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Thursday, December 27, 2007

The case for SanDisk revisited

With SanDisk (SNDK) getting ready to announce earnings on January 28, this is a good time to review the investment case for company.

Back in November I wrote a post titled "SIA Forecast strengthens case for SanDisk." The main points were that the stock had fallen to a level from which it has twice rallied in the past and that semiconductor growth over the next few years was on the rise with the most growth by far in the flash memory category. With the stock at a depressed level and growth for its main product expected to be robust, it seemed like the stock could be a buy for patient investors.

Then, as now, the company's growth potential in terms of unit sales was not the problem. Memory chip oversupply and pricing issues were driving the company's shares lower as margins became increasingly squeezed. This concern continues to plague the company.

According to TradingMarkets.com, up until October, tight supplies had kept a floor under prices. But leading NAND flash manufacturers like Samsung and Hynix have improved their yields so much that when they started boosting production to meet the anticipated rise in demand for the year-end sales season, the market quickly flooded with NAND flash and the sense of tight supplies quickly faded.

Last week, Micron (MU) reported earnings and they were not good, to put it mildly. The kicker for SanDisk was the comment in the Micron release that indicated NAND flash average selling prices were down 30% in the quarter. SanDisk promptly sank on the news.

On the same day, iSuppli released a semiconductor forecast for 2008. The research firm believes that a slowing global economy will reduce the semiconductor growth rate to approximately 7.5% which, though it is still positive, will be less than the previously expected 9.3%. Their expectation is that the first half of 2008 will be weak and, with respect to NAND flash, they do not expect a rebound until the third quarter.

In further evidence of flash suppliers shooting themselves in the foot, DigiTimes reports that suppliers have been willing to compensate memory module manufacturers for the difference between the current contract price and the spot price at a later date. This has actually prompted some module manufacturers to dump more chips onto the spot market in hopes of getting larger compensation later.

Can SanDisk swim against this tide?

SanDisk does have a few things going for it. The company receives royalty payments for the technology patents it holds. These can amount to roughly 11% or 12% of revenues.

SanDisk has a strong retail presence. The revenues derived from their retail memory products (memory cards, music players, USB memory sticks, etc.) that are sold under the SanDisk name is nearly twice the revenues from their OEM channel. SanDisk is, therefore, more than just a chip vendor. Unfortunately, price-per-megabyte has been falling in the retail sector as well.

A major OEM channel for SanDisk is memory for cell phones. There have been predictions of slowing cell phone growth, especially in developed countries where high-end phones are more likely to be sold. Low-end phones will still show growth in developing countries where cell phone penetration is not as high. Even low-end phones need memory so SanDisk will still see some benefit.

SanDisk has been on a recovery trend since a very weak December 2006 quarter. Since then the company has effected some restructuring in order to reduce their expense base. Quarterly earnings so far during 2007 have been going in the right direction with the first quarter showing a small loss followed by the last two quarters showing positive growth.

Conclusion: It appears that the flash memory sector is beginning to turn into a commodity industry. SanDisk is positioned well to continue to be a key player due to their large existing market share and intellectual property. To raise themselves above the level of a commodity producer, the company is emphasizing its retail products and continues to see strong growth in this business segment. The outlook for flash memory is expected to continue to be robust as memory demands in most electronics products continue to grow.

On the down side, competition in flash manufacturing is fierce and oversupply not uncommon. As some of the Korean semiconductor companies seek market share at all costs, pricing pressure will more than likely remain a fact of life. At least one competitor, however, will not be ramping up so quickly. The Intel/STMicro joint venture to manufacture flash is getting off to a slow start with financing being stalled by the credit crunch.

If SanDisk can leverage its strengths it can stay ahead of the technology curve. They could command premium prices by being first to market with more complicated, higher density, smaller footprint products. They could increase margins by improving manufacturing processes, using larger wafers and generating higher yields. They need to continue to build the retail channel and capitalize on their name recognition.

SanDisk still has a chance to show superior growth but the odds are getting longer. The key is the retail business. If they only had someone like Steve Jobs running the show...

Disclosure: author is long SNDK

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