In a challenging market environment, M-Systems Flash Disk Pioneers (Nasdaq:FLSH) provided an impressive quarter with strong execution, raising its guidance for 2004 with accelerated growth of both the USB flash drives and mobile DiskOnChip (MDOC) for the handset market. In spite of this remarkable performance some analysts remain skeptical. Reading their reports reveals that some of their reasons do not stand to reason.
Of the six analysts that expressed their opinion on M-Systems, two are bullish, three believe the current valuation is full and one is negative. Almost all analysts did not evaluate the future developments and products of M-Systems, and hardly analyzed the reasons for its excellent results.
Several analysts believe that M-Systems is at relatively full valuation, as its shares are currently trading at a P/E higher than those of its competitors SanDisk Corp. (Nasdaq:SNDK)and Lexar Media (Nasdaq:LEXR). While this back-of-the-envelope, easy valuation method may be valid for an unsophisticated short-term investor; it is hardly a valid method for an astute, professional analyst mainly for the following reasons:
The market may overprice or undervalue the competition.
All companies, including competing companies are not equal or the same.
Specifically speaking, M-Systems is not in the same markets as SanDisk or Lexar, Its future products are not the same products, it is not selling in the same geographical areas, it does not utilize the same distribution channels, and its business strategy is not the same. Moreover, M-Systems’ financial results and guidance are certainly different from those of SanDisk and Lexar.
RBC Capital Markets analyst Satya Chillara describes M-Systems results as "solid". He expresses skepticism about prospects for M-Systems' MDOC storage solution for mobile telephones, saying, "we remain cautious on MDOC's long-term prospects given its relatively radical approach of displacing NOR while offering NAND storage within cell phones."
In fact, it’s the other way around with NOR flash memory manufacturers (Intel) trying to overcome NAND flash memory’s impressive advantages in price, features and lower heat dissipation. The following quotation from a recent "Electronics Weekly" article should convince him of the superiority of NAND over NOR for data storage for cellular phones: "If a NAND cell measures 4f2 (where f is the minimum feature size of a given lithography process) then a NOR cell measures 10f2," "NAND flash is three times cheaper to make than floating gate NOR technology,” with a much faster write time of NAND compared to NOR.
Chillara also seems to neglect the impressive design wins for MDOC that will turn up as sales within the next 6-12 month and the cell phones already in the market with MDOC inside. MDOC strong sales, about 25% growth QoQ are a prelude for the future. With strong backlog for the next two quarters as customers prepare for the holiday season in the Western world and Japan. The company anticipates higher growth in the second half of 2004 compared to the first half. MDOC is now accepted in mainline multimedia phones from first tier manufacturers.
According to Oscar Gruss's analysts, “Nokia’s 3Q04 outlook (from July 15th) of a worse than-expected bottom line as a result of a continuously tight pricing environment could impact FLSH if NOK decides to pass its expected EPS decline onto its suppliers. NOK’s 3Q04 warning could also be indicative of problems that other leading handset manufacturers (for which FLSH provides its MDOC solution) may be having. We believe that however small this impact may currently be, the potential concern is still noteworthy”.
This assumption was somewhat untimely and unfortunate. Contrary to Oscar Gruss's assumption, Nokia’s warning is not indicative of “problems that other leading handset manufacturers may be having”. Nokia’s results contrasted starkly with those from other cellphone makers, namely Motorola, Samsung Electronics Inc., Sony Ericsson and LG Electronics. All reported strong second-quarter sales of mobile phones. All utilize MDOC in many of their cellular phones.
Nokia predicament is most probably a result of not introducing camera phones, smart phones and other feature-rich phones. Nokia is a fast learner and will fight back to regain market shares, introducing these phones integrating M-Systems' MDOC, and most probably its new memory card.
Craig Ellis of Citigroup Smith Barney (CitiSB) is the father of all disbelievers in M-Systems. It is as if, when data and news about M-Systems flow into his mind, they are filtered and examined not by their own nature and significance, but by predetermined concepts and categories that stand ready receive them.
According to CitiSB, “While M-Systems 2Q upside was dramatic, it was significantly deferred-revenue driven”. ”FLSH coasted to 2Q04 revs and EPS of $86M and $0.15 on deferred revenue strength outpacing our est of $69.5M and $0.11. M-Systems 2Q04 total revenue increased 34% Q/Q to $86 million” from $64 in 1Q04. "
Of the $22 million increase in revenues, $7 million are from deferred revenues for a “net” increase of $15 million. All the same a dramatic 24% “net” increase.
Ellis's hasty calculations also include the “real” revenues of M-Systems, in which he deducted the deferred revenues of previous quarter but neglected to add the deferred revenues of the current quarter.
As for current quarter revenues, suffice it to note that M-Systems starts the third quarter of 2004 with about $50 million in assured revenues
Ellis writes: “OEM business for both SNDK and LEXR was surprisingly weak in 2Q, while FLSH saw OEM order softness in its USB business, USB drives retail sales growth weakened as expected (for both LEXR and FLSH)”.
How is it that in spite of the alleged weakness and softness in both outside equipment manufacturers (OEM) and retail channels, DiskOnKey revenue increased 43% quarter on quarter, to $63 million?
In fact M-Systems reported very strong, greater than anticipated, DiskOnKey sales. Compare this to Lexar's USB drive business that was surprisingly weak in the second quarter, and to weak sell-through data as tracked by NDP. DiskOnKey (DOK) was strong across the board in all geographic areas and marketing channels.
DOK’s second quarter strength is most likely due to M-Systems’ OEM business. M-Systems’ OEM partners IBM (NYSE:IBM), Dell Computer (Nasdaq:DELL), and Hewlett-Packard (NYSE:HPQ), are selling a great number of DOKs. Bundling DOK with PCs is probably now in full swing. This is a huge new market of some 150 million USB Flash Drive units annually compared to 10-15 million units sold in 2003.
M-Systems is entering the third quarter with “a strong DiskOnKey customer list that continues to grow”. Evidently, M-Systems is winning the USB Flash Drive (UFD) market with SanDisk a strong second, and it seems that Lexar will be the odd man out.
The USB flash drive market might become a $1 billion market in 2004. Yet, this market trend is still underestimated by almost all analysts.
It’s impossible to explain why a company that reported such good results, exceeded analysts’ expectations, and left them open-mouthed with astonishment, is disliked by many. Perhaps it is the analysts’ negative mind-set, and their inability to see the whole picture. |
