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SanDisk (NASDAQ:SNDK)

Q3 2012 Earnings Call

October 18, 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

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

James Schneider - Goldman Sachs Group Inc., Research Division

Joseph Moore - Morgan Stanley, Research Division

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

Steven Bryant Fox - Cross Research LLC

Jagadish K. Iyer - Piper Jaffray Companies, Research Division

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

Ryan Goodman - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Ryan Goodman - CLSA Asia-Pacific Markets, Research Division

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

Bobby Gujavarty - Deutsche Bank AG, Research Division

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

Brian Peterson

Harlan Sur - JP Morgan Chase & Co, Research Division

Operator

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

Jay Iyer

Thank you, Gwen, and good afternoon. I'm joined today by 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 comparable GAAP financial measure. That reconciliation is now available along with supplemental schedules on our website at www.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 one-time transactions and does not reflect the effect of any acquisitions, divestitures or similar transactions that may be completed after October 18, 2012. In addition, during our call today, we will make forward-looking statements. Any statement that refers to expectations, projections or other categorizations of future events, including financial projections and future market conditions, is a forward-looking statement. Actual results may differ materially from those expressed in these forward-looking statements. For more information, please refer to the risk factors discussed in the documents we file from time to time with the SEC, including our annual report on Form 10-K for fiscal 2011 and our subsequent quarterly reports on Form 10-Q. SanDisk assumes no obligation to update these forward-looking statements which speak as of their respective dates. I would like to take this opportunity to let you know that we plan to hold our fourth quarter results conference call on Wednesday, January 23, 2013, and we are planning our 2013 Analyst Day for May 8. With that, I will turn the call over to Sanjay.

Sanjay Mehrotra

Thank you, Jay, and good afternoon, everyone. We are pleased to report strong third quarter performance that underscores progress in many elements of our business. We delivered healthy sequential revenue growth in the third quarter, driven primarily by the company in our mobile embedded business within OEM. In addition, our retail revenue grew both sequentially and year-over-year, as we gained share across all major geographies worldwide. Our gross margins expanded sequentially through excellent improvements in product costs, combined with an improved pricing environment. In the OEM channel, we successfully ramped high-volume production of a customized solution for the leading OEM customer, and this product contributed significantly to the strong growth of our embedded mobile business during the third quarter. Additionally, our iNAND MCP and iNAND discrete products revenues grew from the second quarter and our next-generation high-performance iNAND solutions have been qualified in 13 mobile OEM platforms, and have now begun production ramps. For the fourth quarter, we expect continued growth in all of our mobile embedded offerings. We remain focused on advancing our iNAND roadmap to address specifications required for new, higher performance and more powerful mobile product platforms expected to launch during the course of 2013. In SSDs, our clients' products performed well with continuing revenue growth in both OEM and retail channels. Our position in the Client OEM Storage segment continues to improve, with the example being our X100 design win at Lenovo in their ThinkPad X1 Carbon Ultrabook. Our unique SanDisk iSSD solution and U100 SSD, in conjunction with ExpressCache dual-drive caching software from our conducive partnership, continue to do well in the caching segment. In addition, we began sales of the SanDisk ReadyCache SSD caching solution in the retail channel and this represents a new retail product category for SanDisk, and an incremental growth driver for our client SSD business. Our engagement with the leading PC OEMs is strong, with several new programs scheduled for high-volume shipments beginning in the fourth quarter. Our Enterprise SSD revenue declined sequentially, impacted by delayed experience in qualification of 13 new models of our enterprise SSDs, which utilize captive flash memory. The engineering solutions required for these products have been implemented and qualifications with our customers are in progress and proceeding well. In the fourth quarter, we expect to have strong sequential growth in our Enterprise SSD sales, including web usage of our captive flash memory. Our enterprise product roadmap is well-positioned to benefit from the expected demand growth coming from servers and storage area networks in data centers, cloud storage and acceleration of enterprise applications. Our next-generation controller and product development efforts, which are key to our long-term Enterprise SSD growth, are proceeding well. At the recent Intel Developer Forum, for example, we presented our first-generation non-volatile memory express, PCIe SSD in a 2.5-inch form factor. We are also engaged in the development of the SCSI Express, another industry standard for enterprise storage. These standards aim to broaden the adoption of SSDs using the PCIe interface. Initial response to our NBME solution has been very positive, and we expect the overall PCIe market to become a key growth driver for our enterprise-based SSDs in 2013 and beyond. To close my comments on SSDs, we are making progress in penetrating this market and expanding our product roadmap, and we expect strong revenue growth in the fourth quarter in both client and enterprise SSDs, with full year combined SSD sales expected to be more than 10% of our 2012 revenue. From a software perspective, the launch of the FlashSoft or VMware product at the VMWorld 2012 conference was very successful. Several customers are already evaluating our solution in their production environments. Our second software acquisition this year, Schooner Information Technology, is making good progress and it has been integrated well within our enterprise team. The Schooner team is focused on enhancing its Flash optimizing middleware layer, the flash data fabric. Our FlashSoft and Schooner software offerings are designed to deepen our vertical integration reach and uniquely position us to provide our customers with leading-edge Enterprise SSD products and complete I/O and application acceleration software solutions. Our retail products performed very well in the third quarter, driven by a strong back-to-school season in the developed markets, and continued penetration in emerging regions. We gained share in most geographies, enabled by the strength of the SanDisk brands and our diversified product portfolio. Our average retail capacity grew at a healthy rate across all geographies, growing to nearly 10 gigabytes per unit. In addition, we are pleased with our expanding presence in the E-tail channels internationally. We continue to invest in our retail product lines, which remain a competitive differentiator for us and a strong contributor to our margins. Turning to fab manufacturing and technology, the ramp of our 19-nanometer technology progressed well, and it accounted for nearly 2/3 of our captive supply in the third quarter. 1Y nanometer NAND technology development activity is on track to begin production in mid-2013. We are continuing our efforts to scale NAND further to the 1Z generation. In terms of future technologies, mixed NAND and 3D resistive RAM, related research and development is progressing well. We continue to believe that this NAND or any other 3D NAND is 2 to 3 years away from the start of any meaningful production ramp in the industry. We also believe that 3D Z NAND [ph] will not start production until sometime beyond 2015, given its need for EUV lithography, which is still in development phase. We believe NAND will continue to be the dominant Non-Volatile Memory technology in production through this decade, given its large installed base of production capacity and growing applicability. From an industry perspective, based on third-party analyst reports regarding NAND Flash manufacturers' respective capacity and technology status, we now estimate 2012 industry-based supply growth to be approximately 60%, down from our previous estimate of approximately 70%. And for SanDisk, our 2012 captive supply rate growth is approximately 80%. For 2013, we now expect industry supply-based growth rate will be in the 30% to 40% range, lower than the 40% to 50% range we estimated back in July. This, coupled with the expected strength in demand trends, bodes well for healthy flash industry fundamentals in 2013. As we look at our own captive supply base, and given the efficiencies achieved with our technology transition so far, we have not yet made a decision as to when we will resume the ramp of Phase I of Fab 5. And the earliest timeframe for production ramp would be the second quarter of 2013. However, we do expect to substantially complete Phase I expansion in 2013. We expect our 2013 captive supply base growth to be around the low end of the industry range. Factors influencing our bit supply growth in 2013 will include greater X2 mix, a continuing long tail of production of 24-nanometer to support our growing OEM customer requirements for embedded and SSD products and the timing of restarting Phase I Fab 5 expansion. We remain focused on carefully managing demand and supply balance for our customers, prudently planning for wafer capacity additions and also on strengthening the mix of our product sales. In summary, our third quarter performance reflects our strengthening business fundamentals. In the near-term, we believe we are positioned well for the upcoming holiday season in retail. We have started to regain traction with our mobile embedded products in OEM, and we expect strong growth in our SSD sales in the fourth quarter. The demand drivers and fundamentals for NAND Flash are strong, and we are excited about the growth prospects for SanDisk in 2013 and beyond. I look forward to providing you with our fourth quarter results and 2013 outlook early next year. With that, I will turn the call over to Judy for her financial review.

Judy Bruner

Thank you, Sanjay. We are pleased with the sequential improvement in our business this quarter, and we expect continuing gains in the fourth quarter. Our third quarter petabytes sold increased 36% compared to Q2 and 76% year-over-year, with strong petabyte growth in both our OEM and retail channels. With an improved industry supply-demand balance, our sequential rate of price declines subsided to 8% compared to 18% in the second quarter, whereas our year-over-year ASP per gigabyte decline remains high at 49%, reflecting the steep price decline in the first half of the year. The mix of our third quarter products revenue was 41% retail and 59% OEM. In the retail channel, our revenue grew 15% sequentially and 5% year-over-year, and we experienced solid sequential growth in all major product categories. USB sales did very well for the back-to-school season. Our imaging card sales reflected strong growth in high-performance cards where we are gaining share, and our mobile phone card sales grew sequentially and year-over-year. Geographically, our retail revenue increased sequentially in all major regions, whereas year-over-year the growth came primarily from emerging markets. Revenue in our OEM channel grew 33% sequentially and declined 19% year-over-year. Embedded products for the mobile market drove the sequential OEM revenue growth and embedded sales were also up year-over-year. The year-over-year decline in our OEM revenue was primarily the result of mobile card debundling and secondarily, the steep year-over-year price decline. Our OEM mobile card sales were stable on a sequential basis. Our OEM SSD sales more than doubled year-over-year, but experienced a modest decline sequentially due to delays with certain Enterprise SSD products, as Sanjay mentioned. Our license and royalty revenue was down 3% year-over-year due to the market decline in card sales on which we receive royalties, whereas sequentially, our license and royalty revenue increased 5%.

Turning to gross margin, our total non-GAAP gross margin improved sequentially to 31%, as third quarter cost decline exceeded price decline. Our cost per gigabyte improved 13% sequentially and 37% year-over-year, with the cost improvement driven by increased 19-nanometer mix and fab-related cost improvements. Non-captive memory usage remained in the low single-digits as a percentage of our mix and the yen rate in our cost of sales was approximately 79%, similar to last quarter. On a year-over-year basis, the appreciation of the yen had a negative impact on gross margins of approximately 1.5 points. Non-GAAP operating expenses increased sequentially by $6 million to $230 million, with the increase primarily in sales and marketing investments related to our enterprise go-to-market capabilities and retail branding and merchandising. Our 2012 non-GAAP tax rate has increased from 30% to 32%, as a result of a mix change in our profits by geographic jurisdiction. The third quarter tax provision includes a year-to-date catch-up to the higher rate, with the impact of the catch-up offset by certain favorable discrete items. On the balance sheet, cash and short and long-term marketable securities increased by $151 million, and ended the quarter at $5.4 billion on a gross basis and $3.5 billion, net of debt at the maturity value. Cash flow from operations in Q3 was a positive $128 million. Inventory at the end of Q3 remained approximately flat in dollar terms, but has come down in terms of weeks of supply and is now at the higher end of a normal range. The fab joint ventures returned cash to SanDisk of $146 million and we spent $142 million on nonfab CapEx, which included approximately $113 million of production equipment, and approximately $18 million of facility-related spending. We also spent $37 million on share repurchases. Joint venture equipment investments for the benefit of SanDisk have been approximately $435 million year-to-date, and our share of joint venture equipment lease guarantees stood at $999 million at the end of the third quarter. I'll now turn to forward-looking commentary. We expect our fourth quarter revenue to benefit from continued sequential growth in mobile-embedded product sales from fourth quarter retail seasonality, strong sequential growth in SSD sales and a continued healthy industry supply-demand environment. Our fourth quarter revenue forecast is $1.5 billion, plus or minus $50 million.

Turning to gross margins, we have now captured the majority of the cost improvements from the 19-nanometer transition, and we expect a reduced level of cost improvement in Q4. At the same time, we expect a continued favorable pricing environment and we expect our Q4 cost decline to exceed price decline, allowing further improvement in gross margins. Our expected total non-GAAP gross margin for Q4 is 33%, plus or minus 2 points. We expect Q4 non-GAAP operating expenses to be approximately $250 million, reflecting increased investment in future technologies, SSD solutions and seasonal retail merchandising. We expect Q4 non-GAAP other income of approximately $5 million, and a Q4 non-GAAP tax rate of approximately 32%. Because of our share repurchases this year, we expect our diluted share count to end 2012 at or slightly below the level exiting 2011.

Turning to capital investments, the fourth quarter joint venture tool purchases for the benefit of SanDisk are expected to be approximately $100 million, bringing the 2012 joint venture equipment investments to slightly below $550 million. We expect the fourth quarter fab investments to be funded by the joint ventures, with an additional return of cash from the joint ventures to SanDisk. We forecast Q4 non-fab capital investments to be approximately $200 million. This would bring our total 2012 capital investment, which includes joint venture investments and our own CapEx, to approximately $1.1 billion, below our previous estimates. Looking ahead to 2013, as Sanjay commented, we believe that the industry's bit growth in 2013 will be in the 30% to 40% range, and we expect our own bit growth to be around the low end of that range. We currently forecast that the industry will have a healthy supply-demand balance in 2013, leading to a reduced rate of price decline compared to 2012. We also believe our product mix will have a favorable impact on our blended ASP per gigabyte, further moderating our rate of price decline. These estimates for our bit growth and price decline lead us to expect solid revenue growth in 2013. In summary, we are pleased with the improvements achieved in our third quarter results, and we expect that in the fourth quarter we will deliver sequential growth in revenue, gross margin, earnings and cash flow. In addition, we believe that SanDisk is well-positioned to generate continued improvements in 2013. We will now open the call for your questions.

Jay Iyer

Thank you, Sanjay. Thank you, Judy. Gwen, can you poll the floor for questions, please?

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Daniel Amir with Lazard Capital Markets.

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

A couple of questions. First of all, with regards to your OEM business and I guess your Mobile business as well, I mean how should we be looking at that with related to your commentary of product mix being favorable for SanDisk on the ASP front next year? I mean, is this mobile-driven? Is this embedded driven? I mean, if you can give a little more commentary around that, that would be helpful. And I have one follow-up.

Judy Bruner

Sure, Daniel. My comment about favorable product mix for next year is really looking across all of our product lines, not just Mobile. And as an example, I would expect that we would have a favorable impact from our growing SSD sales, in particular our enterprise SSD sales. And within the mobile arena, I expect that we will see strong growth of our iNAND products, which have a favorable impact on the pricing statistic as well as on gross margin. And in addition, given that we expect tight supply next year, I would expect that we would see some continued reduction in the proportion of our revenue that goes to segments like the white label segment. And that also would have a favorable impact overall on the blended ASP per gigabyte computations since those products tend to sell at a lower average selling price. So it's really all in across our product lines and of course, we work hard to manage that mix of products.

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

Okay, great. And the follow-up question, maybe to Sanjay, regarding the supply bit growth that you anticipate next year in the industry, which is 30% to 40%, I mean, at what level do you think that the industry might decide that it needs to invest more heavily in order to meet the potential demand drivers that we could see here around the mobile and SSD growth as well?

Sanjay Mehrotra

So Daniel, I will comment here on how we look at it here at SanDisk in terms of our capacity expansion plans. As we have said before, we remain very prudent in terms of adding capacity and we assess, of course, the demand requirements, as well as our technology transition progress and figure that into our estimations of end-to-end capacity. And when we look at the demand trends, certainly, we look at SSD growth, we look at growth of our embedded business next year and that bodes well for the growth of SanDisk business in 2013. In 2012, as we mentioned, our bit growth is approximately 80%, and we ended Q3 with inventory somewhat in the higher range, toward the high end of the normal range. And we are going to be using that -- this inventory in Q4. By end of the year, we expect to see nominal levels of inventory positioning us well to enter 2013. Q1 also tends to be somewhat seasonally slower quarter in certain segments of the business. So we don't think that Q1 is the timeframe to be adding capacity. The earliest we would consider that would be for Q2. But frankly there, we have time available to us, given the lead times for the equipment, we would rather use that time to look at further demand assessment, as well as further lead on our own technology migration, technology transition plans for 2013. So these are really the factors that we look at in terms of assessing our requirements for bit growth. And we really are not after adding capacity for the sake of capacity. We want a prudent revenue growth and we want to manage the profitable growth of our business.

Operator

We'll go next to James Schneider with Goldman Sachs.

James Schneider - Goldman Sachs Group Inc., Research Division

Maybe just a follow-up on the capacity growth question that was just raised. Can you maybe talk about what -- how you're thinking about in terms of when you do start adding capacity, would you do that in small increments or will you do it in larger chunks, and how you're thinking about the rate at which you add when you eventually do?

Sanjay Mehrotra

So the rate at which we add capacity will certainly depend on our own assessment of demand and assessment of the bits gained through technology transitions and the status of our various technology transition plans. And then we make the decision to add capacity. Again, we'd like to point out we have not made any decisions at this point in this regard. And keep in mind that adding capacity, adds such complex technology nodes, in general, in the industry can only be done at a certain rate. It's not just about throwing CapEx at it. It takes resources to be adding capacity on a monthly basis. So usually, such a ramp of capacity is also metered by the resources and the technology complexities and of course, there are toolsets and all that, bringing those up and releasing them into production. So these are some of the factors that go into it, and we would not expect the rate of capacity growth in the industry if and when it resumes, to be any faster than what it has been in the past. Again, this, I'm talking about on a per month capacity addition basis.

James Schneider - Goldman Sachs Group Inc., Research Division

And then as a follow-up, can you perhaps size the percentage of revenue this quarter for your new custom embedded and MCP sales? How much of that was a percentage of sales in rough terms, and whether you expect that percentage to grow or decline in Q4?

Judy Bruner

What I would tell you is that our embedded revenue within our OEM channel was about 50% of the OEM revenue. And this is embedded. We do not count SSD in embedded. So embedded is really, primarily mobile-embedded, about 50% of OEM. But we're not going to break it down further in terms of the different products within that.

James Schneider - Goldman Sachs Group Inc., Research Division

Could you just address whether it goes up or down in Q4?

Judy Bruner

I would expect that our embedded would grow in Q4.

Operator

We'll go next to Joseph Moore with Morgan Stanley.

Joseph Moore - Morgan Stanley, Research Division

It seems to me it's kind of an unusual situation, if you look at what your customers are doing in smartphones and tablets, they're charging $6 a gigabyte for upgrades for NAND, and kind of using NAND to price discriminate on some of the most important consumer products that are out there. Apple started doing that, but now most of the tablets are doing that. How do you think about them charging $6 a gigabyte, you're getting substantially less than that, and how do you kind of capture more of those dollars as you go forward? Does that help you initiate, maybe more supply discipline just thinking about how -- that potential?

Judy Bruner

Clearly, as we go into 2013, we currently believe that, with an industry bit growth rate in the range of 30% to 40% and with strong demand out there, that there's going to be a very healthy supply/demand environment and we expect that, that will help us gain more value for our products. And so we are optimistic about that for 2013.

Joseph Moore - Morgan Stanley, Research Division

Okay, great. And then on the same note, on the tablet side, do you have an expectation for whether NAND per unit is going to be rising next year, in general? Not at any one customer but across the board?

Sanjay Mehrotra

Yes, so from our estimates in the tablet category, we do fully expect to seeing average capacities increasing in the tablet arena.

Operator

We'll go next to Tristan Gerra with Baird.

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

For next year, you mentioned that you're going to track at the low end of the industry range in terms of bit growth, which intuitively could be, I guess contradicting the expectation that there is continued share gain. So how should I reconcile the 2 for SanDisk, with the expectation that your embedded business could continue to grow and outpace industry growth?

Judy Bruner

Keep in mind that our bit growth in 2012, we believe, was higher than the average industry bit growth in 2012. And we believe, in 2013, that our bit growth will be at the lower end. And I think you have to look at this over a period of time, a few years, really in order to look at market share. And over that period of time, we believe that we have maintained our bit share. But in any given period, it's going to depend on the timing of capacity addition and technology transitions for the different participants in the industry.

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

Okay, and would you expect any meaningful change in your outsourced business over the next few quarters as a percentage?

Judy Bruner

I assume by outsourced, you mean non-captive disks?

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

Correct.

Judy Bruner

Yes. I do not expect that we will see a significant increase in our non-captive, but we will look at the ability to utilize non-captive. Keep in mind that as our business has grown in terms of OEM mix and in areas like enterprise, it becomes difficult to utilize non-captive memory. And of course, our own captive X3 mix is quite optimal for our retail business. So there are somewhat limited ability to use non-captive in the different segments of our business, but we will look at that opportunity, assuming that we can -- that there is availability of the right mix of non-captive memory at the right price when we need it.

Sanjay Mehrotra

I would just like to add one further comment regarding the bit growth next year. As I said before, we are really not after bit growth share. We are really after driving profitable growth and focusing on strategic growth and of course, return to our shareholders as well. So -- and we may have had bit growth capacity additions, that's what we are really focused on driving, strong mix of our revenue next year. So given that we may be on the low end of the bit growth range, we feel pretty good about our captive capacity strategy for next year.

Operator

We'll take our next question from Steven Fox with Cross Research.

Steven Bryant Fox - Cross Research LLC

Just one question on the SSD business. You mentioned some qualification issues on the enterprise side, but it didn't sound like it's materially slowing down the growth, and it seemed like there's been sort of a change in the outlook on the enterprise side. I was just wondering if you could just sort of talk about how your outlook for that business has changed, what the qualification issues were and how the market looks to you now, versus say, 90 days ago?

Sanjay Mehrotra

As we indicated, the qualification issues were around requiring firmware changes in our product, as well as related to our use of our captive memory to have a certain production level screens. And these issues are behind us. The fixes have already been verified, and we are well on our way to driving revenue growth in the enterprise SSD space in the third quarter, and also starting to increase the use of our captive memory in the third quarter and going forward. I'm sorry, I said third quarter, I meant fourth quarter. We are looking at driving the enterprise SSD revenue growth, as well as increased use of captive flash memory in the fourth quarter.

Steven Bryant Fox - Cross Research LLC

And then just really quickly on the retail, you had some positive comments about your own retail sales for this quarter going into next quarter. How much of that is related to SanDisk specifically, versus the retail environment overall? Any comments there would be helpful.

Sanjay Mehrotra

SanDisk brand is really doing very well globally, and we are very pleased with the brand awareness, with the brand strength and the brand premium that we are able to command in pretty much all geographies of the world. And our focus on execution, on driving our retail sales growth, leveraging our brand with a broad set of -- portfolio of products, as well as strong channel partners, are really the keys of SanDisk doing well in retail. We believe we are actually gaining share. We have gained share in Q3 in most major geographies in the world. So I believe that SanDisk is executing exceptionally well, leveraging its retail brand -- with the retail brand on the retail business front.

Operator

We'll go next to Jagadish Iyer with Piper Jaffray.

Jagadish K. Iyer - Piper Jaffray Companies, Research Division

Two questions, Sanjay. First, you talked about 3D NAND. I was wondering, one of your biggest competitors is aggressively pushing on 3D NAND for some level of pilot production in the second half of '13. I was wondering, what is the impact of the royalty streams going forward beyond 2013 into '14? What kind of IPs does SanDisk have on that? And then I have a follow-up.

Sanjay Mehrotra

So we do have IP in the area of 3D NAND. We too have been working on 3D NAND for some period of time. And of course, we do have IP in the area of 3D resistive RAM as well. We do not really get into any aspects of our IP agreements, licensing agreements with other third parties. We have, of course, confidentiality clauses in these agreements. So I cannot really get into the specifics related to any licensing aspects or royalty aspects, but what I can point out here is that SanDisk does have a strong IP position in the area of 3D memory.

Jagadish K. Iyer - Piper Jaffray Companies, Research Division

I just have -- I just wanted to get a sense of whether the royalty could be impacted because of this? That was my question, really.

Sanjay Mehrotra

We expect the royalties for -- from our licensees to continue to be a function of the sales made by the licensees.

Judy Bruner

The sales of their flash memory revenue.

Jagadish K. Iyer - Piper Jaffray Companies, Research Division

Okay, fair enough. Judy, I just have a quick follow-up. You had mentioned that the bulk of the cost savings would probably be completed by Q4. So is it fair to assume that the margin expansion for next year could potentially be driven predominantly by ASPs?

Judy Bruner

What I said was that we expect that cost reduction next year will be somewhat less than it was this year. And there's a couple of reasons for that. One is that the length of the technologies transitions is getting longer, it's just taking longer between technology transitions. Another reason is that we are getting less cost reduction from each successive technology transition. By the way, in addition, we expect that we will have somewhat less X3 mix next year, given our product mix, and our product mix itself is moving towards products that tend to have a higher cost per gigabyte because they, for example, in SSD, has more non-memory cost in it and that causes a higher cost per gigabyte but comes with a higher price per gigabyte as well. So there are many factors that are leading us to believe our cost reduction will be less next year than it is this year which, by the way, is about 36% on a year-to-date basis through Q3. But at the same time, we look to a very favorable pricing environment next year because we expect that there is a strong supply-demand environment in the industry next year and that the price -- that product mix will also give us a further improvement in that ASP per gigabyte, meaning that further moderates our price decline that we get. So those are some of the colors in terms of cost decline and price decline. When we put those together, we believe that price decline for next year can be less than cost decline, and that we are likely to see margin expansion next year.

Operator

We'll go next to Mehdi Hosseini with Susquehanna.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

One follow-up to your guidance. How should we think about ASP traction from Q3 to Q4 versus bit shipment for the product business?

Judy Bruner

We're expecting a favorable pricing environment in the fourth quarter, and we are expecting that, that level of price decline in the fourth quarter will be less than cost decline, but we're not giving a specific price decline forecast for the fourth quarter.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

These are -- the asked question was, that the confusion comes from the recent changes to the spot prices that suggest prices are beginning to move higher on an average basis. So and -- so why are you anticipating a blended -- why are you anticipating price decline into Q4?

Judy Bruner

There are certainly segments where prices are stable or even going up in some cases, and -- but we're not giving a specific overall blended price decline forecast for the fourth quarter. But we do believe that our level of price decline will be less than our level of cost decline.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

Got it. And then just a quick follow-up on gross margin expansion. With the higher mix of SSD, especially on the enterprise into 2013, doesn't it make sense to focus more on an EBIT margin expansion where you can scale the SG&A, especially on the enterprise side?

Judy Bruner

I mean, I do expect that we will have EBIT margin expansion in 2013, because as I said a few minutes ago, I expect that we can have gross margin expansion, and we will manage our expenses carefully. I expect that we can have EBIT margin expansion next year as well. Is that answering your question?

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

But EBIT margin -- could EBIT margin expansion be higher than gross margin expansion?

Judy Bruner

Again, it's too early to provide specific ranges of these estimates for 2013. We, of course, will provide more color on 2013 on our January call.

Mehdi Hosseini - Susquehanna Financial Group, LLLP, Research Division

But conceptually, as SSD mix goes higher, you can better scale the SG&A. Is it thought process, does that make sense?

Judy Bruner

Actually, I would say that in the SSD business, particularly the enterprise SSD business, yes, gross margins could be higher, but I would say that expenses would also tend, in that business, to be higher than the traditional expense model for SanDisk. But we're not changing our model at this point in time, and we're not ready to give any specific guidance for our model for next year.

Operator

We'll go next to Ryan Goodman with CLSA.

Ryan Goodman - Credit Agricole Securities (USA) Inc., Research Division

So another question on the supply expansion strategy. I understand you have growing demand in SSDs in some of these other markets, yet we can see the prices declining in these markets every week and there might be some elasticity kicking in, but we still really haven't seen SSDs go mainstream in the thin and light notebooks yet. And meanwhile, as has been discussed on the call, there are some major NAND customers out there that are capturing remarkable margins on the NAND volume. So I guess I'm curious how you're balancing the rising cost of expanding capacity and the need or want to grow in some of these newer markets with declining prices versus just trying to better monetize the wins you already have?

Sanjay Mehrotra

We are definitely focused on transitioning [ph] the mix of the business, increasing the mix of our client SSDs, the Enterprise SSD, as well as our Embedded Solutions such as iNAND that we have talked about. And these are the product areas that will give us, we believe, stronger margin profiles [ph] in 2013. And as the pricing environment improves, and as our mix of the business strengthens, we believe that we will be addressing the market opportunities, and we'll be well-positioned to address the market opportunities during 2013.

Ryan Goodman - CLSA Asia-Pacific Markets, Research Division

Okay, and then just for a follow-on, kind of a bigger picture question here, there's been some consolidation over the past, I'd say year, maybe 1 to 2 years in the buyers of NAND. I'd be curious, how do you think that has played a role in this slowdown that we're seeing in CapEx spending in some of the market share shift and just the pricing trends overall, and how you think that will continue to play a role in those areas going forward?

Sanjay Mehrotra

I think in terms of the bit growth, the factors there are, that's -- technologies also getting more complex. So the new technologies are taking longer to develop as well as the gigabytes that you gained from a technology transition is lessening compared to the past. And these are factors that are playing out for all players in the NAND industry. And in terms of the production capacity in the NAND industry, this year there has been no new capacity that has been put in place. That consolidation that you are referring to, that does maintain the capacity that is in the industry still out there. It's really -- it doesn't change much of the dynamic of the industry demand-supply outlook. The most important factors there are that the technologies are getting more complex and therefore, the bit gains on new technology transitions is slowing down, as well as the fact that no new capacity got added during 2012 timeframe, results in lower rate of total wafer output growth in 2013. So these are some of the key factors that are really playing a role in terms of the industry capacity growth. And of course, when we ourselves look at making decisions on adding new capacity, other factors that we look at are the future technology, the ROI on the NAND scaling or potential alternative technologies and how that would influence the capacity additions that are made at this point. So these are really some of the factors that I believe, that we look at and these are common set of issues for other industry flash suppliers as well.

Operator

We'll go next to Monika Garg with Pacific Crest Securities.

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

Judy, first question on the guidance. So in the guidance, are you assuming bit shipment quarter-over-quarter for Q4 to be lower than Q3?

Judy Bruner

We really haven't given any specific bit growth guidance. We're really focused on the revenue guidance.

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

Then I would assume on the ASP side too, kind of like just even in the directional side, you would kind of if I play out the number. It seems like the bit shipment growth would be lower for 4Q, and 4Q is traditionally a much bigger quarter so, and I'm assuming the ASP would be directionally at least, lower decline than Q3.

Judy Bruner

Again, we've -- given what I believe is strong revenue guidance sequentially from Q3 to Q4 going from $1.273 billion to $1.5 billion, plus or minus $50 million, and we're not breaking out the specific mix of bit increase and the level of pricing.

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

All right, fair enough. And then on the inventory side, inventory has almost stayed stable from Q3 to Q4. So I would assume that you had the strong bit growth that it draws down to nominal values, and Sanjay kind of hinted to that, that things in Q4 will come back to nominal levels?

Judy Bruner

I do expect that we will use quite a bit of our inventory in the fourth quarter. We did reduce our inventory in terms of weeks of supply on a forward-looking basis in Q3. And as I mentioned in my prepared remarks, the inventory, in terms of weeks of supply, is actually at the high-end of our normal range. So it is within our normal range, but at the higher end, at the end of Q3, and we expect it will come down further in the fourth quarter.

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

Okay, and just the last one for me here. We have seen, and we have talked about too, that NAND cost decline is decelerating. But some of your OEM business is actually a lower margin business. So kind of what steps to do you think you are taking to ensure that we go back to historical margins, prior to present, plus kind of margins?

Judy Bruner

We are managing the mix of our business carefully and we have a variety of prices and margins of our different product segments. And as I think I mentioned earlier, we expect to see strong growth in the mix from some of our higher-margin business next year, such as, as an example, enterprise SSDs and also iNAND, and we expect that we will likely see some reduction in the mix of products such as white label products, which tend to have a lower pricing and lower margin. So we believe that we can manage the mix of our products to maintain a blended gross margin that is favorable for the company.

Operator

And we'll go next to Bob Gujavarty with Deutsche Bank.

Bobby Gujavarty - Deutsche Bank AG, Research Division

Maybe if I can just look back a little bit. If I look like, about 12 months ago, we're sitting here and many of the trends we're talking about today were actually, you can argue, even better yet things deteriorated quite a bit over the next 6 months and I'm not here to point fingers about who got the forecast wrong, but can you talk about maybe how that experience from 3Q of 2011 through the first quarter 2012, how that experience -- what are you doing a little differently? Are you being a little bit more cautious on supply, do you have better realtime feeds on supply and demand? Just curious, what's kind of changed from 12 months ago.

Sanjay Mehrotra

I think, for us, a couple of things are definitely different. One, compared to 12 months ago when we had ramped up Fab 5, which was needed to meet the capacity, the wafer output to meet the demand requirements in the second half of 2011, we have not added any new capacity since the January timeframe in 2012. So that's changed, compared to the same time, similar time a year ago, that no new wafer capacity being brought to most of the year since January timeframe versus last year, when we had added certain capacity to meet the growth requirements. And of course, it continues to emphasize the point to us, that we need to remain very prudent in terms of adding new wafer capacity. The second important factor that is different today versus what it was a year ago is that we have a broader set of embedded products. We have a stronger set of embedded product offerings which we have talked about, related to first half, such as customized Embedded Solutions as well as certain MCP products that we didn't have at that time. Now, it gives us flexibility to add, just really, complete set of opportunities in the marketplace compared to a year ago. So as we have said before, 2 is extremely important, that we do stay well positioned with our product roadmap to address the broad set of opportunities that are ever-growing for flash memory in the industry. And third aspect, that is very different compared to a year ago is really our strengthening position on the SSD front. Again, it goes towards a strengthening [ph] Portfolio, but the industry demand for SSD, given the price volumes that have occurred in 2012, is also building up. I mean, SSDs are growing in a variety of ultrathin devices as well as enterprise applications. So overall, the demand trends in terms of the pickup in SSDs, as well as continuing growth in Embedded Solutions, is boding well for overall industry and certainly SanDisk is now well-positioned with strong set of product offerings for our diverse set of customers and channels.

Operator

We'll go next to Craig Ellis with Caris & Company.

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

And just a couple of follow-ups here. Judy, you characterized inventory as being at the high end of that normalized range. Were you referring to on-hand inventory or on-hand plus channel inventory and how would you characterize the channel inventory environment right now?

Judy Bruner

I was referring to our on-hand inventory at SanDisk. With reference to channel inventory, I would tell you that the retail channel inventory for us at the end of the third quarter was about 5 weeks on a worldwide basis, and that's actually pretty lean. It's a little bit less than it was at the end of the third quarter of the prior year, and even less than 2 years ago, third quarter. So that's in good shape. And with respect to OEM channel inventory, that's in good shape as well. I don't see any issues in the OEM channel inventory.

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

Okay, and then with respect to the fourth quarter's outlook, it sounds like you expect pretty broad-based growth across all the product groups. But can you rank the different products in terms of the rate of growth that you'd expect to see in the fourth quarter?

Judy Bruner

I would expect to see the highest rate of growth most likely in our SSD business in the fourth quarter. And -- then I think it's hard to predict exactly beyond that because, of course, retail tends to be strong in the fourth quarter, but we also expect to see growth in our mobile-embedded business. Strongest rate in SSD.

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

Okay, and lastly, for you Sanjay, you mentioned in your prepared comments some initiatives that you've got in the software arena and the company did talk about good growth for 2013. When you look to 2013, does software start to contribute meaningfully to the top line? And if so, how to think about its impact to gross margins for the company?

Sanjay Mehrotra

Software in 2013 will continue to remain a very small part, really too small to call out. This is an area that will take us a while to develop in terms of revenue opportunity for the company. We are very excited about our FlashSoft and Schooner acquisitions. We believe we have really acquired leading edge competencies to address the caching solutions. As well as with the Schooner acquisition, using their technology to really build certain capabilities into our product offerings as well. So you should not expect to see much, if anything, meaningful in terms of revenue in 2013 from software opportunities. Of course, on the conducive side, with our client SSD, we are getting value through our strong offerings and, but overall, the revenue will still remain small.

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

So it's right way to think about software, as more of a product differentiator than an incremental revenue growth driver?

Sanjay Mehrotra

That's absolutely right.

Jay Iyer

Gwen, we have time for 2 quick questions.

Operator

We'll go next to Hans Mosesmann with Raymond James.

Brian Peterson

This is Brian Peterson in for Hans. Just one quick clarification question, on SSD side, what was the total revenue contribution this quarter, and can you remind us what the mix is between client and enterprise there?

Judy Bruner

We're not breaking out the mix between client and enterprise. The overall SSD revenue was less than 10% of our total revenue in the third quarter, but we expect it will be quite a bit higher than 10% in the fourth quarter, and we expect that it will be over 10% of our total revenue for the full year 2012.

Operator

We'll take our last question from Harlan Sur with JPMorgan.

Harlan Sur - JP Morgan Chase & Co, Research Division

For those certain customers that have both mobile and computer platforms, have you been able to drive your success in mobile with these customers to potential penetration within their computer platforms? Is this an opportunity for SanDisk? What is the company's strategy for achieving this? And when would you anticipate to see a broader design win footprint at some of these customers?

Sanjay Mehrotra

You're asking about customers that have both mobile and computing?

Harlan Sur - JP Morgan Chase & Co, Research Division

Right.

Sanjay Mehrotra

Certainly, being a broad, one-stop shop for flash solutions is absolutely a plus to those customers, and they do see at SanDisk, the ability to bring innovative products, leading edge product roadmap with backing of supply to be able to meet their requirements. So absolutely, we are able to really leverage our diverse set of product offerings in all applications of flash with those customers that participate in multiple aspects of the flash market.

Harlan Sur - JP Morgan Chase & Co, Research Division

Great, and then just my follow-up question. So as you -- as we think about the price declines and the impact that it'll have on SSD and computer-related penetration next year, Sanjay, do you expect that your SSD business will probably be the fastest-growing business for SanDisk in 2013?

Sanjay Mehrotra

Yes, SSD, will be, in terms of the growth rate, will have the highest growth rate for SanDisk in 2013. Mobile and Embedded will also continue to grow very nicely for us. These are already large businesses. SSDs, in terms of percentage growth rate, it will be growing fast. And of course, we continue to do very well in retail as well.

Jay Iyer

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

Operator

Thank you, everyone. That does conclude today's conference. We thank you for your participation.

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Source: SanDisk Management Discusses Q3 2012 Results - Earnings Call Transcript
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