With competition heating up in the market for hot-selling flash memory chips,

SanDisk

(SNDK)

and

Toshiba

will invest $2.6 billion to build a new factory.

The two companies announced Friday that they have begun construction of the facility, located in Yokkaichi, Japan, with the first output slated for the fourth quarter of 2007.

The new facility, dubbed Fab 4, will be the fourth flash chip factory jointly owned by the two companies through various joint venture, and it could double the overall production of the pair's most advanced chips.

"Fab 4 is really about capacity expansion for 2008 and beyond," says SanDisk CFO Judy Bruner.

In 2005, Toshiba and SanDisk started operation of another chip fabrication facility in Yokkaichi, Fab 3, which produces chips on advanced 300mm wafers. Over the past year, SanDisk has committed an additional $1 billion in capital spending in order to nearly triple the plant's capacity to 110,000 wafers a month.

Fab 4, which also will produce chips on 300mm wafers, will have an initial capacity of 2,500 wafers a month, with plans to ramp to 67,500 a month within a year. Ultimately, says Bruner, the facility will match Fab 3's 110,000-wafer-a-month output.

Flash memory chips, which retain data even when power is switched off, are an increasingly popular form of storage in electronic devices such as MP3 players, digital cameras and cell phones.

Earlier this week, SanDisk announced a

$1.35 billion acquisition of

MSystems

(FLSH)

, another flash memory company.

In November,

Intel

(INTC) - Get Report

, the world's No. 1 chipmaker, teamed up with

Micron

(MU) - Get Report

and formed a joint venture to grab a piece of the fast-growing market for flash chips.

Total sales of NAND flash -- the most popular version of flash memory -- in 2006 are expected to hit $16 billion, compared with $11 billion in 2005, according to market research firm Semico Research.

But flash chips also are a volatile commodity market and extremely sensitive to shifts in supply and demand. In the second quarter of the year, NAND flash sales declined 13.5% sequentially, as the average price per bit fell 32%, according to the Semiconductor Industry Association.

Part of the problem, said the SIA, is a slowdown in sales of MP3 players, which has created somewhat of an oversupply of flash chips.

With so many new players entering the flash market, the tech industry must think of new ways to use flash chips to soak up all the incoming supply. Many people expect cell phones and personal computers to increasingly incorporate flash memory, thus keeping demand alive.

SanDisk and Toshiba said the factory under construction, as well as the plans to boost capacity at Fab 3, are all necessary to meet anticipated demand for NAND flash memory products in 2008 and beyond.

"There's a lot of capacity coming on line in the industry, but we believe that there's going to be a lot of new markets, a lot of growth ahead," said SanDisk's Bruner. She pointed to personal media players, computers, digital cameras and the growing prevalence of video as some of the key drivers of flash demand in the years ahead.

Fab 4 will produce chips with 56-nanometer circuitry, two generations smaller than the 90-nanometer circuits used in many of today's chips. Reducing the size of the circuitry allows a company to fit more bits on each chip, thereby lowering its total costs per bit.

Toshiba will fund the construction of the actual building, while both companies will pay for the manufacturing equipment. The production output from the new facility will be equally shared between Toshiba and SanDisk.

Shares of SanDisk were up 0.6%, or 29 cents, at $47.53 in midday trading.