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M-Systems Flash Disk Pioneers Ltd. (FLSH)

Q1 2006 Earnings Conference Call

April 26th 2006, 10:00 AM.

Executives:

Jeff Corbin, Chief Executive Officer

Dov Moran, Chairman, President and Chief Executive Officer

Ronit Maor, Chief Financial Officer

Noam Kedem, Vice President of Business Development and Marketing

Analysts:

Eric Gomberg, Thomas Weisel Partners

Craig Ellis, Citigroup.

Alex Gauna, UBS Securities, LLC

Sam Doctor, JP Morgan

Daniel Amir of WR Hambrecht

Daniel Gelbtuch, of CIBC World Markets

Romy Wilson, Aster Group

Operator

Good morning. My name is Lynn, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the M-Systems First Quarter 2006 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. Operating Instructions. It is now my pleasure to turn the floor over to your host Jeff Corbin. Sir, you may begin your conference.

Jeff Corbin, Chief Executive Officer

Good morning everyone, this is Jeff Corbin, CEO of KCSA Worldwide, Investor Relations consultant to M-Systems. With me on the call today are Dov Moran, President and Chief Executive Officer; Ronit Maor, Chief Financial Officer; and Noam Kedem, Vice President of Business Development in the United States. At this point you should have all received a copy of the press release which was issued earlier this morning. If you haven’t received the release, please refer to M-Systems website at www.m-systems.com.

Before we begin, I would like to mention that the matters discussed in this conference call include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995, including statements about our business outlook for the year 2006, that are based on our current expectations and may involve a number of risks and uncertainties. We caution you not to place undue reliance on these forward-looking statements, as they are subject to various risks, which may cause actual results to vary significantly. These risks include but are not limited to the risk factors detailed in the company’s most recent Form 20-F filed with the SEC and all of its other filings with the SEC. Also, M-Systems assumes no obligation to update such forward-looking statements and disclaims any obligation to publicly revise any such statements to reflect any change in expectations or in events, conditions or circumstances on which any such statements may be based.

With that said, I would like now to turn the call over to Dov, Ronit, and Noam who will provide you with an update on the business during the quarter including a review of the financials. After that Dov, Ronit, and Noam will be happy to answer any questions that you have. Dov.

Dov Moran, Chairman, President and Chief Executive Officer

Thanks. Good morning everyone. Thank you for joining us for our first quarter earnings conference call. Yes I am sure all of you, the fellow M-Systems and the end market know, the first quarter of 2006 was a challenging quarter. With selling prices the megabyte selling about 25% quarter-over-quarter or about 40% for the higher densities during the quarter, I believe we delivered very impressive results. Our revenues exceeded the upper limits of our initial projections by approximately 15%. I believe that it is in this kind of challenging pricing environment that you can measure the company’s strengths in the market. Our better than expected results owed that we have built a robust company with strong foundation. I will elaborate more on our business later in the call. But I will just turn the call over to Ronit, to discuss our financial results. Ronit.

Ronit Maor, Chief Financial Officer

Thank you Dov and good morning everyone. Before beginning I would like to emphasis that the following discussion will include GAAP numbers and pro forma numbers. Our first quarter pro forma results reflect adjustments for the following three items. One, stock based compensation expenses, which totaled $2.2 million in the first quarter. Two, amortization cost relating to the acquisition of Microelectrónica which totaled in Q1 $300,000 net taxes. And three, a one-time capital gain from a sale of an investment which totaled $800,000 net capital gain taxes. Full reconciliation pro forma results discussed on this call to GAAP results is currently available for review on our website at www.m-systems.com and in the press release issued today.

Furthermore, as you all know last week, we announced a change in the accounting treatment of our venture with the flash partner. We now consolidate the result of the venture. In order to allow us to compare first quarter results with previously announced results when we accounted for the venture under the equity asset, I would provide you with pro forma adjusted information and if we have not changed the ventures accounting treatment.

Please note that the ProForma adjusted results are provided so to give you additional insight into M-Systems business and do not reflect the financial results of the company under GAAP accounting.

Full reconciliation of the pro forma adjusted results discussed on this call is also available for your review on our website at www.m-systems.com. This reconciliation can be seen in two stages comparison of GAAP to pro forma results and then comparisons of the pro forma results to pro forma adjusted results which excludes the effect of the consolidation of the venture.

And now for the numbers and I will start with the revenues. First quarter revenues totaled $219 million. Q1 revenues are essentially inline with Q4 results and represent an 87% increase compared with the first quarter of 2005.

These revenues include $24 million due to the consolidation of the venture. Without the effect of the consolidation, our pro forma adjusted revenues are $195 million, only 5% decrease from last quarter and 103% more than double the revenues from the first quarter of 2005. As for the effect of the consolidation of the venture on 2006 revenues, we currently estimate the contribution to revenues as a result of the consolidation to be approximately $100 million.

I will now discuss geographical breakdown of sales. Please note that the following breakdown is based on our pro forma adjusted revenues meaning adjusted to exclude revenues attributable to consolidating the venture. Sales in the US totalled 38% of revenues compared with 42% in the fourth quarter of ’05. Sales in the Far East excluding Japan and the rest of the world totaled 32% of revenues compared with 27% in the fourth quarter. Sales in Europe totaled 18% of revenues compared to 20% in the previous quarter. And NAND totaled 12% compared with the 11% in the fourth quarter. As mentioned, this geographical breakdown does not include $24 million in revenues representing sales of the venture to our flash partner.

Revenues breakdown for the first two quarter again based on our pro forma adjusted revenues excluding revenues attributable to the consolidation was as follows: Sales of DiskOnKey what we now refer to as mDrive to the USB flash drive market, totaled $108 million which represent 55% of revenues in the first quarter. DiskOnKey revenues increased 79% compared with the first quarter of last and decreased 9% compared with the fourth quarter. Sales for the mobile market which include sales of DiskOnChip what we now refer to mDOC into handsets and other portable devices, as well as SIM cards to mobile network operators totaled $61 million which represent 31% of revenues in the first quarter.

Mobile revenues increased 152% compared with the first quarter of last year and decreased 13% compared with the fourth quarter. Sales to the embedded systems markets totaled $26 million or 14% of revenues in the first quarter, which represent 136% increase compared with the first quarter last year, and 66% increase compared with the first quarter.

Moving to gross margin. Pro forma gross margins in the first quarter were 20.6% compared with 21.9% in the fourth quarter. Pro forma adjusted gross margin meaning adjusted to exclude the effect of the consolidation of the venture were 18.5% compared with 21.3% in the fourth quarter. The decline in gross margins is mainly the result of the pricing environment. As Dov already mentioned in the first quarter, selling prices for megabyte decline approximately 25% quarter-over-quarter. Pro forma operating expenses in the first quarter totaled $26 million, operating expenses were up $3 million or 13% compared with the fourth quarter.

Moving to non-operating income and expenses item. Financial income decreased from $1.8 million to $1.4 million mostly due to a lower cash balance. In the first quarter, we have paid out $35 million which reflects the remaining balance of our commitment under the agreement with Hynix. Other income includes one-time gain from the sell of an investment totally $1.2 million. Taxes on the income in the total of $1.4 million includes taxes on our interest income, our operating income primarily attributable to Microelectrónica and taxes on our gain from the sale of the investment.

Our equity losses is an affiliate subsidiary in the amount of $1.2 million relates to the activities of H3. Our non-operating expenses also include minority interest for the amount of $8.8 million. All these results are being GAAP net income for the first quarter of $7 million with EPS of 17%. And pro forma net income of $9 million with EPS of $0.21. Pro forma adjusted net income in EPS are identical to the pro forma net income in EPS as the operating income resulting from revenues attributable to the consolidation of the venture are offset by the minority interest.

As for the inventory levels, the levels are also influenced by the consolidation of the venture. The inventory balance at the end of the first quarter were $76 million essentially flat with the inventory of the fourth quarter. This inventory include $18 million of shipments to customers which have not yet been recognized as revenues. Inventory on consignment and inventory held by the venture on behalf of the flash partner. Our own hand inventories totaled $58 million compared to $52 million in the fourth quarter. The tight inventory control we adopted I felt invaluable this past quarter. Despite of the sharp price decline in February and March, the inventory adjustment were recorded at the end of the first quarter was not significant. Our cash balance at the end of the first quarter were $160 million down from $186 million at the end of the fourth quarter. As already mentioned, the decrease in cash is mainly the result of the fulfillment of our commitment under the Hynix agreement. I will now turn the call back to Dov.

Dov Moran, Chairman, President and Chief Executive Officer

Thanks Ronit. As I mentioned in my opening comments, despite the difficult pricing and settlements, in the first couple of months, we continue to execute well and believe a better than expected results. As soon we realize our DiskOnKey facility sale to these products then drive was the one most affected by the challenging pricing environment in Q1. Yet, the division to measure is very strong quarter, both on OEM model of selling to a wide range of customers to different channels across different geographies along with our supply agreements which provided us with a competitive advantage in the market for selling prices proved themselves invaluable.

U3 continues to be the main focus of our USB business, the USB platform continues to gain momentum, the amount above 50 U3 Smart Drives models offered by 17 companies including several of our customers along with scandisk in about 100 U3 ready software applications available to. U3 is also expanding the new markets. Last week U3 was launched in Japan to our customers and now offering U3 Smart Drives in the Japanese market. In recent days Toshiba, one of the leading USB flash driver manufacturers worldwide also announced its endorsement and intention to ship U3 Smart Drive.

With respect to our mDOC activity, we are very pleased with the feedback we are getting from customers from our next generation mDOC H3, which we announced earlier this year. H3 brings to handset vendors and designers of other consumer electronics devices a significant value proposition. It is the virtually placed solution which requires minimal integration efforts. It can use the latest NAND available and enables the handset vendors the flexibility to upgrade the NAND use throughout the life of the device with no additional integration efforts. And perhaps, most important it is the only multi-sourced solution as our two flash partners Toshiba and Hynix which already announced joint venture to offer H3.

As I mentioned, we are getting great feedback on H3 from the markets and we are already seeing H3 designs to our customers. Our second mobile activity targeting mobile network operators, also made important progress this quarter. Perhaps, most important that 3GSM we announced the commercial launch of the first 512 megabyte high density SIM cards together with Orange and Oberthur. We are finally seeing this market becoming a reality. We hope to be able to make additional announcements later this year.

Our position for Microelectronica is already beginning to bear fruits. As we continue to make significant enrolls with key mobile network operators we believe our expanded presence in the market for Microelectronica has basically added the success of good results. The embedded systems division also had the particular good quarter, with revenues growing 56% compared with Q4 last year. The strengths came from all products family of the division including embedded solutions as well as the family of the Flash Disks.

A new and potentially interesting market in which we have some design win activity is the market of highly finishing DVD players and the new way technology. Looking forward, the recent price declines have expended future growth opportunities for this division as flash becomes more and more competitively priced compared with others.

I will now turn over the call over to Noam who will talk about the long-term value of our company. Noam

Noam Kedem, Vice President of Business Development and Marketing

Thank you Dov. Today, I would like to discuss the generational degradation of raw NAND flash material. Here is the fact. With every new generation of silicon, the usability of raw NANA flash material as storage media diminishes. This degradation caused by multiple interconnected factors. First, there is an issue of decreasing lithography, AKAI manufacturing processor geometry. From 0.4 micron in 2000 to 70 and 60 nanometers today. This decrease in feature size causes severe problems in manufacturing, making it difficult to create and align all the small structures on the silicon wafer.

These manufacturing problems lead to phenomena such as current leakage and increased parasitic capacitance. In layman’s terms, these mounting problems are hard to model and simulate and therefore hard to mitigate without adding considerable circuitry. The question beckons, what is the benefit of smaller, smaller features if one needs to add all that extra circuitry to make it work. To make things even worse when you reduce the feature side, you also reduce the area in which electrons are stored also known as the floating gate. At 70 and 60 nanometers manufacturers literally have to count the number of electrons that can trapped in that tiny area.

Now, imagine having to do all of that on this wafer of one thousand thickness of a sheet of paper or the diameter of the human hair. I think you get the picture. Anyway, lithography is just half of the story. The second half has to do with new technologies, which take incompatibility to new level as fabs work it ever harder to reduce costs. You see what drives fab is cost reduction, achieving compatibility for the sake of device designers is an after thought. Such is the case of transitioning from 512 byte block NAND to 2K byte blocks, large block NAND and soon to extra large 4 kilobyte blocks. These flavors are incompatible with a need to be handle differently by controllers in software.

Then, there is the decisive transition from single level cell SLC binary NAND to multi-level sub MLC technology, which are not all created equal. This of course is the ultimate course for cost savings but it comes at a hefty price. In order to facilitate two bits of data per NAND sale, we have to accommodate four distinct voltage level, each one defined by the number of electrons locked in the floating gate. We need to make the whole thing work reliably at those low and high temperatures with the right air detection and correction code in place. We have to make sure it’s suitable for using low power scenarios such as battery operated cell phones or MP3 players. And that we can retain the stored data reliably through the applications lifetime. We also need to ensure that the flash is capable of enduring an ample number of read/write cycles for the required end application before any block expiration occurrence and in performance level adequate for the task is ahead. This is not an easy thing to achieve even with SLC NAND led alone with MLC. And it is only going to become more difficult with every new generation of raw material.

Just to give you an idea, when I joined M-Systems in 2000 raw NAND was manufactured at 1 million read/write cycles and 10 years of data retention.

Today, raw NAND flash material is approaching a point where read/write cycles are dropping below 10,000 and data retention measured in near months. Where is that all leave us? It focuses attention around M-Systems capability. Capabilities which allow us to take raw NAND flash material and make it smarter for use in a plethora of multimedia rich application driven personal storage devices. It puts an emphasis on our intellectual property portfolio.

Intellectual property used to refine the raw material into process products. It shined a light on our proprietary patents of flash management technologies such as TrueFFS incorporating advanced air defection and correction mechanisms, far more sophisticated than in previous generation. On products such as mDOC H3 which are set to allow fabs to immediately design our latest raw material into end applications without having to resort to further software and system integration efforts. Efforts which do not exactly correlate with their core competencies. As the picture becomes weaker and weaker for raw NAND it may become rosier and rosier for M-Systems. This is precisely where our intellectual property shine. Back to you Dov.

Dov Moran, Chairman of the Board, President, Chief Executive Officer

Thank you Noam. I would like to conclude my comments this morning by providing you with our guidance for the second quarter and the rest of 2006. For the second quarter, we project that our revenues will be lower than the revenues of the first quarter, we will be able to significantly improve our pro forma adjusted gross margins and therefore we present similar or potentially even better pro forma earnings per share compared to Q1.

Let me summarize Q2. Lower revenues significant better margins improve better EPS. Therefore, we believe that 2006 will be another strong year for the company showing significant growth compared with last year. We believe that our net revenues will approach the $1 billion mark. Clearly, a significant milestone in the M-Systems and underscores, how far the company has come in recent years. Let me repeat it. Revenues for 2006 approaching the $1 billion. Each number specially if you compare it to our revenues of 2001, which was $45 million more than 20 times in five years. As I mentioned in our last call, I believe the 2006 will be a great year for M-systems. Thank you for being with us this morning. Ronit.

Ronit Maor, Chief Financial Officer

Thank you. Prior to the Q&A session, our attorneys have asked me to reiterate that the matter discussed in this conference call included forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 including statements about our business outlook for the year 2006 that are based on our current expectations and may involve a number of risks and uncertainties. We caution you not to place undue reliance on these forward-looking statements, as they are subject to various risks, which may cause actual results to vary significantly. These risks include but are not limited to the risk factors detailed in the company’s most recent form filed with the SEC and all of the other filings with the SEC. Also, M-Systems assumes no obligation to update such forward-looking statements and disclaim any obligation to publicly revise any such statements to reflect any change in expectations or events, conditions or circumstances on which any such statements may be based.

Again, we would like to remind you that the full reconciliation of the pro forma and pro forma adjusted results discussed on this call to GAAP results is currently available for review on our website.

Dov Moran, Chairman, President and Chief Executive Officer

Thank you, thank you Ronit, thank you again everybody for being with us this morning.

Ronit Maor, Chief Financial Officer

And we will move now to the Q&A session.

Dov Moran, Chairman, President and Chief Executive Officer

Move to the Q&A, yes.

Question-and-Answer Session

Operator

Operator Instructions. Our first question comes from Eric Gomberg of Thomas Weisel Partners.

Q - Eric Gomberg

Hi, good morning and congratulations on a solid quarter in a tough environment. Dov, I was hoping that you could maybe give us some perspective on what you see in the overall NAND supply/demand environment, and what do you anticipate for ASP, if you can just give us your sense the backdrop and also give us an update on what’s going on in terms of getting more supply you have talked about perhaps another supply agreement this year?

A - Dov Moran

Thanks Eric. When first quarter supply is going to be full, obviously everybody sees it, everybody knows that, SanDisk, into Micron and Hynix. On the other side, the demand is going as well as crest fall as there is very natural both of us moving from low capacities to high capacities bulk the condition of although the elasticity of this market while people are coming to the store and buying higher capacities due to the lower price. Hence in addition to it, new applications that are coming for this market is interesting, so as the player is a huge driver, there will be coming this year clearly cell phones, sometimes personally as US and other applications which are yet to come to this market. In recent environment, let’s say a huge supply well it’s a huge increase in demand, it’s very, very difficult to re predict which one is going to be higher that the supply or the demand conflict. Today, first quarter, second quarter there is obviously a higher supply, we will be on a supply situation and this little bit part of the region that the prices went down, let’s say they went so sharply in the first quarter, at sometimes there will be over demand when it gets over demand that’s a very, very tough question which I don’t see in anybody in this market including all our competitors and our partners and many of the analysts can really predict. This may happen in the fourth quarter, usually fourth quarter is very strong and the demand entered the first quarter is really jumping in a range, which cannot be, that exceeds the demand/supply. And it may happen in 2007 when new applications which will demand high capacities for the cellular phones with embedded flash or say, 2 gigabyte, 4 gigabyte we get to the market. Yes, we need more supply, I think this is a major project of the company for this year for 2006. We need to be in position with to which much higher revenue versus the current revenues and looking yesterday is not enough, we will work very hard on getting, I think we still believe that we can announce a significant in new supply.

Q - Eric Gomberg

Then if I can just ask a follow up on one housekeeping item, can you give mDOC revenue alone on the standalone basis and then just I was wondering you have the press release about the Orange and Oberthur agreement, when is that something that you actually be shipping into the market in real volume, is that in ’06 of ventures, is that still something that we shouldn’t expect till ’07?

A - Ronit Maor

I will take the first question about separating the mobile sales. The problem that we have is actually the services in SIM card market which will though enhance M-Systems results, not very significant but as standalone activity for Microelectronica is closing to the market of the revenues from a competitor point of view is hurt the business so, we have decided to include it since it does go to the mobile market within the revenues of the mobile market. So, unfortunately, we cannot separate the two numbers within that number. Clearly, as you can guess the majority of the number is coming from the sales to the mobile handsets.

A - Dov Moran

And for the second part of the question, we clearly, we will begin shipping the mid of this year, we are in initial production, we are in process of - and we got orders already from a customer or customers and we will be shipping the Mac magazines in the coming quarter or quarters.

Operator

Thank you. Our next question is coming from Craig Ellis of Citigroup.

Q - Craig Ellis

Thanks. Good morning Dov, good morning Ronit. First of all, just to clarify the first quarter results, Dov or Ronit, can you talk a little bit about where you first started to see the upside to initial guidance given the very strong revenue print in and was that in a particular product line with that in a particular geography just helps understand the source of strength in the current quarter?

A – Ronit Maor

If you tell me when we talk about expectations for a decrease on the first quarter dollar wise, the expectation were mostly in the DiskOnKey market, where we most expose the seasonality and it is the majority of our revenues and that is worth again we will mostly surprise that although revenues went down, they went down much less than what is expected. In addition to results to the embedded systems market have increase beyond what we saw the low again dollar wise, the effect is lower.

Q - Craig Ellis

Okay. And then, Dov, just looking at the guidance were sequentially down revenue, I know they are typically your conservative but as we think about modeling it out on a detailed basis, can you just prioritize where you would expect to see relative strength, or relatively greater weakness across the portfolio quarter-to-quarter?

A - Dov Moran

We - what we project currently is lower revenues in USB specialized at markets, the mobile market revenues of the embedded systems, we do not expect a significant increase if at all and therefore, the decrease expected is of course of the U3 specialized market where we do see some sort of a weakness. Now, because we are at the beginning of the quarter of course that’s because of the upside and of course this is what we believe today we decide the results, that can be of course better things can change dramatically and we saw such things in the past.

Q - Craig Ellis

Okay, and then now to get you specific but if we have down revenues in the second quarter as we think about how the business can perform and getting to almost a billion dollars this year, it seems that we are atleast mid teams growth in the third quarter and the 20’s are better growth, and the fourth quarter so, strong second half growth may be set differently those levels are quite a bit below that 2005 second half growth, do you think you can approach 2005 sequential growth mobiles this year?

A - Dov Moran

Craig, I believe at these if you look at our first quarter numbers of 2005, you could see, what you can see a huge increase compared to the first quarter or generally the second half of 2005 was much better than the first half of 2005. We do believe that’s a phenomenal if we are going to see this year first of all, if the nature of the market, second as soon as the new price level if something that we cause customers to moving to higher a higher capacities it tosses, it takes time we are in the middle of the process, the company yet to bear, we do see such a transition from the low capacities to the higher capacities, we do believe this will happen eventually. In addition to it, we do believe that the markets will improve due to the demands – the higher demands expected in the first quarter and this of course will help us to expand the market.

Q - Craig Ellis

Okay, and then lastly Dov, any comments on how we might think about gross margins further out than the second quarter?

A - Ronit Maor

I will take this one. It’s not a mistake that we didn't give guidance for the gross margins and not that we forgot about the currently the pricing environment supply/demand until things will balance, it’s hard for us to put the number and therefore, we are not providing guidance so it’s hard to answer your questions, would it give a specific guidance for the second quarter but as for the second half, I think we will have a better feeling after the environment especially the balance which are supply and demand and the prices would stabilize.

Q - Craig Ellis

Alright thanks, and good job in the first quarter.

A - Ronit Maor

Thank you.

Operator

Operator Instructions Our next question is coming from the Alex Gauna of UBS.

Q - Alex Gauna

Hi, yes, I believe you mentioned that for your Q2 guidance USB flash drives of the primary areas concerned, can you give us a little bit more color on the dynamic going on there, is the uncertainties surrounding inventory that still needs to burn off, is it around any share loss that you can detect and lastly, what you type of bit gross versus ASP assumptions, is that the problem that pricing is still falling on USB’s pricing you can forecast that element of it?

A - Dov Moran

Well, the concerns not due to a share loss, we feel that we have very good mix of customers, our customers are very solid, wonderful job, they did not expect to lose customers. We do believe that the business in the handset business. But the situation today is the prices went down, ASP went down, due to the facts the customers yet are not buying higher capacities and multi sound in M-Systems that alterable capacity for device, it’s used to specialize, is relatively similar to what we saw before therefore being in the sector scale elasticity is just at the beginning, the cost that customers really buy higher capacities did not yet take effect and therefore well, we see a low ASP product and the market is not growing significantly enough, we make the situation of decreasing revenues. That’s the situation a clearly the situation we change eventually when customers will get used to that so that they can buy higher capacities and we will buy higher capacities for decent applications that we are providing to this market, we do believe that U3 is a great application that will generate the needs to buy much higher capacities while you can have a device that enables you to do a better pricing calibrations, they can assume your data your programs and basically sales hedging pockets, everything that you needs one your data, your applications you like. So there is a process, we believe that the process is happening, it’s a matter of time of when will happen, we believe that the high revenues for the USB specialized, those were the higher capacities, those are the usages and a continuation of growth of this market

Q - Alex Gauna

Okay, and a follow-up if I could about the second half assume you mentioned that you expect good growth out of the embedded the mDOC market for the second half and that this should comprise greater than 50% or the majority I think it was the term that you used of revenues, is any more granularity you can give on your targets for sales composition out of the hand set market in the second half and is it correct that you have gone through negotiations or contract negotiations for some of these handset ramps here early in ’06 and that perhaps the ASP has continued to come down from a cost perspective to you that you can get some gross margin on this front in the second half or do you expect to have to re-negotiate in the second half?

A - Dov Moran

Well, we do see a very comfortable results accounts agreements for the end of most of the customers that we have in those for, we will supply it, we don’t expect to see major changes here, successful our customers for them to having results you have and the only issue that we have is how to supply the demand and not the price of the device. On the other side, we are limited on how much we can get of the mDOC obviously and this is not the right time for us to renegotiate the cost or the price of the device with our current partner, what we expect to do and we think this to be a nice upside to us, there to see initial designs of H3 at the fourth quarter of this year, going into production and this of course is the place for upside and probably a place for improving the margins.

Q - Alex Gauna

Thank you very much.

A - Dov Moran

Thank you.

Operator

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

Q - Sam Doctor

Thank you and congratulations and a great quarter. Most of my questions have been answered but I just had a couple, can you give us a little more information on the joint ventures that mDOC based joint venture with Toshiba?

A - Dov Moran

Well we are not -- we cannot say contextually to name us who our partner in this joint venture, you may had your guesses and it’s related to use the flash drive not to the mDOC.

Q - Sam Doctor

Okay, on the mDOC side, can you give us a sense of what the break-out is between handsets between smart phones and feature phones and how is that changing?

A - Dov Moran

I do believe that most of our sales are still at the smart phones that we see more and more feature phones and telling you the truth today I feel this is very difficult to distinguish between smart phones and the feature phones as the feature phones are becoming more and more smarter, but and therefore, really it’s very difficult for me to do this result of differentiation but we do see a nice bunch of feature phones coming to the market user is the mDOC we do see a greater demand season for the mDOC H3 with higher capacities of 1 gigabyte and 2 gigabytes with applications of music MP3 players and video which we really - I really believe that we become a huge driver for the company growth in 2007 and on.

Q - Sam Doctor

Just put that differently, what is the average ASP for the handset that used mDOC, and how is that trending?

A - Dov Moran

Well, we do not provide this data, also the ASP for the device and the reason for it, it’s a company, it’s one of the companies’ financial secrets and basically most of data that exists in the market, that's in contrary to memory cards so USB flash driver, everybody can go to the market and signs and try to buy this. What historical instead of this is, at the range between $5 and $10 and clearly, when we talk about higher capacities let’s say 1 gigabyte and 2 gigabytes, which we are not selling yet, but we will sell in the future, then the prices would be of course higher than this one.

Q - Sam Doctor

Okay, thank you.

Operator

Operator Instructions Our next question is coming from Daniel Amir of WR Hambrecht.

Q - Daniel Amir

A couple of questions here. First of all on the gross margins guidance for the second quarter, is it more related to product mix as USB’s decline and mDOC kind of that stayed flat, or is this more related to supply issues on your wafer costs and falling to that is, what kind of your expectations or maybe at the ASP declines in the second quarter?

A - Dov Moran

Okay, hi Daniel. Okay, gross margins, it relates to our - it’s a combination of wafer costs or to see from our trust of partners for flash and the sales which we have to our forecast in our backlogs. That’s relatable the combination of both of them. In regards to, that was the first part gross margin, second part?

Q - Daniel Amir

Yeah, the ASP decline?

A - Dov Moran

ASP decline is a question mark, we do believe that there will be some ASP decline of USB flash drive (indiscernible) of the conference call that they are projecting to lower prices, we are not rushing to lower prices on our side, we are, I would say, we are more conservative in rushing to lower prices, but we have to follow the markets, we have to follow to help our customers to compete with the stores and to project to the customers good prices and therefore, we follow such price decreases, we do believe that the price decrease that will be in this quarter would be much slower than the price decrease that we sell in the first quarter.

A - Ronit Maor

Let me add to that just I mean, we need to separate between two sets of numbers, there is the comparison between Q1 to Q2 and what would happen to the pricing within the quarter. As Dov mentioned, most of the drop that we saw in Q1 are in February and March, therefore, even prices if here we are stable throughout Q2, we will still see Q1 versus Q2. And since we do expect some probably some decrease also in Q2 as well then we will see an average Q1 to Q2, we are expecting to see a decrease in ASP per megabyte.

Q - Daniel Amir

Okay, and then one follow-up question, can you comment data on the embedded group, we have done well here in the first quarter, it looks like could be stable in the second quarter so what are the drivers there outside I think you start mentioning about the DVD side and into the second half of the year?

A - Dov Moran

Okay, a bit of business is cost wise, many customers knows, many usages, it’s a list of customers that the embedded is very large and including the companies that I believe medicalist (phonetic) orientation, industrial computers, GPS devices and others and therefore, on one side, we are not really seeing a huge jumping revenues as we saw in the USB flash drives, it’s much more conservative companies and businesses. On the other side while flash becomes much lower in costs and competitive with hard drives, more and more applications side adopting solutions that are based on flash and we are there very nice place for products which we do have for many, many years and which are proposing also in very high reliabilities, very high performance and the list of customers is growing and therefore, we see high revenues, there is no specific market that generated this gross, we try to especially the guy who is running the division yesterday and we try to analyze from first hand it’s a growth of 56% quarter-over-quarter, and we then saw the list of customers and the list of applications. We couldn’t really point any specific customers, any specific application that generate the growth except the situation of the world market, for positive markets which is driven by the lower cost of flash. Let me try to emphasize it by, I will make an example. The hard drive cost roughly $100 say, I would say that you can get hard drive for $80 and maybe even for less, but if you look for a reliable hard drive that can serve such applications say hard drive which has smaller small size, you are getting to numbers which are roughly $100. A couple of years ago, to provide something that could be placed such as high hard drive was possible only with capacities of couple of gigabytes or is not even couple of gigabytes, that’s megabytes. Today, with the new prices, you can replace such hard drive. We have set it on gigabytes and these are the tradition where we are hedging and clearly, once this is the situation, the applications that here and the usages are, they are going significantly, let’s say the trend we are seeing and I believe that this trend will continue.

Q - Daniel Amir

Thanks a lot.

Operator

Thank you. Our next question is coming from Daniel Gelbtuch of CIBC.

Q - Daniel Gelbtuch

Superb quarter guys. On the supply side obviously saw that Samsung is no longer a partner, I would like to just hear from you guys what your reaction was to Samsung’s intention that they still are as they mentioned on their call and how do you think, again what other sources beside from another supply agreement, or there any technological breakthroughs you guys are looking at or new technology looking at to increase supply over the course of the next 6 to 12 months?

A - Dov Moran

Hi Daniel, and thanks for the complement. Let me precisely clear regarding the Samsung situation. We had a press release, I think we said ever since we could say in this press release and I cannot add to it anything. Regarding supply, Samsung was not a major supplier to us in the last quarters and this is not because we did not want to buy but due to the nature of supply and our dissatisfaction of things that’s relate to them as a supplier. We do believe that we can dealt Samsung’s supply by extending our procurements from the other suppliers and as I mentioned some, I think with the first discussion for the first by Eric, we are working very hard in order to extend the supply to M-Systems and I see there is a new target as for myself and it can be done until the end of this year.

Q - Daniel Gelbtuch

Okay, and just switching gears with regard to mobile DiskOnChip now that H3 you said is ramping and will be I guess shipping in the fourth quarter, are you qualitatively seeing a shift and the design when mixed towards handsets that have a much higher projected volume, again focussing more in high-end feature phone or even main stream feature phone, are you seeing a rapid shift from the OEMs where previously they have a mentality where they were concerned about software integration etc., and now at H3, they are going to hitch their wagon a little more.

A - Dov Moran

Well clearly, when we began selling the DiskOnChip several years ago, the first cell phones that were sold, we were selling the mDOC to where applications for cell phone featured hedge of the hedge of the companies which were manufacturer, you know it’s a low quantity and maybe a difference, you know it’s a new component, it’s a new supplier, it’s a new solution, let’s have a trial with this sort of model that if we can fail, it won’t be a disaster or it won’t really have the component. As we moved along, we went toward much more main stream cell phones and initially towards really smart phones and otherwise which again are high-end relatively low quantity, as we move along and the solution is great solution and the engineers love it, and it truly provides huge benefit to our customers of having been physical to great solution, adding features, adding functionality, adding performance and are being asset price as it is, let’s say it is beginning to enter into more and more main stream models and this is the trend we are seeing. Clearly, the facts that we are going to use as solution that is going to be multi-sourced, so our customers can buy the solutions from us or from our partners and even if they buy from us we do have multi source for the parts that are establishing the solution, that’s a great important to our customers and I do believe that we will enter these device that we see into main stream cell phones. Just finally, the summary of the answer, one relation is very critical Daniel that dealt us to a new born offer of (indiscernible).

Q - Daniel Gelbtuch

Thank you.

A - Dov Moran

Thank you.

Operator

Thank you, our final question is coming from Romy Wilson of Aster Group. (phonetic)

Q - Romy Wilson

Yes, thank you, Dov and Ronit for achieving good results. Just two housekeeping questions actually, what was the operating cash flow for the quarter?

A - Ronit Maor

It was positive of 6 million.

Q - Romy Wilson

And the number of shares expected for this quarter?

A - Ronit Maor

You can add just few hundred thousand shares.

Q - Romy Wilson

Okay, great quarter guys, thank you.

Operator

Thank you, at this time I would like to turn the floor over to Ms. Noam for any closing remarks.

Dov Moran, Chairman, President and Chief Executive Officer

Thank you. Okay, actually this was a great quarter, it was a great conference call, exactly one hour, thank you very much and looking forward to a talk review in the next quarter and the years to come, thank you.

Operator

Thank you. Thus concludes today’s M-Systems conference call. You may now disconnect your lines. Have a wonderful day.

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Source: M-Systems Flash Disk Pioneers Ltd. Q1 2006 Earnings Conference Call Transcript (FLSH)
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