SanDisk (SNDK)

The big news in semiconductors was the possible takeover of SanDisk by Samsung on Friday, 5th Sep 2008. Let’s for a second assume that Samsung [which already has close to a 50% market share in NAND flash] can indeed acquire SNDK [the #2 player with a little over 10% market share] - and keep the US and EU anti-trust gods happy……

The question of the day is, “how much will it cost Samsung to acquire SNDK?”. There is a short answer and a long answer. The short answer is - not just SNDK’s enterprise value. The long answer is SNDK’s enterprise value plus off-balance sheet obligations [but, paying for these obligations buys SNDK the wafers they need to make chips]. Barrons’s published an article a month and a half ago on how SNDK’s off-balance sheet obligations will affect everything. I think that it is a non-issue I am sure that there is a dozen lawyers looking over SNDK’s obligations that total a whopping $6.5 Billion, of which $1.8 is due within twelve months. Now, why does SNDK have these huge “obligations”?

While SNDK claims to be fabless - and they are in the purest of definitions of fabless, fabless; they have partnerships with various fabs - and, on a rolling nine month projection basis, guarantee to buy a certain number of wafers at preset prices. Sure, SNDK needs these wafers to make their chips, but SNDK also guarantees leases on property, plant and equipment. Out of the $1.8 Billion due in the next twelve months,

a. $1.05 Billion was for fab capacity expansion - including p.p.e and depreciation b. $225 M was for operating expenses c. $474 M was for the purchase of wafers [that SNDK needs to make chips].

Toshiba [which benefits from SNDK's off-balance sheet obligations] is betting huge sums of money on future SanDisk technologies - including a hair-brained 3D cell, which I guarantee will not work. In fact, SNDK hedges in their own 10Q filing and says “For example, our competitors are developing new technologies such as charge-trap flash and three-dimensional technology which if successful and if we are unable to scale our technology on an equivalent basis, could provide an advantage to these competitors“. I think that SNDK has more to fear from Seagate than from 3D or charge-trap based technologies. Also, SNDK will generate royalty and licensing revenues of almost a half a billion dollars in this fiscal year. 70% of this is from Samsung, and this agreement needs to be renegotiated in August of 2009 failing which, SNDK’s financial results will be adversely impacted. Samsung could easily get rid of this $350M/year in royalties and licensing fees by acquiring SNDK.

SNDK’s management is tenacious, always ahead of the curve, and the company makes sure that their engineering and marketing groups are always alert and firing on all cylinders. Since I know too many people who work at SNDK, I will not be too specific or share stories in this note - but will gladly share my thoughts with you over e-mail.

My take: 1. SNDK is uniquely positioned to win the NAND Flash wars. 2. I think that SNDK has one of the most aggressive and successful management teams in the semiconductor industry. Their entrepreneurial spirit will be snuffed out as a Samsung subsidiary [as opposed to them staying independent]. 3. SNDK receives over $500M/year in licensing and royalty revenues, and should be able to renew the agreement with Samsung - without having to litigate. 4. SNDK has a unique fabless [yet with fab obligations] business model - that other companies may want to look at in order to emulate. 5. SNDK’s finances are excellent [once you admit the fact that without the fab agreements in place, they cannot stay in business]. 6. SNDK currently trades at the low end of its PS ratio [which I think of as a useful evaluation criterion for cyclical semiconductor companies]. 7. Historically, SNDK has come out of semiconductor cycles - roaring. Bottom-line: I do not want Samsung to acquire SNDK.

Notes: 1. Bapcha is long SNDK. No positions in other companies mentioned. 2. SNDK’s latest SEC 10Q filing.

Bapcha Published Sep 7, 2008 at http://www.bapcha.com

SanDisk has been the leading supplier of flash memory cards for years and its solid reputation for quality and innovation will keep SanDisk atop the industry in the future.

As the leader in flash memory spending over $260 million annually on R&D, SanDisk is likely to be at the front of any cutting-edge flash memory technology breakthroughs.

Semiconductor stocks worth buying. Verbatim from http://www.bapcha.com

Q: When is it the correct time to buy into a cyclical stock/company/industry ?

A: The correct time to nibble is when the leading company is losing money - while the second and third tier companies have NO pricing power. The clear time to by more is when pricing power returns to the industry - through consolidation, or evolution, or by companies abandoning the industry.

Keeping in mind the above, it is time now to start nibbling at semiconductor stocks. In the semiconductor industry, there is one clear leader - Intel. Then, there is everybody else. Sure, some companies have a limited ability to price their products at levels wherein they make a reasonable amount of money; in prior articles, I talked about Linear Technology (LLTC) and Maxim (MXIM) - each with gross margins in excess of 70%, and then, about ARM Holdings (ARMH) - whose gross margins exceed 85%.

But each of these companies have their respective problems. In the case of Linear, it is the inability of the company to grow its sales. Maxim was [until recently] tainted by a serious allegation of back-dating options; and ARM has a lag of five years from new product release to the time when they receive even a dime in royalties [I am talking about their processors that account for over 80% of revenues].

My criteria for picking semiconductor stocks are based on: a. Gross margins. b. Debt to equity ratio. c. Competitive position (product/technology), pricing power [subjective]. d. Management (subjective). e. Cost structure (technology dependent). f. Valuation - especially price/sales ratio (dependent on a and c).

Keeping in mind that I do not use automated screens [though I sometimes do that as an after-thought], I focus on companies that I know and am familiar with.

The finalists are:

1. SanDisk. SNDK is the best run Flash memory company. #1 Company - Samsung is not really analyzable as it is a conglomerate, and are not subject to SEC filings. The only chink in SanDisk’s armor is their off-balance sheet liabilities outlined in paragraph two and three of the SanDisk/Samsung article that I published in the recent past. Add $6.5 Billion to SNDK’s current enterprise value of $2.25 Billion (at $10/share), we end up with $8.75 Billion. In the last three months, SNDK had negative gross margins on the sale of products. In fact, it was a negative 17.5%. In the trailing nine months, SNDK’s product gross margins were +3.3% - fantastic numbers when compared to their competition. If one adds I know that SNDK is working aggressively at shifting products to tighter geometries, and are targeting higher-end flash markets - where, while pricing is still weak, SNDK has more pricing power when the memory is packaged as a SSD - for an ultra-light/pricey laptop [think MacBook Air].

I expect Dr. Eli [Harari] & Co. to position SNDK to have positive product gross margins in as quickly as nine months (calendar Q3, 2009) - through the process of migration to tighter geometries; by successfully cramming in more “bits” per cell, and through manufacturing efficiencies. Add to this their stream of royalties, SanDisk’s focus on non-volatile memory (unlike its competitors), and SNDK’s efforts to successfully rein back some smaller competitors in Taiwan, SanDIsk emerges as the clear winner from the investment perspective.

2. nVidia. NVDA competes with the ATI division of AMD, and Intel’s (INTC) own graphics chip division. nVidia’s graphics cards/chips span the entire spectrum of graphics chips from smaller chips for PDA’s and cell-phones - to graphic cards that control multiple large-screen monitors, and have several GigaBytes of on-board GDDR DRAM - that cost as much as $2500 a card!

While the analysts’ average of earnings for the announcement on Nov 6th 2008 is a dozen cents a share, I expect them to earn not more than a nickel a share, and while NVDA was victorious in securing the design-in into all Apple laptops, the gross margins will be below what it was [prior to the quarter when NVDA took a charge for a manufacturing/reliability problem]. This is detailed in a prior article of mine. NVDA’s financials are pristine, and the current valuation is compelling. With no debt and $3/share in cash, and Jen-Hsun Huang at the helm, I am sanguine about NVDA’s future - though the graphics market is lined with road-kill with once mighty names like Chips & Technologies, S3, Tseng Labs, Cirrus Logic [the first two were acquired cheap]. Even NVDA almost went belly-up, and this is the reason why I think they will survive - despite the competitive nature of the business. Additionally, operating systems are being targeted to use the spare processing capacity of GPU’s [both Apple's Snow Leopard and Windows 7 will target the ability of the GPU and graphics' memory].

3. Silicon Storage Technologies (SSTI) and Spansion (SPSN). While these are at best second tier players in NOR flash [with some exposure to NAND Flash], both companies have positive gross margins, and SSTI in particular has no debt and cash per share of $1.10. SPSN is a case when the valuation of a company is ridiculously low. For a $2.4 Billion/year business with positive gross margins, the only company with a working SONOS Flash chip, and a debt/equity ratio of 1.0 [but managed to refinance the current portion of their debt recently], I wish I had a hundred million dollars to buy out SPSN.

Disclosures: 1. Long SSTI, SNDK. Will possibly be long SNDK and NVDA in the near future. ©Bapcha’s Stocks, Nov 4, 2008.

I was talking to a couple of people I know, and e-mailing a few more regarding Samsung’s $26/share offer for SanDisk - and SNDK’s prompt rejection of the [as it is now] - friendly overture from Samsung. So, the question was - is a hostile takeover is SNDK possible at all?

For starters, Eli Harari is an excellent CEO, and SNDK is his baby - a symbol of all he has accomplished successfully as a technologist and a businessman. He is proud, and has a modicum of ego (actually, a lot more than that), and cannot imagine himself playing second fiddle to someone in charge of building ships and chips at Samsung. He has built a fantastic business out of making non-volatile memory, and portable music devices (SNDK’s Sansa - though a distant second to the iPod, has sales that are at least thrice that of MSFT’s Zune).

Secondly, there are two anti-takeover provisions in the 8K that I pulled from the SEC Website. Quoting verbatim from the filing referenced in the previous sentence…..

“We have taken a number of actions that could have the effect of discouraging a takeover attempt. For example, we have adopted a stockholder rights plan that would cause substantial dilution to a stockholder, and substantially increase the cost paid by a stockholder, who attempts to acquire us on terms not approved by our board of directors. This could prevent us from being acquired. In addition, our certificate of incorporation grants the board of directors the authority to fix the rights, preferences and privileges of and issue up to 4,000,000 shares of preferred stock without stockholder action”.

In short, they have not one, but TWO ways to stave off a hostile takeover. In addition to these anti-takeover provisions, Toshiba, that benefits from SNDK’s off-balance sheet obligations that I outlined in a previous article, has already said publicly that a Samsung takeover of SanDisk will not go uncontested. Plus, it will corner SNDK between a rock and a DMZ south of North Korea - especially as it applies to Flash Partners I & II - since Samsung has enough Flash capacity to meet all of their, and SNDK’s needs.

Yet, a deal can be consummated if Eli wants one…… Bapcha Published on Sep 16th 2008 at http://www.bapcha.com Disclosures: Long SNDK.

SanDisk's substantial licensing and royalty revenues protect it from any temporary shortages in demand for flash memory that could seriously damage most of its smaller competitors.

SanDisk 2GB SD Card is edging out Apple in the traditionally frenetic Christmas week shopping on Amazon.co.uk’s Electronics & Computing section.