SanDisk Investor's Day Presentations - The Best Makes The Case For Even Better

May.16.14 | About: Western Digital (WDC)

Summary

The company is executing well - a strong Q1 2014 builds off a stellar 2013.

The strategy to dominate the Enterprise Market is paying off with high margins and strong revenue growth.

SanDisk's "Target Financial Model" significantly raises the bar for investor communication.

It will hardly be a surprise to SA readers of my previous post on SanDisk (SNDK) when I say that I was eagerly looking forward to their annual investor's day presentation. The day did not disappoint. Broadcast in HD video, the company featured CEO Sanjay Mehrotra and four of his senior-most lieutenants in four hours of presentations and an hour of Q&A with the assembled audience. It was an impressive ensemble performance that delivered a message that investors in the company, the industry, and indeed the other MIPO companies that compete with SanDisk will want to pay close attention to. This was indeed "must-see" (web) TV.

For those of you who are just now considering an investment in SanDisk, the company is the only pure-play NAND provider, one of the six principal companies worldwide that market NAND "flash" memory. Through its joint venture with Toshiba (OTCPK:TOSYY), the two companies share R&D and manufacturing and in combination possess a formidable IP position in NAND technology. Despite SanDisk's relatively small wafer capacity (approximately 216k wafers per month rising to 233k per month this year) that ranks last in the industry, it has consistently outperformed its larger competitors in terms of gross margin, operating margin, and free cash flow as a percent of revenue. (This last year (2013) the numbers in those three areas were: 47%, 29%, and 28%, respectively.) To say they had a good year last year would be a grave understatement, so there was ample reason for the SanDisk executive management team to be in an expansive mood as they addressed the assembled investors.

In past years, a blow-out performance like they had in 2013 would not have necessarily been any reason for investors to be optimistic about repeating the performance. After all, SanDisk had similar (excellent) years in 2010 and 2011 that were followed by a disastrous 2012, where industry over-supply and hiccups in their retail-heavy strategy lead to a big drop in revenues, profits, and cash flow. Last year saw the emergence of a new strategy that started bearing fruit, and it is to that strategy that we now turn to consider the company's prospects going forward. Fortunately for us, SanDisk did a great job of addressing this strategy in their presentations.

Let's skip to the punch line: SanDisk is now a MARKETING company whose main focus is to offer high-value NAND SOLUTIONS for the ENTERPRISE MARKET. Sanjay Mehrotra's opening remarks made this point brilliantly, and Henri Richard (SVP, WW Commercial Sales & Support) really drove the point home. Folks familiar with SanDisk's history will immediately note the big difference in emphasis because their retail business line used to dominate the company in terms of revenue and profit. No longer. Retail going forward will be a declining share of SanDisk's future revenues and profits. Still important, of course, but the main opportunities for SanDisk are in the data center and with OEMs, where TAM (Total Addressable Market) is growing daily as new applications and new suppliers open up opportunities for the company.

Let's take the last first. A new class of OEMs has arisen in China, and SanDisk grew revenue with them last year 7x over the previous year from $65m to $425m, with that result being fully 25% of 2013 embedded category product sales. 2014 promises to be even stronger. Embedded product is less profitable than the enterprise business, but given the growth, SanDisk has to be a player and they are. Now for the really exciting category, SSDs. SanDisk is now the #2 supplier in market share, growing their client SSD revenues 3x last year from $307m to $922m. Considering they just started offering SSDs in FY 2010, this is a remarkable performance. They are qualified in all of the top ten PC OEMs, and this business will continue to be on a strong growth trajectory as the SSD attach rate for notebooks rises from 15% to 39% in the business segment and 10% to 21% in the consumer segment over the next four years.

But even better than these great numbers is the potential in the Enterprise. Why? Because profits are so much stronger in this segment than in any other. Revenue growth isn't bad either. Sales in 2013 were 2.5x the previous year, and at $267m for 2013 are projected to grow to $1B in 2016. The next year after that Mehrotra is projecting a #1 market share. Considering that SanDisk is the smallest of the NAND suppliers in production and is projecting bit grow below the rest of the industry, this is quite a claim. I think that they can achieve that goal and, even better, that they are significantly underestimating the size of the market they will dominate.

Here's why. Bottom line, the use cases for NAND in the enterprise are growing rapidly, and the economics of these use cases, these applications if you will, offer the customer a slam dunk justification for the investment in NAND over HDD and DRAM. Currently, the estimates for Enterprise TAM are heavily influenced by an analyst community that has been slow to grasp the paradigmatic shift that is overturning ("disrupting" in MBA speak) the conventional wisdom of the "storage" market. (Amazing, I know, but true.) John Scaramuzzo, SVP GM of Enterprise Storage Solutions, followed Richard at the Investor's meeting and offered compelling evidence that this is the case.

His case in a nutshell:

  • The Driver - the "legacy storage I/O bottleneck," which is the widening performance gap between today's processors and HDD performance. (Legacy storage = HDD)
  • The Challenge - aligning the speed of the storage with the speed of the processors.
  • The Environment - a world of "hyperscale" and large enterprise cloud-based customers in which the providers are struggling to contain surging power and space costs.
  • The Solution - the "Flash Transformed Data Center" in which TCA (Total Cost of Acquisition) and TCO (Total Cost of Ownership) are the most important decision criteria.
  • The Vendor Requirement to Win in this New World - a vertically integrated supplier that offers a solution composed of best-in-class NAND product, software design, and advanced system design that concretely and specifically addresses the customer problem. That vendor - SanDisk.

The particulars of the SanDisk brief are brilliantly addressed by Scaramuzzo, so I won't go into them here other than to highlight a couple of the use cases that they document with TCA and TCO metrics. The first is a "virtual desktop consolidation" example in which the decision metrics are faster IOPS (input/output operations per second) and $/transaction. The documented result of a conversion to NAND -- a 57% reduction in TCA for servers and DRAM in a 10k virtual machine deployment where NAND with SanDisk proprietary software replaces 50 physical servers and their embedded DRAM. Example #2, a database management system that requires 100TB of storage and greater than 150K IOPS where SSDs replace HDDs and the $ per IOPS drops from $1.98 to $.07 (this is not a misprint!). (I encourage interested investors to either read the slides or view his presentation.)

The takeaway for investors from a financial perspective is clear. Enterprise Market revenue, which was in 2013 estimated to be $3.5B, is projected to grow to $8B by 2017, and SanDisk is positioned to gain the lion's share of this market as the #1 provider. A second takeaway is one that SanDisk didn't make explicitly, but I believe made implicitly in their 2013 Investor's Conference. TAM estimates, which they have based on industry analyst views, are too low -- way too low, and especially in enterprise solutions. SanDisk thinks that the majority of the HDD market and a good portion of the DRAM market will be in play by 2017, a number that they position as "addressable." How big is that number? Try $44B. This market, in which HDDs will be replaced by high performance SSDs, iNAND™, software and other embedded NAND product is SanDisk's sweet spot and any increase in TAM there will flow in great proportion to the company's bottom line.

Personally, I believe they will be more right than the analysts for two reasons. First, in the enterprise market the innate conservatism of mainframe facility IT managers is being challenged by the new "cloud" economics. Once the word gets out on the compelling economic case for the "flash-enabled enterprise," the NAND rush will begin. Current TAM data is just not modeling this behavior. Second, prices are not going to be declining so much, which means that more revenue and bottom line profit is going to be captured from the bit growth that the industry is producing. Quite simply, there is no reason for SanDisk to be offering product at 50% margins when 60% is attainable. Crazy, I know.

New rule. There is no crying in Oligopoly*.

While there is so much more in this day's content that is worth commenting on, I will close with Judy Bruner's (EVP, CFO and CAO) presentation. In this she not only concisely outlines the recent company performance in 2013, she also presents what she calls the "Target Financial Model," which communicates with superb transparency and lucidity the metric standard to which SanDisk should be held to by its investors. (Micron's investors should be warned at this point that viewing of this material will lead to potentially fatal increases in blood pressure and/or severe depression…).

This is the new TFM:

TFM Targets

2014

2015+

Low

High

Low

High

Rev Growth

4%

10%

10%

15%

Gross Margin

47%

49%

45%

51%

R&D

11%

12%

11%

12%

S&M

4.5%

5%

6%

6%

G&A

2.5%

3%

3%

3%

CAP-EX (inc. R&D)

20%

30%

20%

30%

Operating Exp.

18%

20%

20%

21%

Operating Margin

27%

31%

25%

30%

Free Cash Flow

15%

15%

15%

Click to enlarge

Several items deserve our attention. Note that the revenue growth is very conservative, ranging from 10%-15% in the years 2015 and beyond. This, I believe, is a direct expression of SanDisk's desire to be as transparent as possible while leaving them plenty of upside. UPOD. The same is true in the GM area, where they have raised their guidance from 47%-49% to 45%-51%.

Of much bigger import is the increase in sales and marketing expense from 5% to 6%. This is very good news indeed, because it means that they are taking marketing seriously. This is where slideware becomes reality. The second major takeaway is CAP-EX, which is climbing from 14% last year to 30% a year going forward. No surprises here. Sanjay Mehrotra and his counterparts at the other suppliers have been talking about the tech node transitions becoming more and more expensive as time goes on, and the Target Financial Model now reflects that reality. Operating margin and free cash flow remain steady over the forecasting period at very good levels.

This TFM, if executed, will result in SanDisk being a $10.3B/year business with more than $3B of operating margin over the next four years. All good -- excellent in fact -- but I'm not buying it. They are going to beat these numbers going forward, surprising and delighting customers and investors along the way.

One element of caution regarding SanDisk requires watching, and that is the reaction of OEMs, some of them very large (e.g., IBM (NYSE:IBM)), who are highly motivated to succeed in this Enterprise environment. While my personal view is that the logic of vertical integration makes the economics difficult for solution providers other than NAND manufacturers, the very fact that this market is relatively insensitive to NAND pricing per se means that there will be something of an umbrella effect that will allow a motivated OEM to survive and perhaps even prosper, especially with a name that is practically synonymous with the Enterprise like IBM. Add HP (NYSE:HPQ), Dell, EMC (NYSE:EMC), and a host of smaller players, and we're going to see quite a free-for-all in this space over the next few years.

In conclusion: SanDisk has the strategy, the executive leadership, and the moment. The last element we have not talked about, but it remains the strategic lever on which all else depends. Consolidation has occurred in the industry. At long last, irresponsible state-financed capital is no longer funding competitors. Moore's law is slowing down; the barriers to entry in the industry are large and getting larger as tech node transitions become more capital intensive and time-consuming. Memory that used to be considered a commodity is now extensively customized, specialized for the application, and tailored to individual customer's engineering requirements. Overall NAND demand is surging and supply growth is constrained. Pricing leverage is tending to favor the suppliers. In this favorable environment, many strategies can produce good profits for member firms. One company, however, has the best plan to serve up high margin NAND product and delight the customer at the same time by delivering compelling value and quantifiable bottom-line solutions, and that is SanDisk.

So when you read the next analyst claiming that a new fab will inevitably change the competitive environment in the semi-conductor memory space and that the bad old days of over-supply are just around the corner, ask yourself the following questions:

  1. Are the customer's needs less differentiated than before?
  2. Is product quality and vendor reliability any less important?
  3. Is time-to-market for customers any less urgent than before?
  4. Is the pay-off for having the right product configuration tailored to a high-value customer need that is delivered on a timely basis any less than yesterday?
  5. Does the supplier that is building the capacity have the sales and marketing team to craft the specialized solutions that the customer's require?
  6. Does the company have the software and systems expertise to build and deliver the total solution?
  7. From the supplier perspective, does the vendor producing the extra bits have anything to gain from lower gross margins?

If the answer to any of those questions is no, then take a deep breath and remember: there is no crying in oligopoly.* Long the industry; long SanDisk, long Micron.

Notes:

* If you are a supplier!

* All statistics in this article based on SanDisk slides, which reference both SanDisk and industry analyst data.

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.

Additional disclosure: Also long MU.