BoA-ML Etc

I’m just back from vacation and it seems the last couple of weeks have been eventful in SanDisk World.

In the interests of getting this post up today, I’m going to keep my commentary short.

Share price is up and rightly so. Sanjay in his Deutsche Bank (DB) presentation of 14 September managed to slip in a zinger or two.

I’m including a transcription of a couple of his most interesting comments below.

Following on from Eli’s OPCO comments regarding managed NAND, Sanjay noted that SanDisk now considers “New Channels” among its growth opportunities. These new channels include private label cards, wafers and components.

Most significantly, Sanjay noted that for SanDisk bit demand growth would be upwards of 100% for 2009. New bit supply through technology transitions will be around 50% as expected. The difference will be made up from inventory.

These comments have incredibly bullish implications for Q3 and Q4- both top and bottom line. Not long ago there was great concern that when idled bit capacity came back online this quarter, the NAND market would slip back into oversupply. Not only does this not appear to be in the cards, but demand is so strong that excess inventory is being burned through as well.

Four days after Sanjay’s DB presentation, Bank of America/ Merrill Lynch (BoA-ML) released a bullish SanDisk report on 18 September.

BoA-ML’s analyst, Simon Dong-je Woo seems to have have gotten religion. I am including excepts below. Highly recommended reading. Its worth remembering that this commentary is coming from Seoul- Samsung’s home turf. Even with the Samsung spin, there is a lot to like.

Shlomi Cohen’s Globes’ article this week included a concise summary and put BoA-ML’s recent report in context:

“The turnaround in SanDisk’s business over the past half year can be seen in reports by Bank of America Securities-Merrill Lynch analyst Simon Dong-Je Woo, who began to cover the company in March, with an initial “Sell” rating and target price of $6, which slowly crawled up to $10, as the share price rose to $20.He forecast then heavy losses in 2009 and 2010 for SanDisk, and only slight recovery in 2011.

Woo figured that SanDisk’s partnership with Toshiba would burden it financially, and because of production costs which were higher than market prices, he also saw it at a disadvantage against competitors. Woo saw a difficult market ahead, where prices would collapse due to a chip surplus until at least the end of 2010.

Additionally, he suspected that Samsung would not renew its royalty agreement in which only one month later, in April, he was proven wrong, as Samsung and SanDisk did sign.

On Friday, he turned around, and switched to a “Buy” recommendation from “Sell”, and tripled his target price to $30, much higher than the most optimistic analysts who covered the company, such as Lazard’s Daniel Amir.

Today Woo sees the mirror image of what he saw in March. Instead of chip surpluses, he sees a shortage, because of a sharp cut in investment. Instead of a disadvantage in its joint venture with Toshiba, he sees a very big advantage in production line ownership. A wave is beginning, in his opinion, of positive trends in the NAND market, one which will last at least two years. From the demand side, it originates in higher usage of mobile storage in telephones and media players, led by Apple. In the case that SanDisk will need more chips than it produces by itself, it will be able to buy them from Samsung, which in its new royalties agreement committed to sell to it at low prices.”

Lastly, recent rumors have SD slots in the next generation of iMacs. If this proves true and I suspect it might, this is a trend to like from a trendsetter. The mac tablet now looks like a 2010 story. There would be a lot to like about an SD slot there.

**** Transcription excerpts from Sanjay’s 14 September Deutsche Bank presentation below****

Sanjay Mehrotra
President and Chief Operating Officer

“We have also begun to engage in terms of new channels related to private label cards and sales of wafers and components. I’m please with the progress that we are making in this area as well.”


Q: Of course the pricing dynamics is the thing that we’re probably all curious about. Can you talk about how quickly you think supply can ramp and what can happen and whether you shared [pause] you say you are optimistic, does that mean that you’ll be profitable going forward and GMs can stay at the current levels of 22%? Thank you.

Sanjay: We are certainly optimistic for the second half. As I have said, the bit growth in the future, we have not provided guidance for the bit growth.

But an important thing to note from an industry point of view, is that in 2009, there is no new wafer capacity that has come on line. And in the first half of the year, there was significant cut back in production.

Therefore the bit growth for the year in terms of supply is approximately 50%.

For SanDisk itself, in terms of our demand growth, of course our demand growth will be significantly larger than this 50% number of the supply bit growth because we have significant inventory that we entered the year with and using that inventory as well as using our new supply, new bit supply through our technology transitions, we expect to be doing significantly more than 50% growth in the year.

If you look at our first two quarters, we have done on a year-over-year basis, 100% plus kind of growth. So for the year I would expect our growth to be in the range of 100% plus. In terms of the demand growth.”

There is no update in terms of GM other than what we provided at the time of the Q2. I had noted that the pricing environment in the industry has been better than what we had expected at the time of the Q2 conference call and would expect that to have a positive impact on our revenues for the third quarter as well as on the GMs for the third quarter”

**** Excerpts from Bank of America/ Merrill Lynch 09.18.09 SanDisk Report Below ****

SanDisk Corp Inc

Rating Change BUY
18 September 2009

Simon Dong-je Woo, CFA
Research Analyst
Merrill Lynch (Seoul)

Expecting up cycle; upgrade to Buy

Buy on better-than-expected cyclical momentum

We upgrade SanDisk to Buy from Underperform with a new price objective of US$30, which is derived from the average of our mid- and up-cycle fair values (vs. the average of trough- and mid cycle fair values previously). We target about 2x P/BV (PO implies 1.7-1.8x based on 2010-11E) vs. 2-4x during mid- and up-cycle periods (2002-07) or 1-2x in the recent downturn (2008-2009). The high P/E (19x 2010E EPS using our PO) is a concern, but we think it will be offset by a dramatic earnings recovery through 2H09 and 2010-11. We expect EPS to exceed previous high levels (2006-07) in 2010-11, but remain lower than the 2005 peak.

Tight NAND supply presents new catalyst

SanDisk differs from typical OEMs such as Apple due to its captive chip production (JV fabs with Toshiba) and the option to purchase chips from Samsung. Consequently, the best case scenario for SanDisk should be a NAND shortage. Our research shows tight supply of NAND due to chipmakers’ record low capex spending in 2009-10. Against this backdrop, we raise our ASP assumptions for SanDisk’s products by 30-40% for 2010-11, leading to EPS revisions of over 100% on a higher OPM (15-17% in 2010-11 vs about breakeven previously).

Financials and technologies look good

Financial distress no longer concerns us. SanDisk’s B/S remains healthy (over US$1bn net cash including long-term financial investments), despite large losses in 2H08-1H09. We also note the successful deployment of new technologies such as 3-bit cell (vs. MLC) and 32nm (vs. 43nm) – about one or two quarters ahead of Samsung. We think Korean chipmakers will focus more on DRAM capacity expansion vs. NAND due to relatively better margins and market share gains at the expense of Taiwan DRAM vendors. This also suggests upside to NAND.

Company Description

SanDisk, was founded in 1988 by Dr. Eli Harari who is currently chairman of the board and CEO, manufactures and distributes NAND chip based products such as flash cards, USB drives, solid state drives, MP3 players, etc. The company also receives royalty revenue from various NAND chipmakers and OEMs such as Samsung. SanDisk has large exposure to NAND chip fabrication via JV fabs with Toshiba in Japan.

Investment Thesis

SanDisk should be a major beneficiary of NAND industry recovery. NAND capex spending among chipmakers has been abnormally low in 2009. We expect this to lead to a NAND shortage and new business opportunities for SanDisk through the leverage of its well established JV fabs and options to use Samsung capacity – the JV fabs were company-specific weaknesses during the NAND downturn. We expect 2010-11 profits to exceed the previous highs of 2006-07 but still remain below the 2005 peak.

Expecting up cycle; a new Buy

We are no longer bearish on SanDisk. We now expect a solid earnings recovery in 2H09 and 2010-11. Our new forecasts for OP and EPS indicate an almost up cycle level of earnings through 2010-11 – surpassing the previous upturn average (2006-07) but slightly lower than the 2005 peak. Against this backdrop, we upgrade SanDisk to Buy from Underperform with a new price objective of US$30, which is based on the average of mid and up cycle fair values (vs. our previous PO of US$9.9 based on the average of trough and mid cycle fair values). We revise our EPS estimates by more than 100% due to dramatic changes to our ASP assumptions for SanDisk’s flash card products (about 30-40% higher for 2010-11 on a better supply and demand outlook for NAND chips).

We present five reasons for our SanDisk upgrade:

1. NAND supply-demand will be favorable for SanDisk NAND price, which is a function of supply and demand, is the biggest swing factor for SanDisk’s overall earnings momentum. Since SanDisk has in-house chip production capacity and the option to use Samsung’s fabs under license agreements with Samsung for its end products such as flash cards (note: SanDisk is not engaged in chip sales), NAND chip supply shortage (NAND price hike) warrants a competitive advantage vs. OEMs, which usually purchase NAND chips from Samsung or other non-Samsung NAND chip makers such as Toshiba, Hynix and Micron/Intel.

We acknowledge that our view on the NAND industry has been too conservative, and the NAND price recovery YTD (more than doubled in the past nine months) has been much stronger than expected. Both supply and demand data points have been favorable for chip prices in 2009 – weaker supply (record low capex growth) and stronger demand (upbeat demand from handset applications).  We believe this kind of favorable industry momentum will continue in 2010-11, due to:

(1) Korean chipmakers’ focus on increasing DRAM capex over NAND to take advantage of Taiwanese/Japanese competitors’ financial difficulties and delay of new technology adoption;

(2) Toshiba’s ongoing budget constraints for NAND capex increase – Toshiba’s net debt remains high at over US$10bn vs. about US$4bn EBITDA pa in 2009-10;

(3) Micron’s minimal capex increase for NAND fabs which are under JV with Intel – Micron has actively expanded its DRAM capacity by acquiring a 35.5% stake in Inotera (JV with Nanya in Taiwan) rather than NAND, while its strategic NAND partner, Intel, has also maintained a conservative approach toward new NAND JV fab construction, particularly in Singapore (only shell fab for now); and

(4) our industry analysis now indicates a potential NAND supply shortage if handset applications (NAND embedded smartphones such as iPhones and flash cards for handsets’ external slots) absorb the increase in supply from new technologies such as 20-30nm and 3-bit-per-cell – we are now modeling a slight shortage of NAND chips in 2H09, slight oversupply in 1H10, but shortage again in 2H10 and 2011.

2. OP and EPS will exceed previous highs

We previously thought upbeat 2Q results (OPM: +9% actual vs. our previous estimate of -10%) would not signal a cyclical recovery due to our conservative view on margin recovery and NAND price momentum. However, 3Q data points already reveal another round of upbeat earnings momentum at about 16% OPM (vs. our previous estimate of 7%) due to better-than-expected NAND chip and flash card price momentum. SanDisk is able to source required NAND chips from its JV fabs in Japan (about 30-40% of JV production) at lower than spot prices or JV fabs’ manufacturing cost plus a minimal mark up. This represents a competitive weapon for SanDisk during periods of NAND shortage vs. typical OEMs such as Apple, which purchases NAND chips from Samsung, Toshiba, Hynix and Micron/Intel.

Overall NAND demand remains solid, despite the chip price strength, due to new applications such as smartphones and OEMs’ promotion of high density flash cards for high-end products (eg, solid demand for 4-16GB NAND-based products in various applications such as MP3 players, USB drives, flash cards for handsets and game consoles, etc).

Against this backdrop, SanDisk has raised its flash card product prices for two consecutive quarters (2Q-3Q09) vs. our previous estimate of 5-20% price cuts each quarter. Overall, we raise our ASP assumptions by 30-40% and this leads to EPS revisions of over 100%. Of course our EPS estimates could be revised down on lower ASP projections, but we now expect much lower risks to NAND ASP and tight supply to meet demand in 2H09 and 2010-11. Based on this, we expect SanDisk’s OP/EPS to exceed the previous high level (2006-07) in 2010-11.

If all non-Samsung NAND vendors fail to execute their target spending in 2010, upside to our new estimates could easily be more than 20% on better ASP assumptions. Potential capex increase among NAND chipmakers is a concern but we don’t expect abnormally high capex in 2010-11 due to the capex budget constraints and high gearing ratios of all non-Samsung NAND chipmakers.

3. Potential profit taking shouldn’t be a concern

SanDisk’s share price has doubled YTD along with NAND price strength. This may lead to profit taking among investors who bought the stock early this year. However, the current share price reveals low P/BV multiples (1.5x based on 2009E book) vs. its historical average (2.2x during 2002-07). The stock traded at 1x P/BV during the deep downturn in 2H08/1Q09, but our new forecast suggests better than mid level of earnings momentum or even higher than the previous upturn period (2006-07). Therefore, we think any profit taking driven stock price correction would offer a good entry point for new investors.

4. Financial risks appear low

SanDisk’s net D/E ratio was negative 12% in 2Q09 (net cash), despite large losses in 2H08 and 1Q09. Further, the company’s cash and long-term securities investments (mainly US government and municipal bonds) amounted to US$2.3bn as of 2Q09, which is close to the sum of its gross debt (US$0.98bn) and guaranteed lease obligations for the NAND JV fabs in Japan (about US$1.2bn). We also note lower capex burdens for the JV fabs – less than US$1bn capex pa for the JV fabs for the long term vs. the previous high of US$1.9bn in 2007 and US$1.6bn in 2008. Our model shows EBITDA will remain higher than capex in 2009-11.

5. Technologies better than Korean chipmakers

Samsung is not yet actively using 32nm and 3-bit-per-cell (3bpc) technologies in its NAND chip production (mainstream: 42nm, 2-bit-per-cell). In contrast, SanDisk’s JV fabs have already ramped up scale production using 32nm and 3bpc (smaller chip size vs Samsung’s). Our analysis shows about 20-30% lower cost at 3bpc vs 2bpc. Hynix’s new technology deployment is also lagging that of SanDisk’s JV fabs. Hynix’s mainstream technologies are still 48nm/41nm with minimal exposure to 32nm and 3bpc. Micron has also recently announced its 3bpc technologies using 34nm but Micron’s NAND JV fab capacity is far smaller than SanDisk/Toshiba JV fabs’ (about 110k wpm vs. about 260k wpm). Although new technologies do not necessarily lead to better margins and cost advantages due to different manufacturing yields and product mix (sometimes old generation chips offer better margins), SanDisk’s proven technology leadership via the JV fabs in Japan should be a competitive advantage vs. Asian players including Samsung.

Implications for our DRAM/NAND sector view

We now have three Buy-rated stocks in our global DRAM/NAND universe – Samsung Electronics, Hynix and SanDisk. Of course this is based on the better- than-expected DRAM and NAND price outlook and their respective better than mid-cycle levels of earnings momentum. However, we still remain cautious on the remaining stocks we cover in the sector such as Taiwanese and Japanese memory chipmakers due to their relatively weak margins (large losses among Taiwan DRAM vendors and minimal profit recovery among Japanese chipmakers) and unfavorable financial structure (minimal shareholder value after debts). We acknowledge that our non-Buy rated memory stocks could also outperform if the global supply of DRAM or NAND is insufficient to meet demand, but we remain worried about their inferior competitiveness and high gearing ratios vs. our Buy-rated stocks.

Our answers to frequently asked questions

1.Does BAS-ML expect a hard landing in NAND after 3Q?

No. We expect a soft landing in both NAND spot and SanDisk’s overall earnings momentum through 4Q09 and 1H10, followed by a better-than-seasonal recovery in 2H10 due to chip supply constraints. We do not anticipate any new fab construction for NAND in 2010, just ramp-ups among existing capacity led by Samsung (US fab), Toshiba (Fab 4) and Hynix (M11). Thus, NAND supply in 4Q09 and 2010 will be highly dependent on utilization increases (already over 90% as of September) and die shrinkage on new technologies such as 32nm and 3-bit-per-cell. NAND supply growth cannot be higher than 50% a year (in bit terms) if chipmakers merely rely on chip shrinkage, while our model shows over 50% demand growth in 2010 led by high-end phones and USB drives.

2. Does recent NAND price strength inhibit demand growth?
Yes, but we anticipate minimal impact on demand from stronger-than-expected price hikes YTD. NAND chip and flash card prices are still lower than normal levels following deep erosions through 2007-08, in our view. Retail prices for  1-8GB flash cards and USB drives are in the range of US$5-20, despite YTD price hikes more than doubling, which is still affordable for consumers for external memory expansion for digital products and PCs. Our survey also shows low price elasticity among NAND products with retail prices below US$10-20. That said, we model about a 10-15% QoQ price decline in NAND flash card and USB drives after 3Q but this should lead to margin improvement if SanDisk executes its target cost reductions well on the back of new technologies. We also note solid demand for NAND chips from new applications such as smartphones in 2010-11 and SSD after 2010, even at a 30% pa NAND chip price decline vs over 50% in 2006-08.

3. 3Q results will be an earnings surprise?

Yes, we expect SanDisk’s OP to exceed consensus (our estimate: US$138mn vs consensus: US$52mn) on upbeat ASP and well-deployed new technologies in JV fabs.

4. How will 1H10 seasonal weakness affect momentum?

We model quarterly OP to be about US$90-100mn OP in 1H10 vs US$120- 140mn in 2H09. This could suggest profit taking among investors focusing on near-term earnings momentum. However, we interpret this as a soft landing before an almost up-cycle level of earnings momentum through 2H10 onward – a bigger impact from chip supply constraints on solid demand from seasonality and new applications such as high-end phones and SSD.

5. Can chipmakers raise capex spending on NAND upturn?

Not easily. Including Samsung, all memory chipmakers will likely focus on technology upgrades rather than new fab construction. Further, balance sheets and cash flow at most non-Samsung NAND chipmakers’ are unlikely to remain healthy enough to be aggressive on capex spending in 2010. Samsung management has also addressed its more disciplined capex behavior well despite more visible macro recovery. No Taiwanese DRAM vendors will enter the NAND industry, at least in 2010-11, due to their prioritizing DRAM fab upgrades and ongoing budget constraints for overall capex.

6. Could SSD become upside catalyst?

Not for 2H09 or 2010, due to HDD’s relatively superior cost advantages vs SSD (SSD price is still over 5x higher vs HDD). Our demand model still shows a low contribution of SSD to total NAND demand (9-10% in 2009-10). This is in line with more conservative SSD guidance from Samsung and SanDisk. However, in 2011 or thereafter, SSD should lead overall NAND demand growth along with high-end handsets and USB drives (as external storage for PCs), competing strongly with HDD (the SSD price should be close to HDD for storage below 100GB in 2011).
7. Is M&A theme still valid?

No, Samsung has already addressed the termination of its plan to acquire SanDisk at various analyst meetings. We do not expect any chipmakers or OEMs to try to take over SanDisk unless SanDisk management offers a good M&A price (eg, Samsung’s offering price of US$26 was rejected by SanDisk’s BoD).

8. Long-term competitive landscape?

Samsung and Toshiba/SanDisk JV fabs should continue to occupy about 80% of NAND global market share. The rest (about 10% for each) should be for Hynix and Micron/Intel JV. Renesas (Japan) has already given up its NAND business and newcomers such as Powerchip have also suspended spending on NAND capacity expansion. Thus, the NAND industry will likely be dominated by two big camps, Samsung and the Toshiba/SanDisk JV, for a while.

Price objective basis & risk

We use three valuations to derive our PO of US$30.0. First, the average of mid- and up-cycle fair values based on long-term sales growth and OP margin assumptions at 14% and 15%, respectively (trough-cycle US$18, mid-cycle US$26, up-cycle US$40). Second, 2.0x P/B based on 2010E/11E book value vs historical average of 2.2x P/B. Third, DCF at 12% WACC. Per-share non-core asset book value from securities investments and JV fabs in Japan appears over US$10, which is included in our DCF valuations apart from business value.

Downside risks: (1) unexpected NAND price decline, (2) aggressive capex increases among chipmakers, (3) weak demand from new applications such as smartpohones and SSD, (4) a capacity shift from DRAM to NAND among Korean chipmakers, (5) execution risks to deploy new technologies, and (6) unexpected equity financing.

Upside potential: (1) NAND price strength coupled with more conservative capex among chipmakers, (2) stronger demand from high-end phones and notebooks, (3) market share gains on the back of well-established new technologies such as 30nm and 3 bits per cell, and (4) higher royalty revenue alongside NAND industry recovery.


One Response to BoA-ML Etc

  1. Poofypuppy says:

    Hi Savo,

    Hope you had a nice vacation to Yosemite and CA.

    Great post, thanks as always. I have to chuckle (and feel a tad cynical) when an analyst, who was way behind the pack (e.g. “Sell” rating on SNDK with a price target of $10, when the share price is already at $20), then does a 180-degree flip-flop to try to lead the “Buy” parade with a price target of $30.

    That said, I’m inclined to think/hope that Simon is more right than wrong this time around. I especially like the part about SanDisk (and Toshiba) being ahead of Samsung, Hynix, and Intel/Micron on the 32nm, 3bpc front. That is excellent news, and doesn’t require complex financial modeling or demand forecasting to understand the advantage to be had from that.


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