SanDisk (NASDAQ: SNDK ) is doing very well. In the first quarter of 2014, the company recorded $1.51 billion in revenue, a 13% year-over-year increase. Even more importantly, in the highly competitive memory provider industry, SanDisk managed a 51% gross margin, a quarterly record. The company's focus on SSDs is paying off, with sales of client and enterprise SSDs growing 65% year over year and accounting for 21% of the company's revenue for the quarter.
SanDisk's share price has followed the company's performance and risen almost 75% over the last year. It seems that interest in the memory market is heating up, with competitor Micron Technology (NASDAQ: MU ) posting even more impressive growth -- over 140% -- over the same period. Given the surging share price and hot market, what are some reasons to wait before buying SanDisk?
Reduced cash for shareholders?
In 2013, SanDisk achieved a record free cash flow of over $7 per share, and the company returned 98% of that to investors through a combination of stock repurchases and a newly introduced dividend program. At its 2014 investor day, management pledged to return 100% of free cash flow to shareholders in 2014, including an increase in the dividend starting in the third quarter.
The bad news is that free cash flow will decrease in 2014 as capital expenditures rise. How large might this decrease be? Due to investments in new fab technologies, as well as to costs carried over from 2013, capital expenditure is set to increase from $859 million in 2013 to $1.5 billion-$1.7 billion in 2014. At the midpoint, that's almost a 100% increase, so unless SanDisk can continue increasing its profitability, investors will see a notable drop in returned cash down the line.
The end of an era
Cost reductions in the current technology used for NAND flash production are slowing. There is consensus in the industry that, at most, two more iterations of the technology are possible, beyond which further improvements won't be economically feasible.
This is not the end of growth in flash, though, since a new technology called 3D NAND is being developed by the major players in the flash memory market. Samsung (NASDAQOTH: SSNLF ) , the largest producer of NAND flash, is the furthest along, having started mass production of 3D NAND last August. SanDisk is trying to extend the current 2D NAND technology as long as possible, and expects to ramp 3D NAND production by 2016.
Why does this matter for investors? 2D NAND technology will remain relevant while 3D NAND continues to be developed. But, the next year or two will be a time of transition, inevitably bringing unexpected results and challenges, regardless of the well-laid plans of memory provider companies.
The memory industry has traditionally been characterized by a race between decreasing prices and costs, as companies sold chips that were essentially a commodity. But, increasingly, prices and production costs are not giving a full picture of the business as companies move away from selling commoditized components. In the words of Micron CEO, Mark Durcan, "the future for memory manufacturers is selling memory solutions" that are optimized for clients' end applications, thereby providing greater differentiation and margins.
SanDisk is further along this path than its competitors, and its gross margin reflects this. With a gross margin of 51% in the first quarter, SanDisk compares very favorably with Samsung's 40% and Micron's 34%. But, Durcan's statement makes it clear that SanDisk's competitors are not going away, but that the field of competition is simply shifting.
SanDisk has delivered such good results over the last several quarters that it's possible many investors are starting to imagine a future without setbacks or challenges for the company. The point here is not to dispute that SanDisk is a great company, or that its prospects look good, but simply to sow a little doubt in the idea that SanDisk's future will be one of uninterrupted profitability increases.
Decreases in cash returned to shareholders, a technology transition, and adjustments by the competition are just three reasons that SanDisk's share might not continue to grow as steadily as it's done over the last year. If SanDisk does hit such a bump within the next year, that might provide a better opportunity to buy than right now, when the stock is so hot.
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