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The stocks of storage memory makers like SanDisk (NASDAQ:SNDK), NetApp (NASDAQ:NTAP) and EMC (NYSE:EMC) are highly sensitive to the price (per gigabyte) of memory because of the impact price declines have on their gross margins.

SanDisk’s flash memory gross margins were able to recover in 2009 from the 2008 low caused by production costs exceeding product revenues. SanDisk’s margin recovery occurred in spite of continued flash memory price declines caused by industry-wide oversupply of memory as well as rising demand for higher storage capacity.

We have updated the Trefis price estimate for SanDisk’s stock from $28.28 to $30.15, in part to reflect SanDisk’s improved ability to maintain its flash memory gross margins in the future by reducing production costs.

Below we discuss the significance of the flash memory business for SanDisk, why flash memory prices will continue to fall. and how SanDisk can maintain its gross margins.

Mobile Phone and Digital Camera Flash 50% of SanDisk’s Stock

SanDisk makes money by selling flash memory cards used in mobile phones, digital cameras, camcorders and other digital devices. We expect the rapid increase in storage needs for personal digital media will result in SanDisk’s the amount of flash memory (in gigabytes) shipped to double each year. We estimate that nearly 50% of SanDisk’s value comes from its Mobile Phone Flash Cards and Digital Camera Flash Cards divisions.

Flash Memory Prices to Decline to 8 cents per Gigabyte

Flash memory prices have consistently declined over the years. SanDisk’s Price per Gigabyte (GB) of Flash Memory declined from $2.85 in 2008 to $1.57 in 2009, reflecting a 45% decline. The historical declines are attributable to two factors:

(1) Excess Customer Inventory

The decline in first half of 2009 was a result of immense pricing pressure caused by mobile manufacturers (Nokia (NOK), Samsung, LG) disposing of memory inventories left over from the previous year.

(2) Lower Production Costs

The decline in second half of 2009, lower than the first half, was driven by technological scaling that made it cheaper to store more gigabytes within the same area of the chip.

We believe that the production cost of a GB of Flash Memory for SanDisk declined from $3.30 in 2008 to $1.13 in 2009. This reflects a 66% cost reduction that exceeds the 45% decline in flash memory prices over the same period. Lower costs can be attributed to the ongoing shift toward the cost-effective 3-bits-per-cell architecture in the second half of 2009.

Pricing Declines to Continue

We believe that as the pricing war among mobile and digital device manufacturers intensifies in the future, flash memory manufacturers such as SanDisk will have to reduce prices further. We expect the Price per Gigabyte of flash memory to reach $0.08 by end of the Trefis forecast period.

You can modify our pricing forecast above to see the impact on SanDisk’s stock. Note: Since the pricing declines are significant, small movements in the forecast have a large impact on the Trefis price estimate for SanDisk’s stock.

Control of Flash Production Costs Necessary to Preserve SanDisk’s Margins

We expect SanDisk to continue to benefit from the transition to cost-effective 3-bits-per-cell architecture in 2010, as more than 50% of its products sold will have a 3-bits-per-cell architecture. SanDisk plans to introduce 24nm process technology in 2010 which should lead to lower costs in 2011.

Slower Rate of Production Cost Declines

As mentioned previously, from 2008 to 2009, the rate of production cost reductions (66%) exceeded the rate of memory pricing declines (45%). This resulted in SanDisk’s profit margins increasing from -16% in 2008 to 28% in 2009. However, as further technological scaling becomes challenging, we expect the cost reduction rate to decelerate and reach 20% by 2014.

Margins Stabilizing

As a result of slower cost reductions, we estimate that the difference in the rate of decline between flash memory prices and flash memory production costs will narrow by 2011, and we expect SanDisk’s gross margin to remain at 28% over the Trefis forecast period.

You can modify the forecast above to see how SanDisk’s stock price would be impacted if SanDisk were unable to maintain margins by lowering production costs to offset rapidly decline memory prices.

Source: SanDisk Margins Depend on Reducing Production Costs