Goldman Sachs and Morgan Stanley

Judy B has had a busy couple of weeks. Aside from her CFO duties, she’s become SanDisk’s spokesperson on the financial conference circuit. Her last two stops were the Goldman Sachs Technology and Internet Conference on 26 February and the Morgan Stanley Technology Conference on 3 March.

Maybe it was snow-storm-induced-sensory deprivation, but, curiously, I found both quite interesting.

It feels as though SanDisk is trying to fill in for the missing analyst day by addressing questions the financial community may have while at the same time telegraphing bigger-picture expectations.

The story as I’m hearing/interpreting it:

In a curious twist of karma Samsung did SanDisk a huge favor with last fall’s acquisition offer.

Because of Samsung’s shenanigans, Toshiba went into defensive mode and decided to help SanDisk by restructuring their JV- taking on 20% of SanDisk’s capacity- a value transfer of about $890M from Toshiba to SanDisk. About 2/3 will be in the form of transferring lease obligations from SanDisk to Toshiba and about 1/3 of it will be cash.

This value transfer has given SanDisk most-welcome breathing room in this difficult market.

With this help from a friend and a little luck, SanDisk has a realistic shot at being able to get back to positive product gross margins in the second half of this year. Another quarter or two of benign NAND pricing should do it.

If this should come to pass, SanDisk’s underlying cost reduction roadmap should provide the required underpinnings for stability of the business model.

This is a delicate dance as the current pricing strength in NAND seems driven primarily by the cutback in supply and this will be short lived. NAND players, Toshiba/SanDisk included, are currently running fabs at less than 100%, but by the second half of 2009 fabs are expected to be back at full utilization.

The hope is that market demand will be enough to absorb both this capacity and the not insignificant inventory leftover from 2008. In spite of this miserable market, SanDisk is forecasting such increasing year-over-year demand. We shall see.

In any event, SanDisk has enough cash for 2009 thanks to Toshiba’s $300M± cash payment and the expected $200M IRS refund.

My expectation continues to be that Samsung will re-sign by August. Goldman Sachs apparently has spoken at length with a patent attorney who feels that SanDisk’s position is particularly strong given the recent arbitration win against Samsung.

Samsung should recognize that they have to pay. Now it is just a matter of terms. It could be very risky for them to go unlicensed. Some of their large customers will be very concerned about shipping unlicensed product.

Goldman Sachs

Give Goldman Sachs’ Jim Covello some credit. He managed to both provide comic relief and weave in some interesting tidbits.

The comic relief came when he inadvertently referred to Samsung as Toshiba’s partner instead of SanDisk. Judy corrected him to howls of laughter. Without missing a beat Jim then proceeded to point out how critical SanDisk is to Toshiba for both X3 and for reaching 2Xnm:

“Jim Covello: How is Toshiba balancing their own balance sheet concerns with their need to keep you as a partner? Because that is a difficult dynamic. They really can’t afford to lose you as a partner. I have talked to them and they have said if Samsung weren’t our partner we really don’t have the ability to produce [Judy cuts in]

Judy: SanDisk

Jim: I’m sorry  [much laughter- including Judy]. Freudian slip there. We’ll get to that in a second.

I’ve talked to Toshiba and they’ve said that if SanDisk wasn’t our partner they don’t have the ability to produce below 32nm. They can produce on 32nm, but at 23nm and X3, they wouldn’t be able to produce, so it is critical [pause], you are a critical partner for them. That is clearly part of the reason why they were willing to structure this deal even though their own balance sheet is problematic.

The implication, at least to my mind, is that SanDisk, and likely its IP, will be critical for both X3 and the shrink to 2Xnm (floating-gate NAND) not only for Toshiba but for other players as well.”

The shrink to the 2Xnm node will be an interesting story to watch. Error correction and so forth will become ever more important as the interference between adjacent floating gates increases. And of course such system solutions are SanDisk’s strength.

I wouldn’t be at all surprised if some of the issues of 2Xnm NAND aren’t similar to the challenges that X4 has successfully dealt with.

Quite a bit of time at Goldman Sachs was spent on SanDisk’s off balance sheet lease obligations for fab equipment. Clearly this issue is on a lot of folks minds. Rightly so. I considered trying to summarize her comments. Probably better to just let Judy speak for herself:

“Judy: That’s a long question. [laughs]. Toshiba and we have off balance sheet lease obligations that were used to fund equipment in the fabs- fab 3 and fab 4 and we have been equal guarantors on those leases. The leases are held in the name of the joint ventures, but the parents- Toshiba and SanDisk have been equal guarantors.

And yes, those leases have covenants that are tied to ratings and so, at least on our side, that’s one of the things that I pay attention to relative to wanting to keep our balance sheet strong.

Jim: Makes sense. Let me go a little further there. How close are we to those covenants being triggered I guess and what are the hot button issues?

Judy: OK. So let me give a few facts first and then answer your question- a few figures. Our outstanding lease obligations at the end of 2008, they are denominated in Yen, but based on dollar equivalents were valued at just under $2.1B. That was the size of our guarantee. That number will come down considerably because of the restructuring of the joint ventures. Because some of those lease obligations will transfer to Toshiba. So I would anticipate that by the end of the first quarter, our number is something like $1.5B. OK?

Those leases have 2 covenants. One is a net worth covenant that has plenty of room on it. All of this by the way is detailed in our 10K and also in our 10Q filings.

The second covenant is a ratings covenant. That’s the one you are referring to. That it requires that we maintain our ratings above a certain threshold with either Standard and Poors or with RNI, which is the rating agency in Japan.

Our rating with Standard and Poors is actually below the threshold, so it is not helping or contributing. But we are above the threshold with RNI and we are one notch above the threshold. So our rating with RNI is triple B minus and the threshold is double B+. So if they downgraded us one notch we would still be in compliance. It would be two notches that would cause an issue.

Jim: Its the rating on the JV. Is that correct?

Judy: No it is a SanDisk rating. So these are the covenants for the SanDisk portion of the guarantee.

Jim: OK. What are the discussions like with right now? I’m sure you are having a pretty regular dialog with them. How concerned are they?

Judy: The ratings agencies?

Jim: Yes.

Judy: Well RNI issued a press release two days after our recent earnings release and their press release was that they were maintaining the rating with a negative outlook, So we remain at triple B minus. Clearly they are watching the industry and us carefully.

I think if the pricing trends that we are seeing in the component market were to remain, that’s a positive sign. If capacity grows overall and doesn’t get too over exuberant. That’s a positive sign.  But they are going to watch it carefully. So they look at both the operating results on the P&L and they look at the strength of the balance sheet as well.

Let me remind you that actually for some portion of these leases we did go into noncompliance back in 2008. This is in July of 2008 because those portions at the time had a covenant that was only tied to S&P and we were downgraded by S&P. The result of that was that we renegotiated those leases with the lease holders and we agreed to pay a slightly higher spread and they changed the covenant package. They changed it to match the rest of the new releases. So they now all have the same covenant package.

Jim: Do you think you have the bandwidth to do that? Is there a similar type of potential?

Judy: That would be my hoped for outcome- that we would be able to negotiate some type of new package that probably would encompass high spread, maybe some security. Clearly they have the right to ask for payment if there is a noncompliance. The hoped-for outcome would be if we were in that situation that we would negotiate some outcome there, but again that is one of the reasons that we want to keep the balance sheet strong is to try to not be in that position.

I also found the discussion of the Samsung re-sign very interesting. Note the commentary surrounding the discussion with the patent attorney (Goldman Sachs):

“Judy: There is clearly uncertainty right now in the financial community as to the renewal of the license agreement with Samsung who is our largest licensee. So that uncertainty clearly is an overhang I think.

Jim: And can you update us or tell us anything about that at all?

Judy: I really can’t say anything more than what we said on February 2 which is that the two parties are talking and that we are in discussions relative to a renewal for the current agreement which expires in August of 2009.

Jim: How adversarial vs amicable is that dialog now especially considering the discussions around the M&A activity that happened late last year?

Judy: I can’t comment on how the conversations are going, but I will comment that we are talking.

Jim: Do you hope to have resolution before August or do you think there is a realistic chance that we go beyond August and it winds up in court?

Judy: We clearly hope to have a resolution before August. We have said that if there isn’t a resolution that we would pursue litigation.

Jim: Isn’t the litigation pretty cut and dried in your favor because you already won a court ruling that says that they have to pay you. So it wouldn’t be clear to me what they would hope to achieve. As you know, we had a call with a patent attorney and we looked at this in pretty good detail. It is a pretty cut and dried thing. They lost a court case and they have to pay you royalties. What is their negotiation point about why they potentially wouldn’t pay or is it just strictly price? They recognize that they have to pay and it is just a matter of what price.

Judy: We have said that we think we have a very strong position. There is a lot of IP that is applicable to their products. More IP than there used to be when we first signed the agreement back in 2002 [reference to the msystems arbitration win]. So we think we are in a very strong position and clearly I think it would be very risky for them to go unlicensed including based on how some large customers might react to that or be concerned about that in terms of shipping unlicensed product. So I think there is a number of reasons why reaching an agreement here makes sense.

Jim: Final question from me on this topic. I promise. How much of the difficulty in the negotiation is the issue around what they’re already licensing, the SLC and the MLC vs what the rates would be or what they would like in the future X3, X4, 3D technology?

Judy: I really can’t comment on how a license might be structured. Clearly which technology is included in that license is one factor which has to be negotiated in addition to price. So all of that enters into the discussion.”

This post seems long enough, so I’m going to stop here.

Rather than dig into the the Morgan Stanley Technical Conference as well, I’m just putting up the transcription. Worth the read.

Apparently, Samsung has been able to keep its NAND GMs up thanks in part to its ‘”fusion” differentiated NAND products, such as OneNAND. These are the very products that Samsung copied from msystems, and the very same that Samsung now has to license from SanDisk.

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5 Responses to Goldman Sachs and Morgan Stanley

  1. Poofypuppy says:

    Excellent information, thanks Savo.

    SanDisk’s current situation seems analagous to a deep sea diver who had found a treasure chest of gold at the bottom of the ocean with sharks swimming overhead. The big question is if the diver can return safely to the surface to replenish his oxygen supply and recover the treasure before he gets eaten by the sharks (or runs out of air).

    Regards,
    Poofy

  2. savolainen says:

    Hey Poofy,

    I like your deep sea diver/ treasure chest analogy. Too bad its so accurate. 😉

    I’d add that likely the diver is going to have to make several trips before the bulk of that treasure can be lifted to safety.

    I am somewhat resigned to an equity offering in the fall- following the good news of a new Samsung license agreement. My guess is that SanDisk will line up all the good news it can including SSDs and so forth. Then after the hoped for pop in price- the offering.

    While SanDisk is fine on the cash front for 2009, 2010 is another matter. This year SanDisk will pick up about $500M (total) from Toshiba and the IRS. The Toshiba payment is a one-time deal. Maybe SNDK will be able to recover more from the IRS in 2010, but I’m guessing this was the big number.

    This $500M will cover CapEx. Down big from $1.6B in 2008.

    SanDisk will be able to get away with “only” $500M because:

    SNDK’s 32 nm manufacturing process employs essentially the same fab equipment-set used for 43nm technology, and therefore the CapEx investment needed to convert the production lines to the smaller geometry is relatively modest. [Eli from Q4 cc]

    I am pretty sure the NAND competition is not so fortunate. And therefore I think their 3X ramps are going to take a while- but that’s another story.

    Even if 2010 CapEx is once again only $500M, I’m not sure where this $500M is going to come from- if not from an equity offering. The bulk of the cash on the balance sheet seems required to satisfy lease obligations. And given the state of the economy, its hard to imagine enough cash being generated by the business. Toshiba’s tapped out. Judy has already ruled out taking on more debt. Which brings us back to the equity offering- which has been described as less than — $500M.

    Some of SanDisk’s treasure may be recoverable near-term in spite of all this. MLC SSDs look poised to take off in 2010. The upcoming G3 models this summer will be 43nm MLC. If these live up to the hype, the 32nm variety for 2010 should hit the sweet spot. SanDisk looks to have the MLC 32nm volume ramp knocked- right on schedule. A good thing too.

    Best,
    Savo

  3. Poofypuppy says:

    Hi Savo,

    Thanks for the additional note about CapEx, I agree it’s a big concern for SanDisk going into next year. In this tough economic climate, raising additional capital to sustain investment cannot be taken for granted. But if it’s any consolation, Samsung faces its own major challenges (reporting its first net loss since 2000), and could find it tough to commit billions of future CapEx dollars for 2Xnm NAND fabs, regardless of the IP licensing renewal. If Samsung does renew with SanDisk, then they need to pay for both licensing and the new fabs. If they don’t renew, that would mean litigation costs and/or committing the 2Xnm facilities to SLC-only production.

    Micron and Toshiba have financial issues of their own, and Intel (although it remains fairly strong and has said it will invest $7 billion in facilities in the next 2 years) seemed to hint it could exit flash production and just buy chips from others.

    So despite the economic downturn, SanDisk’s rollout of X3 and X4 comes at a good time, when the whole industry has to slow down or stop at the edge of the [3Xnm to 2Xnm] river, with the large financial (and technical) resources needed to cross it.

    I continue to be curious about the latest plans and progress regarding 3D.

    Regards,
    Poofy

  4. savolainen says:

    Hi Poofy,

    I am also curious about the planning and progress with SanDisk 3D R/W. When I get some time, it would be interesting to check out how the patent parade has been doing.

    On the production front, last we knew (2008) OTP was down to 80nm and qualified at TSMC. R&D at TSMC was focused on the next generation- 45nm.

    Slides from the August 2008 Flash Summit make reference to 45nm with 8 layers. This purportedly was the fifth generation. First was 250 nm and one layer.

    One of the casualties of this CapEx crunch is the 3D equipment for fab 4. SanDisk had been planning on spending $400M. While the R&D guys are no doubt disappointed, this is likely not that big a big setback.

    The science is the key. With Toshiba on board now contributing to R&D, I expect things are moving right along at least on the lab side.

    R&D was focussed not just on 45nm but scaling the diodes to 32nm/ 22nm while working in parallel on R/W.

    Back in 2007, Eli said that he thought 3D had the potential to eventually replace all NAND, in 5 to 7 years- 2012 to 2014. At the time 2012 seemed like the far distant future.

    Today 2012 looks far closer.

    With the easy Capex $ no longer an option, it appears that 32nm NAND is going to be with us for a while. The longer it stretches out, I think the more likely we’ll see 3D at the next leg down- if they’ve got it figured out.

    Both Toshiba and SanDisk have said that 3D R/W is the likely tech for the 10ish nm generation, two generations from today. I’m wondering if we might see sooner, say at 22nm?

    After all, right now 2012 is looking like the earliest 22nm NAND (as we know it) could arrive in significant volumes. A new generation of expensive litho equipment will be required. If this equipment is only going to be good for one node and a couple of years, it will be a stretch to rationalize the investment.

    On the other hand, if 3D R/W is achievable at 22nm, the investment in that equipment could pay off for a while.

    Best,
    Savo

  5. Poofypuppy says:

    Interesting info, thanks Savo.

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