Wednesday, February 17, 2010

Sandisk (NASDAQ:SNDK): Upgrade to Overweight on Attractive Risk-Reward - Morgan Stanley

Morgan Stanley has had a change of heart on Sandisk (NASDAQ:SNDK) and is upgrading the name to Overweight from Equal-Weight and establishing $37 price target (prev. NA)

While the stock has tripled from trough levels last year, the firm believes consensus estimates do not fully reflect potential upside to NAND flash product margins – amid a backdrop of stable pricing and favorable supply-demand fundamentals – and will be revised higher through the year. In addition, they think many investors view memory stocks purely as short-term “cyclical plays” and could be overlooking the longer-term secular drivers for NAND flash memory usage in smartphones, tablet-style portable devices, and solid-state drives (SSDs).


Why upgrade to OW now?
Morgan Stanley is turning constructive on SNDK based on recent checks that suggest NAND flash pricing will track above their prior expectations for a seasonal decline of +20-30% in Q1. In addition, their updated proprietary capex model suggests memory capex is skewed more towards DRAM this year ~60-65%, which boosts their confidence in disciplined NAND supply. Morgan Stanley's bullish outlook on NAND flash demand is also consistent with MS Wireless Equipment team’s recent forecast of above consensus 37% Y/Y smartphone growth over the next 2-3 years.

As a pure play on NAND flash supply-demand, they think above positive market trends uniquely benefit SNDK over the next 12 to 18 months by supporting a) moderate price declines for SNDK’s retail card and OEM component products, b) 35% or better product gross margins on cost reduction from transition to 24nm technology, and c) modest investment in capex and JV’s to strengthen the company’s balance sheet. The firm also thinks SNDK’s actions from last year to reduce captive wafer supply and develop a broader OEM channel should continue to move the company towards a less capital intensive and sustainably profitable model over future cycles.

Morgan Stanley believes NAND will be in undersupply for the next 12-18 months. After three years of oversupply and +60% annual price declines, they believe SNDK and the flash industry overall are in a “sweet spot” of balanced supply and demand. SNDK and peers have been reluctant to add new capacity after returning to profitability and appear focused on repairing their balance sheets and pursuing sustainable growth.


The Morgan Stanley global memory team estimates a 3% undersupply for NAND flash memory in 2010 based on 70% bit supply growth and 80% bit demand growth. Firm thinks memory makers are proceeding cautiously with plans to add new wafer start capacity and instead direct capex investments to node shrink and multi-level cell (MLC) technology that effectively increase “bit” production without requiring construction of costly new fabs. They believe investors underestimate the degree to which supply for NAND is constrained in the near-term given 1) low level of NAND equipment shipments and 6 -12 month lead-time to ramp new capacity after orders are placed, and 2) reluctance by SNDK and peers to make significant capex investments given their desire to repair balance sheets on the back of the prior cycle.

Guidance Appears Conservative, Raising FY10 Estimates. Given their bullish outlook on NAND fundamentals this year, they think management guidance for 2010 appears conservative, and they adjust their estimates above full year revenue and margin guidance. This lifts MSCO's FY10 EPS estimate to $3.10 or 34% above consensus. Firm arrives at their new PT of $37 by applying a 12x multiple, the low end of SNDK’s historical trading range and the average for our global memory group.

Valuation looks attractive on revised estimates and recent pull back. SNDK stock has declined ~17% YTD on expectations reset of seasonal demand weakness. Risk-reward looks attractive at ~1:2 at current levels, with $48 as MSCO's bull case and $18 as bear case. SNDK trades at 9x their revised CY10 EPS estimates or significantly below its 5-year historical range of 12 - 25x.

Notablecalls: This is a significant change of heart on Morgan Stanley's part. Recall, their Semiconductor team stayed neutral-to-negative on Sandisk throughout the run from $15's to $30's, calling the stock an an outright short in the upper part of the move. They also got stopped out of their negative Research Tactical Idea (RTI) right around the top.

J.P. Morgan & UBS pretty much followed the same pattern, reiterating their Sell/Underweight ratings on the name throughout the run.

A bloody mess, if you ask me. They all got it wrong. I got it wrong as I agreed with their views. About the only firm that got it right was ThinkEquity.

Now coming back to today's upgrade I must say I do like it. MSCO is basically calling for 12-18 months of NAND undersupply which is a fairly bold prediction that will get people's attention.

The stock is down almost 20% from its recent highs, which suggests a 1-1.5 pt move is likley in the cards. I would not be surprised to see SNDK trade above the $29 level if the market plays ball.

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