SanDisk Earnings Preview: Does The Rally Grow Long In The Tooth?

| About: Western Digital (WDC)

One of our best performing stocks from mid-2012 forward, SanDisk (SNDK) reports its calendar Q4 13 results after the bell on Wednesday night, January 22, 2014.

Analyst consensus is expecting $1.57 in earnings per share (EPS) on $1.7 billion in revenue for expected year-over-year growth of 19% and 10% respectively.

If 2014 analyst consensus is sustained, current estimates are for $6.73 billion in revenues and $5.81 in earnings per share, for expected year-over-year growth of 9% and 12%, respectively. (The easy earnings comparisons from late 2012 and early 2013 are now over.)

Since its dip into the low $30s in mid-2012, SNDK has benefited from 2 very important tailwinds:

1.) A weaker yen, which has really helped drive gross margins. Every 10% depreciation in the yen typically is worth 400 bps of additional margin to SNDK (with a limit of course);

2.) Due to a "constrained" supply environment, bit pricing has been very strong: typically SNDK grows megabytes mid teens y/y, with some weakness in pricing driven by ASP declines. For the last 4 quarters, SNDK's ASPs have grown -3%, +5%, +2%, and +7% respectively. Last quarter, the 3% drop caught my eye since (supposedly) the fundamentals around supply remain strong. For comparison, during 2012's collapse its ASPs fell 22% and 18% in the March and June quarters of 2012;

This company is uber-cyclical, and although sell-side analysts have been talking about the continued discipline around supply coming back online, the fact is that when it does, numbers get cut in a hurry and investors can give up a lot of alpha.

Technically SNDK's all-time high was $78-$79 back in January, 2006. The ensuing few years were quite painful.

We trimmed 25% of our SNDK position that we wrote about here after the July '13 report, and then again here.

Peak gross margin for SNDK in late '05, early '06 was 45%, and then again the gross margin hit 52% in 2010, although the stock price never followed.

Last quarter, SNDK printed a 50% gross margin, and as long as I've followed the company and the fundamentals, establishing positions at these gross margin heights was a bad idea.

We have a 1.5% position in SNDK, down from 4%-5% last summer, and we may or may not sell before Wednesday night's earnings report.

Trading at 11(x) cash-flow the valuation on the stock isn't completely unreasonable, but that is typically the case with cyclicals: they must be sold when the valuation looks cheap, and bought when there are no earnings and cash flow is thin.

Our internal model values SNDK currently at $95 per share, but the same model had a $31 intrinsic value estimate for SNDK in March, 2012, one quarter following, or 90 days after the same model assigned a $54 intrinsic value estimate, and right before earnings fell out of bed. The sector supply conditions changed that quickly from December, 2011 to March, 2012.

Morningstar doesn't assign an intrinsic value estimate to SNDK, which tells you how fast the supply conditions can change.

This is a great company with a great management team, but SNDK is in a sector where conditions can change dramatically and quickly.

We are close to exiting the position. Just not sure when we sell the final position. Most analysts are saying "it is different this time" and that there is supply discipline around bit supply. That could be the case, but how often does this end badly?

Be careful out there, and thanks for reading.

Disclosure: I am long SNDK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.