A Terrible Quarter

Q2 was a terrible quarter. Weak sales of $816M were significantly below guidance of $875M to $950M and Street consensus of $912.0M. (Non-GAAP) EPS went red: -$0.10, well below the Street’s $0.14. Channel inventory ended Q2 between 8 and 9 weeks.

Second quarter non-GAAP product gross margin was 5.7% or 10 points below the middle of the guided gross margin range that SanDisk provided in April.

As bad as Q2 was, Q3’s outlook is even worse: total revenue between $750M and $850M with product GMs of zero. Inventory is expected to increase in Q3 and its possible that even after Q4’s holiday season inventory could be higher than Q2. Not a pretty picture.

Excerpts from two analyst reports follow — Classic glass half-full or half-empty snapshots of SanDisk. Covello of Goldman Sachs is the optimist while Ellis of Citigroup has thrown in the towel for 2008.

Covello has SanDisk as a “Buy” with a $30 target. Ellis sees SanDisk as a “Sell” with a $14 target.

Covello bases his $30 target on a valuation of $23 for SanDisk royalties and only $7 for the product business (.5X ‘09 sales). No credit for SNDK cash, as it is offset by lease commitments.

Reading between the lines Covello seems to think that Samsung will resign as a SNDK licensee.

Am inclined to agree. The outstanding question would be for how much? Seems a given that (x2) MLC royalty will be reduced. On the plus side would be x3, x4 and last, but not least 3D R/W.

Personally I was pleasantly surprised by Eli’s willingness to discuss SanDisk’s 3D efforts. Compared to previous tight-lipped commentary, he gushed.

It seems clear that progress is being made on 3D read/write. Eli referred to it as “a major technology” where investment is “accelerating” and a technology “we believe will replace NAND flash sometime in a the next decade when it [NAND] can no longer be economically scaled.”

This could simply be bluster calculated to mask near-term company shortfalls. The recent Toshiba 3D license agreement would seem to indicate otherwise. No SanDisk press release, but the news is out thanks to SEC filings.

I’m posting a Q2 conference call transcript. Definitely worth a read.

**** Excerpts from GS 07.21.08 SNDK Report Below ****

SanDisk Corporation (SNDK)

Buy

James Covello
Kate Kotlarsky

The Goldman Sachs Group

Terrible quarter but supply slowdown big positive; royalties are key

What’s changed

SanDisk reported weak Q2’08 sales of $816mn (-4% qoq), significantly below guidance for sales of $875mn-$950mn. Operating LPS (including ESOs) was -$0.21, $0.26 below our $0.05 estimate and ~$0.27 below the Street’s GAAP EPS estimate. EPS downside vs. our estimate was driven by lower sales and a lower gross margin, partially offset by a higher tax benefit and a lower sharecount. Q3’08 sales guidance of $850mn is below the Street’s $1bn estimate, driven by lower bit shipments as well as weak ASPs. In light of the difficult industry environment, management noted that SanDisk will be delaying the 2nd phase of its Fab 4 ramp and the ramp of Fab 5. We are reducing our estimates on lower revenues and gross margins: CY08E EPS to -$0.65 from $0.85, CY09E to $0.25 from $1.60.

Implications

We maintain our Buy rating. While the ASP environment remains difficult, we believe that SanDisk’s royalty stream alone is worth ~$23 or 30% above the current stock price, and is therefore significantly undervalued. Further, we are encouraged that SanDisk and others are taking steps to reduce the level of supply coming on-line in ‘09, which should help fundamentals in 2H’09/2010. History suggests that periods when the NAND industry goes through a supply correction (‘05 and 2H’06/1H’07), SNDK significantly outperforms and we would expect a rally in the stock when excess supply is fully worked down. Also note that SanDisk’s capex cuts are in-line with our view that the current fab pushouts are impacting 2008 SPE orders, consistent with SPE managements’ bearish tone at Semicon last week.

Valuation

We are reducing our 6-month price target to $30 from $35, based on: (1) $23 for the royalties, (2) $7 for the product business (.5X ‘09 sales). We are not giving SanDisk credit for its cash, as it is offset by lease commitments.

Key risks

The key risk to our price target is losing Samsung as a licensee.

**** Excerpts from Citi 07.22.08 SNDK Report Below ****

SanDisk Corp (SNDK)

Downgrade To Sell; No Clear Path To Profitability

Sell/Speculative 3S
from Hold/High Risk
Price (21 Jul 08) US$15.60
Target price US$14.00
from US$20.00
Expected share price return -10.3%
Expected dividend yield 0.0%
Expected total return -10.3%
Market Cap US$3,506M

Craig A Ellis
Asiya Merchant, CFA

Downgrade To Sell: We had warned NAND fundamentals were eroding sharply since June 19th but the outlook miss was far worse than expected. We now see: 1) A huge profitability hole as C08/09 EPS plunge to -$0.15/-$0.30 from $1.23/$1.29, 2) an inventory overhang through 4Q08, 3) falling cash flow vs cap ex needs in C09/10, and 5) stock headwinds in late-4Q08 as industry seasonality rolls over. TP to $14 for downside of 10% to AMC $15.60.

2Q08 Results A Huge Miss – Revenues missed big (-4% to $816.0M; Street $912.0M) as did product gross margin (5.7% vs 14-18% guide) so after in-line opex ($224.5M), PF EPS were -$0.10, far below the Street’s $0.14. As bad, on- hand inventory jumped 15% (to 112 days), and channel inventory rose to 8-9 weeks, each material overhangs to 2H08 gross margin improvement.

3Q08 Outlook Worse – A $800M revenue mid-pt (-2% qq; 20% below Street) allows for aggressive pricing (CIR now -25%) to start clearing excess inventory. On 0% product gross margin, we now model -$0.22 EPS (from $0.31, Street $0.41). On hand inventory expected to build further in 3Q08, a 4Q08 risk.

Street EPS To Get Crushed; Stock Sponsorship the Casualty – Street EPS should fall toward CIR’s new ests and some downgrades are likely (9 Buy, 10 hold, 1 Sell). Stalwart Bulls will argue bad news is priced in (stock –13% AMC), though history argues otherwise when 1Q’s ugly seasonality lies ahead.

Delays C09 Capacity: A delay to the phase-2 ramp of fab IV appears a “+” but since new phase I capacity ramps through YE08, we see little help till ~2Q09.

Throwing In the Towel; Sell Ahead of A Seasonally Ugly 4Q08

We are throwing in the towel on SNDK shares for 2008, expecting industry fundamentals to get decidedly worse by late-2008 before potential improvement in mid-2009. Further, we increasingly suspect that saturation has started to negatively impact product growth rates for USB drives and MP3 player products, suggesting a demand-side bail-out may prove less probable than the Street or SNDK might hope. In addition, there is really no supply moderation help from SNDK’s fab-IV actions until around 2Q09, in particular as the phase-I build-out persists through year-end 2008, and as Fab III and Fab IV transition to 43nm early next year, adding further effective capacity. In summary, we are left with: a) with little confidence in current estimates, b)potential for near term degradation in industry’s structural dynamics, c) essentially no sustainable company-specific catalysts until 2Q09, and d) no reasonable case for downside support at after-market levels given crushed earnings power and moderating cash generation versus cap ex needs.

SNDK’s ugly print is likely to contribute to a tough tech tape Tuesday. That said, we caution against takeaways beyond the memory sector as: a) we had forecast SNDK’s results/outlook were likely to be much poorer than the rest of our coverage, b) much of SNDK’s issue is due to its own excess production, an affliction not found elsewhere in our coverage, and c) SNDK’s largest two handset customers have historically been MOT and SNE, lending high concentration to the worst part of the handset supply chain, with no offsets.

Positives and Negatives

Positives

Royalty revenues of $129M were higher than CIR’s $124M

Operating expenses were in line with St at $224M, slightly below CIR’s $230M

43nm transition continues to progress well with 65%+ contribution to bit production mix by year end.

3 bit per cell to represent 20% and 50% of bit production by year end 2008 and 2009E, respectively

2008E and 2009E capex commitments reduced to $2Bn (from $2.4Bn) and $2.5Bn (from $3Bn) respectively

Negatives

Product revenues fell 4% to $816.0M, well below consensus of $912M

SNDK bits grew 120% YoY versus 150 – 170% prior guide
Product gross margins was just 5.7% (guide 14-18%; CIR 17.0%)

EPS of ($0.10) vs St at $0.13

2Q inventory up $100M q/q (-7% impact on GM); DOI flat at 111 days (all time high).  Inventory expected to increase in 3Q given higher fab output.

OEM units (bundled mobile cards) down ~2% qq (off a 33% decline in 1Q), impacted by mix shift to low end handsets in 1H08 and MOT/SNE exposure.

Guided total revenues of $750-$800M, significantly below CIR/St at $1.05Bn/$1.12Bn

Expects 3Q pricing to be more aggressive than 2Q (to blow out inventory) with 2008 pricing to be ~60% YoY (vs. 50-55% prior guide)

Product gross margins guided to 0%, down 570 bps given inventory reserves and limited benefit from shrink/3 bit per cell.

Operating expenses to remain at 27 to 28% of sales (continued investment in R&D, SGA spend necessary to blow through excess inventory) vs. target
model of 18 to 20%.

Cash flow from operations was ($327M) vs. +$17M expected given lower net income, inventory reserves and higher international receivables.

2008E revised capex to exceed cash flow from operations by ~$400M, 2x CIR’s prior estimates.

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3 Responses to A Terrible Quarter

  1. bob77977 says:

    hi savo, thx for your post.

    “Personally I was pleasantly surprised by Eli’s willingness to discuss SanDisk’s 3D efforts. Compared to previous tight-lipped commentary, he gushed.”

    I could sense two more hints by eli.

    MegaSIM was mentioned. may be connected to google’s android as you implied before ?
    scheduled to 2H08.

    higher capacities USB drives were mentioned ( 16, 32 GB),
    anything to do with the cooperation with microsoft ?
    was also scheduled to 2H08.

    and then, there was the confession about not realizing the problematic nature of vista regarding flash SSDs. we are late to the market because of that but the question is, are we late compared to competitors or are we still ahead of them ? could be they discovered about it before us ?

  2. savolainen says:

    Greetings bob77977,

    I also noticed that Eli brought up MegaSIM. I don’t know why he would even mention it, unless the potential was still alive. Too bad no one asked about it on the conference call.

    The Google Android story should be interesting and soak up a lot flash memory. The timeframe seems to have slipped a bit, but the dynamics appear unchanged.

    The post-PC era is bearing down on us. The mobile phone is morphing into a computing device. After Apple, Google looks nicely positioned, but they’ve still got to show they have the right stuff.

    Apple hasn’t missed a beat. The iPhone is roaring along. The iPhone App store looks poised to take off. As a computing platform the iPhone looks to be miles ahead of the competition including Android.

    It seems only a matter of time before we hear about a 32 GB iPhone. Probably sooner rather later given the drop in cost of NAND. Price elasticity at work.

    Personally a 32 GB iPhone is the capacity I covet. Doubt I’m alone.

    I also agree with you about the potential of the MSFT/SNDK U3+ for late 2008. I suspect virtualization to be a big deal in the next few years.

    I doubt MSFT/SNDK U3+ product announcements, if and when they arrive, will do much for the SNDK stock price near term though.

    NAND over-supply is the big problem for SanDisk and all the other NAND players.

    Best,
    Savo

  3. bob77977 says:

    hi,thanks,

    “the timeframe …….”
    now there are talkings about a merger between android and symbian, if true, we should expect a delay but then maybe a quicker and more nassive adoption.

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