Although the fundamentals of SanDisk provide a basis for our decision to highlight SanDisk as the featured stock of the week this week, the fundamentals are just the first step to reaching our conclusions. After taking a closer look at the reasons for the weakness in SanDisk's share price. We will then look at the technical trading patterns of first the market and then we'll do the same for the stock itself to determine where and when we should trade SanDisk as the highlighted stock of the week this week.
First let's tackle the issue of the fundamentals. Before we get too far into this analysis please remember that Wall Street always looks ahead. Wall Street develops expectations, and then Wall Street wants to see results. SanDisk, at first glance, is not an expensive stock. The PE multiple versus its recent growth rate in the October earnings release seem to suggest of the stock is trading near a level of fair value. The problem is that the recent pricing erosion in NAND flash memory has caused some concerns on Wall Street that weren't there a few quarters ago. In the last quarter flash memory pricing had eroded quite a bit more than Wall Street had been expecting. Again, flash memory is a commodity, and it fluctuates widely with supply and demand; this is par for the course for SanDisk. In the third quarter Sandisk reported NAND flash memory had declined by 25% during that quarter and the company expects additional declines of 15 to 20% in the fourth quarter.
The continued price erosion in the NAND memory market exists not only the fourth quarter of 2006, but also in the first half of 2007. This has Wall Street very concerned. SanDisk has a solid business and they are a leader in their industry, but they are faced with declining margins. That's why Wall Street has trouble with the stock at this level. The simple fact of the matter is that Wall Street is concerned about future growth rates. The first half of 2007 is expected to be a very slow season. That's because of the rollouts that we've already seen in 2006.
ipods MP3 players, phones which incorporate digital music, and the upcoming iPhone from Apple. All have created a significant demand for NAND memory. However, for SanDisk that demand came in 2005 and 2006. Here's an example: in the fourth quarter of 2006 Wall Street expects 130 million MP3 phones to be shipped. In addition, in January, Apple (AAPL) is expected to roll out its iPhone. Wall Street expects 11 million iPhone's to hit the market in January. At first glance this seems like a high level of demand for NAND memory. However, we need to remember that the actual demand on the wholesale level comes prior to the retail purchase of these products. Specifically, the demand for NAND memory from SanDisk occurs prior to the sale of the actual unit.
Unfortunately for SanDisk, and for the rest of the players in the flash memory market, the supply versus demand for NAND flash memory has increased to a relatively concerning level. This brings us back to economics 101. Do you remember supply and demand? The more supply, the lower the price. That's what's happening in NAND flash memory at this time. There is simply an oversupply of NAND flash memory in the market today. As a result, the prices of NAND are going down, and the margins at SanDisk are eroding. Coupled with an expected weak first-half of 2007, Wall Street has reason to be concerned about the future growth of the company.
SanDisk is a leader in an industry where the market cycles are extremely volatile. Market cycles are something that we come to expect as investors, but in the case of SanDisk these market cycles are extreme. That's simply because flash memory is such a commodity. SanDisk will have its day in the sun again, but that time is not likely to be soon. We are expecting SanDisk to have a much better second half of 2007 from a fundamental perspective. The glut of NAND flash memory should work its way through the market by then and pricing power in the flash market should stabilize once it does. And once that pricing because evident Wall Street will embrace SanDisk again. From a longer-term perspective, buying SanDisk sometime in the first half of 2006 is probably the best bet for any potential buyers. Wall Street should have an indication on price stability in the NAND flash memory market. By then.
So the next question is what will SanDisk do between now and then? What's going to happen to the price of the stock? I mentioned earlier in this article that the price earnings multiple of SanDisk is somewhat in line with its recent earnings growth rate. This tells us that SanDisk's business model is not likely to erode significantly. SanDisk isn't going away; however, we shouldn't expect the stock to perform well again until pricing stabilization comes in to the flash memory market.
To understand where the stock is headed we need to turn to technical analysis. Our technical analysis of SanDisk shows us that the stock had tested a level of longer-term support in the July. The natural progression tells us to expect the stock to trend higher and test resistance again after testing support. However there's a catch. When a stock like SanDisk moves from a level of longer-term support towards a level longer-term resistance it first faces an intra-channel resistance level. In order to make it all the way to an official test of longer term resistance the stock must first pass above intra-channel resistance. Unfortunately, SanDisk could not pass this intra-channel resistance level after testing support. Instead, after testing intra-channel resistance SanDisk turned lower. From a technical perspective, this was the first indication of a bearish chart pattern.
The turn down from intra-channel resistance was our first indicator. The second bearish indicator in SanDisk may be coming soon. Based on our technical analysis, SanDisk is very close to breaking longer-term support. If you're looking at a chart of SanDisk at this time please understand that the longer-term support level that existed in July is different now [we have pinpointed longer term support as longer term parameter #1 in our real time trading report for SNDK.] It has been adjusted higher. In any case, if SanDisk breaks this level of longer-term support after having failed to increase beyond intra-channel resistance. A second bearish indicator will exist within the technical charts of SanDisk.
Traders who are interested in SanDisk at this time should beware. If this break occurs, SanDisk will almost surely decline aggressively. In fact, the bearish chart pattern which already exists will most probably become much more bearish.
So why did we choose to end this as the featured stock this week?
We are expecting the market to decline from a level of midterm resistance towards a level of midterm support this week. If that happens, the weak stocks in the market will decline. SanDisk has already established itself as a weak stock relative to the rest of the market. With that and the fact that the stock is so close to breaking a level of longer-term support, we believe that if SanDisk breaks longer-term support while the market is declining that SanDisk could experience an aggressive decline this week.
This is not a longer-term analysis. This recommendation is for trading purposes only. Once support levels break, like we expect in SanDisk this week, stocks usually have abrupt moves. That’s what we are expecting from SanDisk.