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SanDisk Corp. (SNDK - Analyst Report) reported third quarter 2012 adjusted earnings of 42 cents per share crushing the Zacks Consensus Estimate of 29 cents. The adjusted or non-GAAP earnings per share exclude amortization of acquisition-related intangible assets, convertible debt interest and tax gains, but include stock-based compensation expense. However, the results came 63.3% short of the year-ago period but 179.3% above the prior quarter level.

The beat was mainly attributable to solid recovery in the mobile embedded and retail businesses, strong geographic contribution and favorable supply/demand metrics. The company’s shares surged 3.59% in after-market trade reflecting positive expectations for the fourth quarter 2012 and fiscal 2013.

Revenue

Total revenue for the third quarter was $1.27 billion, down 10.1% on a year-over-year basis but up 23.3% from the previous quarter. The quarter’s result came slightly above the Zacks Consensus Estimate of $1.22 billion. The sequential revenue improvement came on the back of strong performances in both the OEM and Retail verticals.

Within OEM, mobile embedded business and sales of SSDs grew the most. In Retail, market share gains were noticed across the geographical regions. Retail products witnessed solid back-to-school demand and penetration in emerging regions.

SanDisk stated that the improvement in Retail was mostly due to continued investments, which helped in achieving competitive advantage over the peers.

Segment wise, Product revenue decreased 10.6% year over year to $1.18 billion, while License and Royalty revenue came in at $91.0 million, down 3.3% year over year. Both the segments performed well in comparison to the previous quarter.

Operating Results

Reported gross margin in the quarter was 30.1%, down from 43.2% in the year-ago quarter. The year-over-year margin decline was due to higher cost as well as high-level of price declines. But the sequential improvement was due to moderated price declines coupled with cost optimization.

Operating margin was 10.4% versus 27.3% in the year-ago quarter. The company’s total operating expenses increased 10.9% on a year-over-year basis. Higher operating expenses were mainly due to 11.1% and 19.4% year-over-year increases in research and development and selling and general expenses, respectively. But this was slightly offset by lower general and administrative costs.

Net income on a GAAP basis was $76.5 million or 31 cents per diluted share compared with $233.3 million or 96 cents in the year-ago quarter.

Excluding the amortization of acquisition-related intangible assets, convertible debt interest expense and related tax adjustments, but including stock-based compensation expense, non-GAAP net income for the third quarter was $102.7 million or 42 cents per diluted share compared with $279.6 million or $1.15 in the year-ago quarter.

Balance Sheet & Cash Flow

SanDisk generated $127.9 million in cash from operating activities, compared with $19.1 million in the prior quarter. Capital expenditure was $142.4 million. Cash and short-term investments were $2.60 billion versus $2.54 billion in the previous quarter. Long-term marketable securities were $2.82 billion. Convertible debt for the quarter was $1.67 billion, up from $1.65 billion in the previous quarter.

Outlook

Management has provided an upbeat outlook for the fourth quarter of fiscal 2012. It believes that price declines could moderate further, resulting from improving supply/demand situation in the industry. Management also expects higher demand for its mobile and SSD solutions, which will likely boost its revenue growth during the fourth quarter.

The company is planning to focus more on the iNAND technology, as this is going to be a driver for its mobile-embedded products. It expects the launch of several new smartphones and tablets, Ultrabooks and other end-client PCs, running on SSDs. This will boost demand for NAND Flash gadgets aka SSD.

For SSDs, SanDisk is confident about strong demand from the Enterprise sector. It is also planning to introduce next-generation controllers soon to capitalize on the growing enterprise storage demand. It is also expecting a surge in client SSD demand. Taking all these factors into consideration, the company expects its total SSD contribution to be 10.0% of total revenue in 2012.

Anticipating the changing market scenario, SanDisk now expects fourth quarter revenue in the range of $1.50 billion, plus or minus $50 million, reflecting 18.1% sequential improvement.

Now that it has transitioned to 19-nanometer chip production facility, SanDisk expects majority of the cost improvements from this. Also, expected positive turn in the pricing environment will allow further improvement in gross margin. The company expects non-GAAP gross margin of 33% (+/- 2.0%). Non-GAAP operating expenses will be roughly $250.0 million for the fourth quarter, which reflects continued investments. Non-GAAP other income is expected to be approximately $5.0 million and the tax rate is projected at approximately 32.0% on a non-GAAP basis.

The Zacks Consensus Estimate for fourth quarter and 2012 are pegged at 54 cents and $1.60 per share, respectively.

Our Take

SanDisk posted stellar third quarter results with both the bottom and top lines surpassing the Zacks Consensus Estimates. Though the results came below the year-ago levels, the sequential comps were better than expected. Revenues from OEMs and Retail started recovering. Fourth quarter guidance was encouraging too.

Though lackluster PC sales, European issues, competition from Micron Technology Inc. (MU - Analyst Report) and currency fluctuations could hurt the fundamentals a bit, we remain overtly positive on management’s commentary of a turnaround story in the coming quarter and beyond and strong secular demand for NAND flash.

Currently, SanDisk holds a Zacks #1 Rank, implying a short-term “Strong Buy” rating.

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