10 Hidden Gems in SanDisk's Annual Report (SNDK, AAPL)

SanDisk Corporation (NASDAQ: SNDK) has just jointed the waves and waves of companies which have filed their 2010 annual reports under the form 10-K with the SEC.  Most investors do not read these to see what is driving a company and what is under the hood.  We usually review these to look for those hidden gems and data points that can be a win for a or be a risk for investors.  We have taken out ten hidden gems from SanDisk’s annual report for review since the world of consumer electronics is believed by the investment community to be so reliant on SanDisk as the leading independent maker of NAND flash technology.

Revenues from Royalties… Most consider that SanDisk gets its all of its revenues from manufacturing and selling NAND Flash, but SanDisk has a royalty business as well.  It noted, “We have an extensive patent portfolio that has been licensed by several leading semiconductor companies and other companies in the flash memory business.  Our cumulative license and royalty revenues over the last three fiscal years were approximately $1.28 billion.” That comes to an average of more than $100 million per quarter in revenues from royalties and the estimate for the coming quarter is $1.25 billion.  Royalty revenues are generally deemed to be much higher in profits and margins than operating revenues.  It noted, “We have various patent licenses with several companies including, among others, Hynix, Intel Corporation, or Intel, Lexar Media, Inc., or Lexar, a subsidiary of Micron Technology, Inc., or Micron, Panasonic, Renesas Technology Corporation, or Renesas, Samsung, Sharp Electronics KK, or Sharp, Sony and Toshiba.” This also declined in the first quarter of last year due to its renewed license pact with Samsung and it noted that there are risks about future renewals as well later in its risks section.

The lack of Apple ties… The only two places that Apple Inc. (NASDAQ: AAPL) is mentioned throughout its 10-K is as competition in the digital audio market (iPod versus Sansa).

Limitations of NAND Technology… SanDisk admits that NAND will have limitations and it is planning for “the next-next thing”… It noted, “we have been able to scale NAND technology through fourteen generations over approximately twenty years.  However, the pace at which NAND technology is transitioning to new generations is expected to slow due to inherent physical technology limitations.  We currently expect to be able to continue to scale our NAND technology through a few additional generations, but beyond that there is no certainty that further technology scaling can be achieved cost effectively with the current NAND flash technology and architecture.  We also continue to invest in future alternative technologies, including our 3-Dimensional, or 3D, Read/Write technology, which we believe may be a viable alternative to NAND when NAND can no longer scale at a sufficient rate, or at all.  However, even when NAND flash can no longer be further scaled, we expect NAND and potential alternative technologies to coexist for an extended period of time.”

Unlike other companies, the backlog is less important… As of the end of fiscal years 2010 and 2009, SanDisk’s backlog was $380 million and $268 million, respectively.  We already noted that the coming quarter revenue expectations were $1.25 billion, so this backlog that is so important elsewhere is not so important here.  SanDisk even notes that its customers can change or cancel orders with limited or no penalty and limited advance notice prior to shipment.  So in using backlog, guidance ahead is often likely difficult to give and is why the big beats or bad misses trends come about.  It even noted, “we do not believe that our backlog, as of any particular date, is indicative of future sales.”

Customer Concentration and competition… In fiscal years 2010, 2009 and 2008, revenues from SanDisk’s top 10 customers and licensees accounted for approximately 46%, 42% and 48% of total revenues, respectively.  Investors may be happy that all customers were individually less than 10% of total revenues in fiscal years 2010 and 2009.  In fiscal year 2008, Samsung accounted for 13% of total revenues through a combination of license and royalty and product revenues.  Competitors here went on and on, but just some were listed as Toshiba, Samsung, Intel, Micron, Western Digital, Seagate, STEC, and on and on.

Material reliance on Toshiba… Its joint venture with Toshiba is rather important for its supplies of materials.  SanDisk noted, “The majority of our memory is supplied from the flash ventures with Toshiba.  This represents captive memory supply and we are obligated to take our share of the output from the flash ventures with Toshiba or pay the fixed costs associated with that capacity… From time-to-time, we also purchase non-captive NAND memory supply from other silicon suppliers.”  SanDisk noted further that it holds or will hold a 49.9% ownership position in each of the current Toshiba and SanDisk venture entities.  Interestingly enough, the company noted on competition, “Our primary semiconductor competitors include Hynix, Intel, Micron, Samsung, and Toshiba.”

Competing and ‘other’ technologies… While limitations of NAND were noted above, SanDisk noted, “Other technologies compete with our product offerings and many companies are attempting to develop memory cells that use different designs and materials in order to reduce memory costs.  These potential competitive technologies include several types of 3D memory, a version of which we are jointly developing with Toshiba, phase-change, ReRAM, vertical or stacked NAND and charge-trap flash technologies.”  The good news is that SanDisk is not letting the world pass it by.  The bad news is that there is no assurance that SanDisk will lead 3D memory even though the company has noted that flash memory will coexist with it for some time.

Dependence upon gross margin for future activities… While SanDisk has nearly $3 billion between its cash and short-term investments, the company has noted throughout that it has a hurdle on gross margins that it has to maintain in order to fund expansion and R&D activities ahead.  It noted, “If we fail to maintain adequate product gross margins and profitability, our business and financial condition would be harmed and we may have to reduce, curtail or terminate certain business activities, including funding technology development and capacity expansion.”  And on that front it also noted, “Competitive pricing pressures and excess supply have resulted in lower average selling prices and negative product gross margins in the past, and if we do not experience adequate price elasticity, our revenues may decline.”

Lease covenants on debt… Under certain conditions, the Flash Ventures’ master equipment lease obligations could be accelerated as the master lease agreements contain customary covenants for Japanese lease facilities.  One hurdle is that the company must maintain a minimum stockholders’ equity of at least $1.51 billion and a failure to maintain a minimum corporate rating of either BB- from S&P or Moody’s or a minimum corporate rating of BB+ from Rating & Investment Information.  On this it noted, “As of January 2, 2011, Flash Ventures were in compliance with all of their master lease covenants.  As of January 2, 2011, our R&I credit rating was BBB, three notches above the required minimum corporate rating threshold for R&I and our S&P credit rating was BB-, which is the required minimum corporate rating threshold for S&P.”

Use of derivatives for Forex and currency fluctuations… SanDisk does use derivatives to hedge its currency exposure.  As of January 2, 2011, it had foreign currency forward contracts hedging exposures in Euros, British pounds and Japanese yen.  Foreign currency forward contracts were outstanding to buy and sell U.S. dollar equivalent of approximately $289.2 million (buy) and $125.1 million (sell) in foreign currencies.  On hedging it noted, “The Company currently has two currency swap transactions with one counterparty to exchange Japanese yen for U.S. dollars for a combined notional amount of ($469.0) million, which requires the Company to maintain a minimum liquidity of $1.5 billion for one of the transactions and $1.0 billion for the other, on or prior to, June 24, 2012 and $1.0 billion after June 24, 2012 for both.  Liquidity is defined as the sum of the Company’s cash and cash equivalents and short and long-term marketable securities.  Should the Company fail to comply with this covenant, the Company may be required to settle the unrealized gain or loss on the foreign exchange contracts prior to the original maturity.  The Company was in compliance with these covenants as of January 2, 2011.”

Again, not all data points “hidden” in annual reports are meant as negative issues.  Many points are actually positive.  Most investors generally do not look through annual reports and therefore often do not fully understand aspects or certain risks in companies they want to invest in.  As always, Know what you are investing in!

JON C. OGG