Technology

At a Flashpoint in Flash Memory


With music, photography, and video all going digital, demand for tiny but reliable storage devices is white hot. MP3 players, digital cameras, and digital camcorders all use "flash memory" cards designed to take a beating but not a lot of battery power. In addition, sales of flash memory drives -- thumb-size gadgets that plug into a computer's universal serial bus (USB) port and transfer large files between different devices -- could jump 30%, to 48 million units, next year, predicts iSuppli, an El Segundo (Calif.) market research firm that also expects the total flash memory market to expand 31% in 2004, to $12.6 billion.

That's good news for two of the biggest names in the field -- SanDisk (SNDK) in Sunnyvale, Calif., and Lexar Media (LEXR), located across San Francisco Bay in Fremont, Calif. -- both of which expect a record year in 2003. SanDisk, which has about 38% of the market for flash that goes into consumer products, according to Susquehanna Financial Group, expects revenues to soar at least 85%, to more than $1 billion in its fiscal 2003, which ends Dec. 28. Its profits could rise 325%, analysts say, to $2.17 share.

Lexar Media, which has about 24% of the retail market, expects a 115% increase in 2003 revenues, to at least $375 million, with earnings soaring 600% to 42 cents a share.

WHO'S RIGHT? Based on those performances, the two companies' stocks have been off the charts. SanDisk shares are up 276%, to $76.30, so far this year, while Lexar Media's have gained 198%, to $18.70. Despite the big run-up, many analysts have maintained positive ratings on the companies, saying the shares have further to rise. "The industry is growing on a multiyear trend," says Kalpesh Kapadia, a C.E. Unterberg, Towbin analyst who has a buy rating on Lexar Media but doesn't cover SanDisk. (His firm has done business with Lexar Media.)

The question is: Are the optimists right -- or are SanDisk and Lexar Media shares nearing a dot-com like peak? Though these stocks may have further to run, even the bulls don't expect anything close to 2003's pace. Kapadia's price target for Lexar Media is $26 over the next 12 to 24 months -- an appreciation of 39%. The targets of various analysts for SanDisk suggest a similar trend, based on expectations that its earnings will climb 16% in 2004, according to the consensus estimates of analysts tracked by Thomson First Call, vs. Lexar Media's anticipated 53% profit increase.

And that's if the consensus is right. At least one industry bear believes that both stocks are significantly overvalued even now. Mark Basham, a Standard & Poor's equity analyst, sees two major threats: For starters, he thinks more competitors will enter the market soon. Worse, growth in demand for flash memory products could slow more than expected if sales of consumer electronics turn disappointing, he warns.

"It's dangerous to extrapolate from the current growth rates for the next two, three, four, or five years," adds Basham, who has an avoid opinion on SanDisk, thanks to his 12-month price target of $39. (Basham doesn't own any SanDisk shares, though he says other S&P divisions may have ties to the company.) He doesn't cover Lexar.

SLIGHT EDGE. Basham's is a lonely voice of doom -- one that the companies themselves downplay. "New entrants are always of concern," concedes Eli Harari, SanDisk's president and chief executive. And the chip market is cyclical, he agrees. But, he adds: "In the future we feel the markets are price-elastic and very strong. I think that the [current] stock [price] may reflect an understanding of our strong market position."

Of course, not everyone agrees with that, either. No question, SanDisk is bigger than Lexar Media. It also has a stronger intellectual-property portfolio -- measured by the number of patents it owns for flash memory technology -- that gives it a slight edge in product development, analysts say.

In the third quarter ended Sept. 28, SanDisk derived about $22 million, or 7.8% of its revenues, from licensing royalties, vs. Lexar Media's roughly $4.4 million, or 4.6% of revenues. "SanDisk's licensing royalties basically subsidize its R&D," says Satya Chillara, an analyst with W.R. Hambrecht & Co. in San Francisco. Chillara has a buy rating on SanDisk and is one of the few with a sell rating on Lexar Media, which he believes will be hurt by increasing competition and shrinking margins. Lexar Media denies this is the case. (Chillara and his firm don't own any shares or have any banking relationship with either company.)

"EARLY STAGES." SanDisk is also the "undisputed leader" in the fast-growing market for cell phones equipped with digital cameras, Chillara adds. Its revenues from storage for camera phones will rise to about $200 million in 2004 from around $60 million to $80 million this year, he predicts.

Yet Lexar Media has strengths, too -- ones that SanDisk doesn't match. It has been dominant in the digital camera market, which Kapadia and other analysts view as a source of continuing opportunity. Less than 30% of U.S. households own a digital camera, and the market penetration is lower in Europe, Kapadia says. "The digital camera market is still in the early stages of a secular uptrend," he wrote in a recent research note to investors.

Lexar Media also holds the lead -- a 31% market share, the company says -- in the booming USB drive market. These devices "were the hottest thing for the back-to-school season," says Tai Nguyen, a senior analyst at Susquehanna in San Francisco. W.R. Hambrecht's Chillara sees SanDisk chipping away at Lexar Media's market share, particularly in USB drives. Lexar Media professes to be unworried. "While more competitors are entering the market, the growth of the category is going to far outweigh any small shift in market share," contends Jim Gustke, Lexar Media's general manager for marketing.

STOCK SCAM.Handicapping this two-company race is also complicated by a unique problem at SanDisk: It could potentially be forced to take as much as a $100 million noncash charge. That's because a lawyer at its Taiwanese law firm fraudulently sold $100 million in stock of another company that the law firm was holding on SanDisk's behalf, SanDisk said in its Oct. 15 third-quarter earnings statement. The same lawyer then took the proceeds from the sale of the SanDisk-owned stock, the company added.

However, the risk that SanDisk would have to take such a charge is low because the law firm has vowed to make up for any loss to SanDisk, Paul Coster, an analyst with J.P. Morgan, wrotes in a recent note to investors.

In such a hot market, perhaps the biggest worry for both SanDisk and Lexar Media is the cost of supplies. Betsy Van Hees, iSuppli's principal flash memory analyst, says both could suffer a decline in margins if the makers of flash chips, the key semiconductor components that go into flash memory -- raise prices. Van Hees adds that Toshiba, a supplier to SanDisk, and Samsung, a supplier to Lexar Media, are hard-pressed to meet demand for flash chips -- and that price hikes of as much as 5% to 10% may be in the offing in the fourth quarter. "Short-term, their margins may get squeezed," Van Hees says.

UNDENIABLE HIT. Lexar Media says supplies of flash chips aren't a problem because it has a strategic relationship with Samsung. Its fourth-quarter margins "may be off a couple of points," Gustke adds, but only because the fourth quarter is when it runs its biggest promotions of the year.

The question remains, however: Can stocks that have risen so far so fast keep climbing? Devices that depend on flash memory are undeniably a hit with consumers: "Generally speaking, the industry has underestimated the growth of the market," says J.P. Morgan's Coster. What investors need to worry about is whether Wall Street is overestimating the prospects of two proven winners -- as it often does. By Eric Wahlgren in New York


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