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SanDisk (SNDK) is a global leader in NAND flash memory cards. Its products are used in consumer devices such as digital cameras, mobile phones and flash drives. After cutting its Q1 outlook SanDisk stock fell by 10%, and this may offer an opportunity to buy the stock at a discount.

(Click to enlarge)

Let's take a look at the financials:

(In Million $) 2007 2008 2009 2010 2011
Revenue $3,896 $3,351 $3,566 $4,826 $5,662
Operating Cash Flow $652 $87 $487 $1,451 $1,053
Capital Expenditure $-287 $-185 $-60 $-109 $-193
Free Cash Flow $366 $-97 $428 $1,343 $860

Revenue has grown by over $2 billion over the last two years, and free cash flow as been positive with the exception of 2008.

Owner Earnings

Owner earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines owner earnings as follows:

These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges ... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume ... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.

I'll calculate owner earnings by taking the five-year average capital expenditure and subtracting that from the operating cash flow. I'll also subtract stock-based compensation from the operating cash flow since it has a dilutive effect on the company but is routinely included in the cash flow figure. I'll also add interest payments adjusted for taxes since interest is tax deductible.

(In Million $) 2007 2008 2009 2010 2011
Operating Cash Flow $652 $87 $487 $1,451 $1,053
Interest Payments $19 $33 $77 $89 $135
Stock-based Comp. $0 $97 $95 $77 $63
Avg Capital Expenditure $-167 $-167 $-167 $-167 $-167
Owner Earnings $497 $-143 $289 $1,287 $914

Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the owner earnings figures to determine SanDisk's Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the owner earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability.

(In Million $) 2007 2008 2009 2010 2011
Owner Earnings $497 $-143 $289 $1,287 $914
Invested Capital $7,234 $5,932 $6,001 $8,776 $10,174
CROIC 6.88% -2.39% 4.83% 14.67% 8.99%

2008 and 2009 were weak years for SanDisk, but CROIC for 2011 was 9%, which means that given, say, $1 million in invested capital (retained earnings for example) the company will generate $90,000 in cash on that investment. Here's what the balance sheet looks like:

Cash and Cash Equivalents $2,848
Investments $2,766
Debt $1,604
Pension Obligations $0
Minority Interest $-4
Net Cash (Debt) $4,013
Diluted Float 243
Cash/Share $16.47

SanDisk has $16.47 in net cash and investments on its balance sheet, which represents more than a third of the company's market capitalization. This large cash position offers protection against weak demand.

Valuation

I use a discounted cash flow analysis to determine the fair value of a company. I will use a discount rate of 15%, and you can read about my view on discount rates here. The average analyst estimate for five-year earnings growth is 15.78%, while the CROIC is 9%. I'll be conservative and set the initial owner earnings growth rate to 6% and allow that growth rate to decay to a perpetual rate of 3% over the next 20 years according to the growth table below.

Year

1 2 3 4 5 6 7 8 9 10
% 6% 5.85% 5.7% 5.55% 5.4% 5.25% 5.1% 4.95% 4.8% 4.65%
Year 11 12 13 14 15 16 17 18 19 20
% 4.5% 4.35% 4.2% 4.05% 3.9% 3.75% 3.6% 3.45% 3.3% 3.15%

Using these parameters I arrive at a fair value of $54.86, which is about $10 higher than the most recent share price. A table with buy targets for various margins of safety is listed below.

Margin of Safety Buy Target
10% $49.37
15% $46.63
20% $43.89
25% $41.14

Conclusion

SanDisk currently trades at about a 20% discount to my fair value estimate and offers a compelling value. The recent drop in market price has opened up an opportunity, and SanDisk's ample cash cushion should protect the company against short-term demand weakness.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SNDK over the next 72 hours.

Source: There Is Opportunity In SanDisk