SanDisk’s (SNDK) CEO Sanjay Mehrotra on Q3 2014 Results – Earnings Call Transcript

SanDisk assumes no obligation to update these forward-looking statements which speak as of today.

This communication does not constitute an offer to buy or solicitation of an offer to sell any securities. The tender offer to purchase all of the outstanding shares of common stock of Fusion-io, Inc. is being made solely by means of the offer to purchase, the letter of transmittal and related documents, which contain the full terms and conditions of the tender offer and have been mailed to Fusion-io’s stockholders and filed with the SEC. Investors and security holders of Fusion-io are urged to read these and other documents filed with the SEC, as well as any amendments or supplements to those documents carefully in their entirety when they become available, because they contain or will contain important information about the proposed transaction.

With that, I’ll turn the call over to Sanjay.

Sanjay Mehrotra – President and CEO

Thank you, Jay, and good afternoon everyone. We are very pleased to report record revenue, strong earnings and cash flow, and to have returned more than half a billion dollars of capital to shareholders during the quarter.

With the acquisition of Fusion-io, SanDisk now has the most comprehensive enterprise portfolio in the industry. Our solutions range from the highest performance, lowest latency products that enable application acceleration and disrupt traditional IT architectures, to products that have a compelling value proposition to replace hard drives in a variety of applications.

This portfolio, coupled with our broad and expanding customer reach and well established vertical integration capabilities, positions us well to accelerated our momentum in the fast-growing market for enterprise flash. We expect our enterprise SSD revenue to surpass $1 billion in 2015, a year ahead of our previously stated timeline.

Our enterprise SSD revenue grew strongly on a year over year basis during the third quarter, driven by our SaaS leadership position and growing presence in enterprise SATA, and it was further bolstered by a partial quarter of revenues from Fusion-io solutions.

We have now converted the vast majority of Smart Storage’s products to captive NAND flash and this provides us with an important advantage as we pursue several large opportunities with hyperscale customers.

We are delighted to report first revenue shipments of ULLtraDIMM, our high-performance, low-latency SSDs to leading server and storage OEMs. [Design] traction for ULLtraDIMM SSDs continues to grow with successful qualifications at Super Micro Computer and Huawei, achieve in the third quarter.

The Fusion-io business performed in line with our expectations post-acquisition. On the product front, multiple OEMs have now qualified and are offering our next-generation Fusion-io PCIe products. Our plan is to continue supporting the majority of Fusion-io products on non-captive NANDs in 2015.

In addition to the growth of the enterprise SSD portfolio, we are pleased that Dell will begin incorporating SanDisk DAS Cache software into certain Dell-powered edge servers as part of the base configuration.

This FlashSoft server side caching software that allows customers to benefit from server attached SSDs as a cache, for an application’s most frequently accessed data. Following the completion of the Fusion-io acquisition in late July, we have made excellent progress in integrating Fusion-io into SanDisk.

To best realize the capabilities, talent, and scale of the two teams, we have decided to accelerate the combination of the legacy SanDisk enterprise storage solutions group and the newly added Fusion-io team by forming one enterprise storage organization under John Scaramuzzo.

As planned at the time of the acquisition of Fusion-io, the sales team has been integrated under the leadership of Henri Richard. Lance Smith has decided to leave SanDisk to pursue other opportunities.

In client SSDs, we saw healthy year over year revenue growth as attach rate of SSDs to PCs continues to increase, and our overall market share position remains strong. During the quarter, we had a successful launch of our X3-based SanDisk Ultra II SSD for retail and the product has garnered several awards from top reviewers.

We also began shipment of our 1Y nanometer X2 SSDs and qualification efforts for our 1Y nanometer X3 SSDs are underway with multiple OEM customers. Our combined sales from enterprise and client SSDs drove 27% of our third quarter revenue.

Trying to mobile embedded, the launch of several new smartphones containing our embedded solutions enabled healthy sequential revenue growth with particular strength from sales growth of custom embedded solutions. We believe that Apple’s decision to increase the embedded storage in their mid-tier and top-tier iPhone to 64 GB and 128 GB respectively is indicative of pent-up consumer demand for higher storage capacities.

We expect other OEMs to follow suit by increasing their embedded storage capacities in their respective offerings and this bodes well for the prospects for our iNAND portfolio as well, as well as the overall demand for [unintelligible] flash.

We are pleased with the broadening customer traction of our embedded X3 solution. Our X3 flash and systems technology capabilities allow our customers to increase overall mobile device capacities at competitive cost structures while still delivering outstanding application experience.

In retail, revenue increased slightly from the previous quarter but declined modestly on a year over year basis with growth in Micro SD cards offset by decline in SD cards. Our over global retail presence remain solid, backed by our valuable brand and consumer recognition of our high-quality products. We are positioned well as we head into the seasonally strong period of the year.

Turning to industry demand, we continue to see multiple strong growth drivers for flash, and the demand outlook remains robust. Even as mobile market shares shift among different OEMs, overall smartphone shipments remain on a strong trajectory and we are very pleased to see the average capacity growth in these devices drive strong demand for flash.

In client computing, I’m sure you will agree with me that once you have become used to an SSD-powered laptop, there is no going back. Consequently, the increasing penetration rate of flash in corporate laptops will spill into the consumer space and drive significant growth in flash penetration in the PC platforms in the years ahead.

Finally, enterprise and hyperscale customers continue to work with market leaders like SanDisk to find new ways to use flash in an ever-increasing number of applications and workloads, as flash technology is a critical foundation of the modern day responsive enterprise. To summarize, we believe that near term and secular demand drivers for flash remain strong, and we continue to be confident in the future prospects for the industry.

Trying to fab operations and technology, we completed the planned 5% wafer capacity expansion in Fab 5 phase one, bringing SanDisk’s annualized wafer capacity to approximately 2.8 wafers. We also recently celebrated the opening of Fab 5 phase two and we have started moving equipment into the new clean room to support our 15 nanometer node RAM.

We are on track to begin product shipments of 15 nanometer this quarter, with meaningful production in Q1 of 2015. We believe our 15 nanometer technology node, using both X2 and X3 architectures, will be the lowest cost memory technology in the industry in 2015, with capability to serve all product apps, ranging from consumer to enterprise.

As we discussed last quarter, our mix of 1Y nanometer production is relatively consistent through the second half of 2014 at 60%, while we maintain a long tail of 19 nanometer production for strategic customers and begin our 15 nanometer production ramp in Q4.

Our estimate of industry supply [bit] growth for 2014 is slightly below 40% and SanDisk captive bit supply will be slightly below 25%, given the long tail of 19 nanometer production. For 2015, both 19 nanometer and 1Y production will continue even as we ramp 15 nanometer.

We continue to prudently manage our capacity expansion to ensure appropriate ROI, given the future transitions to 3D. With this in mind, we are planning an approximate 5% capacity expansion in 2015.

This capacity expansion, along with our technology transitions, results in expected captive supply bit growth in the range of 30% to 40%. For the industry, our estimates for 2015 supply bit growth are also in the range of 30% to 40% and we continue to expect a healthy industry supply demand environment in 2015.

Our 3D NAND technology development continues to make good progress and we expect to be in pilot production in the second half of 2015, with target volume production in 2016. I would now like to take a moment to recognize and congratulate my dear friend, Dr. Eli Harari, founder and retired chairman and CEO of SanDisk, who was recently honored by President Obama with the National Medal of Technology and Innovation.

This award is the highest honor the United States can bestow to recognize Eli’s leadership in advancing the field of science and technology. Eli’s contributions have had immeasurable impact on our lives and society. We are incredibly proud and honored to have been a part of the journey that Eli pioneered over two and a half decades ago. Congratulations, Eli, on this well-deserved and prestigious award.

To conclude, we are pleased with our third quarter results. We are driving hard in innovation and execution, in a vibrant industry with strong secular demand drivers. SanDisk has an industry-leading solutions portfolio and roadmap, and our deep ecosystem and customer engagement are second to none.

Our outstanding technology, systems engineering, supply chain capabilities, and our ability to attract key talent are key competitive advantages for us, and we believe we have what it takes to create new, differentiated opportunities for our business and continue to be a leader in our market. We look forward to completing a record 2014 and to executing on our plan for another strong year in 2015.

With that, I will turn over the call to Judy for the financial review and outlook.

Judy Bruner – EVP of Administration and CFO

Thank you, Sanjay. Q3 was another strong quarter for SanDisk, with revenue growing 7% year over year to an all-time record of $1.75 billion. We delivered excellent gross margins, very strong free cash flow, and non-GAAP operating margin of 28%, even with restructuring charges and the inclusion of the Fusion-io business.

With rapid progress on our integration initiatives, we are well on our way to meeting our goal of Fusion-io being accretive to earnings in the second half of 2015. On a year over year basis, our commercial channel revenue grew 13%, while retail revenue was down 2%.

The primary source of our growth in the commercial channel was SSDs, both enterprise and client solutions. Within the retail channel, sales of SD cards decreased due to the declining camera market, partially offset by growth in demand for micro SD cards.

Sequentially, our commercial revenue grew 8%, driven by embedded growth, and our retail revenue grew 5%, driven by back to school USB sales and mobile cards. Sales in the retail channel comprised 32% of our Q3 revenue mix, compared to 35% in the year ago quarter.

Our total petabytes sold increased 9% sequentially and 43% year over year. Our captive bit sales grew faster than our captive bit supply, resulting in further reduction to our captive inventory levels. Our overall inventory increased sequentially because of the non-captive inventory acquired in the Fusion-io transaction.

Looking at revenue by product category, our SSD revenue grew 48% year over year, with the strongest growth coming from enterprise SSDs. Sequentially, our SSD revenue grew 1% with growth in enterprise SSD revenue offset by a decline from client SSD.

The sequential decline in client SSD revenue reflected demand timing from certain customers as well as our own supply allocation decisions. Our embedded revenue was down 16% year over year, and up 30% sequentially.

The sequential increase in embedded revenue came from both custom embedded and iNAND solutions. Our removable products revenue, which includes sales in both retail and commercial channels, was flat year over year and up 1% sequentially.

Our Q3 non-GAAP gross margin increased sequentially to 49%, benefitting from a stronger mix of product sales and a higher usage of X3 memory, which made up more than 50% of our revenue bits. Our blended price per gigabyte and cost per gigabyte both came down 3% sequentially, inclusive of the impact of product mix and average capacity growth.

1Y nanometer technology comprised approximately two-thirds of our petabytes sold, and the yen rate in our cost of sales was 101, consistent with the rate in the second quarter.

Our Q3 non-GAAP operating expenses increased $63 million sequentially, with $25 million of the increase reflecting restructuring charges and the remainder of the growth driven by 10 weeks of Fusion-io operating expenses.

Without the impact of Fusion-io, SanDisk’s standalone expenses were approximately flat from the second quarter, less than originally forecasted, primarily due to the timing of certain R&D expenditures.

Restructuring expenses were $10 million less than originally forecasted, largely due to lower charges for IT integration and employee severance. Related to the Fusion-io acquisition, our GAAP costs and expenses also include $11 million of stock compensation charges related to acceleration of Fusion-io equity awards held by certain former Fusion-io employees, $17 million related to amortization of acquisition-related intangible assets, and $5 million of inventory step-up charges.

Our non-GAAP Q3 diluted share count declined sequentially by 1.9 million shares, as share repurchases more than offset dilution from the 2017 warrants and employee shares. Our non-GAAP tax rate came down slightly and our non-GAAP EPS was $1.45, inclusive of restructuring charges.

Q3 cash flow from operations was a robust $588 million, and cash used for capital investments was $116 million, yielding free cash flow of $471 million. During Q3, our capital return was $525 million, including $458 million spent on share buybacks and $67 million delivered to shareholders in cash dividends.

On a year to date basis, total capital return stands at 95% of free cash flow, and we have repurchased 8.75 million shares.

Our share of joint venture fab investments during Q3 was $243 million, and non-fab capital purchases were $87 million, bringing total year to date gross capital purchases to approximately $870 million.

Our Q3 fab capital investments were funded by joint venture working capital, $60 million of operating leases, and a net $29 million contribution from SanDisk. Our cash flow statement also reflects $1.07 billion spent on the Fusion-io acquisition, which is net of $190 million of cash acquired.

On the balance sheet, our inventory dollars grew by $30 million sequentially, inclusive of $77 million of non-captive inventory received in the Fusion-io acquisition. Our captive inventory has fallen two quarters in a row, and while we entered the year expecting to draw down inventory, we now have pockets of supply constraint exacerbated by the lower 2014 supply bit growth resulting from the long tail of 19 nanometer production for strategic customers.

I will now turn to forward-looking commentary. For the fourth quarter, we have strong demand signals from our customers in all key product categories. We expect to further reduce our captive inventory levels in Q4 to fulfil demand. However, we expect to be in supply allocation and this will constrain our growth in some areas in Q4.

We will prioritize our business according to our strategic priorities and customer relationships. Our fourth quarter revenue forecast is $1.8 billion to $1.85 billion. As we look to 2015, we plan to increase our supply bit growth from less than 25% this year to a range of 30% to 40%. Given the lean level of inventory we will have at the end of 2014, our 2015 revenue bit growth will likely need to be at the low end of that range.

For Q4, we expect our non-GAAP gross margin to be between 47% and 49%. Our yen rate in the fourth quarter is determined primarily by third quarter purchases, which include some hedges placed approximately a year ago, yielding an expected fourth quarter yen rate in cost of sales similar to the rate in the last two quarters.

Our Q4 2014 wafer purchases, which will impact Q1 2015 cost of sales, will be based approximately on two-thirds market rate purchases in Q4 and one third on hedges placed a year ago at approximately 99.

With the current yen denominated content in our cost of sales, a 10% move in the yen rate in our cost of sales generates approximately a 200 basis point change in our gross margin. To date, we have not placed any hedges for 2015, so if market rates stay comparable to today, this will be a benefit to 2015 costs.

We expect Q4 non-GAAP operating expenses of $380 million to $390 million, reflecting a full quarter of Fusion-io related expenses and inclusive of restructuring expenses of approximately $15 million. Q4 non-GAAP other income is forecasted at approximately $3 million, and we expect our non-GAAP tax rate to be equal to the Q3 rate of 31.2%.

We expect our Q4 non-GAAP diluted share count to come down to approximately $228 million, reflecting continued share repurchases.

We are refining our estimate of 2014 capital investments from $1.4 billion to $1.3 billion, with Q4 gross investments expected to be approximately $400 million inclusive of both joint venture and non-fab investments.

The fourth quarter cash usage for capital investments is expected to be approximately $150 million, bringing the full year cash usage for capital investments to approximately $350 million for the combination of joint venture and non-fab investments.

In summary, we expect that 2014 will be another record year in both revenue and earnings. With the broadest portfolio of enterprise and consumer flash solutions in the industry, SanDisk is uniquely positioned to capitalize on the opportunities ahead. We are investing for the future while also generating strong free cash flow and executing a market leading capital return program.

We will now open the call for your questions.

Jay Iyer – Senior Director, IR

Thank you, Judy. Thank you, Sanjay. Operator, can I ask you to poll the floor for questions. And if I can ask the callers to limit themselves to one question and a brief follow up.

Question-and-Answer Session

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