Sandisk (NASDAQ:SNDK): Into the Strait of Messina; Downgrading to Underperform - Pacific Crest

From Notable Calls

Pacific Crest is downgrading Sandisk (NASDAQ: SNDK) to Underperform from Sector Perform saying they see fair valuation in the mid-to-high $20's.

Model and market changing; risks increasing. Firm says they think the NAND market has moved from a growth business to a cyclical business, perpetually in search of an application or market. SanDisk apparently believes this to be true, because instead of investing in extending their brand, the company has chosen to sell wafers and finished product to the Asian module houses that are largely considered its competitors.

It appears that the market views the opportunity in SNDK as if the days of heady growth are back, or as if the company’s admirable job of restructuring is operations will drive long-term and structurally higher profitability. Pacs sees it differently. They see a company in transition, and one in search of a next act. Unfortunately, a next act does not appear to be on the horizon any time soon. In short, they have become more cautious for the following reasons:

- A notable increase in “Alternative Channel” activity
- The negative implications of selling into alternative channels: negative ROI of increasing market share in traditional card market and the burden of captive manufacturing
- This strategy’s impact on SNDK’s multiple
- Realization that the appropriate multiple on even the most optimistic EPS assumption yields full value (peak) at current prices.

This alone would be sufficient to drive a rerating of most stocks, yet there are many things we can add to the above list. These include:

- The prospect of additional wafer capacity coming on line in 2H2010
- Marginal free cash flow generation even under optimistic scenarios for profitability
- A royalty stream running at 50% of prior year levels from its major licensee, Samsung
- The need to take on the major NAND players Samsung, Toshiba, Hynix and Micron, all of which have superior scale, in the embedded market. Three of those companies have a product portfolio that allows them to bundle/integrate other products
- No new volume “killer app” for NAND in the near term; the adoption of notebook SSD looks to be several years away

Notable Alternative Channel Activity Increase in a Supposedly Healthy Market
This is the issue that has recently gotten the firm's attention. After discussions with numerous supply chain contacts in Asia, it appears that SanDisk has notably increased its efforts in this area. SanDisk began this effort in Q3 of last year; the company revealed that it would sell wafers, unmarked cards/drives, and downgrade products into the memory module industry. Last year, this strategy was interpreted as an effort to work off excess inventory that SanDisk had been carrying because of the down-cycle. Conventional wisdom holds that the current NAND environment is healthy—strong pricing, no incremental capacity, iPad launch, and so on. Yet what Pacs found was a meaningful increase in availability of SanDisk wafers and unbranded cards in the Asian module market during 1Q2010. Several module houses said they can get meaningful quantities of unbranded cards and 3-bit per cell wafers from SanDisk, and they heard from one contact that even traditional 2 bit/cell MLC wafers were for sale. Pacs believes the pricing is often aggressive, and they think that Samsung now views SNDK as its primary competition for business with the Asian module houses.

Hard to Spin This Positively, Except Perhaps in the Short Term
There are a number of ways to view this development. First, it could imply that overall NAND industry demand is less healthy than it appears, as it begs the question: why would SanDisk be willing to enable its competitors in a market that is thought of as marginally undersupplied? Second, it could reveal that the market for X3 (3-bit/cell) devices is not as robust as hoped, as this is the primary product that seems to be available to Asia module houses. The commentary about aggressive pricing also seems to be at odds with how SNDK characterized X3 pricing at its analyst day in February.

“Pricing competitive to X2: Expands Gross Margin and Improves Return on Invested Capital”

- SanDisk Investor Day Presentation, p. 51

Third, it could imply that SanDisk does not think that further share gains of its own brand yield a positive ROI.

Implies Different, and Lower, Multiples for SNDK
Pacs argues, that the morphing of the business model should lead to a lower multiple more in line with those associated with either the NAND semi manufacturers SanDisk is beginning to resemble, the competition to which it is selling, or a combination of both. It suggests a P/E ratio closer to 8x to 9x or a P/S ratio closer 1.2x to 1.3x.

In recent conversations regarding SanDisk, the firm notes they have heard the case made that the company could earn as much as $4.00 in 2010, if it can post revenue upside and expand margins through the year. While they think numbers in this range are highly unlikely, they assume for the purposes of this exercise that the company reaches those numbers. Given what they think are the appropriate multiples for the changing business, its current price implies full valuation (paying the median multiple for peak earnings is typically a stretch). If EPS comes closer to Pacs' number, or consensus, the stock should have downside from here (based on their multiple). From otheirperspective, the valuation has more chance of deflating from here.

At $2.50 in earnings, downside goes to $25. The risk/reward tilts heavily toward risk—it’s time to exit the shares.


Notablecalls: I think this is a fairly significant call from Pacific Crest's Semiconductor team, headed by Kevin Vassily. The comments of meaningful quantities of unbranded cards in the alternative channel spell trouble. Not to mention the more L-T oriented comments regarding the morphing of Sandisk's business model.

SNDK will report in two days, which makes the call even more important. Note that most other firms (have two tier-1's out this morning) are calling for a strong quarter. But do note that while J.P. Morgan is calling for strong numbers, even they are mindful of current valuation and are reiterating their Neutral rating.

I think these comments from Pacs will hit SNDK stock today. I'm guessing the stock will be down 1pt+ today, putting $36.50 level in play.

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