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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