4 Reasons SanDisk Corporation Will Maintain Strong Margins

SanDisk (NASDAQ: SNDK  ) released its first quarter earnings last week, soundly beating market expectations. Earnings per share came in at $1.44 on a non-GAAP basis with revenue of $1.51 billion. Those numbers represent an increase of 71% and 13% year over year, respectively.

The company saw significant growth in its Enterprise SSD segment where it partners with VMWare (NYSE: VMW  ) and Western Digital (NASDAQ: WDC  ) . Outperformance in SSD revenue is important because SanDisk focuses on the high-end high-margin section of the market. SanDisk is able to leverage its vertical integration into stronger sales for high-quality drives. As a result, gross margin for the quarter rose to 51.2% from 40.5%.

Going forward, you will want to know if it can continue to produce such strong margins. And I think it can, here are four reasons why SanDisk's gross margin should continue to please.

Strong software solutions
As mentioned, SanDisk saw significant growth in its SSD segment. For the quarter, revenue from SSDS increased 61% to account for 28% of total revenue. The company generated around 20% of revenue from SSD sales in 2013, and expects that number to rise to 25% in 2014.

Investors should expect SanDisk to continue its strong performance in SSDs, which should drive gross margin higher. The company recently received certification from VMWare for its Flashsoft enterprise storage software layer to work with VMWare's software. This allows enterprises using VMWare virtualization software to use SSDs for high-speed caching memory. This improves performance, making SSDs more attractive to IT departments.

VMWare currently controls over half the market for virtualization, but competition has increased. Some of those competitors have strong hardware integration, so VMWare's work with SanDisk is key to both companies.

Although Flashsoft works with all brands, SanDisk is betting that increasing the demand for SSDs will benefit the company. I'm inclined to agree, as SanDisk has shown in recent quarters that it's able to outperform the broader market in SSDs. Gartner is projecting 41% annual growth in the market from 2012 through 2014, and SanDisk, as mentioned, increased sales 61% this quarter and 170% in the previous quarter.

SMART Storage Systems technology
SanDisk's acquisition of SMART Storage Systems has helped the company win several new designs over the last six months on the strength of its ULLtraDIMM designs. The company replaced its legacy architecture with SMART's Guardian technology as it's better able to scale the technology. This is another reason SanDisk is poised to capitalize on the overall growth in the SSD market.

Hybrid drives
It understands, however, that not every company is going to upgrade their servers to flash drives. That's why it's partnered with Western Digital to create hybrid drives that utilize hard disc storage combined with a solid state drive.

Western Digital is making several moves to attack the enterprise market as PC sales shrink, including its own SSD products. Hybrid drives are expected to grow rapidly over the next few years while SSD prices remain significantly higher than traditional hard drives. Western Digital's decision to partner with SanDisk (instead of going it alone) gives it access to SanDisk's NAND supply from its joint venture with Toshiba.

In the short-term, this partnership will certainly boost SanDisk's enterprise business, propping up its gross even further. There is the risk, however, that Western Digital will drop SanDisk as a NAND supplier should it continue gaining ground with its own SSD business.

Weak Yen
SanDisk's partnership with Toshiba means that a large portion of its cost of goods is in the form of Japanese Yen. With the weakness in the Yen, SanDisk has benefited greatly. Last quarter, the company achieved an exchange rate of 99 Yen per U.S. Dollar. In the first quarter of 2013, the company was exchanging $1 for 81 Yen. As the Yen rate remains elevated, SanDisk stands to gain.

Of course, the Yen rate isn't something that SanDisk can control, but it has taken steps to hedge its exposure to the currency. The company has contracts to hedge about one-third of its exposure to the Yen, so it should maintain a favorable impact from its NAND production in Japan.

Strong earnings from better margins
Many investors see the opportunity ahead of SanDisk to grow its revenue; flash storage is growing in numerous sectors from mobile devices to PCs and is of course a big trend in enterprise storage. It's important to understand, however, that the company's position on the high-end of enterprise SSD storage means that it can have an even bigger impact on its earnings going forward.

Priced at under 14 times forward earnings, SanDisk presents value compared to other semiconductor makers. Based on its strong margins, its earnings growth potential implies that investors may be getting a deal on the stock at today's price, despite the 10% price increase after its most recent earnings report.

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