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SanDisk (NASDAQ:SNDK)

Q2 2012 Earnings Call

July 19, 2012 5:00 pm ET

Executives

Jay Iyer

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

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

Analysts

James Schneider - Goldman Sachs Group Inc., Research Division

Monika Garg - Pacific Crest Securities, Inc., Research Division

Tristan Gerra - Robert W. Baird & Co. Incorporated, Research Division

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

Uche X. Orji - UBS Investment Bank, Research Division

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

Steven Bryant Fox - Cross Research LLC

Harlan Sur - JP Morgan Chase & Co, Research Division

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

Doug Freedman - RBC Capital Markets, LLC, Research Division

Joseph Moore - Morgan Stanley, Research Division

Operator

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

Jay Iyer

Thank you, Mikhail, and good afternoon, everyone. Joining us on the call today are Sanjay Mehrotra, President and CEO of SanDisk; and Judy Bruner, Executive Vice President of Administration and CFO.

Before we begin, please note that any non-GAAP financial measures discussed during this call as defined by the SEC in Reg G will be reconciled to the most directly comparable GAAP financial measure. That reconciliation is now available, along with supplemental schedules on our website at sandisk.com/ir. Please note that non-GAAP to GAAP reconciliation tables for all applicable guidance will be posted on our website. This guidance is exclusive of any onetime transactions and does not reflect the effect of any acquisitions, divestitures or similar transactions that may be completed after July 19, 2012.

In addition, during our call today, we will make forward-looking statements. Any statement that refers to expectations, projections or other characterizations of future events, including financial projections and future market conditions, is a forward-looking statement. Actual results may differ materially from those expressed in these forward-looking statements. For more information, please refer to the risk factors discussed in the documents we file from time to time with the SEC, including our annual report on Form 10-K fiscal 2011 and our subsequent quarterly reports on Form 10-Q. SanDisk assumes no obligation to update these forward-looking statements, which speak as of their respective dates. With that, I will turn the call over to Sanjay.

Sanjay Mehrotra

Thank you, Jay, and good afternoon, everyone. As we expected, the second quarter reflected continued weakness in our product sales to mobile OEMs, partially offset by strength in retail. Our solid state drives sales grew sequentially to 10% of total second quarter revenue and we strengthened our enterprise SSD solution offerings with the acquisition of Schooner Information Technology. We made good progress in developing new products for the mobile market and we expect these products to drive revenue growth starting in the third quarter of 2012.

In the second quarter, as we discussed previously, the bundled card opportunity with handset OEMs continued to decline due to a combination of OEMs reducing their [indiscernible] costs and increasing their mix of embedded flash smartphones. Although we have seen modest increases in retail card bundling by some operators in certain regions, it is premature to assess if reductions of the OEM card bundling has provides sustained to meaningful increases in retail. We made a major effort we did last year on expanding with only spending the card product portfolio to enable resumptions in the growth of our mobile OEM embedded category. I'm pleased to report that we began initial revenue shipments of our customized embedded solution for a key customer late in the second quarter. From Q3 onward, we expect this new customized embedded solution to contribute significantly to our revenue.

During the second quarter, we also successfully completed qualification and began initial shipments of our new multi-chip package solution to certain budget smartphone customers. The MCPs are essentially our iNAND embedded products packaged with mobile DRAMs. We have engaged with various other OEM customers in completing additional qualification for our MCPs. Additionally, our next-generation, high-performance iNAND is currently in testing and qualification stages with various mobile OEM customers. We expect these next-generation iNAND to begin production ramp in the third quarter. Overall, we are driving aggressively towards reinvigorating the growth of our embedded business and are encouraged with the success achieved so far.

Turning to SSDs, our Client SSD sales continued to scale nicely, driven by both new and existing SSDs, as well as by embedded iSSD products. SanDisk's high-performance X100 SSD was successfully qualified at several customers and started production shipments in the second quarter. We also started production shipments for several platforms using SanDisk solutions in caching applications, the majority of which carry the SanDisk SSD modules or our SSD-based ExpressCache software. These programs represent significant progress for SanDisk in the Client OEM SSD market with design wins at 9 million PC OEMs. In Enterprise SSDs, we have strong sequential growth from our Flash drives. We also began shipments of our first-generation PCIe solution at 200 and 400 gigabytes capacities, initially targeted for sales through value-added SSD sellers and distributors. Our objective with this product launch is to seed the market and nurture our opportunities in the segment that is looking for cost performance optimize, PCIe SSD solution. Initial feedback from the industry analysts and solution partners on our PCIe SSDs has been positive. I'm also pleased to note that some of our enterprise SSDs have started to shift with our captive memory. On the software front, we have successfully integrated the FlashSoft team into our Enterprise Storage Solutions group and achieved initial software revenues for the 'caching solutions', and gained positive traction with our target OEM customers. In addition, we acquired Schooner Information Technology and its team that has solid expertise in database and data store markets. Schooner started portfolios helping design and optimize, exploring the capabilities of NAND Flash memory, multi-core processing power and high-speed networking infrastructure present in the data centers. The FlashSoft and Schooner acquisitions are highly complementary, and they enable SanDisk to provide performance acceleration solutions at higher level and as application sales. We are delighted with the progress we are making towards providing greater value added and innovative storage solutions on our enterprise customers.

We have had a solid quarter despite the weak global macroeconomic environment, with sequential revenue growth from SSDs and a richer mix of high-performance imaging products. [indiscernible] strong sales and market share gains in emerging markets was 150% year-over-year increase in units sold, and we also gained shares in U.S. and in Europe. These [indiscernible] our high-performance microSD cards and USB 3.0 flash drives as we continue to demonstrate our performance leadership in the industry. From an information technology standpoint, our 19-nanometer transition accounted for about 1/2 of our production mix in the second quarter, with excellent [indiscernible] on both X2 and X3 technologies. We have been, and expect to remain, the industry leader in the use of X3 memory. Every industry transitions to increasingly powerful embedded mobile and SSD applications, the high-performance [indiscernible] solutions required, we believe, will primarily use X2 memory. Consequently, as our share of these markets expands, we expect to increase the mix of X2 memory in our products in the foreseeable future. [Indiscernible] between industry supply and demand that began in the fourth quarter of 2011 persisted well into the second quarter. However, since the early part of 2012, there has been significant industry-wide slowdown in data capacity growth, causing moderation in the pace of industry supply growth beginning in the second quarter. The resulting improvement in pricing trends was especially noticeable towards the end of the second quarter.

As we go forward into the second half of 2012, we anticipate the launch of several new smartphones and tablets, along with a number of SSD-equipped Ultrabooks and other end-client PCs to drive continued increases in demand for NAND Flash. As a result, we expect an improved industry supply and demand and pricing environment in the second half of 2012.

Turning to industry base growth, we now forecast lower industry supply growth for both 2012 and 2013. This is the result of the industry slowdown in capacity growth, a continued slowdown in technology transition and a longer deal of technology nodes driven by OEM requirement. We now estimate industry base growth for 2012 to be in the 70% range. For 2013, we now estimate industry base growth to be in the 40% to 50% range, down from the 50% to 60% range estimated previously. As to SanDisk's capacity growth, we have not made any decision on further ramp of Phase 1 of Fab 5 and do not expect new SanDisk major capacity increase until sometime in 2013. We believe that flash demand growth fueled by smartphones, tablets and SSDs will outstrip this supply growth in 2013, supporting stronger industry fundamentals.

In conclusion, we expect solid acquisition of revenue growth in Q3 and Q4 due to an improved supply and demand balance, strong secular demand drivers and our expanding portfolio of products and solutions, which allow us to address a broader set of market opportunities. Our SSD SKUs continue to grow nicely and we are moving the company higher up the value chain with our SSD software solutions. We continued to manage our capacity growth prudently and remain focused on profitable growth by leveraging our expanding product portfolio and our diversified mix of customers and channels. And we continue to target -- we will continue to make targeted investments in technology to sustain our competitive cost structure and in resources to grow our Enterprise and Client storage solutions. Given our market initiatives, technology investments and focus on execution, we look forward to improved performance in the second half of 2012 and beyond. With that, I will turn the call over to Judy for our financial overview and outlook.

Judy Bruner

Thank you, Sanjay. Our second quarter results were consistent with the forecast we provided in April, and our expectations remain intact for improving financial performance across the second half, reflecting our expanding OEM product portfolio, our growing presence in the SSD markets and an improved industry pricing environment.

Starting with a review of second quarter revenue, our petabytes sold increased 5% sequentially and 52% year-over-year. And our ASP per gigabyte declined 18% sequentially and 52% year-over-year. The mix of our second quarter product revenue was 45% retail and 55% OEM, reflecting sequential growth in retail revenue of 10% and a sequential decline in OEM revenue of 28%. On a year-over-year basis, our retail revenue was up 1%, while our OEM revenue declined 39%. Within the retail channel, we experienced strong sequential revenue growth in both Asia and Europe, and modest growth in the U.S., with high-performance imaging products and SSDs being the primary growth drivers. On a year-over-year basis, retail revenue declined in the U.S. and Europe and experienced strong growth from Asia and Latin America, driven by mobile cards and USBs.

Across our retail regions, we experienced strong average capacity growth in our imaging and USB products. The demand for high-performance imaging cards plays to our strengths, and these products have a positive impact on our gross margin mix. Within the OEM channel, our revenue declined from both mobile cards and mobile embedded products, and our revenue increased nicely from SSDs, both sequentially and year-over-year. Our license and royalty revenue was down 12% sequentially and 6% year-over-year, with the decline related to reduced licensable revenues of our licensees.

Turning to gross margin, our total non-GAAP gross margin was 28%, equal to the midpoint of our forecasted range. Our total cost per gigabyte improved 9% sequentially and 35% year-over-year. Non-captive memory represented approximately 3% of our Q2 revenue, down from approximately 8% in the first quarter. The yen rate in our cost of sales was approximately 79, resulting in a sequential positive benefit of approximately $5 million and a year-over-year negative impact of approximately $26 million.

Non-GAAP operating expenses increased sequentially by $19 million to $224 million, very close to our forecast. R&D increased $11 million related to SSD hardware and software development, NAND development for 1y and 1z nodes and spending on future technologies. G&A increased $5 million primarily due to a onetime insurance recovery in the first quarter, and the $3 million increase in sales and marketing related primarily to SSDs and seasonal retail merchandising expenses.

Our second quarter non-GAAP operating expenses were roughly flat on a year-over-year basis as reduced incentive compensation has offset increased investments related to technology and SSDs.

On the balance sheet, cash and short and long-term marketable securities decreased sequentially by $212 million and ended the quarter at $5.3 billion on a gross basis and $3.3 billion net of debt at the maturity value. Cash flow from operations in Q2 was a positive $19 million. Inventory at the end of Q2 represented approximately 1 quarter's worth of supply. With growing second half revenues and no capacity expansion for the remainder of the year, we believe inventory will return to lower normal levels in the second half.

Our primary cash outflows in the second quarter included $113 million related to share repurchases and $96 million for CapEx. The fab joint ventures delivered net cash of $19 million to SanDisk. Joint venture capital investments for the benefit of SanDisk have been $335 million year-to-date, bringing total SanDisk capital investment, including non-fab CapEx, to $575 million year-to-date.

Our share of joint venture equipment lease guarantees stood at $950 million at the end of Q2.

I'll now turn to forward-looking commentary. As Sanjay described, we believe that the improved supply-demand environment experienced late in Q2 will continue in the second half, resulting in a better pricing environment. In addition, we expect to benefit from sequential growth in our mobile embedded revenue and continuing growth in our SSD sales. Our third quarter revenue forecast is $1.20 billion, plus or minus $50 million.

Looking ahead to the fourth quarter, we expect to benefit from continued sequential growth in sales of our mobile embedded products and SSDs, as well as retail fourth quarter seasonality. For Q3, we are forecasting that our price decline and cost decline will be in relative balance, allowing gross margins to stabilize. Our expected blended price decline reflects an improved industry pricing environment, as well as growing sales of high-margin SSD solutions, offset by an increased mix of lower-margin, custom embedded solutions.

Our expected total non-GAAP gross margin remains consistent with Q2 at approximately 28% plus or minus 2 points. We currently expect our gross margin to begin improving in the fourth quarter with a continued favorable supply-demand environment and an increasing mix of higher value-added product sales.

In terms of operating expenses, our key focus areas for investment are SSD solutions, enterprise sales and marketing capabilities and our three-pronged memory technology strategy. These are strategic investments that we believe will have significant payback over time, so it is important that we make these investments even when profitability is below our target model. We expect non-GAAP operating expenses of approximately $235 million for the third quarter and approximately $910 million for the year, down from the $920 million forecast we provided in April.

We expect non-GAAP other income to remain at approximately $5 million on a quarterly basis, and we forecast our tax rate to be approximately 30% on a non-GAAP basis. In terms of fab capital spend, the investments for the remainder of the year will be focused on technology transitions with no added wafer capacity. We expect the joint ventures to continue to be a net source of cash to SanDisk in the second half of the year. We expect our total capital investment for 2012 to be approximately $1.2 billion, including about $700 million at the fab joint ventures and about $500 million of SanDisk CapEx.

In total, we expect the 2012 cash outflow for these investments to be approximately $400 million, with $221 million spent year-to-date. In summary, we believe our second half performance will benefit from an improved demand-supply environment and growing sales for mobile embedded products and SSD solutions. And we expect to deliver improving revenue, earnings and cash flow across the second half of 2012. We will now open the call for your questions.

Jay Iyer

Mikhail, can we -- can you poll the floor for questions, please?

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Jim Schneider from Goldman Sachs.

James Schneider - Goldman Sachs Group Inc., Research Division

I was wondering, with respect to your qualification of embedded products that you talked about, last quarter, you mentioned some of them had been completed in Q2. Can you share with us whether you've completed all the qualifications with customers that you intended to complete in Q2? And then maybe talk about how you expect the ramp of those embedded products to turn into sales in Q3 and Q4. In other words, is the ramp expected to be significantly higher in Q4 than they are in Q3?

Sanjay Mehrotra

With respect to the customized solution, we indicated in the prepared remarks that we qualified that with our customer and we began shipments, and customized solution sales will drive significant revenue increase for us in Q3, as well as will continue to be strong for us in Q4 as well, we expect. Regarding iNAND, we are in the stages, as mentioned in the prepared remarks, of qualification at various customers, and we expect some of these qualifications to complete in Q3 timeframe and for the products to start going in production, driving revenue opportunity going forward. Regarding MCP, some of these MCP solutions are qualified. They are providing us some revenue increase in Q3 as well, and we expect more qualifications for MCP solutions in Q3 and going beyond as well. So we are continuing to evolve our embedded products roadmap consisting of customized solutions, iNAND solutions, as well as MCP, and making good progress on it and these will contribute -- one of the key factors, in terms of our revenue increase projections for the second half.

James Schneider - Goldman Sachs Group Inc., Research Division

That's very helpful. And then if I could just follow up on the gross margins for a second. Can you talk about the impact of the relative mix of the embedded solutions, as well as the solid-state drives into Q4? In other words, how should we expect gross margins to inflect upward in Q4 if the embedded is much stronger than the SSD by the end of the year?

Judy Bruner

Sure. As I indicated, there is a mix of different products within the mobile embedded solutions. And for example, iNAND tends to have stronger gross margins than our average, whereas the customized embedded solution has lower gross margins than the average. MCP solutions also tend to have somewhat lower gross margin percentage because of the DRAM component of those solutions. So we will have a mix of the embedded solutions growing across the second half, and at the same time, we will have, we believe, strong growth in the SSD solutions. And we have strong gross margin contribution from the Enterprise SSDs and Client SSDs also have good gross margin. So there's really a mix here and we are managing the mix of our portfolio. And with that and the improved supply demand environment, we believe we can have consistent gross margins in the third quarter and begin to see improving gross margins in the fourth quarter.

Sanjay Mehrotra

And I'm not sure if your question was only to me, but only regarding mobile products or all new products. And here, I just want to point out that on the SSD side, I mentioned in our prepared remarks that we had several SSD designs that got qualified, the client computing customers and are ramping in production in the third quarter. And of course, we have additional qualifications in progress with the Client SSD customers. And similarly, on the Enterprise SSD side, we continue to be engaged in qualifications with customers to expand our reach in the enterprise storage space.

Operator

The next question comes from Monika Garg from Pacific Crest Securities.

Monika Garg - Pacific Crest Securities, Inc., Research Division

First of all, I just wanted to understand, could you provide details on how the vertical NAND, development of that is progressing and when do you expect qualification on that product?

Sanjay Mehrotra

As we have discussed at our Analyst Day, as part of our three-pronged strategy, we are continuing to drive the business scaling of NAND, as well as partnering with Toshiba on vertical NAND, what we call bit cost scalable (BiCS) technology, and the third prong is the 3D divesture plan. We have continued to make progress on these. In terms of future ramp-up or timing of introduction of these technologies in production or ramp-up, we will let you know once we are ready with those. Mainly, there are no substantial updates since our Analyst Day on this other than continuing to advance technology development work on this. And of course, we are continuing to work on NAND scaling with respect to 1y and 1z technology, and as we have said before, we plan to launch 1y technology in 2013 timeframe.

Monika Garg - Pacific Crest Securities, Inc., Research Division

Okay, very helpful. Just the last question here. SNL [ph] talked yesterday that they are seeing orders for NAND capacity build out in 2013. So I'm just trying to reconcile though that commentary with your commentary, where you were guiding down the bit growth for 2013. So any comments on that would be very helpful.

Sanjay Mehrotra

The key factors with respect to the NAND-based growth in 2013 are that in 2012, there has been minimal new wafer capacity addition. In fact, right now, as announced by various suppliers, there is no new wafer capacity that is being added in the industry. And that has an impact on the bit growth in 2013 timeframe. And our estimate is also based on technology transition, timings for next year, as well as productivity of the new technology nodes. And keep in mind that SanDisk is one of the leading players in terms of manufacturing flash memory with our joint ventures. So I believe that based on all our internal assessment in this regard regarding capacity and technology strata, we believe that the new -- the bit supply growth in production in 2013 will be in the range of 40% to 50%.

Operator

The next question comes from Tristan Gerra from Baird.

Tristan Gerra - Robert W. Baird & Co. Incorporated, Research Division

How should we look at production cost declines in the second half versus the first half? And is there any quantification you can point to that?

Judy Bruner

Sure. In the first half of the year, our cost decline sequentially was 11% in Q1 and 9% in Q2, and I believe 36% year-over-year in Q1 and 35% year-over-year in Q2. And we now believe that we will be at the high end for the year of the 25% to 35% cost decline range that we described at the beginning of the year. So we now believe we'll be at the high end of that range for 2012, with cost decline in the second half similar to what we just experienced in the third quarter.

Tristan Gerra - Robert W. Baird & Co. Incorporated, Research Division

Great. Very useful. And a quick follow-up...

Judy Bruner

In the second quarter, excuse me. In the second quarter.

Tristan Gerra - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then a quick follow-up is, are you still shipping in the white label card market, and is it fair to assume that your exposure in that segment is going to decline in the second half?

Judy Bruner

We are still selling to the white label market, but our sales to that market have declined. And yes, it is fair to assume that they will continue to decline.

Operator

The next question comes from Mehdi Hosseini from Susquehanna International.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

Mehdi Hosseini, Susquehanna International. I have 2 questions. Sanjay, can you help me understand or get a feel for the SSD mix into the second half? You talked about continued growth, but how should we think about the mix? And also, Judy, how should we think about the free cash flow trend into the second half, especially since inventories are coming down?

Sanjay Mehrotra

So in the second half, SSD revenues will continue to grow for us in Client SSD applications, as well as in Enterprise SSD applications. So we are looking forward to solid growth, sequential growth for SSD business in the second half. And keep in mind that our embedded business, embedded mobile business will also grow sequentially, we expect, in the second half. So overall, these are the 2 key drivers of growth. And we are not prepared to comment on the mix of the SSD as well in terms of SSD sales as a percentage of revenue in the second half of the year. We have said earlier that for 2012, we would expect SSDs to be more than 10% of our total revenue.

Judy Bruner

As to your question on free cash flow, I do expect that we will have positive free cash flow in the second half of the year, free cash flow being measured as cash flow from operations, less cash flow used for investing in CapEx, capital investments, including the joint ventures. And as I indicated earlier, we expect the joint ventures to be a source of cash in the second half of the year. So free cash flow, we expect to be positive in the second half.

Operator

The next question comes from Uche Orji from UBS.

Uche X. Orji - UBS Investment Bank, Research Division

It's Uche Orji. So let me just go through real quick, can I get some clarification on the royalty revenue? Judy, you mentioned something about less license for revenues in Q2. Any color as to what that is? And also, do you have an estimate of -- for royalty contribution in Q3? You've talked about industry fundamentals improving. Any idea as to how we should think about royalty contribution for Q3 given the follow-up we saw Q1 to Q2?

Judy Bruner

Sure. So in terms of the decline in our license and royalty revenue from Q1 to Q2, keep in mind that the industry had some pressure in the first quarter in terms of NAND revenue, and that factors into our license and royalty revenue. And also, we received some of our license and royalty revenue related to card sales. And so with the debundling trends that we've talked about for a while now, that also played a factor in the sequential decline in our license and royalty revenue. As we move to the third quarter, best estimate at this point would be that the license and royalty in Q3 would be similar to the license and royalty in Q2. And but of course, the card debundling may continue to play a factor in that Q3 license and royalty, but we expect it similar to Q2.

Uche X. Orji - UBS Investment Bank, Research Division

Hopefully. Okay, that's helpful. Just to understand your CapEx, I know it's -- you're talking about $500 million for SanDisk, $700 million for the JV. I'm not sure how much of that is your headquarter's building. And just in terms of any more color you can provide around what's in that CapEx will be helpful.

Judy Bruner

I believe I indicated at our Analyst Day that we spent about $88 million on the corporate headquarters. We're spending a little additional money in order to do some renovations during the year. But the bulk of the $500 million of SanDisk CapEx is related to production equipment, both assembly and test equipment, at our captive back-end facility and at contract manufacturers.

Uche X. Orji - UBS Investment Bank, Research Division

Helpful. And just one last question. On microSD cards, one of the areas we've seen strength in the smartphone market has been, obviously, in the low-end Chinese smartphone markets. What is your sense of SanDisk's engagements with microSDs in that customer area? And as we look at your view of Q4, what is your expectation for pricing dynamics in the microSD? And I say that because that seems to be one of the areas where we saw improvements earlier on in Q2 before we started to see any change in the mainstream non-contract pricing. So any commentary around that would be helpful for me.

Sanjay Mehrotra

We are very well-engaged in the Asia markets and at the Chinese market and certainly, with the growth of smartphone sales and growth of large -- of the low-end smartphone sales, certainly, there is card opportunity there. But let me tell you, we have very, very strong shares in mobile cards through the various customers that we sell to. We sell in China as well. But overall, in terms of bundled card opportunity with mobile phones in general in all regions combined, we would expect this to continue to decline during the rest of 2012.

Operator

The next question comes from Craig Ellis from Caris and Company.

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

Judy, you mentioned that you'd expect inventory to decline in the third quarter and the fourth quarter. Can you quantify how much of the decline you're looking for in 3Q, either on a day's basis or another metric?

Judy Bruner

As I mentioned, the inventory is about a quarter's worth at the end of Q2. A more normal range for us would be 8 to 10 weeks of inventory, and I expect that we will get into that range in the second half.

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

And you expect to get into that range in the second half. So not saying that you'll get there in the third quarter by the time you exit the year?

Judy Bruner

Yes. I don't want to predict exactly when we'll be there, but I definitely believe inventory will come down in the third quarter and that it will be at much more normal levels in the second half.

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

Okay. And then just a follow-up on some of the earlier gross margin questions. I think in the first quarter, there was a $25 million inventory charge. Was there a charge in 2Q? And the second sourcing down to 3% in the second quarter and given where inventory is, just are we looking at a second half where there's no second sourcing that you have to worry about, just a margin dynamic?

Judy Bruner

Okay. First, on the inventory reserves, the $24 million charge that I talked about in Q1 was a charge related to lower of cost or market inventory reserves. And in terms of lower of cost to market inventory reserves, the net change in those reserves in Q2 was very small. So very insignificant. There, of course, are always other types of inventory-related charges, which is normal to inventory, and that occurred in Q1 and it occurred in Q2. But the number that I called out was lower at cost to market and that was a very small number in the second quarter. In terms of your question on non-captive -- use of non-captive memory, which was about 3% in our revenue in the second quarter, I do not expect that that is going to increase in the second half. At this point, as we indicated, we have started to shift our enterprise SSDs using captive memory and we have ample inventory on the balance sheet. So I don't expect non-captive usage to go up in the second half.

Operator

The next question comes from Steven Fox from Cross Research.

Steven Bryant Fox - Cross Research LLC

Just a couple of questions, please. Just to be clear on the range of gross margins expectations for the quarter. It's basically related to volume and mix, and there's no other major swings that could affect -- that you're contemplating in that. Can you just -- any kind of detail on that? And then secondly, with the expectations for a retail improvement in the fourth quarter, what are you generally hearing from the retail environment in terms of the macro and tack-on demand for your products, especially on the high-end side?

Judy Bruner

Okay. So on your gross margin question, you mentioned volume and mix and asked if there was anything else that was a big factor in gross margins. And those are clearly 2 important factors. And I would point out that mix is increasingly playing an important factor in our gross margins. As I mentioned, we have many SSD solutions that have quite a bit higher than average gross margin. We have other solutions like the customized embedded, mobile embedded solution that has lower-than-average gross margin. So mix is very important. But in terms of other factors, of course, pricing is a key factor. And here, we believe that there will be a more favorable pricing environment in the second half than in the first half. We saw that start to change in the latter part of the second quarter. And of course, our execution on cost reduction is also a key factor. Non-captive mix is a factor, but as I mentioned, that was only about 3% in Q2 and I don't expect that that will go up in the second half. Another factor is the yen, but we are about 70% hedged for the year in terms of the yen, so I don't expect that that could have a wild impact on our gross margin even if the yen rate were to start to move. It can have some impact, but not a wild impact. Okay, your second part of your question was related to retail, and I wasn't clear if you were asking about retail gross margins or retail demand?

Steven Bryant Fox - Cross Research LLC

Retail demand. You mentioned the fourth quarter to be helped by seasonality, and I was just trying to get a feel for the type of seasonality you're expecting relative to, say, products that are using the Client SSDs or high-end imaging products.

Judy Bruner

Well, we've typically seen stronger fourth quarter demand seasonality in our retail business, and we expect that that will be the case again. Typically in retail, the fourth quarter is -- does have quite strong demand for the high-end imaging products, as you just mentioned. In terms of the SSD, the retail SSD products, we don't have much historical experience with that. I would tend to think those are not as much of a holiday period purchase as, say, imaging or USBs. I would tend to think that retail SSD sales would have less seasonality with them.

Steven Bryant Fox - Cross Research LLC

Any normal -- excluding SSDs, you're looking for sort of normal seasonality in Q4, though, for retail?

Judy Bruner

Of course, there are some macroeconomic conditions around the world that are somewhat depressed at the moment. So it's hard to, at this point, give a comparison to previous years. But we expect that the fourth quarter retail demand will be stronger than the third quarter retail demand.

Operator

The next question comes from Harlan Sur from JPMorgan.

Harlan Sur - JP Morgan Chase & Co, Research Division

SSD products are now 10% of total sales. Can you just give us a sense of how that breaks out in terms of Enterprise versus Client? And then on the Client side, it seems like the market is adopting more dual drive configurations for Ultrabooks in the second half of the year. I know that we've been waiting for hybrid drive configurations to sort of fill the void between SSD and HDD. Sanjay, what's your sense of when we're going to see more hybrid drive configurations and how well positioned is SanDisk in this product category?

Sanjay Mehrotra

So your first question regarding the mix between Client SSDs and Enterprise SSDs, we are not giving split. The total SSD business is 10%, and both Client SSD as well as the Enterprise SSD revenues grew nicely in the quarter. With regard to the caching solutions, SSDs getting used for caching and dual drive that you mentioned, yes, that's correct. And what we see in terms of our Client SSD revenue is that it is almost a 50:50 split in terms of revenue between the caching applications for SSD and the standalone SSD. And as certainly, hybrid drive is a growth opportunity and we would expect that to start building up as an opportunity for our industry, as well as for SanDisk in 2013 timeframe. And we are certainly engaged and planned to be a supplier of flash solutions to the hybrid disk drive industry as well.

Harlan Sur - JP Morgan Chase & Co, Research Division

Great. And SanDisk is leading the market, as you mentioned, in the 3-bits-per-cell technology. I know that most of your embedded solutions, as you mentioned, are 2-bits-per-cell. What are the actions that the team is trying to take to try to move 3-bits-per-cell technology into your embedded products? Obviously, this would give the team significant cost advantage over your competitors. It's a tough technology to do, so is there any activity at SanDisk to try and enable this? And any view on timing?

Sanjay Mehrotra

So as we have mentioned before, as the applications are becoming increasingly more powerful, the requirements for flash memory in terms of performance, as well as other attitudes, are only increasing further and further. And at the same time, as the technology is scaling, flash memory technology is scaling, the flash memory's inherent characteristics at the flash memory chip level tends to degrade bit scaling of the technology. Therefore, the gap between the future technology capabilities and the expected future requirements for flash memory solutions and the applications is only increasing. This advanced sophisticated system techniques are certainly required, and for the increasingly powerful devices of the future that will require a higher and higher performance, X2 memory is more suited, and we are focused on developing leading edge in the product solutions for mobile embedded, as well as for SSDs, which will primarily be using X2 memory. Of course, we will continue to look for opportunities to advance our system capabilities and look for opportunities for X3-based solutions as well. But I would expect that the primary part of the market in the future in embedded solutions and SSDs will remain X2-based.

Operator

The next question comes from Daniel Amir from Lazard Capital Markets.

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

So a couple of questions here. First of all, on the bundled card environment, can you give us more clarity, how much do you think maybe we have a permanent shift here on the bundled card OEM or -- and how you exactly manage this business in the next few quarters, if this is more of a permanent transition, given that this has had a fairly big impact on your business in the past? And I have one follow-up then.

Sanjay Mehrotra

So based on our understanding of customer requirements in the future and the trends that are building up in this business, as I mentioned, we think that the bundling requirements in the future for mobile phones will continue to decline. And in our forecast, we have taken that into consideration. And basically, as I mentioned earlier, that bundled card opportunity is getting reduced either because of certain OEMs, mobile OEMs facing pressure on their bond cost and bundling cards with lower capacity, but also because of increasing shift toward high enough capacities of embedded flash in the smartphones, which are reducing the bundling opportunities for big mobile OEMs.

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

Okay. And then on the SSD side, I mean you've been fairly acquisitive, I guess, in the past few quarters. Do you feel that you have enough for the product portfolio needed in order to compete in both the Client and Enterprise side? Or are you still looking to further fill in gaps on the software side, which sounds like that's becoming more and more critical for you in terms of potential success on the Enterprise level?

Sanjay Mehrotra

So I will answer your first question, but I want to make a comment related to your previous question. And I just want to add that even though card bundling is reducing, but the embedded flash opportunities in mobile phones, particularly smartphones, really continue to increase well. And with our expanding and strengthening portfolio of embedded products, we expect to be driving growth in all our mobile markets through the embedded product solutions. So we'll certainly look at declining bundling opportunity, but we look at increasing embedded growth for us going forward. Regarding SSDs in Clients and Enterprise, we believe we have a pretty solid product portfolio now both in Client as well as in Enterprise side of the business. Client SSD, we have a broad portfolio of [indiscernible] offering iSSD solutions, which are very small form factor, SSDs products, caching solutions, as well as high-performance SSDs. And we are well positioned in Ultrabook, as well as other PIN devices and growing our customer base and channel penetration. You know that we have been very small in our SSDs in retail and we look at this as a growth opportunity for us in the future. So I think we have a strong product portfolio, very good customer engagement and increasing channel penetration to drive the Client SSD. And on the Enterprise SSD, our fab products continue to be the leadership products in the market. And that's where a lot of the revenue growth is coming in. PCIe is another new market opportunity for us. We introduced our PCIe product in Q2 and realized in Q2 revenue from those, and we look at this as becoming a growing contributor for us in the future, as well as certainly, our software solutions, from what -- extend our vertical integration and they help us provide even increase value to our customers in terms of enhancing the performance of the SSDs through these software solutions. So we are actually very pleased across the board on SSDs, with our Client SSD and Enterprise SSD products, solutions, the vertical integration capabilities that are, in totality, able to bring tremendous value to our customers. And of course, we will continue to look for opportunities, for acquisitions that allow us to further strengthen and give us competitive -- even further strengthen our competitive position in the marketplace.

Operator

The next question comes from Doug Freedman from RBC Capital Markets.

Doug Freedman - RBC Capital Markets, LLC, Research Division

Judy and Sanjay, if you could -- if I could focus in a little bit on one of the things that I think has been most challenging for us to track, and that is sort of the average density that you're seeing in the end markets in each one of the products that is consuming NAND. Do you happen to have any information regarding what your customers are using sort of in the handset mode in tablets and then on notebooks, maybe your SSD averages?

Judy Bruner

We don't provide those kind of numbers every quarter, but clearly, actually, we had strong growth in average capacity this past quarter. And in terms of the overall average, average capacity for the quarter was 6.5 gigabytes. We have, of course, very different average capacities across our products and in terms of Enterprise SSDs being over 500 gigabytes on average and selling cards as low as 2 gigabytes. So very different numbers across our product line. But the overall growth for the quarter, I believe, was about 12% sequentially -- 11%.

Doug Freedman - RBC Capital Markets, LLC, Research Division

If I could move on and talk a little bit about your strategy in the embedded and custom embedded, are there any actions that you can take where that could occur that could cause your embedded custom solution to see margins rise? Is there a way to see -- is it yield-dependent? Are there things that can occur that can help the margins there? And then when you look at your other embedded solutions where you're buying a mobile DRAM, what are the factors that go into the margins there that could possibly move around? How long do you think you're going to need to buy mobile DRAM? Can you move to an all-SanDisk solution at some point in time?

Judy Bruner

So in terms of our various embedded solutions, the cost reduction or -- excuse me, the gross margin is going to be influenced primarily by our cost reduction and moving those solutions to new lower-cost nodes, reducing the costs of the controllers that go into those products. And then of course, the pricing environment. And as we indicated, we think the pricing environment is more favorable in the second half than in the first half. In terms of the MCP types of products, we don't have any plans to have any captive DRAM capability. So we will continue to purchase those components and we have some good supply arrangements in place.

Doug Freedman - RBC Capital Markets, LLC, Research Division

I just want to make sure I understood what you said, that pricing in the marketplace can impact your embedded custom solution margins, that those -- they're not on a sort of fixed contract with your customers? There is some sort of uploading element?

Judy Bruner

We negotiate pricing with our OEM customers on at least a quarterly basis.

Jay Iyer

Mikhail, we have time for one more question.

Operator

The next question comes from Joe Moore from Morgan Stanley.

Joseph Moore - Morgan Stanley, Research Division

Can you just tell me, as you look out to next year, what do you think happens to NAND content per smartphone and per tablet? It seems -- particularly at the high end, where it seems like we've had this 16, 32, 64 gigabyte stack for a while. And then do you think that can move up next year?

Sanjay Mehrotra

In terms of average capacities and smartphones and tablets, if you look at third-party reports as well as what we gain from our interactions with the customers, average capacities will certainly keep on increasing because smartphone penetration within the mobile sector continues to increase. And even the smartphone, the high-end and the midrange smartphone continue to do very well in the market. So all of these will drive in the smartphone. Average capacity increases over the course of next 2 to 3 years by anywhere from a factor of 2 to 3 from where they are today. So average capacities will continue to increase in smartphones, as well as in tablets. And certainly, as flash memory cost or prices become attractive in the future, you will see continued shift to increased capacity in these devices, or devices with high-capacity flash getting offered in the marketplace, just like you've seen those over the years in the past as well. So while the trend for average capacity increases in smartphones and tablets, we believe we'll continue to be strong in the future.

Jay Iyer

Thank you, Joe. Unfortunately, that's all the time we have today. Thank you again for joining us. A webcast replay of today's call should be available on our IR website shortly. Thank you again and have a good evening.

Operator

Ladies and gentlemen, this concludes the conference call for today. We thank you for your participation. You may now disconnect your lines and have a great day.

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