Not All Chip Stocks Are Made the Same: Buy SanDisk Corporation (SNDK)

SanDisk Corporation (SNDK) is not getting the credit it deserves for the level of profitability it achieved in 2010. And I am not talking about the accounting profits, but the economic profits, which grew 1000% last year while accounting profits grew only 213%.

You can ignore the “bear signals” from stock technicians and fears over a glut in the tablet business when it comes to SNDK.

The company’s financial achievements in 2010 are testament to the scalability of SanDisk’s operations.  As a 35% increase in revenues generated a 1000% increase in profits, SanDisk’s financial performance in 2010 gives investors a peek into what I believe to be a very profitable future for this company. Here are some of the most important financial stats for investors:

• 2010 is the most profitable year ever in terms of accounting earnings, economic earnings, and free cash flow in our model, which goes back to 1998.
• SNDK’s return on invested capital (ROIC) increased from 11% in 2009 to 34%, the highest level.
• As a % of revenue, the $839mm increase in the company’s economic profit ranks in the top 7% of the 3000+ companies we cover.
• The company generated over $1bn in free cash flow, 12% of its enterprise value, in 2010.

Now, one good year of profit does not necessarily make a good stock. As regular readers know, in order to be on our “most attractive” stocks list, a company has to be cheap as well as profitable. And SNDK does not disappoint. The current valuation of the stock implies the company’s profits will permanently decline by 35%. In other words, not only is the market not giving SNDK any credit for growth, it is docking the stock with a 35% decline in profits with no potential for growth from that depressed level. This analysis is based on assessing the future cash flow expectations embedded in SNDK’s current stock price, $46.60 as of close on 4/4/11, using our dynamic discounted cash flow model.

The risk/reward of this stock is quite compelling. Downside risk is low as the valuation already implies a permanent 35% decline in profits. How much worse can the valuation get? Upside reward potential is strong as the stock has to go over $72/share to trade at value that implies the company’s profits will maintain at current levels, still a no-growth scenario.

The bear argument on SNDK is that the company’s margins will erode as current and new competitors offer cheaper versions of the same products that SNDK provides. My answer to that concern is (1) the scalability of SNDK’s business model enables SNDK to lower prices while sacrificing minimal to no profit and (2) the market for flash memory cards will continue to grow at a strong rate. SNDK would have to lose a lot of pricing power and market share to experience a 35% decline in profits.

To summarize, SNDK’s stock present an excellent buying opportunity at current levels because it meaningfully underestimates the future cash flow potential of the company.

SNDK gets our “very attractive” stock rating because the business is throwing off a lot of cash, showing strong growth in profits while its valuation implies economic earnings will permanently decline by 35%.

For details on what causes the dif­fer­ence between eco­nomic ver­sus account­ing prof­its during the last five fiscal years, see Appen­dix 3 on page 10 of our report on SNDK. See Appen­dix 4 to learn how SNDK increased net operating profit after tax (NOPAT) and its NOPAT mar­gin from 11.1% to 26.0%. SNDK’s ROIC (detailed in Appendix 7) rose from 11.3% to 33.9%. SNDK’s invested cap­i­tal grew more slowly than revenues; so invested cap­i­tal turns rose from 1.02x to 1.30x during the last reported fiscal year.

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