Western Digital Corporation (WDC) Q4 2005 Earnings Report, Transcript and Summary

Good afternoon and welcome to the Financial Teleconference for SanDisk® Corporation for the Fourth Quarter of 2005. I am Lori Barker Padon, SanDisk® Director of Investor Relations. Today with me is Eli Harari, President and Chief Executive Officer, SanDisk® and Judy Bruner, Executive Vice-President of Administration and CFO. The agenda for today’s teleconference is as follows. Eli will serve with remarks on SanDisk® and trends in our market, Judy will follow up with our fourth quarter financial results and future guidance. We will conclude the teleconference with your questions. An audio replay of this conference call, a copy of today’s prepared comments including metrics will be made available on SanDisk® Investor Relations website. By now all of you have seen our press release with the associated Form 8-K filed this afternoon. I would like to remind everyone that today’s comments including our question and answer session will include forward-looking statements within the meaning of section 27A of the Securities Act of 1933, as amended in Section 21E of the Securities and Exchange Act of 1934, as amended, that are based on our current expectations. Forward-looking statements in this teleconference are generally identified by words such as believe, anticipate and impact, may, will, and other similar expression. In addition any statements that refer to expectations, projections and other characterizations for future events and circumstances are forward-looking statements. There are significant risks and uncertainties that could cause our actual results to differ materially from those expressed in these forward-looking statements. The risks and uncertainties are detailed in our Form 10-K of fiscal 2004 or Form 10-Q in our press release and Form 8-K. Listeners are cautioned not to place undue reliance on those forward-statements, which speak only as of the date hereof. We do not intend to update information contained in this…

Thank you Eli and good afternoon everyone. There is no question in that 2005 was a fantastic year for SanDisk®, for all of 2005 revenue grew 30% and net income grew 45%. Our ASP per megabyte declined 52% leading to the emergence and growth of new applications for NAND flash. Our megabyte sold increased 166% and this growth could have been higher if we had more supply. We were able to reduce cost at a rate faster than the decline in ASP leading to expansion of our gross margin and operating margin. Our full year operating margin was a record 25% and the consistency of our operating model was notable with Q4 2005 representing the 13th consecutive quarter of operating margins above 20%. Our fourth quarter product revenue was up 35% year-over-year and 29% sequentially. Megabyte sold grew 49% sequentially at the high end of our previous forecast and ASP per megabyte declined 13% slightly less than we had previously anticipated in part due to the modest growth in average capacities and a strong mix of digital audio players which carry a slight in higher price per megabyte. As is typical in the fourth quarter sequential growth was strongest in the retail channel where our revenue was up 31% over the third quarter. Our OEM revenue grew a robust 22% sequentially based on the strength of handset business. Handsets have now displaced Digital Still Cameras as the mainstay of our OEM business, with cards for handset accounting for 76% of our fourth quarter OEM revenue. For the fourth quarter the OEM channel contributed 23% of our product revenue up from 19% in the year ago quarter. On a geographic basis our product revenue mix in Q4 was 54% Americas, 24% Europe and 22% other international regions. License and royalty revenue…

Thanks. I have a couple of questions, looks like your MP3 players are pretty strong in Q4. Do you know, what seasonality might dictate in terms of their share of the overall, in Q1 and how sort of, share of various applications and products might go from Q4 to Q1?

Yes we expect very strong seasonality with MP3 players. So, Q4 for the two players is absolutely is turning to be gorilla quarrel. We expect a significantly lower units and dollar revenues from MP3 players in Q1.

And what you think, it's going to make up that flat in terms of application segments?

We have already pointed out that Handsets are very very significant market and we expect that, as well as the fact that we have, now a very larger, really a number of markets as all contribute. The Ultra Product line for example, U3 product line and we are going to launch a number of very sexy products towards the end of Q1 that we showed at the CES Show, the Sansa™ e200 will be launched in March. The new U3 cruisers would be a launching also. There is whole number of products across different markets. So we certainly are not dependent on just MP3 markets to drive our Q1 revenue.

Great, my second question is related to the licensing and royalty side. Can you provide us an update on beating the front as to, what, I guess, events might unfold over the next quarter which could impact your licensing revenue needs either the way or what events might unfold in the next six months?

We’ve already pointed out in my prepared remarks that there is tremendous amount of activity going on. In the SD situation there are suits and counter suits and continuations and IPC actions and that is not the only thing. So there is lot of things going on and we are very very aggressively pursuing new entrance that we feel and existing players that we feel should take the license to our pattern.

Thank you.

Hi Good Evening. A couple of core questions. How are you going to gauge, if and when your elasticity is working in the market place. What kind of things you are going to look to, what kind of things can we look to, when should we expect that to see if the price cut is kicking in the kind of elasticity that you would need to soak up the incremental supply, and then I have a couple of follow up. Thanks.

The main metric for that would be the Megabyte per unit, that we ship in retail, that’s the first place, when people start moving their preference from 512 Megabyte to Gigabyte. We are now – to achieve 600055 Megabyte per retail, average Megabyte per unit that means you are closer to the 512 Megabyte to the Gigabyte. As the cost of the Gigabyte cards comes down quite significantly, we do expect that people will start switching that and that will be first place to where you will see that. But it is not so much, the first reaction is not so much, increase in units because that requires new applications that increase Megabytes per unit.

Great, first follow-up with the, on inventory, what do you expect inventory to do in calendar Q1?

We would expect inventory to continue to grow in Q1 given continued steep ramp for Fab3 across the first quarter.

Okay and then my final question, I understand that demand drivers, we all do about how great the demand drivers are for NAND flash. Do you worried all about how many of the DRAM companies seem to be start moving, seem to be moving incremental capacity from DRAM over to NAND and obviously at some price. NAND can observe all this incremental supply, did you worry about the impact that is going to have on pricing as you move throughout the year if the DRAM companies continue to be so aggressive in that migration, that’s it from me, thanks.

Yeah, this is complex answer ofcourse, and I am sure you know it, but basically it is really, two aspects of that. Definitely we are worried about our new suppliers getting new capacity switch from DRAM to NAND flash. That part of the second aspect which is that, the output that you get from the 300 mm 70 nanometer MLC wafer is so dramatically greater. Then what do you do from switching from 90 nanometer DRAM wafer to 90 nanometer Binary NAND or even 70 nanometer Binary NAND on 200 mm wafer. Most of the DRAM capacity today in the world is 8 inch. And the conversion of 8 inch DRAM wafers to NAND at 90 nanometer is not going to see a bit significant crunching in terms of, the contributor over the numbers, total numbers of Megabytes added for the industry, really very very substantial. In other words, we are getting to very large numbers now. And we think that DRAM conversion, that’s was the easy task DRAM guys, is going to become spend swing and basically at that point we move to 300 mm and leading edge NAND MLC.

Thank you very much

Thank you.

And our next question will come from Mark Edelstone with Morgan & Stanley.

Hi Good Afternoon guys. Thanks for the data, I had one question, you have might got it but Judy had missed it, what was the contribution from MP3 players in the fourth quarter?

We didn’t provide for the fourth quarter. We provided it for the year and I said that the revenue from Digital Audio Players moved from 6% of our revenue in 2004 to 13% for 2005.

And we did say that revenues in Q4 quadrupled, Modem quadrupled the revenues from MP3 players in the prior quarter which was very very steep increase. I think, it is definitely was one of our better players. No comment on that. And as far as your comment about all of this information that Judy due to provide, I do not, I would not wish with you guys, I would not want wish to be a financial analyst, with all these GAAP and Non-GAAP-.

Just multiply it by about 30 more companies?

Yeah that’s what, I can just imagine this is unbelievable, anyway, that is what we got to do.

Okay, thanks for the clarification there. I guess, my question is, Eli, is looking at the Sansa™ players that you brought out, showed at CES certainly seems like those are going to be well received in the market. So, what if you kind of give us your views as to what you think the potential there could be when you look at the fourth quarter of this year and I got a couple of quick follow-up.

Yes, so session that we had for the e200 Sansa™ has been universally very very positive and we are very excited about it. But our strategy, as we said, in MP3 players is to basically offer good, better and best. The e200 is best and we will serve very very well in that part of the market for customers that want and high end, high quality products but also want an open, way to get the content through subscription services from Napster, Real Networks, home music and so on. But we are also pretty much focused on the midst to low density MP3 players under 4995 to the 1995 for instance. We think that is going to be, where we can move a lot of Megabytes and the lot of units during the year. However the e200 is a very exciting product for sure. And again in long end, we do think that Handsets would be the primary comrade for distribution of music. Just by the shear numbers, we are talking 11 million cards in the fourth quarter compared to, this is very very large number, compared to all iPods 14 million iPods sold in the quarter, you see that we are and we haven’t really touched the surface with handsets.

Okay, thanks. Judy, an accounting question. I just want to make sure my understanding is correct here, with the price reductions that you are taking and with 7 to 8 weeks of channel inventories. It seems like that should line up every things goes according to your plan that you should be able to end the quarter without having a take any type of charges for price protection, is that correct?

Well remember that because we recognize revenue in the retail channel based sell through, at the time we recognize the revenue we know what price the product is being sold to the consumer at. So the pricing and the impact of the price protection lines up with sell through. And if you look at our balance sheet at the end of the fourth quarter there is a line for deffered income from sales to the retail channel, that number includes our estimated impact of the price protection which we accrued the end of the fourth quarter for all of the known price moves across all the geographies in the first quarter.

Okay, is that the major factor as to why it is down quarter-to-quarter then?

Yeah.

Okay, then just last question, Eli, can you just walk us through what the current Fab3 ramp plan looks like as you go to 2006?

We were certainly ahead of our plan in the fourth quarter, the ramp in the fourth quarter was substantially faster than we had guided you or that we thought was possible, it is really tremendously strong execution and we are definitely on schedule to meet the guidance that we gave you that by the end of Q1 we will be at 30,000 wafer hours and we’re certainly not come on top of that point. We will try to provide some more guidance on that at the Analysts Conference but in general this Fab is performing extremely well and we’re pleased with the cost structure as the number of wafers increases at a very fast pace the fixed cost does not increase at the same pace and as now cost are coming down at a very fast pace. As we expect, basically through the rest of the year continuing through the cost reduction that would be quite significant every quarter aid through increasing the volume, amortizing the cost, fixed cost over greater volume leads to the yield improvement and sees through the transition to 70 nanometer MLC.

What where the output for Q4 Eli?

We’ve not broken that, but the contributor to the inventory as, the high inventory at the end of Q4 is because this is very rapid ramp every week basically and increase in the output.

Great. Thanks a lot guys. Judy Bruner, Executive Vice-President of Administration & CFO: Okay, if we could limit the questions to one or two for each of the analysts that would be great that way we could answer everybody else, thanks so much.

And our next questions will come from Daniel Gelbtuch with CIBC World Markets.

Hey guys! Congratulations. I was wondering if you guys have seen Samsungs (indiscernible) clearly do you think there some of efforts with MLC, have you seen any product in the market and also what do you expect to see on the pricing for your non-captive sourcing. Are you expecting to see similar price reductions over the course of the quarter?

We are shipping some of the MLC in some of our products, and we’ve said all along that we want to be one of the primary customers NAND/MLC because, like to pages called. But it is well known that they have been and in fact their own on numbers indicate that there have been somewhat ramping after the MLC had lower pace than projected from the beginning of 2005. As far as price reduction non-captive, I argue upon and absolutely, I mean they have, we fully expect overtime competition will match our pricing, but this move is primarily to really stimulate new demand also suffice that, the new capacity coming on board does not become excess capacity.

Okay and just switching gears one second to U3, can you comment and what your expectations are for your volumes, your percentage of volumes for USB drives how will be U3, how much will not by the end of the year.

We expect majority if not all of our Cruiser USB flash drives to the U3 enabled for the rest of year, definitely we are moving in the right direction in both parts of the NAND systems. I think I am pretty confident about the direction we are taking, very, very pleased about U3.

Thank you very much.

Thank you Daniel.

We’ll now go to Eric Gomberg, Thomas Weisel Partners

Congratulations on the strong 2005.

Thank you.

Obviously you had some additional momentum on the wireless side, I was wondering if you could discuss a little about the visibility there, what type of bundling and after market growth you’d expect to be and I have a follow-up.

Oh. We have the great deal of visibility on the handset, you are talking about the handset. Right okay some people when they say wireless they mean WiFi. We are working with all major handset makers and we are very, very pleased with the adoption of MicroSD and Memory Stick™ for Dual, the demand in the fourth quarter, we could have shipped more, frankly we could sold significantly more than 11 million units and we were frankly constrained backend capacity of assembly, and by the way that now is behind us. We do have ample backend assembly and test capacity to meet the demand and the demand is kind of Bimodal, the low capacity 64 megabyte for general purpose maybe the camera phones and the 512 megabyte primarily for the MP3 phones.

Okay, just have a question also now on margins, a quick one for Judy, as far as the past, should we expect faster growth of R&D or SG&A. The question is also on gross margins for the year, you said I think 32 to 35 on product gross margin. Just wondering you said more captive than external last year that you should be able to cost reduce faster then your own ASP declines. So wondering why product gross margins would be down from 35.5 of 2005.

Okay so let me take that one first and then I’ll go back to your question about G&A versus R&D. So really the overall gross margin for the year is impacted by our forecast for a sequential decline from Q4 to Q1 but then we expect as I said the cost reduction that we will enjoy in the middle part of the year could be at a faster rate then the so subsequent price declines and subsequent quarters. So we work our way back up but leading to an average overall range of 32% to 35%. Which you know if were at the high end could be very close to 2005, and even at the lower end is better than my experienced in 2004. But also keep in mind the mix of the products and as our mp3 players are becoming a bigger mix of our overall revenue, as I indicated those two carriers somewhat lower gross margin percentage eventhough they are contributing significant gross margin dollars given the higher non memory components within the build-up material mix. And as to your first question you asked whether R&D would grow which will grow faster R&D or G&A and generally I would say R&D in particular given the R&D team that we have picked up now for Matrix as well as our investments in 55 nanometer and 45 nanometer throughout 2006.

Okay Thank you.

And our next question come Satya Chillara with American Technology Research

Yeah! Hi guys. I know you would talk about greater visibility into cellphones can you talk about well before that Judy said 13% of the revenues come from handset in 2005. Can you give us some sort of insight into what would that be by the end of 2006 whatever that revenue might be?

We will try to provide more information at the Analyst Conference at February 23rd but certainly we expect it to be on the rapid growth path and it will certainly higher than 13%. I mean I’d be surprised if it is lower than that.

Okay in terms or maybe can you answer the question which regions are you seeing the MP3 phones really taking up based on the OEM activity that you’re seeing, where do you get all this demand coming from?

We had been shipping really only to the US in any substantial number of MP3 players. Almost exclusively through really two of our main retail customers, so the room for expansion is very, very substantial opportunity to leverage our channels through other chains as well as geographically outside of the United States. We believe a very substantial and primarily so at a low and mid end price range not at the high end.

Okay. One last question for Judy. Judy what is the plan for captive to non-captive in 2006 with the 300 mm expansion and so on. Are there is any changes in the plan in terms of captive to non-captive mix.

I had indicated in my prepared remarks that we expect 30% to 35% in the first quarter and then to move into the 25% to 30% range in subsequent quarters.

So based on that margin should improve right? So why are you still conservative in terms of 32 to 35 kind of gross margin.

Well as I indicated a while ago, mix is an impact and we of course will see how things roll out over the course of the year.

Okay, this model really does give us the tremendous possibility that we’ve always said a very, very importantly 2005 was clearly was supply constraint with captive and we market out really on non-captive in 2006 the situation maybe a flipped and that is the beauty of our model.

Okay, thank you.

And we will go now to Craig Ellis of Citigroup.

Yeah! Thanks and congratulation on the reduction ramp on the fourth quarter.

Thank you.

Some clarification on the inventory for the fourth quarter did the backend in terms of any tightness bearing on the inventory dollars between the backend assembly.

No not really as Eli indicated a minute ago by the end of the fourth quarter we really did not have any backend assembly or test bottlenecks. We cleared those issues.

Okay, then Eli back in October you talked about 50% price for Megabit declined, right now maybe a little bit have you added 50% to 55%. If you think about how you could manage that both strategically and tactically. If you got a supply you could press that pick up share by increasing price not only in the first or the second quarter. Can you show your thinking about how you might use that price for Megabit declined?.

Well, the most important thing for us is to focus on our cost reduction to make sure that, we reduce our cost faster and we would reduce our megabyte. Secondly, there is no point leaving money on the table and driving pricing faster than we can actually supply the market. So, we will, you could also frankly, view the strategy of basically linear price reduction throughout the year, it’s a kind of like, the most demanding environment but, it’s really, is not as effective in our experience in generating stimulation, simulative effect. So, we will definitely use our cost advantage to drive the demand to our benefit, to our advantage, to make sure that 100% of our output, captive output is very sound world wide.

Okay. That sounds like, something that looks more like 2004 than gradual price declines?

No, we’ll take it one quarter at a time, we’ll see how it goes.

Okay, all right, and then lastly, any update on what you are seeing with regards to iNAND™ in design and switch backlog.

iNAND™ we announced September, it is about 3 ½ months ago, we are seeing initially a good response, we expected be a winner in Handset, it has not just very very easy designing and very attractive cost structure but also the security cost/security, but it will be most in the second half of the year in terms of our volume reduction and it will be a relatively small contributor still in 2006.

Okay, Judy, one more, I think, I heard you say, bit growth of a 180% to 190%, is that correct? A – Judy Bruner: Correct.

And that assumes the 25% to 30% non-captive resourcing? A – Judy Bruner: Correct.

Okay.

Our next question from Sam Doctor with J.P.Morgan.

Thank you. A couple of good questions for you. Mostly of the questions have been answered but you have an update on the pre packaged media on SC cards?

I am sorry, under what?

Prepackage media grew by cards and do you think the distribution of content?

Okay, it’s a groupwise. The concept again, great concept and has been a tremendous door opener for us, promoting the record labels, that component owners, and by distance again, it’s a long term market development evangelizing and this is a very very good start. So, we are very very pleased with that.

Okay. And on the Matrix acquisition, what was the kind of applications do you expect to see in 2006 what is driving revenue for this year?

2006 the revenues are really driven by growing their business which is preprogrammed cards primarily for video game application, software distribution, games and music and the key for us is to get them on accelerated technology roadmap and develop a much broader customer base in the application to technology, the archival technology is very, very interesting you know frankly very exciting, and we will talk some more about that again on February 23rd.

Ok great thank you.

Thank you. Judy Bruner, Executive Vice-President of Administration & CFO: Looks like we might have more time for two more callers, thank you.

Our next question comes from Vijay Rakesh with Oppenheimer

Yeah, I was just wondering when you look out at the Q1, so you are looking at about flat to about up 10% bit growth, what the price as you mentioned is that across, is that blended ASPs or?

Yes for blended decline in ASP per megabyte of 25% to 30 %.

Okay, and can you characterize what the MLC output was in the quarter. And what do you expect that in the quarter?

MLC on 70 nanometer is 100% MLC we don’t make any Binary on 90 nanometer, its mostly MLC, over 90 % of MLC.

And your 8 Gig, what percentage was it Q4 and where do you see Q1?

On the 70 nanometer, all of Q4 opt for 8 gigabit, but we are now rolling out the chat version, the 40 gigabit lower than -?

Okay great. Thanks

Thank you.

And our final question today will come from Doug Rudisch with Brookside Capital. Q – Doug Rudisch: Hi just a question on MicroSD the cell phone cards, just can you review sort of the price premium you’ve been able to extract on that form factor, if any and if you’ll be able to hold it over time.

No we are not extracting any premium from MicroSD we are selling it in the same priced OEMs as we do a MiniSD or SD for that matter, we are developing the markets, we’re not trying to extract a premium, our cost on the MicroSD is, I believe about the same to MiniSD. We don’t want to use pricing to get customers to decide MicroSD is ideal for all the new generation of ultra slim handsets that’s really the only way, frankly that they can get a decent sized card in a very very small form factor if you take the connecter into consideration.

And your market share there’s wide and how you expect that to evolve over the course of the year?

We have made MicroSD an industry standard, we want other people to supply it, we would like to have the lion share of the supply but we think its very important that there are other supplies, we expect to collect royalties, substantial royalties as MicroSD become very popular and the other suppliers that take license from the SD association we share in the royalty that’s generated from that.

Any analytic view of where your market shares now and where you will think it will go over the course of the year?

I am sorry, say it again

Any quantitative view of where you your market share is now in that form factor and where it will go in the course of the year?

MicroSD to the extent we have very, very high market share in the, I don’t know if its 80% or - but it is somewhere along there we don’t expect to keep that for long time and we have probably have lost some market share because of our inability in the fourth quarter to meet our customers demand and you know, we would like to be the majority supplier of MicroSD going forward.

Thank you very much.

Thank you, So I would like to thank you for attending SanDisk® today we are excited about the opportunities ahead of us and look forward to meeting many of you during our up coming Analyst Day February 23rd,thank you very much.