Supply Saps SanDisk

Quarterly sales surge but too many chips will force a price cut.
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Updated from 5:11 p.m. EDT

SanDisk's

(SNDK)

first-quarter sales surged 37% in a seasonally slower period, but profit fell primarily as a result of a technology write-off related to its Matrix acquisition.

Although the results were in line with analysts' expectations, investors pushed down the stock in after-hours trading. Shares of SanDisk were off 3.2%, or $2.09, to $63.45.

SanDisk executives acknowledged that supply of NAND flash chips exceeded demand in the first quarter, creating a moderate buildup of inventory among its customers. Consequently, SanDisk said it will make deeper price cuts in the current quarter than it had initially intended, with the average price per megabyte estimated to fall by 20%.

The company said it was sticking to its initial forecast of 50% to 55% price declines for full-year 2006.

Inventory issues, along with a power outage at one of the company's chip fabrication facilities dinged margins in the first quarter. The product gross margin level was 28.4%, compared with the company's projection of 30% to 32% product gross margin.

Still, SanDisk executives offered a bullish outlook of a 35% to 45% sequential increase in total megabytes sold in the current quarter and improving gross margins in the second half of the year.

"The supply/demand balance in first half of this year is somewhat challenging, however we remain focused on our strategy for the long term," said CFO Judy Bruner in a conference call with analysts following the release of the results.

The Sunnyvale, Calif., company posted revenue of $623 million in its fiscal first quarter and earnings of $35.1 million, or 17 cents a share. A year ago, revenue was $451 million.

Excluding various items such as stock-based compensation expenses and acquisition-related charges, SanDisk earned $90 million, or 44 cents a share, in the latest quarter.

The results were largely in line with a Thomson First Call survey that had expected EPS before items of 44 cents on revenue of $624.3 million.

The company had earned $74.5 million, or 39 cents a share, a year earlier.

The company said it increased the number of megabytes sold in the first quarter by 4%, near the midpoint of its guidance of flat to 10% sequential bit growth.

SanDisk sold 13 million mobile flash cards for cell phones during the quarter, with 2 million of those cards sold in retail channels.

"I think the silver lining in this entire thing is the mobile card retail uptick," says American Technology Research analyst Satya Chillara, whose firm has no banking ties with SanDisk. It's a huge market, says Chillara, and SanDisk is just scratching the surface.

While the flash cards that come bundled with cell phones are typically low-capacity 128MB cards, CEO Eli Harari told analysts in the conference call that he expects cards sold through retail to be in the 512MB or 1GB capacity, though he cautioned it would take time for the retail cell-phone card market to develop.

Sandisk has proactively slashed prices as a way of enticing consumers to buy higher-capacity flash chips.

The average price per megabyte sold in the first quarter declined 24%, in keeping with SanDisk's projections of 25% to 30% price cuts.

As competitors have boosted their output of flash chips, and demand has slowed in the first quarter of the year however, the market has been inundated with more supply than it can absorb.

"Spot pricing in the last two weeks in March was atrocious," said Harari, with some people dumping inventory "at all costs."

Revenue from licensing and royalties in the first quarter was $85.5 million, slightly above the company's projections.

SanDisk said it expected licensing revenue to decline in the current quarter to between $75 million and $80 million.

Harari also alluded to

Micron Technology's

(MU) - Get Report

recent proposed acquisition of

Lexar Media

(LEXR)

, saying that he did not believe it would alleviate Micron's challenges in playing catch-up in the NAND flash market.

And while there have been reports that SanDisk is exploring making a competing bid to acquire Lexar, Harari said he would not comment on rumors.