Wednesday, October 22, 2014

SanDisk Corporation offers strong Q3 results for mixed reactions.

SanDisk Corporation reported earnings on October 16th after the bell and dropped sharply in the afterhours (-5%). The stock did not hold any of these losses and made a strong recovery throughout the next few trading days. The company beat UASBIG estimates for revenue and EPS coming in at $1746.5 billion USD and 1.45 dollars per share (non-GAAP), respectively. Our estimates for revenue & EPS were $1699 BB USD & 1.4 Dollars per share, respectively.  Street consensus was around 1.36 for EPS and $1766.9 billion USD (Factset).
The company appeared to have very strong results compared to company guidance and is still on pace to meet its revenue guidance for the year. The company is absorbing the very large acquisition that was made this year very impressively, posting strong net margins and revenues. After a very harsh sell-off the results and guidance this quarter were refreshing. The company is aggressively pursuing market-share in the high growth enterprise storage market and having success here. This will result in a decreased reliance on key customers as this business becomes a larger percentage of sales. This will also allow the company to serve higher margin customers during times of supply constraint, the cited reason for the current pressure on gross margins. Supply constraints cause SanDisk to allocate a larger percentage of sales to high volume – low margin customers in the short term. In the past companies have increased capacity during these cycles and destroyed pricing when product releases and computer sales decreased.
The words “supply constraints” should be music to investor’s ears. Oversupply is arguably the most critical factor in explaining sharp drops in margins for semiconductor companies across the board. We are attracted to the oligopoly structure of the NAND market specifically and the apparent supply constraints that are in effect. The only company who announced severe capacity expansion was Samsung. The nature of the facilities was not announced. It could therefore be NAND flash, DRAM, logic, etc. We perceived this news as irrelevant, but also as part of the reason for the severity of the recent sell-off in SNDK stock. These facilities will not be complete until mid-2017, giving the few competitors at least two more years of pricing power.
SanDisk manufactures its NAND with Toshiba, through a joint venture, and the two announced capacity additions of no more than 5% per year. Micron completed NAND capacity expansions in 2013-2014 and the effect on industry pricing has already run its course. SK Hynix has been using capital to repair facilities after a fire in one of their DRAM plants as well as expand DRAM capacity. The company has not announced capacity expansions in NAND to date. Overall, we believe that most capital expenditures going a couple years out will be to upgrade existing facilities. Every other competitor mentioned must also allocate capital to their DRAM, and logic chip businesses. This decreases the likelihood of them adding capacity to NAND, especially as DRAM demand is spiking and the logic market is mainly controlled by only one key player (Intel).
The company has proven manufacturing excellence and this expertise will carry over in the 3D NAND era of flash memory. A look at reviews/tests on Samsung 3D NAND hard drives reveals that the only advantage is a quicker shut-down time. SanDisk will work together with Toshiba and take the time to leverage this technology for performance improvements and cost savings. Samsung appears to have rushed this technology introduction and we believe SanDisk/Toshiba will enjoy a second-mover advantage. Employees of this partnership are responsible for the original invention of NAND flash memory.

To conclude we believe the stock is highly de-risked, and at an extremely attractive valuation. We believe this stock will be a top performer going into 2015 and any near term weakness should be used as a buying opportunity. The company will continue to grow earnings at an alarming rate after it integrates Fusion-IO with the existing business and unlocks many potential synergies. The supply demand situation in the NAND industry will be favorable for the foreseeable future. We believe that SanDisk Corporation stock will specifically outperform due to improving margins, higher sales growth, and higher EPS growth. We believe that the company can return to non-GAAP gross margins above 50% in the next 12 months due to a more favorable product mix, price stability, and reduced manufacturing costs. Success in the Enterprise storage market will allow SanDisk Corporation to grow sales at a faster rate than competitors. SanDisk is able to finance growth with a very cheap rate on convertible debt. This allows them to use a very high percentage of free cash flow for capital return programs including share buy-backs and dividend issuance. Our current price target is $112 per share.

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