Q2 played out pretty much along the lines of the best case scenario- with the upside reinforced with one-time income events.
Release of inventory reserves accounted for an $87M benefit.
Licensing revenue of $120M exceeded guidance of $85-$95M. This was purportedly due to higher than expected sales prices of NAND in Q1 at Samsung and Hynix.
Personally I suspect that this licensing revenue also included a one-time boost from Samsung coughing up the $20M nicked last quarter.
In any case, I agree with Lazard that “GM is the real story.” and that the SanDisk “story is back on track.”
I am including excerpts from LCM’s 23 July report below. Dan Amir knows the company well and seems to be well ahead of the pack on the SanDisk story.
I am also including excerpts from Goldman Sachs’ 27 July 2009 report. GS has SanDisk on its mind. Following earnings, SanDisk had significant mentions in three GS reports in five days. I am including the last, in which GS contemplates SanDisk’s valuation through the prism of intellectual property.
Both LCM and GS agree that the biggest near-term threat to the stock price is demand. NAND supply will be up in the 2H of 2009. The outstanding question is whether demand will keep up.
When asked about such demand late this year by Craig Ellis on the cc, Eli pointed to Apple’s recent $500M prepayment agreement with Toshiba for NAND supply. Apparently Apple feels it prudent to lock up supply. Apple’d be whistling a different tune if they felt NAND market was over-supplied.
As Eli said, “So we’ll see.”
In the coming weeks, hopefully, I’ll get to some of the themes touched on in the conference call.
Two of the most interesting are the NAND shrink roadmap and Micron. SSD’s are right in there too- SanDisk’s products and purported SSD IP.
I’ve been on the road recently and otherwise occupied. Now that I’m back home, hopefully I’ll have the time to catch up with comments as well.
****23 July 2009 LCM Excerpts Below ****
July 23, 2009
Lazard Capital Markets
SNDK: Moving in the right direction; bumping up our price target to $22 from $20; BUY
2Q results come in strong. SNDK reported a solid quarter with rev/EPS of $730.6M and $0.36, vs. our estimates of $713.9 M/$(0.16) and the Street’s $702.9M/$(0.17). The Q/Q ASP and bit change were +12% and -7%, vs. our estimates of 1% and 5% respectively. Licensing revenue of $120M exceeded guidance of $85-$95M due to higher than expected sales prices of NAND in 1Q.
GM is the real story. Product GM came in at 22%, leaving our 3.4% est. in the dust. Excluding an $87M benefit from the release of inventory reserves the product GM was 7.7%, still quite impressive. The stronger GM was due to better pricing and lower COGS. The 3Q underlying product GM is expected to be slightly up from 2Q’s 7.7%; including the benefit of net inventory reserves, product GM should be 15%-20%. In 4Q, inventory reserves will have been depleted but underlying product GM should see a significant jump due to migration to 3xnm and 3bit/cell production. We estimate product GM of 17% in 3Q and 12.5% in 4Q.
Guidance somewhat conservative. SNDK’s 3Q guidance is $725-$775M, within range of consensus est. at $765M though softer at the mid range. We believe mgmt took a cautious approach on guidance due to the soft summer demand and lack of visibility. We are modeling -6% ASP/MB and MB shipments up 11%, although we could see upside if Sept. prices tend to be tighter.
The story is back on track. We believe SNDK is back on track to profitability, with a 2H stable NAND mkt, strong yields on 3bit, lower COGS, and lower inventory. Since cashflow was less dilutive at -$24M, we are encouraged that SNDK’s financial structure is improving.
Our estimates. We are revising our estimates to reflect guidance. Our 3Q estimates are now $747.9M/$0.09 vs. $787.4M/$(0.14) previously. Our new 2009 estimates are $2.9B/$(0.08) vs. $3.07B/$(0.97) previously.
Risk and valuation. Our price target of $22 is based on 1.5x 2010E sales. (Our previous target was based on 1.5x 2009E sales.) The primary risk relates to near- term NAND pricing and holiday demand.
We believe that the SanDisk story has turned around and that investors should continue to accumulate shares. We believe that the street continues to underestimate the earnings power, the improving business model and the balanced NAND industry as factors that will result in an improving story. Finally, as SNDK shifts to 3bit, we believe that it will have a cost advantage in the market. We are raising our price target from $20 to $22 which is 1.5x 2010E sales.
2Q results come in strong. SNDK reported a solid quarter with rev/EPS of $730.6M and $0.36, vs. our estimates of $713.9M/$(0.16) and the Street’s $702.9 M/$(0.17). The Q/Q ASP and bit change were +12% and -7%, vs. our estimates of 1% and 5% respectively. SNDK raised prices in both the retail and OEM channels which led to a decrease in MBs shipped. Capacity utilization exiting the quarter was 100% and should continue to be so for the rest of 3Q. However, depending on demand, we could see utilization decline in 4Q. Licensing revenue of $120M exceeded guidance of $85-$95M due to higher than expected sales prices for NAND in 1Q at Samsung and Hynix.
GM is the real story. Product GM came in at 22%, leaving our 3.4% est. in the dust. Excluding an $87M benefit from the release of inventory reserves the product GM was 7.7%, still quite impressive. The stronger GM was due to better pricing and lower COGS. The 3Q underlying product GM is expected to be slightly up from 2Q’s 7.7%; including the benefit of net inventory reserves product GM should be 15%-20%. In 4Q, inventory reserves will have been depleted but underlying product GM should see a significant jump due to migration to 3xnm and 3bit/cell production. We estimate product GM of 17% in 3Q and 12.5% in 4Q. We could see better product gross margins in 2010 due to continued migration to 3xnm and 3 and 4bit production; our estimate is somewhat cautious at ~15% product GM for 2010 as we wait to see how we exit
Guidance somewhat conservative. SNDK’s 3Q revenue guidance is $725- $775M, within the range of the Street’s expectation of $765M. Overall, we believe that management is being conservative regarding demand expectations over the summer, especially considering shortages in parts of the market. GM should continue to expand in 3Q with costs/MB decreasing and volumes ramping. We are modeling -6% ASP/MB due to the slower seasonal demand and MB shipments to increase 11% in preparation for the holiday season. The company may need to rely partially on non-captive supply in 3Q. NAND industry remains rational. NAND players are more rationale in their approach to pricing and supply since Feb. We believe this will continue into the
2H. If demand picks up and Apple comes with additional orders in the fall, we could see a further tightening of the market, which would be favorable for SNDK.
Our estimates. Our 3Q est. are now $747.9M/$0.09 vs. $787.4M/$(0.14) previously. Our new 2009 estimates are $2.9B/$(0.08) vs. $3.07B/$(0.97) previously. Our FY10 est. are $3.189B/$(0.18). We are taking a cautious approach to 2010 as demand remains unclear for the holiday season. We continue to see SSD as a potential long-term driver for the company; however, our current impression is that the company is not that well positioned with the G3. In addition, the recent up move in pricing pushes out the potential adoption of SSD.
**** 27 July 2009 Goldman Sachs Excerpts Below ****
July 27, 2009
Buy QCOM and SNDK: market eventually gets royalty streams right
SNDK (Buy): Significant upside to our royalty value of $22/share We believe that SanDisk has one of, if not the most, valuable IP portfolios in the memory industry, which remains significantly undervalued by the market. Today, SanDisk receives royalty payments or has cross licensing agreements with 3 out of 4 NAND flash manufacturers, as well as a number of third party flash card suppliers, and generates 40%-60% of its operating income via its royalty/licensing business. However, we believe the market continues to undervalue the royalty business, which we estimate is worth about $5 bn ($22/share) vs. SanDisk’s market cap of $4 bn ($18/share). We believe that the current market dislocation creates an attractive entry point in the stock and recommend adding to positions.
SanDisk (SNDK, Buy): We see significant upside in the stock given our view that the royalty business is worth $22/share vs. the stock at $18
SanDisk has arguably the best IP portfolio in the memory space. We continue to believe that SanDisk has one of, if not the most, valuable IP portfolios in the memory industry as it relates to multi-level cell (2-4 bit per cell) technology. Additionally, we believe the company has important IP around the next generation memory technology, called 3D, which could create significant upside to the company’s licensing/royalty business over the longer term, if SanDisk is successful at licensing the technology.
While the company has struggled to successfully monetize its IP through its product business (i.e. selling NAND flash cards), it has been, and continues to be successful in generating meaningful revenues and earnings via its license and royalty stream. Of the four NAND manufacturers that compete with SanDisk (Samsung, Hynix, Intel, and Micron), Micron is the only one that is not currently licensed to use SanDisk’s MLC technology. Both Samsung and Hynix pay SanDisk royalties in order to be able to sell their NAND- based products while Toshiba and Intel have a cross licensing agreement with the company. Although SanDisk believes that any company in the business of NAND manufacturing should be paying SanDisk royalties or be licensed to use its technology, Micron has been able to manufacture NAND without a payment to SanDisk thus far.
Our view is that over the last several years, SanDisk has been focused on renegotiating its royalty agreement with Samsung (which expires in August of 2009) and has not been focused on pursuing negotiations with Micron. However, now that the Samsung agreement has been successfully renegotiated, we expect SanDisk to focus more of its efforts on negotiating a form of payment with Micron.
The license/royalty business drives a significant part of SanDisk’s earnings…
Over time license and royalty revenues have accounted for 10%-15% of SanDisk’s total sales. However, the royalty stream has been a much more significant driver of the earnings power for the company, accounting for 40%-60% of SanDisk’s operating income when the company has generated positive earnings and significantly offsetting operating losses when the company has lost money during industry downturns (see Exhibit 7).
…however, the IP remains significantly undervalued by the market. However, despite the company’s strong IP portfolio and the importance of the IP in driving SanDisk’s operating model, we believe the market is significantly undervaluing SanDisk’s royalty business today, which we estimate is worth approximately $5.0 bn (about $22/share) vs. SanDisk’s market cap of $4 bn (about $18/share).
As we showed in Exhibit 2 above (replicated in Exhibit 8 below), the market appears to be ascribing a negative value to SanDisk’s royalty business today as most of the focus has shifted to the losses in the company’s product business. Note that we arrived at the implied negative value for the royalty business by doing the following. Firstly, we applied Micron’s historical EV/Sales multiple to SanDisk’s product business as we view Micron as the closest comp to SanDisk’s product business. We then backed out the product business valuation from the company’s historical enterprise value, to arrive at the implied historical royalty value, which is negative today.
We would highlight that the implied value is negative despite: (1) its significant positive contribution to both SanDisk’s operating income and free cash flow, in contrast to the product business (for both SanDisk and Micron), which is being ascribed a significant value despite generating little/no earnings over the course of a full cycle, and (2) the fact that SanDisk was successful in renegotiating its licensing/royalty agreement with Samsung in May of 2009, which we believe has been an overhang on the stock and the royalty valuation for some time.
Interestingly, our analysis also shows that the last time the implied market value for SanDisk’s royalty business significantly deteriorated and ultimately turned negative was around the last royalty negotiation with Samsung, which took place in August of 2002, following the burst of the tech bubble in 2000/2001. We believe a similar scenario is materializing today, where the value of the royalty stream has been declining as industry fundamentals have deteriorated, and ultimately turned negative in late 2008 as the expiration of the royalty agreement with Samsung drew closer.
While the value of the royalties can fluctuate slightly with the market, as approximately 2/3 of the royalty stream is tied to Samsung’s revenue trends, we estimate that the royalty value has been in the $5 bn to $7 bn range (about $20-$30 per share) over the last several years versus the severe fluctuations that have been implied by the market. We would also note that SanDisk’s new agreement with Samsung does not include rights to SanDisk’s 3D technology, which if licensed to Samsung in the coming years, would imply significant upside to the current royalty value of $5 bn.
As we mention above, SanDisk’s stock is currently trading approximately 20% below our estimated valuation of the royalty stream, which we believe significantly undervalues the company’s IP portfolio. We expect this valuation discount to correct, as NAND fundamentals recover and SanDisk’s profitability improves, as was the case in 2H05/1H06, and 2007. Similar to Qualcomm, the market valuation of the royalty stream had previously reached, and even exceeded our implied value estimate during industry upturns, and we expect a similar pattern to take place, beginning in 2H09.
Our DCF model values the royalty business at $22/share vs. the stock at $18.
We continue to value SanDisk’s royalty stream at $22/share, as we show in Exhibit 9 below. Our view continues to be that SanDisk derives most of its value from the company’s royalty stream and we ascribe zero value to the company’s product business, which generates little earnings over the course of the cycle. Our valuation methodology for the license/royalty business is as follows:
• Our valuation is based on a DCF model, which forecasts SanDisk’s royalty business out to 2016 (year when the current agreement with Samsung expires) and assigns a terminal value to the royalty business post 2016.
• The terminal value calculation is a perpetuity value. However, while a typical DCF model would assume a certain growth rate in the business into perpetuity, our terminal value for SanDisk’s royalty stream assumes zero growth, and is arguably more conservative.
• The component of the royalty business that is tied to Samsung is based on a royalty rate applied to Samsung’s NAND revenues in any given quarter or year, which we forecast based on our views of bit shipment growth and ASPs. While most of Samsung’s NAND business today is based on MLC (multi level cell technology) vs. SLC (single level cell technology), we have separate royalty rate assumptions for the MLC and SLC business in the model.
Beginning in 4Q09, we have assumed a 50% reduction in the royalty rate Samsung will pay SanDisk, in-line with the recently negotiated agreement. Since SanDisk receives royalty payments from Samsung on a one quarter lag, we assumed a 50% reduction to Samsung’s royalty rate beginning in 2010. However, our estimate for 4Q09 assumes that half of the royalty payments from SanDisk during the quarter will be based on the old rate and half will be based on the new rate, which is consistent with SanDisk’s guidance. [Note that Exhibit 9 below has been cropped for legitability. The original chart goes out to 2014. Starting with 2010 GS estimates IP revenue other than Samsung as flat-lining at $160M through 2014. SNDK should do far better]
We recommend buying the stock, particularly given the recent pull back. We believe that the pull back in the stock last week creates an attractive entry point in the stock and recommend that investors aggressively add to positions. We see about 25% upside to our 12-month price target of $23, which is based on:
(1) An 85% weighting of our fundamental implied value of $22/share, or the implied value/DCF value of SanDisk’s royalty stream.
(1) A 15% weighting of our M&A component for SanDisk (to reflect our view that the company could be an attractive takeout candidate) with a 40% premium to our royalty implied value estimate of $22/share. The premium is roughly in line with the historical premia paid for tech deals since 2001, which have ranged from 30% to 50%, and slightly below the 56% premium offered by Samsung in May 2008 when initial discussions between Samsung and SanDisk took place.
Importantly, our price target for SanDisk assumes zero value for the company’s product business given our view that the product business generates minimal earnings over the course of a cycle. As a result, we assume that the value for the company resides primarily in the company’s license and royalty business vs. the product business.
The key downside risks to our price target include a significant leg down in demand in 2H2009 and inability to monetize its memory IP.