Morningstar
Analyst Note 01-17-08
The dramatic fall in Spansion's stock price over the past
several months has concerned and surprised us. We
believe the initial weakness had to do with the weakness
in the price of computer memory chips and the weakness
in the share prices of fellow memory chip companies. But
the discrepancy between our fair value estimate and
Spansion's market price is still so pronounced that we
have been searching for other possible explanations.
One issue that we highlight in our Analyst Report is
competing memory technologies. We have been
monitoring phase-change memory (PCM), which is the
most visible possible competitor to present-day solid-state
memory technologies. PCM chips work similarly to DVDs,
using heat to melt a memory cell and differentiating
between ones and zeros by whether a cell is melted or
not. The concept for PCM chips has been around since the
mid-1970s, but thus far, we are not aware of any in
commercial production (Intel announced it would offer
commercial PCM products by the end of 2007, but we
have not seen any to date). Theoretically, the technology
is good: faster than flash memory and more reliable.
However, our discussions with memory industry insiders
and our own research lead us to believe that PCM
technology is inferior to NOR and NAND flash in certain
aspects and may not be able to make significant inroads
into the solid-state memory market.
We have looked at our valuation assumptions for
Spansion and believe them to be valid. The only way we
can get to the present share price for Spansion is by
assuming that the firm ceases to exist in the next three to
five years. We believe that fear is unfounded.
Over the time that we have followed Spansion, we have
been impressed by the firm's operational savvy and
high-touch marketing model. Because of its manufacturing
advantages and its consistent focus on providing value-creating solutions for its customers, it has moved
from a third-place market share to number one against
such enormous competitors as Intel, STMicroelectronics,
and Samsung. Its charge-trapping technology is innovative
and allows higher-density chips to be produced for less
money than competing methods. Finally, after speaking at
length with CEO Bertrand Cambou, COO Jim Doran, and
other Spansion executives, we have never failed to be
impressed by management's no-nonsense, strategic
approach and the concrete tactical steps it has taken to
succeed in the NOR flash industry.
On the basis of these factors, we are sticking with our fair
value estimate, despite the negative investor sentiment.
Spansion reports its fourth-quarter and full-year results
Tuesday. At that time, we will be asking management
about the competitive landscape and listening closely for
hints that our valuation assumptions are verifiably too
optimistic.
...
Valuation
Our fair value estimate for Spansion is $14 per share. We
assume that the NOR market, while shrinking in dollar
value in 2007, will increase to roughly $10 billion in 2011,
driven by increased demand for mobile phones and
embedded devices in developing economies. Furthermore,
we believe that high-quality products and good customer
service will allow Spansion to continue to win market
share each year. We project that by 2011, Spansion will
hold roughly 40% of the market, Intel and
STMicroelectronics combined will hold roughly 25%, and
Samsung will be a strong third at 15%, with the remainder
scattered among smaller producers. These assumptions
generate a compound annual growth rate of 10%, much
lower than the firm's historical growth rate of 25% per
year. We believe gross and operating margins will
improve from present levels as depreciation related to
heavy capital expenditures works itself off the income
statement and research and administrative efficiencies
are realized. Under our assumptions, Spansion will break
even in 2008 and turn profitable in 2009 on an operational
level. These assumptions generate returns on invested
capital that reach a maximum of 9% in 2011, less than our
assumed 11% cost of equity. We forecast an operating
loss of more than 6% in 2007 as a result of tough
operating conditions. This assumption turns the value of
Spansion's cash flows over the next five years negative, meaning the total estimated worth of the firm comes after
our forecast period ends in 2011.
...
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