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SanDisk: Time for a Margin Call

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If the yen stays weak or gets weaker, it serves as a major tailwind to SanDisk's operating income and EPS.

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On the last earnings call SanDisk (NASDAQ:SNDK) stated that it had fixed the yen costs of its wafer purchases for Q2 at a USD/JPY rate of approximately 86; therefore, the bulk of any benefits from further yen weakness would be realized in the second half of the year. Fast-forward to today and the USD/JPY is up about 11% to 96 since that conference call.

We have been told several times by SNDK that a 5% move in the yen equals about 200-300 bps of change in gross margins -- to the good if the yen falls, to the bad if it rises. If we crudely translate the 11% drop in the yen since January into a 500bps improvement in gross margins for H2 2013, it should result in an EPS benefit of about $.60 over Q3 and Q4. So far, consensus for full year 2013 estimates have inched up a meager $0.05 since January.

I'm not so foolish to think that sell-siders aren't aware of the impact of the yen weakness on their models, but I will also point out that Q4 2012 EPS came in 19% ahead of estimates in large part because of the weakness in the yen. Why that was not in the models, God only knows.

Bottom line: If the yen stays weak or gets weaker it serves as a major tailwind to operating income and EPS. One might argue that such benefit is a "low quality" way to increase earnings. I'd counter that when currency moves are an integral part of your operating costs, the benefit/harm should be no different than variances in other COGS (cost of goods sold). And to the extent that the benefit in this case is of the "real cash" kind, I'm perfectly comfortable putting a multiple on those extra pennies. So, what is a reasonable multiple on these EPS?

Rather than offer a number, I'll answer the question this way. Considering the amount of net cash on SNDK's balance sheet, I'll take the liberty of focusing on an EV/EBITDA multiple rather than the P/E. I know some purists don't like that, but so be it.

Currently SNDK is trading at the lowest EV/EBITDA multiple...ever. I understand that such a statement is often a trap when applied to cyclical companies, because cyclicals by definition are cheap at tops and pricey at bottoms, and should be traded accordingly. But here is where I'll go back to my original thesis, which with two years of hindsight has been working pretty well: SNDK's business for the next one to three years will be all about Solid State Drives, not its cyclical NAND memory. By 2015 SSDs will contribute as much as 50% of SNDK's revenues, and SSD growth may not top out for several years after that. So until the SSD story plays out, I'm not going to treat SNDK as a cyclical company. I'm going to look at it as a growth story. Under that premise, here is a quick table showing the stock price based on different EV/EBITDA multiples. The EBITDA/share estimates for 2013 and 2014 are mine, but they basically consist of current estimates plus a gross margin improvement of 500 bps.



My base case scenario is a 10 multiple and the corresponding price objectives of $70 for this year and mid $80s in 2014. But don't expect me to scoff at the idea that before the SNDK / SSD story is told, SNDK stock will have traded in the triple in the digits.
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Position in SNDK.
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