Whereas the last post looked at the headwinds SanDisk will be facing in 2011, this post will look at the tailwinds.
In many respects the tailwinds are more complex, or at least don’t fit neatly into categories. The promise for 2011 and 2012 can be found in the underlying dynamics of 2010.
2010 was a rather spectacular year for SanDisk.
Booming markets and a strong supply/demand environment are a powerful combination. Sometimes SanDisk was a grinder of a locomotive. Sometimes jet propelled. Sometimes both.
Mobile emerged as a mega-market with multiple subsegments including most importantly smartphones and tablets.
NAND became a strategic component in the mobile internet ecosystem.
SanDisk rode this exploding demand to record revenue, record gross margin, record operating margin, record profits and record cash flow thanks in large part to its OEM wins.
SanDisk was able to optimize pricing and profitability thanks to its product mix, its range of channels and its broad set of customers.
This post, like the last, is primarily based on SanDisk’s CFO Judy Brunner’s presentation at this year’s analyst day in February. Judy spent quite a bit of time on the relationship between cost reduction, pricing and gross margins.
Rightly so as this is the key dynamic driving the tailwinds.
Cost Reduction, Pricing, and Gross Margins
The top graph on the slide above shows cost reduction vs price reduction. The scale starts at zero and moves upward with negative numbers- a bit unusual.
The higher cost reduction, the better.
The lower the price reduction, the better.
The larger the gap between the two, the better for product gross margins.
Which are graphed correspondingly on the bottom half of the slide.
In 2010 SanDisk delivered 46% cost reduction on a per GB basis. As SanDisk has been saying for some time, the ability for the industry to reduce cost is slowing down. And that is reflected here.
From 2005 through 2009, SanDisk’s cost reduction was between 50 and 55% per GB every year. In 2010 it was 46%. Although lower, SanDisk believes that this was still industry leading cost reduction.
SanDisk believes that it is the industry leader in terms of actual cost.
The 46% cost reduction in 2010 reflected the very strong performance of its 32nm transition and the increasing usage of X3 within its products.
In terms of the price reduction, SanDisk reported 19% reduction in ASP/GB, in line with industry price reductions.
This is notable, because during 2010 SanDisk expanded the OEM mix of its business. SanDisk went from 50% OEM in 2009 to 62% OEM in 2010.
SanDisk’s OEM products carry a lower ASP/GB. Also within OEM SanDisk expanded the embedded portion of its business quite a bit.
And embedded products tend to carry higher average capacity.
Moving up the average capacity curve leads to a lower ASP per GB. So the fact that SanDisk was able to expand OEM, expand embedded and still deliver price decline- ASP/GB decline in line with the industry- says a lot about its ability to achieve a price premium in both retail and in OEM while optimizing its pricing across its broad set of customers and broad set of products.
The gap that SanDisk was able achieve in 2010, the gap between cost decline and price decline, 46% vs 19%, allowed SanDisk to deliver record product GMs- 43%, a full 30 points improvement from the underlying product GM achieved in 2009.
And then 2011 arrived.
As described in the last post, SanDisk has hit headwinds in Yen exchange rates, non-captive mix and Fab 5 start-up costs. Added together these headwinds were expected to shave 7 to 9 points from 2011 product gross margins, before the March Tohoku earthquake and tsunami hit Japan.
This catastrophe resulted in Toshiba/SanDisk fab downtime, supply constraints and increased requirements for non-captive supply.
All additional downward pressures on product gross margins.
If this were the end of the story SanDisk would be in a world of hurt.
As it turns out the underlying strength of the business is pushing back. At analyst day SanDisk thought these tailwinds would add back a couple points of gross margin for 2011. The 7 to 9 points down from 2010 would end up only 5 to 8 points down.
At the Q1 conference call in April, these couple of points of recovery had grown to a half dozen. The total non-GAAP gross margin range for 2011 was raised to 41% to 44%.
Compared to the record 46% non-GAAP gross margin of 2010, 41% to 44% is quite respectable.
Given how things are going another bump up could be coming with Q2 results.
So what’s behind this optimism?
At the 2011 Analyst Day in February, Judy pointed to four potentially positive factors to watch for in 2011. Its probably a safe bet that at least two or more of these factors is doing better than expected.
24 nm, X3, Memory & Non-Memory Cost Reduction and Pricing
The key driver of cost reduction during 2011 will be SanDisk’s transition to 24 nanometer. In the Q1 conference call Sanjay Mehrotra, SanDisk’s President and CEO, noted that the 24 nanometer technology, utilizing both 2-bits per cell and 3-bits per cell architectures, continues to ramp well and is expected to account for the majority of SanDisk’s captive output in the second half of 2011.
Sanjay also noted that SanDisk doesn’t anticipate the recent events in Japan to cause any meaningful changes to the schedule of the ramp of 24 nanometer or the recently announced 19 nanometer technology.
In the Q1 conference call Judy wouldn’t give specific projections on a quarter-by-quarter basis, other than to say that the transition started in the fourth quarter of 2010 and is progressing across 2011.
The transition to 24 nanometer is not the only driver of memory cost reduction per GB. X3 mix also plays a part. SanDisk went from essentially zero X3 in 2008 to 50% X3 in 2009. In 2010 SanDisk achieved greater than 50% X3 usage.
For 2011, SanDisk has again projected greater than 50% X3 usage. As OEM embedded is becoming ever more important, this is one to watch closely. SanDisk says that it is making very good progress in getting X3 adopted into embedded solutions, but won’t get more specific than that.
Non-memory cost includes things like transformation costs and non-memory materials. Non-memory cost reduction per GB was higher in 2009 than in 2010. SanDisk was able to reduce non-memory cost per unit about the same in both years- about 35% per unit in both years. But average capacity grew less in 2010 than it did in 2009.
Increased scale helps with both memory and non-memory in terms of reducing SanDisk’s cost per GB. SanDisk is expanding its Shanghai Assembly/ Test Facility.
Last, but not least is pricing. Suffice it to say that NAND pricing has been strong and looks like it will continue to be strong throughout 2011.
When all is said and done for 2011, it seems entirely possibly that tailwinds might cancel out the significant headwinds.
Another bump or two and gross margins will be back at 46%.
If this is how it goes, 2011 earnings will profit.
The big deal though will be 2012, when the headwinds look likely to lighten up.