SanDisk was founded in 1988 by Dr Eli Harari who remained Chairman and CEO until the end of 2010. The company is a world class, pure play, technological innovator in NAND flash memory storage which is used in a wide range of devices for which traditional spinning disk storage isn’t appropriate such as digital cameras, USB drives, tablets, smartphones and certain high end laptops. The company also receives royalty streams from various competitors such as Samsung for the use of their technology.
I first came across SanDisk when researching the industry of a previous holding Western Digital, but I didn’t dig too deeply until I saw it mentioned in the T2 Partners year end letter as one of their top 10 holdings. Of course the reason that Western Digital was so cheap was because the HDD business is in secular decline, mostly because of the increasing capacity and affordability of the products produced by SanDisk and its peers.
SanDisk stock presents an excellent buying opportunity because the current price meaningfully underestimates the future cash flow potential of a company that is intertwined as a vital facilitator in the growth industry of smartphones, tablets and increased data storage globally in enterprise and in our private lives. I view SanDisk as a high quality Growth at a Reasonable Price idea. It is also a “Magic Formula Stock” which means that it is attractive on a purely quantitative basis. I can see the stock trading well into the $60-70 range over the next year or two offering 50-70% upside.
You probably recognise the name from memory cards for your digital camera or USB stick but that was the SanDisk of 2008, the rest of the world has begun to catch up to their technology which is increasingly embedded in all high end computer devices.
Imagine 128GB of memory inhabiting something smaller than a penny. SanDisk has just made it a reality, in its relentless, market leading pursuit of better, smaller, faster flash memory storage solutions.
SanDisk specialises in NAND Memory which is a type of non-volatile storage technology that does not require power to retain data. NAND flash has found a market in devices to which large files are frequently uploaded and replaced. Mp3 players, digital cameras and USB drives use NAND flash. Flash memory is much more expensive than traditional HDD memory, but it is more compact, durable, offers faster access and uses less power, so its usage has grown dramatically with the proliferation of mobile computing and the increasing sophistication of peripheral electronic gadgets. A consensus is emerging that flash drives will be used for requirements of speed and power efficiency and older HDD’s will be used for needs of capacity. Online transactional processes and high frequency trading are two good real world examples where SSD has a functional advantage worth paying for.
To quote Whitney Tilson in T2 Partners year end letter…
“Historically, the flash memory business has been commodity-like, with chronic excess capacity and rapidly declining prices. Due to industry consolidation and explosive growth in end demand, however, we think SanDisk is on the verge of very strong secular growth, with improving margins, which should lead to explosive profit growth and a meaningful revaluation of the stock. The best stocks are ones that combine high earnings growth and an expanding multiple on those earnings, and we think SanDisk is poised for both.”
SanDisk is an industry leader and has two very important strengths that should lead it to sustained success: its distribution channels and its low cost leadership. First, it has a strong global reach with 57 percent of its sales being international and has at least a 28 percent market share in all parts of the world including a 34 percent market share in the United States and a 32 percent market share in Europe. Second, the company has a lot of relationships with consumer hardware companies including Apple, Samsung, HP, Dell, Nokia, Motorola, and HTC.
When these companies’ products are bought, they come embedded with a SanDisk storage device, so consumers become familiar with the SanDisk brand and are more likely to use the SanDisk memory devices. Third, the company’s products have a very strong retail presence. SanDisk reports that its products are available at over 250,000 stores worldwide and are available at 19 of the top 20 consumer electronics retailers in the United States.
SanDisk is able to use its high cash flow and position at the front of the market to fund research to cut costs and stay ahead of its competitors. This way, it can outprice them, maintain and expand on its market share, and increase revenues and profits.
The NAND market is mature and oligopolistic with a few major players dominating supply (Samsung, SanDisk, Micron and Hynix). Furthermore Apple currently constitutes around 30% of global demand for NAND storage and has the influence to move prices based on their new product releases.
The NAND market has doubled in size in the past 5 years, going from $12bn in 2006 to $25bn in 2011. The multi-year growth story looks likely to continue due to growing demand from smartphones, tablets, notebooks etc.
To emphasize the rate of change and growth we are seeing here, we can pretty much say that tablets didn’t exist 3 years ago and now they are an integral part of many lives.
A slide below with a selection of consumer end products that SanDisk memory is embedded within.
SanDisk is probably the industry leader for innovation and technology as evidenced by their being the first to produce sub 20nm scale of miniaturization, something which was previously thought impossible. The jargon at this point begins to bamboozle me but I read that they were the first to design, patent and sell a “4 bit per cell architecture at 43nm node” and that a greater proportion of their production and sales are done at the cutting edge of technology than their peers. This is demonstrated in the use of their “X3 Technology” which has a 15-20% cost advantage over what the competitors are using and is in around 50% of SNDK production.
One of the biggest concerns to pricing power in the industry is that supply outstrips demand, due to a downturn or exuberant expansion of capacity from suppliers. Pricing is volatile in these markets and this was one of the problems faced by HDD producers leading to volatile quarterly earnings. The participants in the NAND market appear to be behaving rationally and all are talking about cautious expansion of capacity in line with demand and no-one seems willing to slash prices to take market share. On top of this, only SanDisk (35%) and Samsung (40%) have sufficient scale to materially affect the capacity growth of the total industry. SanDisk has also indicated they will use “non-captive” supply which essentially means outsourcing production as that retains flexibility, enhances cash flow and protects them from building out excess capacity in house. This is prudent although it is not profit maximising, non-captive supply has margins of around 10% relative to 40% for their own supply.
In summary, it seems that the participants are all acting rationally and although supply growth will be healthy as manufacturers expand their facilities, it will be not be sufficient (on current ramp up forecasts) to remove the tightness in the market due to the superior demand growth. This means that margins and profitability are likely to protected and the curse of excess capacity is less likely to plague the industry.
SanDisk has taken steps to move away from the retail/consumer market which it traditionally served with its USB sticks and memory cards towards servicing businesses, a market which is currently growing faster. With their May 2011 acquisition of Pliant Technology for $318m, SanDisk is ready to exploit the full range of possibilities in the market by producing high performance solid state drives (SSDs) to transform cloud and data center applications by reducing physical office space requirements, purchase cost and power usage.
Within the mass storage market there is increasing focus on “speed of access” to data rather than purely cost per gigabyte, this switch obviously favours NAND over traditional HDD. This adds just another element to the potential growth story in the flash storage market.
Toshiba JV in Japan
SanDisk does not directly produce their flash drives, they do so via a JV with Toshiba in Japan. The benefit of this is cost sharing and a reduction in the capital intensity of SanDisk’s business. These high volume manufacturing facilities allow the company to ship more than two million flash products every day, and have contributed to a 50,000-fold reduction in the cost of flash memory over the last 20 years.
This is listed as an asset on the balance sheet marked at a value of $2.2bn however in reality it produces no profits to SNDK and costs them money each year as it is essentially their factory. The properties and capacity is clearly worth a substantial sum if they were to sell their share back to Toshiba however.
SanDisk has a portfolio of patents and is not shy about litigating to protect them. In addition to its NAND products SanDisk benefits from IP royalties it receives to the tune of around $350m per year from licensees like Samsung and Hynix for using their patented technologies. Because of the nature of these revenues they cost SanDisk nothing and come in as near pure profit. The fact they receive these royalties is testament to their technology leadership within the industry.
SanDisk has a rock solid balance sheet with $5.5bn of cash, short term investments and marketable securities against long term debt of $1.6bn equating to a net position of $3.9bn, 39% of the market capitalization or $16 per share. SanDisk has the strongest balance sheet amongst the 20 largest semiconductor companies according to Nomura.
In October 2011 SNDK announced a buyback programme totalling $500m over the next 5 years. They have previously completed a 2 year $300m program over just 12 months in 2006 so I am hopeful they will be accelerating the purchases at current prices. In Q3 2011 they also retired $222m worth of convertible debt, further strengthening the balance sheet.
The Apple Opportunity?
Apple is the most important individual customer to the entire NAND market accounting for 30% of global demand and around 10% of SNDK revenue (does the market even know this?). Apple is popularizing the benefits of flash memory in its many consumer products however it is possible that Intel will advance the cause further by adopting them in their ultrabook for the consumer and enterprise spaces. Is this the first sign of a move away from HDD for even laptops? Once you have experienced the immediacy of flash memory it is quite evident that HDD is an inferior product.
Apple has an increasingly litigious relationship with Samsung which has the potential to put their major strategic NAND relationship in jeopardy, throwing up an opportunity to steal the market’s biggest customer. It could be argued that only the SanDisk/Toshiba JV has the scale and expertise to step up and take Samsung’s place as supplier number one to Apple – Micron and Hynix are just too subscale. News on this could be a major catalyst.
Certain people have even suggested that it makes sense for Apple to just buy SanDisk to secure supply and use some of its massive cash pile. Certainly the SanDisk earnings would be awarded a much higher multiple under the Apple banner. Seems unlikely but something to think about.
The Cloud – Opportunity or Threat?
In 1999, the idea of a new paradigm pushed the multiple on anything related to the computer industry or the internet to dizzying highs. Since then it has been a relentless grind lower and it’s simple to explain why; the industry had no revolutionary themes for investors. Tech investors are by their very nature growth orientated innovators, they don’t like the incumbents, they like the disruptors. As Ben Rogoff of Polar Capital’s Technology Fund joked to me once regarding my value orientation “Don’t bring your sh*t to MY party!” Interestingly, he observed that historically tech investors have seldom made money after the multiple on stocks in the sector has contracted, the money is made when these growth stocks go from expensive to extremely expensive during the adoption phase. Now, the industry and investors have found a new revolutionary theme: cloud computing. The “marquee” cloud name is Salesforce.com and it trades on something like 600x earnings.
“Cloud Computing” is defined as “The practice of using a network of remote servers hosted on the Internet to store, manage, and process data, rather than a local server.” The threat is that we no longer need hundreds of gigabytes of storage in every home as we download everything we need from a central library in the cloud. If network speeds are high enough, why would anyone need local storage? This would mean the total storage required would vastly reduce and the storage market NAND and HDD would shrink dramatically. This is the reason that SanDisk trades like a stock in run-off mode.
YouTube quoted their database at 45 Terabytes in 2006 and by 2011 they were saying 9000 Terabytes. This growth seems likely to remain exponential for the foreseeable future as more leisure time is spent online. The one thing we can all probably agree on is that “content” will continue to be produced, arguably at an increasing rate due to the democratization of dissemination that home studios, webcams, YouTube, blogs etc have all brought about. Furthermore the quality and size of the content is increasing, whereas previously a movie video file was 700MB now an HD movie can consume 4 or 5 gigabytes, a six-fold increase. Content is cumulative too, books written 300 years ago are getting digitized and adding to a global library alongside blog posts and video diaries created today. Content production of any sort requires storage, and whether it is stored on the cloud, on an external hard drive, on a tablet, on a smartphone or all of the above – it WILL be stored somewhere.
We should also remember that there are major security issues involved in cloud storage. How safe really is it? Can it be relied upon 24/7, 365 days a year as most businesses will require? What you might find is that the cloud is viewed as the great big back up drive in the sky and all data is still duplicated on the ground for daily and immediate use/security – good news for SanDisk and their total addressable market. I think it will take years before we all truly trust “the cloud” to be our one and only source for data.
Remember, it was once thought that the development of the PC would lead to a “paperless office”, clearly reality has borne out something quite different! The threat of “the cloud” might be similar.
Sensitivity to Yen Weakness
For the past 5 years SanDisk has been suffering due to relentless Yen strength which has consistently surprised macro commentators. This Yen strength against the Dollar acts as a major headwind to SanDisk earnings as their wafer purchases from the JV with Toshiba which are denominated in Yen. It has been estimated by analysts, and commented on by the CFO, that roughly 1% depreciation in the Yen drives a 1% increase in EPS. SanDisks investments into the JV are also denominated in Yen and therefore their future funding exposure will cost less in a weak JPY environment. Given the overvaluation of the Yen and the arguably extreme fiscal/demographic issues the country faces I would expect material Yen weakness at some point over the next few years. To quote John Mauldin, “Japan is a bug in search of a windshield”. At some point, “speculators” and “bond vigilantes” will turn from the Euro crisis and they are far more likely to look East than to look to the US.
SanDisk management have suggested that they believe the stock is currently trading below liquidation value – this is why they have in place an aggressive buyback programme to reduce the share count and maximise shareholder value. Their breakdown of value is below with one adjustment I made to make it more conservative; they used just Debt of $1.6bn rather than Total Liabilities which I swapped in. Management calculations result in a liquidation value of $42 per share.
JV Wafer Capacity at 50% of value – $2.9bn
Accounts Receivable at 50% of value – $0.119bn
Inventory at 50% of value – $0.24bn
PPE at 50% of value – $0.135bn
Cash – $5.5bn
Royalty Value ($350m x 10 multiple) – $3.5bn
Total Liabilities – ($3.2bn)
Total = $9.194bn
Shares Outstanding = 243 million
Liquidation Value per Share = $37.83
Given the Margin of Safety demonstrated above in the Liquidation Scenario we can approach looking at a target price with some conservatism. In general, I think if you can’t find that a company is cheap on the back of an envelope it’s not worth doing more work on it. If you do enough Gerrymandering and “assuming” you can make anything look cheap. You can also lose a lot of money.
Analyst estimates for 2013 FCF per share is $7.70 which we can reduce by 20% to account for analyst optimism taking it to $6.16.
Taking the current share price of $42.
$42/$6.16 = 6.8x 2013 FCF or a Free Cash Flow yield of 14.7% per annum.
Let’s also assume that the cash and marketable investments stays flat at $16 per share which is again, probably conservative. If we net off this from the share price then we are looking at $26/$6.16 = 4.2x 2013 FCF or an ex-cash Free Cash Flow yield of 23.8% per annum.
If we use the analyst estimate numbers without reducing them for their optimistic bias then we are looking at an ex cash 2013FCF multiple of just 3.4x!
Based on a reasonable multiple of 9x a conservative FCF estimate plus the cash & investments gets you to a share price of $71.44 or a 70% premium to today.
There may even be upside to these numbers based on the effective deployment of buybacks at low prices, a substantial weakening in the Yen and the potential for the acceleration in the rate of change in technological adoption by enterprises and consumers.
I see a lot of similarities between SanDisk and my investment in Western Digital last year. The industry is generally seen as unattractive due to the requirements of constant innovation to keep pricing stable, cyclical demand, threats of “the cloud”, the commodity nature of the product etc. I would make two differentiating points – SNDK operates in a much faster growing industry than WDC or Seagate, they are in a sense the disruptors and furthermore, at the price WDC was offered at last year it was a good investment regardless of growth, I think SNDK is priced just as cheaply today despite a much rosier outlook.
The bear argument on SanDisk is that the company’s margins will erode as current and new competitors offer cheaper versions of similar products that SNDK provides. I would address these concerns twofold
1) SanDisk has the scale and technological expertise to make it the low cost producer in the industry, it would be difficult for someone to maintain profitability whilst trying to steal share via price. For example, in their retail business SanDisk has a 15% price premium to competitors as customers are willing to pay for the brand.
2) The market for flash memory cards and SSD’s will continue to grow at a fairly spectacular rate and growth can hide a multitude of sins.
SanDisk would have to lose a lot of pricing power and market share to experience large declines in their profitability.
It is comforting to see that SanDisk is a stock where a number of high quality hedge funds have a stake. This is re-assuring because it shows that their analysts (whom I assume are of a pretty high quality given the funds historical performance records) are obviously similarly attracted to SanDisks GARP qualities. Viking Global own $160m of stock, Third Point own $35m of stock (down from $70m in 2011), Balyasny Asset Management own $10m worth and finally T2 Partners own $8m, which I believe is around a 4% position for them. Finally, Joel Greenblatt also owns the stock for his Magic Formula fund.
Insiders also own a substantial amount of the stock too, founder Dr Eli Harari owns $162m worth of stock which he added $3m to in February 2012. CEO Sanjay Mehrota owns $1.8m worth of shares. Catherine Lego, a director, owns $12m and the Chairman, Michael Marks owns $2m.