Edwin Mok - Needham & Company

I have a question regarding ASP. Last first quarter, when you reported first quarter last year, you talked about having some deferred action on pricing and deferred through the second quarter in terms of price reduction. And also in the fourth quarter of last year, you also talked a little bit about that. How are you guys pricing your product this quarter? Are you guys basically -- you already took all your price action you need and that pricing maybe stabilized or even improved throughout the second quarter?

Judy Bruner

As I said, we do expect that pricing will moderate in the second quarter. So far this quarter, we’ve taken very little action in terms of any firm price movements and we are very focused on profitability. But pricing plays out over the course of the quarter and we evaluate this on a weekly, even daily basis. But so far this quarter, we’ve taken very little action.

Edwin Mok - Needham & Company

Great. My follow-up question to that is do you guys see any benefit of selling to the emerging markets, either because of the weaker dollar or the fact that being a premium brand, you might be able to get a higher premium there?

Judy Bruner

I’m sorry, I didn’t hear you -- sell to what market?

Edwin Mok - Needham & Company

To the emerging markets or the international markets, like China and --

Sanjay Mehrotra

You know, as we have said, we are very pleased with our results on international sales and we are very much focused on driving the sale of our products across all geographies and of course, as we price the product, as we drive the sales, as we look for market share, we of course keep our profitability objectives and our inventory objectives in mind all the time.

And the SanDisk brand is recognized as a trusted brand and we of course continue to optimize our pricing to get premium in all of the geographies as well.

Edwin Mok - Needham & Company

Great. One last question -- regarding your OEM business, especially for the mobile part, you talked about a deeper ASP decline there. Does that have anything to do with a switch to iNAND from mDOC, given that mDOC was a lower density product and you mentioned you have a [inaudible] there? Could you talk about that trend as well going forward? Do you see more customers using a product like iNAND versus mDOC?

Sanjay Mehrotra

So first of all, in terms of the price decline on the OEM mobile business, the 17% year-over-year price decline that Judy mentioned on OEM was pretty much determined by the mobile OEM business, and in the mobile OEM business, a very large part of our business is OEM cards that are bundled with the mobile phones. And the primary reason for the decline in this for the OEM mobile phone from Q107 to Q108 was of course competitive factors but also a very significant increase in the average capacity that is shared into the mobile OEM space.

In terms of average capacity, Q107 were slightly above 300 megabytes per unit and in Q108 for OEM mobile, those capacities were over 800 megabytes per unit. So as you shift the average capacity so significantly higher, that amplifies the price decline effect as well.

Now regarding your question on iNAND, certainly we are shifting in terms of embedded solutions from mDOC to iNAND and in Q1 we announced a 16-gigabyte iNAND product and we are seeing strong interest in our iNAND product from the handset manufacturers and we plan to continue to gain more design wins for iNAND and continue to sell not just embedded iNAND products but the cards, which are the big part of our OEM business and actually a big part of the overall mobile OEM market as well.

Edwin Mok - Needham & Company

Great. Thanks for answering my questions.

Lori Barker

Next question, please.

Operator

We’ll take our next question from Amit Kapur with Piper Jaffray.

Amit Kapur - Piper Jaffray

Great, thanks. Just a quick follow-up on the international conversation; Sanjay, you kind of mentioned the number of retail distribution points you were able to add during the quarter. Could you break that down in terms of how many were in the U.S. and then outside of the U.S.?

And following up on that geographically, what do you expect your stronger markets to be and how important is it continue to expand the distribution channels into those markets to fuel that growth?

Sanjay Mehrotra

I want to be clear that the mobile -- the storefronts that I was talking about, the increase in the storefronts was related to mobile. Of course for all of our business, the storefronts that we sell our products are more than 220,000 at this point. The mobile storefronts that we have added are pretty much across all geographies but certainly in the emerging markets, we are continuing to add storefronts at a rapid clip.

And for the mobile business, we have strong business in the EMEA market, but the Asia-Pac markets are picking up, as well as in the U.S. markets through the various channels, including the MNOs, we are seeing a strong pick-up and growth off our mobile demand.

Amit Kapur - Piper Jaffray

Great and just a quick follow-up; in terms of the handset market and the mobile market, what proportion of your revenue do you see is derived from that market? And with some of those end markets shifting towards low-end phones, are you seeing any impact in terms of the memory card sell-through?

Sanjay Mehrotra

I’m not sure I’m clear on the question. You are asking for the mix of our business in the mobile between OEM and retail?

Amit Kapur - Piper Jaffray

No, just in terms of your overall revenue, what proportion of that revenue would you say is tied to the handset market?

Judy Bruner

In total, the proportion of our revenue from the mobile market has not changed much from the 36% that we had for 2007.

Amit Kapur - Piper Jaffray

Okay, great. And do you see any signs that the industry shift towards low-end phones would maybe slow some of that attach rate?

Sanjay Mehrotra

Actually, we are seeing attach rates to continue to increase, as well as -- you know, not only from the new phones but also from the installed base, so that combination is driving the unit sales higher in the mobile space and as more and more phones are coming out with multimedia features and as we increase the awareness of the consumers regarding the card slot in the phones, that’s also helping drive their attach rate higher.

And as I indicated earlier, both on the OEM side as well as on the retail side, we are continuing to see the average capacities increase. So overall, we are optimistic and feel pretty good about the demand drivers in the mobile phone space.

Amit Kapur - Piper Jaffray

Great. Thanks a lot.

Operator

We’ll take our next question from Craig Ellis at Citigroup.

Craig Ellis - Citigroup

First, a couple of clarifications; on the OpEx, Judy, you mentioned that you came in higher than the model. It looked like that was in G&A. Can you just identify how much of that was the legal expense that you mentioned and is that recurring, and how much of that was the bad debt?

Judy Bruner

Of the increase in G&A from Q4 to Q1, approximately half of that increase was related to legal and approximately half of it was related to the increases to our bad debt reserves.

Craig Ellis - Citigroup

And is the legal a recurring expense that we should expect to see in future quarters?

Judy Bruner

You know, the legal expense varies a lot. It’s a little bit hard to predict on a quarter-to-quarter basis but we are very focused on containing it as much as possible, so I would expect it will come down, clearly as we move forward.

Craig Ellis - Citigroup

Okay, and then switching gears on royalty, the guidance was nice, above my model but was there anything either one-time in nature or otherwise from the fourth quarter to the first quarter, given the dynamics of how that’s reported, that drives such a good number?

Judy Bruner

There is nothing new. You might recall that last year I talked about the fact that there are some milestones in some of our royalty contracts that make the quarter-to-quarter numbers a little bit difficult to predict but there is nothing new, nothing unusual in terms of either Q4 or Q1 or our forward forecast.

Craig Ellis - Citigroup

Okay and then lastly, given the first half margin profile in the products business, can you just talk about what it is that gives the company confidence that we will see a ramp in gross margins in the second half of the year? Last year obviously we had a 70% increase in contract pricing from the trough to the September peak but it would seem pretty aggressive to expect that type of thing this year. So what gives the company confidence either on the pricing side or on the cost reduction side that we can see a good second half margin ramp?

Judy Bruner

Well of course we have a pretty good view as to the technology transitions that we are executing in our fabs and clearly we believe the technology transitions this year in 2008 follow a pretty similar pattern to the pattern that we saw in 2007, so we have a fair degree of confidence that we will be able to execute and recognize strong cost reduction in the second half of the year.

In terms of pricing, it is our view that pricing will moderate this quarter and that it will be more moderate in each of the three quarters of the remainder of this year relative to Q1, and we believe that based on some of the indications we are seeing on the supply side and the industry overall and we believe that because overall demand really is strong for the industry.

You know, keep in mind that our retail business even in the U.S., which is subject right now to a soft economy, still grew 12% on a year-over-year basis. And international was very strong.

So those are the two key factors, technology transitions and our expectation of more moderate pricing, that lead us to believe that we will see stronger gross margins in the second half.

Craig Ellis - Citigroup

Great, thanks, Judy.

Operator

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

Paul Coster - J.P. Morgan

Thank you. Judy, if I can remain on the same subject of gross margins, can you first of all tell us what the captive versus non-captive was this quarter and moving forward? And then I would like to just talk a little bit about the gross margin impact of Fab 4 ramping. I seem to remember that when we went to Fab 3, initially margins took a dip because of low absorption rates and following some OpEx expense into gross. Are we going to see a similar thing this time? Apparently not according to your opening remarks.

Judy Bruner

Sure, Paul. On captive/non-captive mix, we were very close to 100% captive in terms of our mix this quarter and I would expect that we will remain largely captive for the rest of the year, probably non-captive will be something like 5% or maybe even less than 5%, for 2008.

And then in terms of Fab 4, as I indicated we had no start-up costs in our Q1 cost of sales results relative to Fab 4. And what that essentially means is that we didn’t have any costs that would be characterized as unusual relative to the overall wafer costs that we are experiencing in Fab 4. So we really believe that the ramp is going well and that it is not a detriment to our gross margins going forward.

Paul Coster - J.P. Morgan

Okay, and then one last follow-up; you talked of cycles. It feels like we’ve just been through a cycle and it lasted approximately 12 months. As we move forward, do you see us going through a sort of positive cycle through the end of year and then back into seasonally weak kind of period? Or are you expecting this next cycle to have a different duration, and if so, why?

Eli Harari

Of course, no one can tell but we view this as not a short cycle. We see this actually -- frankly, it’s into the sixth quarter, or you could even look at it as into the third year. Really pricing in 2006 and 2007 was pretty aggressive and I’ve been saying for all this time that cumulatively, it comes to a point where this becomes very, very difficult and I believe that that’s where the industry is right now.

When people have exhausted all their 300-millimeter conversion and technology transitions and high volume and so on and are still having to sell at cost or below cost, that tells you that there is either going to be consolidation or basically people are not going to put new capacity in place and that by itself will correct the industry.

Now it is true that, as I’ve said before today, that last year first quarter we had a very negative quarter for the industry and we all thought that was a one-time event because everybody learned how to manufacture MLC in the fourth quarter of 2006. We said that’s a one-time event.

We are seeing the same kind of situation first quarter of this year and we clearly can’t blame it on MLC. The question really is, is every first quarter going to be the same thing where people bring up additional production capacity and it’s unabsorbed.

I think the reason why people, companies such as ourselves and our competitors aren’t putting so much resources, investment, CapEx, technology and so on is because we do all believe that this industry is very young and will grow and eventually some of these very large applications will soak up demand even in a seasonally weak first quarter.

Ideally it would be good if you could throttle back new capacity in the first quarter to be in line with first quarter seasonality, but as we know that’s not possible. The best that we can say right now for our industry is that capacity and inventories typically may in fact typically in years forward rise in the first half of the year and be consumed in the second half of the year and the question is how do different companies manage that excess supply so as to intelligently drive the creation of new markets without tremendous pain.

Paul Coster - J.P. Morgan

Thank you.

Operator

We’ll take our next question from Daniel Amir with Lazard.

Daniel Amir - Lazard Capital Markets

A couple of things here; first of all, I think in your analyst day you were commenting about profitability of 2008 compared to ’07. And I think at the time you commented that it could be -- you should expect that it should be a more profitable year. Is that still the case that you expect that that way, or are we kind of on hold here following I guess the first half of the year?

Judy Bruner

Daniel, it’s still early in the year and so we are still very focused on trying to achieve the ranges that I provided at the analyst day and you know, the key factors that will influence that are clearly are ability to execute on cost reductions, the pricing that unfolds over the course of the year, volume, and the -- however, the one factor that there has been some change in from analyst day until now is the continuing depreciation of the U.S. dollar relative to the YEN, and that does put some pressure on our product gross margins and in turn on our operating margins.

But that said, we are still very focused on trying to achieve the ranges that we described at the analyst day.

Daniel Amir - Lazard Capital Markets

Okay, thanks. And one follow-up question -- on the X3, where are we in terms of cost parity compared to the current MLC production? And when do you see I guess the X3 becoming lower cost in terms of benefiting your margins?

Sanjay Mehrotra

With respect to X3, right now we are ramping up production in 56-nanometer, so the key really is our focus in terms of three steps.

The first step, the most important step for us is to continue to ramp up 43-nanometer aggressively, and that 43-nanometer at this point is two-bits per cell technology. And of the production that is remaining from that 43-nanometer ramp-up, we want that 56-nanometer production to have as much of three-bit per cell as possible.

And third and important aspect is that we are bringing up three-bit per cell in 43-nanometer as well, which we will sample by the end of the year and will be getting into production the early part of next year. And ultimately next year, we plan to as indicated at the analyst day, have approximately 50% of our bits in 43-nanometer three-bit per cell technology.

So for three-bit per cell with comparable yields and comparable technology, it gives us a cost benefit of 15% to 20% at the product level compared to the same technology on two-bit per cell.

Daniel Amir - Lazard Capital Markets

Okay, thanks a lot.

Operator

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

Harlan Sur - Morgan Stanley

A few of your competitors are struggling with yields at the 60-nanometer nodes and below. Can you just give us a sense on where your yields and densities are at 43-nanometers relative to your internal targets?

Eli Harari

The reason for struggling with 60-nanometer is that it’s -- this technology is very tough and there have been a number of competitors that have tried to squeeze the last kind of ring of technology out of their existing toolset at the 60-nanometer and in some cases, 57-nanometer.

We and Toshiba made the decision three years ago to make the switch very early on to 300-millimeter and to not use the 70-nanometer equipment set beyond 200-millimeter and in fact, move at that time -- this was three years ago -- to immersion scanners, very advanced technology. We did that with the 56-nanometer technology in very high volume, so the move to 43-nanometer does not require for us really any significant new learning and we therefore expect a very smooth and very rapid ramp-up of 43-nanometer with good yields and a relatively quick transition from 56 to 43-nanometer.

Harlan Sur - Morgan Stanley

Okay, great, good to hear. And then switching gears, I think you might have commented a little bit about this but U.S. retail was weak in Q4. I think Judy, you said you saw 12% growth in the first quarter. I’m just curious in terms of what you are seeing here early in Q2 in U.S. retail from a demand perspective.

Judy Bruner

It’s really too early to call anything in retail for Q2 because the seasonality patterns for Q2 are really fairly back-end loaded with, as we describe it, Mother’s Day and Father’s Day, graduation, proms, so that’s been pretty typical that the seasonality is really in the second half of Q2.

Eli Harari

I think the stimulus package should help in the United States and typically, this is like the second Christmas for retailers, so I think they are going to do everything they can to draw consumers back into the stores. We’ll see what happens.

Harlan Sur - Morgan Stanley

Okay. Thank you for that. And my final question, your CapEx outlook for 2008, I’m assuming based on your commentary that it is still around $2.4 billion. Is that correct?

Judy Bruner

At this point, I would not change anything in the CapEx outlook for this year that I laid out at the analyst day.

Harlan Sur - Morgan Stanley

Okay. Thank you very much.

Operator

We’ll take our next question from Sidney Ho with Merrill Lynch.

Sidney Ho - Merrill Lynch

Let me try to ask a gross margin question from a slight different angle; without asking you to predict pricing, how should we model the cost reduction side of the equation on a quarterly basis for the rest of the year, considering the ramp of 43 and 56 and there is usually a corollary between cost savings that show up on the P&L.

And also can you repeat what you said about crossover, the timing of the crossover for different technologies? I didn’t quite get the last --

Judy Bruner

Sidney, I had laid out at our analyst day that we expect our cost reduction for 2008 to be between 50% and 55% relative to 2007. But we are not going to break that down in terms of specific quarterly ranges. However, generally the pattern that I’ve talked about is that it will follow a relatively similar pattern to last year, where -- and that is that the low point is really the second quarter. And then in the second half, we begin to see more benefit from the technology transition to primarily to 43-nanometer and in that regard, Q4 should see more than Q3 and again, very similar to the kind of pattern we saw last year.

Sidney Ho - Merrill Lynch

And in terms of the crossover timing, sorry?

Sanjay Mehrotra

In terms of the 43-nanometer production, we have said before that in Q4 timeframe of 2008, we expect 43-nanometer to be contributing approximately the same as 56-nanometer did in Q4 2007, so approximately two-thirds of our base production in Q4 of 2008 we expect to be based on 43-nanometer technology.

Sidney Ho - Merrill Lynch

How about from a cost standpoint between 43 and 56 crossover, not just unit shipment?

Sanjay Mehrotra

So in terms of crossover, our 43-nanometer yield, this is the first quarter we are ramping up and basically, a crossover of 43-nanometer yields is very much within the guidance that Judy has provided of 50% to 55% overall cost reduction during the course of the year.

Sidney Ho - Merrill Lynch

Okay, I get that -- I’m sorry, just two really quick questions; can you tell us how much inventory reserves that you take during the first quarter? And are you saying with your royalty revenue guidance for the full year 450 to 500? And if you are, then it looks like first half royalty is about the same as second half. Thanks.

Judy Bruner

Sidney, I’m not going to give specifics on the inventory reserves but I will tell you -- I’ll give you an answer similar to the answer I gave last quarter one, and that is that the incremental reserves that we took in the first quarter relative to the previous quarter were an impact of about 2.5 points on our gross margin.

So the total reserves were greater than that but the incremental impact was about 2.5 points.

And then in terms of royalty revenue, yes, I would still go with the $450 million to $500 million range that we’ve talked about previously.

Lori Barker

I believe we have time for one more question.

Operator

We’ll take our final question from Erik Solomon at Morningstar.

Erik Solomon - Morningstar

I just wanted to follow-up with something that you had said during the analyst day meetings about the new product announcements, specifically for the Sansa line, and what you mentioned on the call, the enterprise business as well. I wonder how soon we can expect new Sansa products. And on the enterprise business, how do you see the demand for those new products?

Eli Harari

For the Sansa line, the Sansa Clip, which is a very nice, kind like a sports device, is doing very, very well and is the -- you know, driving the unit volume at that below $100 price range.

The Sansa Fuze is an absolutely great product. We can’t make it fast enough and we -- we are shipping it as fast as we can. It’s flying off the shelves and it’s really a great product, tremendous value proposition and a beautiful product.

On the enterprise, this is a relatively small team that we are trying to beef up as quickly as possible because the opportunity is very, very large. It’s a niche market but a very profitable niche market. We just recently announced a FIPS certification, which is a very important security level that we have achieved. And this is one of the teams that we’ve inherited from msystems. We want to grow that business. The customers really are not -- they don’t buy a Cruzer drive; they buy a complete service for a 20,000 sales force automation, things of that nature.

So this is a nicely profitable business and we will nurture it and it will be a significant business for us in the years ahead. But it is not a major consumer of Flash memory, certainly not for the next few years.

However, the point I was trying to make was we are constantly expanding our decommoditized business exposure, market exposure, where we see even small markets that we see an opportunity to grow to several hundred million dollars level business with very good gross margins, and we are talking about certainly north of 50% gross margin, to kind of allow us to average over some of the commodity business.

Erik Solomon - Morningstar

Thanks very much.

Eli Harari

With that, I want to say thank you all for coming, for listening to this conference call. Undoubtedly we are in a challenging environment; however, conditions we believe should improve gradually. We have a seasoned management team that has been through these downturns before. We are approaching this downturn as an opportunity to grow our market share but at the same time we are really prioritizing our profitability. So thank you for listening and we’ll see you next quarter. Thanks. Bye.

Operator

And this does conclude today’s conference. We thank you for your participation. You may now disconnect.

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