Getting Ready to Go Long SanDisk

SanDisk Corp. (SNDK) is down 14% in pre-market, and makes a very tempting buy, but waiting is a virtue here as I expect a round of downgrades, and we will take a hard look at it if we can pick it up around $40. It seems to me people are overreacting to margins, which fell from 37% to 32% over the past year.

A large part of this fall was due to the company's move to sell their own MP3 players. Their problems weren't all about the MP3s, but they intended to stuff all those expensive flash chips into them, so not only are they clogging up the warehouse, but chips they usually would have gotten out the door (had they sold them to someone else) are now sitting around as unsold inventory.

They claim an 18% market share in a very slow quarter, but that 18% number will come back to haunt them if it goes down in Q4, even if earnings right themselves. But, like I have said, they are a "volatile" stock, and this whole thing may be a nice way to shake out the retail buyers before Q4.

The analysts are focused on a "60% drop in average selling price per megabyte."

Wow that's silly! So they can now give your much more storage for less money and people think that's bad? Better dump Intel too based on that logic, more ticks per buck over there for the past 20 years!

Eli Harari [CEO] said: "We expect to benefit in the fourth quarter from projected seasonally strong holiday sales of digital cameras, handsets, flash audio players, USB flash drives and gaming consoles and we now believe growth in our megabytes sold will be approximately 200% for 2006."

Sales were up 27% to $751M, a $14M beat. Income is .61 a share vs .57 and the big costs were R&D and marketing -- no surprise there with a new product roll-out. The real concern for the company is the "inventory glut" of flash memory chips, a problem that led SanDisk to start stuffing them into MP3 players in the first place.

Unlike OPEC, SanDisk is dealing with their inventory surplus by lowering prices to spur demand; we'll see who is smarter next quarter.

So far this year (9 months):

• Revenues are up from $1.4B to $1.85B.
• Income is down from $252M to $234M.

What impacted earnings?

• R&D is up $65M during this period.
• Sales and marketing are up $50M as they roll out a new line.
• G&A is up $49M as they expand.

The company also seems to have taken out too much money for taxes -- $153M vs. $148M last year, when they earned more, but I'm no accountant...

So while I sympathize with people who paid 300% of last year's July selling price for this company, I am actually looking forward to picking up some of this great company at more reasonable prices.

Read all of Phil Davis's articles on Seeking Alpha.

Comments

[Ryan Gallagher:]

I wonder if the operating expenses had anything to do with the fact that the company moved its R&D operations from Sunnyvale to Milpitas this quarter. A clear one-time cost. Still, there is concern of redundancy in the company after its recent aquisitions.

As for the flash memory prices dropping, how much further until more markets open? We already have hybrid-drives (hard-disk + flash) of which MS Vista will take advantage, not to mention full flash drives replacing hard disks in some laptops. The price of flash is primarily what's keeping these markets small. The price falling may actually be a good thing in the long run.

I have to agree with you on this, SanDisk should be a good long position. I'm looking forward to benefit from the market's "silliness".

2006 Oct 20 10:37 AM

[Asif Suria:]

While I doubt full flash drives will appear in laptops anytime soon, I am very encouraged by their new line of Sandisk Sansa MP3 players, which I mentioned in my <b>blog entry about RealNetworks</b>...

The price per megabyte is likely to drop much faster than the price of their MP3 players and hence I agree with Phil that this drop is a buying opportunity after this falling knife hits starts quivering.

2006 Oct 20 12:02 PM

[Ryan Gallagher:]

I agree that full flash drives in home user laptops are several years off, and beyond flash prices still have technical hurdles to overcome. But they are currently being . Like many tech innovations, they will likely start out for specialized usage and slowly make their way into home products as prices fall.

There will still be a transition through hybrid-drives long before full flash drives. The hybrid drives will probably start gaining popularity as early as 2007 due to Vista. It's still to be seen whether SanDisk will take advantage of this or lose it to others like Samsung.

Another effect of Vista on SanDisk may be due to its ability to use a USB flash disk as cache to improve performance. It'll be interesting to see if all those upgrading to PC running Vista in Q1 will also upgrade to 1GB+ USB drives as well. I doubt that we'd see a spike in sales due to this, but it will likely continue to push consumers to higher GB levels.

Beyond MP3 players, in the short- to mid-term I think SanDisk will see benefits from the mobile market with increasingly strong sales of their MicroSD line. This is a relatively young market; as you recall that mobile phone makes only recently started adding removable flash to their main camera product lines. Further, cameras on mobile phones are increasing in resolution as fast as MicroSD is increasing in storage capacity.

My point is that flash memory makers like SanDisk seem to have more markets open as flash prices drop. This can be seen in their history, such as with MP3 players, and will likely continue for at least the next few years.

2006 Oct 20 01:29 PM

[WC Whiner:]

Did I read a different earnings report than you? I see $.51 current vs $.55 previous, YoY. If you "[exclude] the impact of stock compensation expense and amortization of acquisition related intangible assets and the related tax effects," sure, but why do you do that? If I could get SNDK options for free, I never would have been short going into this report.

FD: still short. I shall consider covering if 06Q3 GDP, out in exactly a week, is unexpectedly strong. I am looking for

2006 Oct 20 06:11 PM

[WC Whiner:]

..man, seekingalpha still hasn't learned how to sanitize less-than signs. That comment is supposed to end, [less-than sign]1.5%, a disappointment to the market, since Bloomberg still reports consensus around 2.4%. If GDP beats my expectations I shall scale back on consumer-products shorts like SNDK and my current, net underexposure.

2006 Oct 20 06:13 PM

[Philip Davis:]

Although they don't make is easy to find in their 8-K, it seems the bulk of the GAAP adjustment is the Matrix acquisition. Since there was no compensation allowance last year, in evaluating a comany's performance, I prefer the apples to apples approach, especailly when the compensation runs at expected levels.

Google is a great example of this - assuming there are no future shenanigans, they have done a great job of getting their compensation under control and I expect other tech companies to emulate their success there.

As a buyer of a company, I want to know if they can keep innovating and sell more stuff at a profit - that Sandisk can obviously do! Also, you need to look at the macro environment in which there is a huge price war going on and I think we will have evidence next week that Sandisk is likely to outlast their competitors at this level.

In fact, Harari fired a warning shot by claiming that megabytes sold will be up 200% for the year without raising guidance - in other words, we are prepared to bury our competitors in low-cost chips!

That being said, I'm a buyer at $40, not $50 and just the other day I told my people to stay well away from this stock at $60. I just feel that, when the dust settles, SNDK will come out a winner in the chip wars.

As to GDP, CAT just told us they are looking for 2% - I'll take their forecast over the OMB's anytime!

2006 Oct 21 06:10 AM

[WC Whiner:]

The $.61/$.55 is ex-Matrix all around? I think it's ex-Matrix acquisition costs, but not ex-Matrix contributions to top or bottom lines. Rollup businesses (cf M-Systems) have to account for the prices they pay. Sandisk already did the usual in-process-R&amp;D writeoff on Matrix, so the current GAAP amortization seems more than fair.

Yeah, the avalanche of chips from expansion of capacity generally is what had me worried in the first place. All else equal at $40, I cover; at $50, I haven't, at least not until I see more economic data.

The OMB isn't even on my radar. CAT's 2% seems less unlikely than the purported consensus number, though my bet as I said is lower. I expect the spin to be "just wait for Q4!" If wrong, I'll cover more than just the SNDK short.

2006 Oct 21 01:48 PM