Updated from 4:35 p.m. EST

Hefty acquisition charges pushed SanDisk ( SNDK) into the red in its fourth quarter, despite stronger-than-expected sales of its flash memory chips.

But investors seemed more concerned with comments during the company's post-earnings conference call about the glut of flash chips on the market, leading to steep price declines that are eroding the company's profit margins.

The price declines will lead to lower price per megabytes across all of SanDisk's product lines in the current quarter, and have prompted SanDisk to sideline the lower-margin USB flash card business that accounts for half the revenue of M-Systems, the Israeli company SanDisk acquired for $1.5 billion in November.

Shares of SanDisk plunged more than 10%, or $4.54, to $38.29 in extended trading Tuesday. The stock is down 38% since October, when investors first took fright at the steep decline in SanDisk's average price per megabyte sold.

SanDisk said it had no intentions of backing off its manufacturing capacity expansion plans, despite the supply glut, expressing confidence that the falling prices would spur demand later in the year - a phenomenon known as elasticity.

In fact, SanDisk executives said they would likely need to contract with third party chip manufacturers in the second half of 2007 in order to meet expected demand.

NAND flash memory chips, which store data even without power, are a popular form of storage in digital gadgets like MP3 players, cell phones and digital cameras.

The popularity of NAND flash has lured new players into the market, such as Intel ( INTC) and Micron ( MU), which formed a joint venture to make the chips at the end of 2005.

Milpitas, Calif.-based SanDisk reported a $35 million loss in the three months ended Dec. 31, reflecting a $186 million write-off of in-process technology acquired through its purchase of M-Systems and Matrix Semiconductor.

The loss also included an additional $61 million in acquisition, tax and stock-option charges.

At this time last year, SanDisk posted a profit of $134 million, or 68 cents a share.

Excluding the charges, SanDisk said its net income in the fourth quarter was $192 million, or 87 cents a share.

Analysts polled by Thomson Financial were looking for EPS of 72 cents.

Revenue increased 55% year over year, to $1.16 billion, thanks to contributions from M-Systems. Excluding M-Systems sales, SanDisk said fourth-quarter revenue was $1.05 billion, slightly ahead of Wall Street expectations of $1.02 billion in revenue.

"In Q4 we experienced excellent sales across the board, in both the retail and OEM channels and spanning across our consumer cards, mobile cards, MP3 players and USB flash drives," CEO Eli Harrari said in a statement.

Total megabytes sold in the quarter, excluding contributions from M-Systems, increased 73% sequentially, compared with SanDisk's initial expectation of 50% to 60% megabyte growth in the quarter.

While the fourth-quarter's 17% sequential decline in average megabytes sold was in line with SanDisk's guidance of 15% to 20% price reductions, the price erosion represented a 62% decline on a year-over-year basis. That follows the third quarter's 60% year-over-year pricing decline.

Some level of price decline is natural in the NAND flash market, and is in fact considered a positive aspect, since it makes the chips cheap enough to become used in a greater variety of electronic devices.

The trick is to reduce manufacturing costs in synch with the price declines, which chipmakers do by upgrading to new generations of manufacturing technology. Earlier this month, SanDisk announced that it plans to transition from producing chips featuring 70-nanometer circuits to chips based on smaller 56-nanometer circuits in the current quarter. But even with the manufacturing advances, CFO Judy Bruner confessed that consistent declines of 60% or more, created by oversupply of flash chips, could not be sustained by the flash industry."Its leaders, ourselves included, cannot consistently reduce costs at that rate," Bruner said.

Bruner said it was impossible to predict flash pricing beyond the first quarter. While she said SanDisk could grow its sales of megabytes and its profit margins if price declines in the 50% range, the company's profit margins will experience continued "margin pressure" if prices continue to fall at the 60% range.

SanDisk projected that its adjusted product gross margin will dip to between 24% and 28% in the first quarter, vs. 32.3% in the fourth quarter.

Management said they would de-emphasize M-Systems' business of selling USB flash cards to PC makers, which are then rebranded with the PC maker's name. While that business accounts for about half of M-Systems' revenue, SanDisk executives said it carried low margins and that the company was better off focusing on selling higher-priced, SanDisk-branded USB cards.

Product sales will decline between 25% and 30%, reflecting the seasonally slower first quarter of the year as well as the current pricing challenges, SanDisk said.

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